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Unformatted text preview: ECO4554 FINAL EXAM REVIEW CORE PRINCIPLES TOPIC 1 Topic 1 (Economic Efficiency) If there are no externalities, no increasing returns to scale, and no public goods, the allocation of resources in a competitive market is economically efficient in the sense that no other allocation would make any person better off without also making someone else worse off. [Note: Allocation of resources means (1) what goods, services, and activities are provided with the available resources and (2) how much of each resource is used in the provision of each good, service, or activity.] 1-3. (Core Principle) Competitive markets may fail to supply the efficient quantity of a good or service in each of the following settings. For each one, explain how and why competitive markets may fail. a. Provision of the good or service is characterized by increasing returns to scale. [Illustrate your explanation with a diagram. Show consumers demand (D), suppliers average total cost (ATC) and marginal cost (MC), the efficient quantity (Q*), and the competitive equilibrium quantity (Q). Explain in your answer what feature(s) of the diagram illustrates increasing returns to scale and why the efficient quantity is not also the competitive equilibrium quantity.] If the average total cost is decreasing, then marginal cost must be less than average total cost at all output amounts (because average cost is decreased by more production then the extra cost of producing one more unit is less than the existing average cost) As the scale of production expands, output increases proportionally more than inputs. When increasing returns to scale exists, suppliers cannot earn a positive profit if price is equal to marginal cost. However, when the price is equal to the marginal cost (or the point where Q* & P* intersect) is where the efficient quantity lies, creating financial loss for the supplier. If any supplier were to actually keep their prices at the efficient quantity they would go out of business. Therefore, the companies that do stay in business increase the price of their product or service to P (where ATC and D intersect) in order to avoid losses. Because the quantity demanded for this product or service is less at the new price of P the efficient quantity is not met. The definition of market equilibrium states that the supply is equal to the demand at an agreed upon price. In this case (increasing returns to scale) the market equilibrium and the efficient quantity are not the same because price is not agreed upon. b. The good or service either confers external benefits (a positive externality) or imposes external costs (a negative externality) on third parties. [Illustrate your explanation with two diagrams, one for external benefits and one for external costs. For the positive externality, show marginal social benefit (MSB), marginal private benefit (MB), and marginal cost (MC). Remember that marginal social cost and marginal private cost are the same thing when there are no external costs. For the negative externality, show the same thing when there are no external costs....
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