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Microeconomics (literally, very small economics) is the study of the economic behaviour of individual consumers, firms, and industries and the distribution of production and income among them. It considers individuals both as suppliers of labour and capital and as the ultimate consumers of the final product. It analyzes firms both as suppliers of products and as consumers of labour and capital.

Microeconomics seeks to analyze the market form or other types of mechanisms that establish relative prices amongst goods and services and/or allocates society's resources amongst their many alternative uses.

Fundamental concepts in microeconomics
Scarcity - Opportunity cost - Supply and demand - Elasticity - Consumer and producer surplus - Aggregation of individual demand to total, or market, demand

Consumer theory
Consumer Theory - Preference - Indifference curve - Utility - Marginal utility - Income

Production and pricing theory
Production, costs, and pricing - Production theory basics - X-efficiency - Factors of production - Production possibility frontier - Production function - Economies of scale - Economies of scope - Profit maximization - Price discrimination - Transfer pricing - Joint product pricing - Price points

Industrial organization
Market form - Perfect competition - Monopoly - Monopolistic competition - Oligopoly - Concentration ratio - Herfindahl index

Welfare economics
Welfare economics - Pareto efficiency - Kaldor-Hicks efficiency - Edgeworth box - Social welfare function - Income inequality metrics - Lorenz curve - Gini coefficient - Poverty level - Dead weight loss

Market failure
Market failure - Collective action - Information asymmetry - Externality - Social cost - Free goods - Taxes - Tragedy of the commons - Tragedy of the anticommons - Coase's Penguin

Financial economics
Efficient markets theory - Financial economics - Finance - Risk

International trade
International trade - Terms of trade - Tariff - List of international trade topics

General equilibrium - Game theory - Institutional economics - Neoclassical economics - Austrian economics.


Applications and Complications

The simplest way to estimate the opportunity cost of any single economic decision is to consider, "What is the next best alternative choice that could be made?" (This is even though most economic decisions involve multiple alternatives.) The opportunity cost of paying for college this semester could be the ability to make car payments. The opportunity cost of a vacation in the Bahamas could be the down payment money for a house.

Note that opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate.

It is important, as individuals and as societies, to compare the opportunity costs associated with various courses of action. However, some opportunities may be difficult to compare along all relevant dimensions.

Economists often try to use the market price of each alternative to measure opportunity cost. This method, however, presents a considerable difficulty, since many alternatives do not have a market price. It is very difficult to agree on a way to place a dollar value on a wide variety of intangible assets. How does one calculate the cost in dollars, pounds, euros, or yen for the loss of clean air, or the loss of seaside views, or the loss of pedestrian access to a shopping center, or the loss of an untouched virgin forest? Since their costs are difficult to quantify, intangible values associated with opportunity cost can easily be overlooked or ignored.

To overcome this difficulty, economists have identified certain opportunity costs as spillover costs (or external costs). If a chemical producer dumps its waste products into a river, the company has effectively shifted part of the cost of its production onto those living downstream who like to fish. If a billboard company blocks the seaside view of passers-by, some of its gain in advertising revenue is being paid by the passers-by who enjoy natural vistas, instead of by the company's advertisers.

Typically, spillover costs are imposed by a narrower group (often called a special interest group) which benefits more quantifiably and more concretely, and they are borne by a wider group -- perhaps even the public at large -- which pays less quantifiably and less concretely. For this reason, spillover costs are most often controlled by politics and government regulation rather than by markets. Regulations against pollution and building codes restricting billboard locations are examples.

Special interest groups, with a particular political or financial gain in mind, usually find incentives to underestimate or ignore the opportunity costs associated with their activities or agendas (especially when the opportunity costs are spillover costs, that can be imposed upon others), but at times such groups find incentives to overestimate them.

Another difficulty in fixing opportunity cost exists on the macroeconomic level, and is empirical in nature. Discovering the real effect of a change in production of butter specific to the production of guns in an economy as large and multifarious as, say, that of the United States, would be nightmarishly complex.

For that reason, opportunity cost is usually figured within some specific budget of resources. For example, "If the state spends $200 million more on highways it will have $200 million less to spend on schools." Or, "If our company invests $10 million in R+D, it can't give a $1 million Christmas bonus to each of its top ten executives." Or, "If I buy fifty lottery tickets, I won't have these two twenties and one ten left in my wallet for groceries."

Although opportunity cost can be hard to quantify, its effect is universal and very real on the individual level. The principle behind the economic concept of opportunity cost applies to all decisions, not just economic ones. The word "decide" comes from the Latin decidere, meaning "to cut off"; being the prefix de plus the root caedere, "to cut". By definition, any decision that is made cuts off other decisions that could have been made. If one makes a right turn at an intersection, she or he precludes the possibility of having made a left turn. And so forth.

Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.

An Eternal Truth?

Many see the concept of opportunity cost as one of the very few profound "eternal truths of economics," a result of the universal nature of scarcity as the Economic Problem. A classic illustration of the concept (posed by Otto von Bismarck) envisions an imaginary economy capable of producing only two products: Guns and Butter (i.e. military goods versus civilian goods). If all the resources of this economy were used to produce guns, let's imagine that 100,000 guns could be produced. If, instead, all the resources were used to produce butter, let's imagine that 100,000,000 units of butter could be produced.

So, should this economy's resources be used in practice to produce 50,000,000 units of butter, there will be an opportunity cost in terms of guns. Instead of the 100,000 guns the economy could have produced, it may now only be able to produce 50,000. Conversely, should this economy's resources be used in practice to produce 75,000 guns, there will be an opportunity cost in terms of butter. Instead of the 100,000,000 units of butter the economy could have produced, it may now only be able to produce 25,000,000.

the guns and butter PPF

The graph that depicts opportunity cost between any two given items produced by a given economy is known in economics as the production possibility frontier or curve or "PPF." The curve describing this frontier is not straight, but is curved outward away from the axes to reflect the higher marginal costs that become inevitable due to diminishing returns at the extremes. In the real world, the point on the graph that describes the two given items' position will always lie somewhere well within the frontier (as shown), due to the resources used by all the other goods and services that the given economy produces. However, in the imaginary economy discussed above which produces only guns and butter, the economy will be operating on the PPF (as shown by the arrow) if all resources (inputs) are fully utilized and used most appropriately (efficiently). The exact combination of guns and butter produced depends on the mechanisms used to decide the allocation of resources (i.e., some combination of markets, government, tradition, and community democracy).

This choice can also change. But any move upward or to the right along the PPF involves an opportunity cost. (Scarcity means that cannot go above or the right of the PPF.) Any increase in gun production (a move upward) would reduce the amount of butter that can be produced, while increase in civilian production (moving to the right) would reduce the economy's ability to produce military products. On the PPF, scarcity and opportunity cost prevail.

Others argue that while it is true for most individuals that most or even all choices incur some sort of opportunity cost (i.e., that something is being given up), the concept of opportunity cost does not always apply when viewed from the societal level. Suppose that the economy starts with large amounts of unused capital equipment and unemployed labor, as in the United States (and many other countries) in 1939. In that case, the "guns and butter" economy is inside its PPF (and not due to the production of other outputs). In this situation, it is possible to raise the employment of both capital goods and labor, raising the production of both military goods and civilian goods. In fact, the U.S. did exactly this at the onset of World War II.

This is an example of "Keynesian inefficiency" being solved by increasing aggregate demand. More generally, if inputs are either underemployed or inappropriately employed, the production of both guns and butter can be increased by abolishing inefficiency. In the graph, the economy moves from the "inefficient points" inside the PPF to the PPF itself.

Unfortunately, we may not always be able to get this "free lunch" because special interests often oppose such policies. They may impose institutional opportunity costs that represent more than natural or technological scarcity. Thus, we may see a price that represents political, economic, or social power rather than opportunity cost.

The position of the PPF is not static. It shifts outward (upward and/or to the right) when an economy’s ability to produce increases, i.e., an increase in the aggregate number of guns and butter that can be produced. This can happen if the availability of resources (factors of production) increases, or if technology or management skills improve. Few if any of these changes are "free": for example, increasing the amount of capital goods requires sacrifice of current consumption. Thus, there is a clear opportunity cost. Some shifts may be inexpensive, however, as with some technological change.

The PPF shifts inward when an economy’s ability to produce decreases, reflecting a decrease in the aggregate number of military and civilian goods that can be produced. This is possible due to some major disaster, such as hurricanes or military invasion. The PPF of the Roman Empire probably shifted inward due to the "barbarian" invasions and the end of regular law and order.

The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). The graph depicts an increase in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new market-clearing equilibrium point on the supply curve (S).

In microeconomic theory, the partial equilibrium supply and demand economic model originally developed by Alfred Marshall attempts to describe, explain, and predict changes in the price and quantity of goods sold in competitive markets. The model is only a first approximation for describing an imperfectly competitive market. It formalizes the theories used by some economists before Marshall and is one of the most fundamental models of some modern economic schools, widely used as a basic building block in a wide range of more detailed economic models and theories. The theory of supply and demand is important for some economic schools' understanding of a market economy in that it is an explanation of the mechanism by which many resource allocation decisions are made. However, unlike general equilibrium models, supply schedules in this partial equilibrium model are fixed by unexplained forces.

Assumptions and definitions

The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market and none of them have the capacity to influence the price of the good. In many real-life transactions, the assumption fails because some individual buyers or sellers or groups of buyers or sellers do have enough ability to influence prices. Quite often a sophisticated analysis is required to understand the demand-supply equation of a good. However, the theory works well in simple situations.

Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard. In such cases, economists may attempt to find policies that will avoid waste; directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing" markets to enable efficient trading where none had previously existed. This is studied in the field of collective action.


Demand is that quantity of a good that consumers are not only willing to buy but also have the capacity to buy at the given price. For example, a consumer may be willing to purchase 2 lb of potatoes if the price is $0.75 per lb. However, the same consumer may be willing to purchase only 1 lb if the price is $1.00 per lb. A demand schedule can be constructed that shows the quantity demanded at each given price. It can be represented on a graph as a line or curve by plotting the quantity demanded at each price. It can also be described mathematically by a demand equation. The main determinants of the quantity one is willing to purchase will typically be the price of the good, one's level of income, personal tastes, the price of substitute goods, and the price of complementary goods.

The shape of the aggregated demand curve can be convex or concave, possibly depending on income distribution, as shown in this paper: http://www.economicswebinstitute.org/essays/consumers.htm


Supply is the quantity that producers are willing to produce at a given market price. For example, the potato grower may be willing to sell 1 million lb of potatoes if the price is $0.75 per lb and substantially more if the market price is $0.90 per lb. The main determinants of supply will be the market price of the good and the cost of producing it. In fact, supply curves are constructed from the firm's long-run cost schedule.

Simple supply and demand curves

Mainstream economic theory centers on creating a series of supply and demand relationships, describing them as equations, and then adjusting for factors which produce "stickiness" between supply and demand. Analysis is then done to see what "trade offs" are made in the "market", which is the negotiation between sellers and buyers. Analysis is done as to what point the ability of sellers to sell becomes less useful than other opportunities. This is related to "marginal" costs, or the price to produce the last unit that can be sold profitably, versus the chance of using the same effort to engage in some other activity.

File:Simple supply and demand.png
Graph of simple supply and demand curves

The slope of the demand curve (downward to the right) indicates that a greater quantity will be demanded when the price is lower. On the other hand, the slope of the supply curve (upward to the right) tells us that as the price goes up, producers are willing to produce more goods. The point where these curves intersect is the equilibrium point. At a price of P producers will be willing to supply Q units per period of time and buyers will demand the same quantity. P in this example, is the equilibrating price that equates supply with demand.

In the figures, straight lines are drawn instead of the more general curves. This is typical in analysis looking at the simplified relationships between supply and demand because the shape of the curve does not change the general relationships and lessons of the supply and demand theory. The shape of the curves far away from the equilibrium point are less likely to be important because they do not affect the market clearing price and will not affect it unless large shifts in the supply or demand occur. So straight lines for supply and demand with the proper slope will convey most of the information the model can offer. In any case, the exact shape of the curve is not easy to determine for a given market. The general shape of the curve, especially its slope near the equilibrium point, does however have an impact on how a market will adjust to changes in demand or supply. (See the below section on elasticity.)

It should be noted that on supply and demand curves both are drawn as a function of price. Neither is represented as a function of the other. Rather the two functions interact in a manner that is representative of market outcomes. The curves also imply a somewhat neutral means of measuring price. In practice any currency or commodity used to measure price is also the subject of supply and demand.

Effects of being away from the equilibrium point

Consider how prices and quantities not at the equilibrium point tend to move towards the equilibrium. Assume that some organization (say government or industry cartel) has the ability to set prices. If the price is set too high, such as at P1 in the diagram to the right, then the quantity produced will be Qs. The quantity demanded will be Qd. Since the quantity demanded is less than the quantity supplied there will be an oversupply (also called surplus or excess supply). On the other hand, if the price is set too low, then too little will be produced to meet demand at that price. This will cause an undersupply problem (also called a shortage).

Now assume that individual firms have the ability to alter the quantities supplied and the price they are willing to accept, and consumers have the ability to alter the quantities that they demand and the amount they are willing to pay. Businesses and consumers will respond by adjusting their price (and quantity) levels and this will eventually restore the quantity and the price to the equilibrium.

In the case of too high a price and oversupply (seen in the diagram at the left), the profit-maximizing businesses will soon have too much excess inventory, so they will lower prices (from P1 to P) to reduce this. Quantity supplied will be reduced from Qs to Q and the oversupply will be eliminated. In the case of too low a price and undersupply, consumers will likely compete to obtain the good at the low price, but since more consumers would like to buy the good at the price that is too low, the profit-maximizing firm would raise the price to the highest they can, which is the equilibrium point. In each case, the actions of independent market participants cause the quantity and price to move towards the equilibrium point.

Demand curve shifts

When more people want something, the quantity demanded at all prices will tend to increase. This can be referred to as an increase in demand. The increase in demand could also come from changing tastes, where the same consumers desire more of the same good than they previously did. Increased demand can be represented on the graph as the curve being shifted right, because at each price point, a greater quantity is demanded. An example of this would be more people suddenly wanting more coffee. This will cause the demand curve to shift from the initial curve D0 to the new curve D1. This raises the equilibrium price from P0 to the higher P1. This raises the equilibrium quantity from Q0 to the higher Q1. In this situation, we say that there has been an increase in demand which has caused an extension in supply.

Conversely, if the demand decreases, the opposite happens. If the demand starts at D1 and then decreases to D0, the price will decrease and the quantity supplied will decrease—a contraction in supply. Notice that this is purely an effect of demand changing. The quantity supplied at each price is the same as before the demand shift (at both Q0 and Q1). The reason that the equilibrium quantity and price are different is the demand is different.

Supply curve shifts

When the suppliers' costs change the supply curve will shift. For example, assume that someone invents a better way of growing wheat so that the amount of wheat that can be grown for a given cost will increase. Producers will be willing to supply more wheat at every price and this shifts the supply curve S0 to the right, to S1—an increase in supply. This causes the equilibrium price to decrease from P0 to P1. The equilibrium quantity increases from Q0 to Q1 as the quantity demanded increases at the new lower prices. Notice that in the case of a supply curve shift, the price and the quantity move in opposite directions.

Conversely, if the quantity supplied decreases, the opposite happens. If the supply curve starts at S1 and then shifts to S0, the equilibrium price will increase and the quantity will decrease. Notice that this is purely an effect of supply changing. The quantity demanded at each price is the same as before the supply shift (at both Q0 and Q1). The reason that the equilibrium quantity and price are different is the supply is different.

See also: Induced demand

Market 'clearance'

The market "clears" at the point where all the supply and demand at a given price balance. That is, the amount of a commodity available at a given price equals the amount that buyers are willing to purchase at that price. It is assumed that there is a process that will result in the market reaching this point, but exactly what the process is in a real situation is an ongoing subject of research. Markets which do not clear will react in some way, either by a change in price, or in the amount produced, or in the amount demanded. Graphically the situation can be represented by two curves: one showing the price-quantity combinations buyers will pay for, or the demand curve; and one showing the combinations sellers will sell for, or the supply curve. The market clears where the two are in equilibrium, that is, where the curves intersect. In a general equilibrium model, all markets in all goods clear simultaneously and the "price" can be described entirely in terms of tradeoffs with other goods. For a century most economists believed in Say's Law, which states that markets, as a whole, would always clear and thus be in balance.


Main article: Elasticity (economics)

An important concept in understanding supply and demand theory is elasticity. In this context, it refers to how supply and demand change in response to various stimuli. One way of defining elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arch elasticity because it calculates the elasticity over a range of values, in contrast with point elasticity that uses differential calculus to determine the elasticity at a specific point). Thus it is a measure of relative changes.

Often, it is useful to know how the quantity supplied or demanded will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded?

If you do not wish to calculate elasticity, a simpler technique is to look at the slope of the curve. Unfortunately, this has units of measurement of quantity over monetary unit (for example, liters per euro, or battleships per million yen), which is not a convenient measure to use for most purposes. So, for example, if you wanted to compare the effect of a price change of gasoline in Europe versus the United States, there is a complicated conversion between gallons per dollar and liters per euro. This is one of the reasons why economists often use relative changes in percentages, or elasticity. Another reason is that elasticity is more than just the slope of the function: It is the slope of a function in a coordinate space, that is, a line with a constant slope will have different elasticity at various points.

Let's do an example calculation. We have said that one way of calculating elasticity is the percentage change in quantity over the percentage change in price. So, if the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the elasticity is 2/5 or 0.4.

Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity. If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic. An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve. (See that section below)

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand. For example, how much would the demand for a luxury car increase if average income increased by 10%? If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve, because at all price levels, a greater quantity of luxury cars would be demanded.

Another elasticity that is sometimes considered is the cross elasticity of demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods. Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be −20%/10% or, −2.

Vertical supply curve

It is sometimes the case that the supply curve is vertical: that is the quantity supplied is fixed, no matter what the market price. For example, the amount of land in the world can be considered fixed. In this case, no matter how much someone would be willing to pay for a piece of land, the extra cannot be created. Also, even if no one wanted all the land, it still would exist. These conditions create a vertical supply curve, giving it zero elasticity (i.e., no matter how large the change in price, the quantity supplied will not change).

In the short run near vertical supply curves are even more common. For example, if the Super Bowl is next week, increasing the number of seats in the stadium is almost impossible. The supply of tickets for the game can be considered vertical in this case. If the organizers of this event underestimated demand, then it may very well be the case that the price that they set is below the equilibrium price. In this case there will likely be people who paid the lower price who only value the ticket at that price, and people who could not get tickets, even though they would be willing to pay more. If some of the people who value the tickets less sell them to people who are willing to pay more (i.e., scalp the tickets), then the effective price will rise to the equilibrium price.

The graph below illustrates a vertical supply curve. When the demand 1 is in effect, the price will be p1. When demand 2 is occurring, the price will be p2. Notice that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only affect price.

Diagram of vertical supply curve

Other market forms

In a situation in which there are many buyers but a single monopoly supplier that can adjust the supply or price of a good at will, the monopolist will adjust the price so that his profit is maximized given the amount that is demanded at that price. This price will be higher than in a competitive market. A similar analysis using supply and demand can be applied when a good has a single buyer, a monopsony, but many sellers.

Where there are both few buyers or few sellers, the theory of supply and demand cannot be applied because both decisions of the buyers and sellers are interdependent—changes in supply can affect demand and vice versa. Game theory can be used to analyze this kind of situation. (See also oligopoly.)

The supply curve does not have to be linear. However, if the supply is from a profit-maximizing firm, it can be proven that supply curves are not downward sloping (i.e., if the price increases, the quantity supplied will not decrease). Supply curves from profit-maximizing firms can be vertical, horizontal or upward sloping. While it is possible for industry supply curves to be downward sloping, supply curves for individual firms are never downward sloping.

Standard microeconomic assumptions cannot be used to prove that the demand curve is downward sloping. However, despite years of searching, no generally agreed upon example of a good that has an upward-sloping demand curve has been found (also known as a giffen good). Non-economists sometimes think that certain goods would have such a curve. For example, some people will buy a luxury car because it is expensive. In this case the good demanded is actually prestige, and not a car, so when the price of the luxury car decreases, it is actually changing the amount of prestige so the demand is not decreasing since it is a different good (see Veblen good). Even with downward-sloping demand curves, it is possible that an increase in income may lead to a decrease in demand for a particular good, probably due to the existence of more attractive alternatives which become affordable: a good with this property is known as an inferior good.

An example: Supply and demand in a 6-person economy

Supply and demand can be thought of in terms of individual people interacting at a market. Suppose the following six people participate in this simplified economy:

  • Alice is willing to pay $10 for a sack of potatoes.
  • Bob is willing to pay $20 for a sack of potatoes.
  • Cathy is willing to pay $30 for a sack of potatoes.
  • Dan is willing to sell a sack of potatoes for $5.
  • Emily is willing to sell a sack of potatoes for $15.
  • Fred is willing to sell a sack of potatoes for $25.

There are many possible trades that would be mutually agreeable to both people, but not all of them will happen. For example, Cathy and Fred would be interested in trading with each other for any price between $25 and $30. If the price is above $30, Cathy is not interested, since the price is too high. If the price is below $25, Fred is not interested, since the price is too low. However, at the market Cathy will discover that there are other sellers willing to sell at well below $25, so she will not trade with Fred at all. In an efficient market, each seller will get as high a price as possible, and each buyer will get as low a price as possible.

Imagine that Cathy and Fred are bartering over the price. Fred offers $25 for a sack of potatoes. Before Cathy can agree, Emily offers a sack of potatoes for $24. Fred is not willing to sell at $24, so he drops out. At this point, Dan offers to sell for $12. Emily won't sell for that amount so it looks like the deal might go through. At this point Bob steps in and offers $14. Now we have two people willing to pay $14 for a sack of potatoes (Cathy and Bob), but only one person (Dan) willing to sell for $14. Cathy notices this and doesn't want to lose a good deal, so she offers Dan $16 for his potatoes. Now Emily also offers to sell for $16, so there are two buyers and two sellers at that price (note that they could have settled on any price between $15 and $20), and the bartering can stop. But what about Fred and Alice? Well, Fred and Alice are not willing to trade with each other, since Alice is only willing to pay $10 and Fred will not sell for any amount under $25. Alice can't outbid Cathy or Bob to purchase from Dan, so Alice will not be able to get a trade with them. Fred can't underbid Dan or Emily, so he will not be able to get a trade with Cathy. In other words, a stable equilibrium has been reached.

A supply and demand graph could also be drawn from this. The demand would be:

  • 1 person is willing to pay $30 (Cathy).
  • 2 people are willing to pay $20 (Cathy and Bob).
  • 3 people are willing to pay $10 (Cathy, Bob, and Alice).

The supply would be:

  • 1 person is willing to sell for $5 (Dan).
  • 2 people are willing to sell for $15 (Dan and Emily).
  • 3 people are willing to sell for $25 (Dan, Emily, and Fred).

Supply and demand match when the quantity traded is two sacks and the price is between $15 and $20. Whether Dan sells to Cathy, and Emily to Bob, or the other way round, and what precisely is the price agreed cannot be determined. This is the only limitation of this simple model. When considering the full assumptions of perfect competition the price would be fully determined, since there would be enough participants to determine the price. For example, if the "last trade" was between someone willing to sell at $15.50 and someone willing to pay $15.51, then the price could be determined to the penny. As more participants enter, the more likely there will be a close bracketing of the equilibrium price.

It is important to note that this example violates the assumption of perfect competition in that there are a limited number of market participants. However, this simplification shows how the equilibrium price and quantity can be determined in an easily understood situation. The results are similar when unlimited market participants and the other assumptions of perfect competition are considered.

Decision making

Much of economics assumes that individuals seek to maximize their happiness or utility; however, whether they rationally attempt to optimize their well-being given available information is a source of much debate. In this view, which underpins much of economic writing, individuals make choices between alternatives based on their estimation of which will yield the best results. Many important economic ideas, such as the "efficient market hypothesis", rest on this view of decision making.

However, this framework, once called "homo economicus", has for decades been the focus of unease even by those who apply it. Milton Friedman once defended the idea by saying that inaccurate assumptions could produce accurate results. Alfred Marshall was careful to differentiate the tendency to maximize happiness with maximizing economic well-being. The limits of rationality have been the subject of intense study, for example, Herbert Simon's model for "bounded rationality", which was awarded a Nobel Prize in 1978. More recently, irrational behavior and imperfect information have increasingly been the subject of formal modeling, often referred to as behavioral economics, for which Daniel Kahneman won a Nobel Prize in 2002. An example is the growing field of behavioral finance, which combines previous theory with cognitive psychology.

The new model of information and decision making focuses on asymmetrical information, when some participants have key facts that others do not, and on decision making based not on the economic pressures but on the decisions of other economic actors. Asymmetrical information and behavioral dynamics lead to different conclusions: in a world of asymmetrical information, markets are generally not efficient, and inefficiencies grow up as means of hedging against information. While not yet universally accepted, it is increasingly influential in policy, for example, the writing of Joseph Stiglitz and financial modeling.

History of supply and demand

Attempts to determine how supply and demand interact began with Adam Smith's The Wealth of Nations, first published in 1776. In this book, he mostly assumed that the supply price was fixed but that the demand would increase or decrease as the price decreased or increased. David Ricardo in 1817 published the book Principles of Political Economy and Taxation, in which the first idea of an economic model was proposed. In this, he more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand.

During the late 19th century the marginalist school of thought emerged. This field mainly was started by Stanley Jevons, Carl Menger, and Léon Walras. The key idea was that the price was set by the most expensive price, that is, the price at the margin. This was a substantial change from Adam Smith's thoughts on determining the supply price.

Finally, most of the basics of the modern school theory of supply and demand were finalized by Alfred Marshall and Léon Walras, when they combined the ideas about supply and the ideas about demand and began looking at the equilibrium point where the two curves crossed. They also began looking at the effect of markets on each other. Since the late 19th century, the theory of supply and demand has mainly been unchanged. Most of the work has been in examining the exceptions to the model (like oligarchy, transaction costs, non-rationality).

Criticism of Marshall's theory of supply and demand

Marshall's theory of supply and demand runs counter to the ideas of economists from Adam Smith and David Ricardo through the creation of the marginalist school of thought. Although Marshall's theories are dominant in elite universities today, not everyone has taken the fork in the road that he and the marginalists proposed. One theory counter to Marshall is that price is already known in a commodity before it reaches the market, negating his idea that some abstract market is conveying price information. The only thing the market communicates is whether or not an object is exchangeable or not (in which case it would change from an object to a commodity). This would mean that the producer creates the goods without already having customers—blindly producing, hoping that someone will buy them (buy meaning exchange money for the commodities). Modern producers often have market studies prepared well in advance of production decisions; however, misallocation of factors of production can still occur.

Keynesian economics also runs counter to the theory of supply and demand. In Keynesian theory, prices can become "sticky" or resistant to change, especially in the case of price decreases. This leads to a market failure. Modern supporters of Keynes, such as Paul Krugman, have noted this in recent history, such as when the Boston housing market dried up in the early 1990s, with neither buyers nor sellers willing to exchange at the price equilibrium.

Gregory Mankiw's work on the irrationality of actors in the markets also undermines Marshall's simplistic view of the forces involved in supply and demand.

Special Cases of a Supply Curve

As described above, the general form of a supply curve is that it is upward sloping. There are a few rare cases in which the supply curve may be backward bending. A well known example is for the supply curve for labor: backward bending supply curve of labour. As a person's wage increases, they are willing to supply a greater number of hours working, but when the wage reaches an extremely high amount (say a wage of $1,000,000 per hour), the amount of labor supplied actually decreases.

In economics, elasticity is the ratio of the incremental percentage change in one variable with respect to an incremental percentage change in another variable. Elasticity is usually expressed as a positive number (i.e., an absolute value) when the sign is already clear from context.

Generalised cases

Keeping in mind the example of price elasticity of demand, these figures show x=Q horizontal and y=P vertical.

Figure 1: Illustrations of Perfect Elasticity and Perfect Inelasticity.

In this example the demand curve (D1) is perfectly elastic.
In this example the demand curve (D2) is perfectly inelastic.

Template:- Generalised cases of elasticity are frequently used in discussions that characterise circumstances for which detailed information is not available and/or irrelevant to the discussion. There are five such cases of elasticity.

  • E = 0 Perfectly inelastic. This special case of elasticity is represented in the figure to the right above. Any change in P will have no effect on Q.
  • E < 1 Inelastic. The proportional change in Q is less than the proportional change in P.
  • E = 1 Unit elasticity. The proportional change in one variable is equal to the proportional change in another variable.
  • E > 1 Elastic. The proportional change in Q is greater than the proportional change in P.
  • E = infinity Perfectly elastic. This special case of elasticity is represented in the figure to the left above. Change in P is zero, so elasticity is infinite.

Mathematical definition

File:Unit elasticity.png
Unit elasticity for a supply line passing through the origin.

The general formula for elasticity (the "y-elasticity of x") is:

Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle E_{x,y} = \frac{{\rm percent\ change\ in}\ x}{{\rm percent\ change\ in}\ y}}

or, more formally,

Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle E_{x,y} = \frac{\partial ln(x)}{\partial ln(y)} = \frac{\partial x}{\partial y}\frac{y}{x}}

A common mistake for students of economics is to confuse elasticity with slope. Elasticity is the slope of a curve on a loglog graph only, not on a regular graph (taking into account whether the independent variable is on the horizontal or the vertical axis). Consider the information in figure 2--this is a special case which illustrates that slope and elasticity are different. In the above example the slope of S1 is clearly different from the slope of S2, but since the rate of change of P relative to Q is always proportionate both S1 and S2 are unit elastic (i.e. E = 1).


Elasticity is an important concept in understanding the incidence of indirect taxation, marginal concepts as they relate to the theory of the firm, distribution of wealth and different types of goods as they relate to the theory of consumer choice and the Lagrange Multiplier. Elasticity is also crucially important in any discussion of welfare distribution: in particular consumer surplus, producer surplus, or government surplus.

The concept of Elasticity was also an important component of the Singer-Prebisch Thesis which is a central argument in Dependency Theory as it relates to development economics.

This page deals with the various forms of economic surplus, including producer, consumer, government, and social/total surplus. For information about a budget surplus, see budget deficit.

The term surplus is used in economics for several related quantities. The consumer surplus is the amount that consumers benefit by being able to purchase a product for a price that is less than they would be willing to pay. The producer surplus is the amount that producers benefit by selling at a market price that is higher than they would be willing to sell for.

If the government intervenes, using, for example, a tax or a subsidy, then the graph of supply and demand becomes more complicated and will also include an area that represents government surplus.

Combined, the consumer surplus, the producer surplus, and the government surplus (if present) make up the social surplus or the total surplus. Total surplus is the primary measure used in Welfare Economics to evaluate the efficiency of a proposed policy.

A basic technique of bargaining for both parties is to pretend that their surplus is less than it really is: sellers may argue that the price they asks hardly leaves them any profit, while customers may play down how eager they are to have the article.

In national accounts, operating surplus is roughly equal to distributed and undistributed pre-tax profit income, net of depreciation.

In heterodox economics, the economic surplus denotes the total income which the ruling class derives from its ownership of society's (productive) assets, which is either reinvested or spent on consumption.

In Marxian economics, the term surplus may also refer to surplus value and surplus labour.

Consumer theory relates preferences, indifference curves and budget constraints to consumer demand curves.

Indifference curves and budget constraints

Using indifference curves and an assumption of constant prices and a fixed income in a two good world will give the following diagram. The consumer can choose any point on or below the budget constraint line BC. This line is diagonal since it comes from the equation Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle X \times px + Y \times py \leq Income} . In other words, the amount spent on both goods together is less than or equal to the income of the consumer. The consumer will choose the indifference curve with the highest utility that is within the budget constraint. I3 has all the points outside of their budget constraint so the best that they can do is I2. This will result in them purchasing X* of good X and Y* of good Y.

link between indifference curves budget constraint an consumers choice.

Income effect and Price effect deal with how the change in price of the commodity changes the consumption of the Good

Price effects

More usefully, this can now be used to predict the effect of various shifts in the constraint. The below graphic shows the effect of a price shift for good y. If the price of Y increases from where it is at BC2, the budget constraint will shift to BC1. Notice that since the price of X does not change, the consumer can still buy the same amount of X if they only choose to buy good X. On the other hand, if they choose to buy only good Y, they will be able to buy less of good Y since its price has increased.

To maximize the utility with the reduce budget constraint, BC1, the consumer will re-allocate consumption to reach the highest available indifference curve which BC1 can touch. As shown on the diagram below, that curve is I1, and therefore the amount of good Y bought will shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. The opposite effect will occur if the price of Y decreases causing the shift from BC2 to BC3, and I2 to I3.

link to shifting price of good y and quanity of goods consumed as a result

If this shifts are repeated with many different prices for good Y, a demand curve for good Y can be constructed. If the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed. The below diagram explains this for good y.

example of going from indifference curves to demand curve

Income effect

Another important item that can change is the income of the consumer. As long as the prices remain constant, changing the income will create a parallel shift of the budget constraint. Increasing the income will shift the budget constraint right since more of both can be bought, and decreasing income will shift it left.

link to shifting income of consumer and quntity of goods consumed as a result

Depending on the indifference curves the amount of a good bought can either increase, decrease or stay the same when income increases. In the diagram below, good Y is a normal good since the amount purchased increased as the budget constraint shifted from BC1 to the higher income BC2. Good X is an inferior good since the amount bought decreased as the income increases.

example of a normal good and an inferior good

Substitution effect

Every price change can be converted into an income effect and a substitution effect. The substitution effect is basically a price change that changes the slope of the budget constraint, but leaves the consumer on the same indifference curve. This effect will always cause the consumer to substitute away from the good that is becoming comparatively more expensive. If the good in question is a normal good, then the income effect will re-enforce the substitution effect. If the good is inferior, then the income effect will lessen the substitution effect. If the income effect is opposite and stronger than the substitution effect, the consumer will buy more of the good when it becomes more expensive. There is a generally agreed upon example of this happening, known as a Giffen good.

example of substitution effect

To download a free software to make your own experiments with consumer choice, substitution and income effects you may go to: http://www.economicswebinstitute.org/essays/consumertheory.htm

The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process. The interpretation of this relationship between price and quantity demanded of a given good is that, given all the other goods and constraints, this set of choices is that one which makes the consumer happiest.

Aggregate, or market, demand curves represent the sum of these individual demand curves. An important question is whether market demand curves can also be thought of as being generated by a utility-maximization process. Does the aggregated demand curve show how to optimise the total utility (happiness) of society? Does it show how to optimise something else? The answer to these questions is no; market demand curves generally have no utility interpretation.

Moreover, even if market demand curves could mathematically be rationalized by a utility function; they still cannot be economically rationalized as generating an overall welfare index. There are several reasons for this

  1. Each person's individual total utility gleaned from purchases depends on the size of his or her budget, but the distribution of wealth (and thus her budget) is a separate (free) variable in the aggregation. In other words, changing the distribution of wealth (such as giving needy people more resources) will produce a different total for society's utility.
  2. Each person's demand curve is a function of his or her budget, so that if the distribution of wealth changes (by changing the distribution of prices and thus salaries, and so on), all of the individual demand curves change. The aggregate effect of such a change is not simple unless all the consumers have wealth-independent consumption patterns --- that is, unless the pauper and the billionaire spend the same fraction of their budgets on each item.

Markets cannot be claimed to select an optimum in the sense of the greatest total utility of society; indeed, there is not even general agreement on how total utility should be defined. However, under strictly competitive conditions, market outcomes do represent a Pareto optimum.

It has been known since at least 1953 (Gorman, W.M., Community Preference Fields, Econometrica, 21: 63-80) and 1982 (Shafer, W. and Sonnenschein, H., Market demand and excess demand functions, in K. J. Arrow and M. D. Intriligator (eds), Handbook of Mathematical Economics (Vol. II), North-Holland, Amsterdam) that no reasonable assumptions can circumvent these problems.

This article is about "utility" in economics and in game theory. For utility companies and similar concepts, see public utility. For utilities in computers, see computer software. See also Utility (patent)

In economics, utility is a measure of the happiness or satisfaction gained from a good or service.

The concept is applied by economists in such topics as the indifference curve, which measures the combination of a basket of commodities that an individual or a community requests at a given level(s) of satisfaction. The concept is also used in utility functions, social welfare functions, Pareto maximization, Edgeworth boxes and contract curves. It is a central concept of welfare economics.

The doctrine of utilitarianism saw the maximisation of utility as a moral criterion for the organisation of society. According to utilitarians, such as Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1876), society should aim to maximise the total utility of individuals, aiming for 'the greatest happiness for the greatest number'.

Utility theory assumes that humankind is rational. That is, people maximize their utility wherever possible. For instance, one would request more of a good if it is available and if one has the ability to acquire that amount, if this is the rational thing to do in the circumstances.

Cardinal and ordinal utility

There are mainly two kinds of measurement of utility implemented by economists: cardinal utility and ordinal utility.

Utility was originally viewed as a measurable quantity, so that it would be possible to measure the utility of each individual in the society with respect to each good available in the society, and to add these together to yield the total utility of all people with respect to all goods in the society. Society could then aim to maximise the total utility of all people in society, or equivalently the average utility per person. This conception of utility as a measurable quantity that could be aggregated across individuals is called cardinal utility.

Cardinal utility quantitatively measures the preference of an individual towards a certain commodity. Numbers assigned to different goods or services can be compared. A utility of 100 units towards a cup of vodka is twice as desirable as a cup of coffee with a utility level of 50 units.

The concept of cardinal utility suffers from the absence of an objective measure of utility when comparing the utility gained from consumption of a particular good by one individual as opposed to another individual.

For this reason, neoclassical economics abandoned utility as a foundation for the analysis of economic behaviour, in favour of an analysis based upon preferences. This led to the development of tools such as indifference curves to explain economic behaviour.

In this analysis, an individual is observed to prefer one choice to another. Preferences can be ordered from most satisfying to least satisfying. Only the ordering is important: the magnitude of the numerical values are not important except in as much as they establish the order. A utility of 100 towards an ice-cream is not twice as desirable as a utility of 50 towards candy. All that can be said is that ice-cream is preferred to candy. There is no attempt to explain why one choice is preferred to another; hence no need for a quantitative concept of utility.

It is nonetheless possible, given a set of preferences which satisfy certain criteria of reasonableness, to find a utility function that will explain these preferences. Such a utility function takes on higher values for choices that the individual prefers. Utility functions are a useful and widely used tool in modern economics.

A utility function to describe an individual's set of preferences clearly is not unique. If the value of the utility function were to be, e.g., doubled, squared, or subjected to any other strictly monotonically increasing function, it would still describe the same preferences. With this approach to utility, known as ordinal utility it is not possible to compare utility between individuals, or find the total utility for society as the Utilitarians hoped to do.

Utility functions

While preferences are the conventional foundation of microeconomics, it is convenient to represent preferences with a utility function and reason indirectly about preferences with utility functions. Let X be the consumption set, the set of all packages the consumer could conceivably consume. The consumer's utility function Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle u : X \rightarrow \textbf R} assigns a happiness score to each package in the consumption set. If u(x) > u(y), then the consumer strictly prefers x to y.

For example, suppose a consumer's consumption set is X = {nothing, 1 apple, 1 orange, 1 apple and 1 orange, 2 apples, 2 oranges}, and its utility function is u(nothing) = 0, u(1 apple) = 1, u(1 orange) = 2, u(1 apple and 1 orange) = 4, u(2 apples) = 2 and u(2 oranges) = 3. Then this consumer prefers 1 orange to 1 apple, but prefers one of each to 2 oranges.

In microeconomics models, there are usually a finite set of L commodities, and a consumer may consume an arbitrary amount of each commodity. This gives a consumption set of Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle \textbf R^L_+} , and each package Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle x \in \textbf R^L_+} is a vector containing the amounts of each commodity. In the previous example, we might say there are two commodities: apples and oranges. If we say apples is the first commodity, and oranges the second, then the consumption set X = Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle \textbf R^2_+} and u(0, 0) = 0, u(1, 0) = 1, u(0, 1) = 2, u(1, 1) = 4, u(2, 0) = 2, u(0, 2) = 3 as before. Note that for u to be a utility function on X, it must be defined for every package in X.

A utility function Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle u : X \rightarrow \textbf{R}} rationalizes a preference relation <= on X if for every Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle x, y \in X} , u(x) <= u(y) if and only if x <= y. If u rationalizes <=, then this implies <= is complete and transitive, and hence rational.

In order to simplify calculations, various assumptions have been made of utility functions.

Expected utility

A von Neumann-Morgenstern utility function Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle u : X \rightarrow \textbf{R}} assigns a real number to every element of the outcome space in a way that captures the agent's preferences over both simple and compound lotteries (put in category-theoretic language, u induces a morphism between the category of preferences under uncertainty and the category of reals). The agent will prefer a lottery Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_1} to a lottery Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_2} if and only if the expected utility (iterated over compound lotteries if necessary) of Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_1} is greater than the expected utility of Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_2} .

Restricting to the discrete choice context, let Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L : X \rightarrow [0,1] } be a simple lottery such that Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L(x_i) = p_i} , where Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle p_i} is the probability that Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle x_i} is won. We may also consider compound lotteries, where the prizes are themselves simple lotteries.

The expected utility theorem says that a von Neumann-Morgenstern utility function exists if and only if the agent's preference relation >= on the space of simple lotteries satisfies four axioms: completeness, transitivity, convexity/continuity (also called the Archimedean property), and independence.

Completeness and transitivity are discussed supra. The Archimedean property says that for simple lotteries Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_1} >= Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_2} >= Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_3} , then there exists a 0 <= p <= 1 such that the agent is indifferent between Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_2} and the compound lottery mixing between Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_1} and Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_3} with probability p and (1-p), respectively. Independence means that if the agent is indifferent between simple lotteries Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_1} and Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_2} , the agent is also indifferent between Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_1} mixed with an arbitrary simple lottery Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_3} with probability p and Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_2} mixed with Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle L_3} with the same probability p.

Independence is probably the most controversial of the axioms.

Daniel Bernoulli has shown how the personal utility vary with the personal degree of risk aversion, itself linked to the initial wealth situation of the person.

Discussion and criticism

The theory of consumer choice has come under criticism from different angles. One is behavioral economics, where different experiments show that consumers have a higher loss aversion than preference for a related gain. Also, estimations for small probabilities and their utility payoffs are difficult for laypersons to estimate (See Matthew Rabin's homepage for some puzzles connected with consumer theory).

In economics, marginalism is the theory that economic value results from marginal utility and marginal cost (the marginal concepts). Marginalism is the notion that what is most important for decision making is the marginal or last unit of consumption or production. For example, one automobile is very useful for getting around. An additional automobile might be useful in case the first is being repaired, or for spare parts, but it is not as useful as the first. A third automobile has even less utility than the first two. Given the price of cars, one would not expect many people to own three cars because the benefit they receive on the third car would be unlikely to exceed the price.

The theory of marginal utility was independently developed around 1870 by William Stanley Jevons in England, Carl Menger in Austria and Leon Walras in Switzerland. HH Gossen had also posited a connection between value in exchange and marginal utility, but it was ultimately popularised by the three European economists. These advances in economic thought are known as the Neoclassical Revolution (or Marginal Revolution).

Theories of Value

Diamond-water Paradox

The diamond-water paradox is the observation that even though water is essential to human life, the price of water is relatively low. Diamonds are frivolous and unimportant for human existence, yet the price of diamonds is substantially higher. Adam Smith, the esteemed and perhaps most famous economist, described the paradox in his seminal work The Wealth of Nations.

Cost of Production

Adam Smith and David Ricardo both theorized that value is a result of the cost-of-production. Smith concluded that the economic value of a good is dependent on the amount of labor required to attain it. It followed that diamonds are expensive because it requires a lot of labor to find and mine them (labor theory of value). In long-run equilibrium, prices reflect costs per unit produced and a rate of profit that is equalized between sectors. Some economists, particularly many classical economists still believe this. However, this does not explain why emeralds, which are harder to find and more expensive to extract than diamonds, are not valued as highly, nor why large, easily extracted and easily found diamonds are worth much more than small, hard to extract ones.

The origins of marginalism come from Ricardo's theory of land-rent, in which the price of land depends on the productivity of the least productive land in cultivation—the marginal land. Thus, all else equal, as the demand for agricultural crops increases, the price of land rises as farmers move to less productive land.

Subjective Value

Anne Robert Jacques Turgot brilliantly solved the diamond-water paradox. He saw that value is subjective—it is in the eye of the beholder. That is, things do not have inherent value, but have value only insofar as people desire them: "Comparison of value, this evaluation of different objects, changes continually with the need of the person."Template:An Where water is plentiful, people value diamonds highly. A person stranded in a desert, however, would value water over diamonds.

Those who endorse subjective value theory (including mainstream modern economists) believe it is a refutation of intrinsicist value theories, such as the labor theory of value, which is a cornerstone of Marxism. Behavioral economics theorists explicitly seek to research and model how subjective framing of decisions affects the value an individual places on goods and outcomes.

Carl Menger and Eugen von Böhm-Bawerk, members of the Austrian School of economics, took subjective value further, developing the theory of marginalism.

Marginal Utility

Marginal utility, or marginal benefit, is the additional utility (satisfaction or benefit) that a consumer derives from an additional unit of a commodity or service. The concept grew out of attempts by 19th-century economists to explain the fundamental economic reality of price. Austrian economist Friedrich von Wieser coined the term.

The Austrian economist Eugen von Böhm-Bawerk gave probably the most memorable description of the marginal theory of value, one often used by economics textbooks. Loosely translated it is:

A pioneer farmer had five sacks of grain, with no way of selling them or buying more. He had five possible uses: as basic feed for himself, food to build strength, food for his chickens for dietary variation, an ingredient for making whisky and feed for his parrots to amuse him. Then the farmer lost one sack of grain. Instead of reducing every activity by a fifth, the farmer simply starved the parrots as they were of less utility than the other four uses, in other words they were on the margin. And it is on the margin, and not with a view to the big picture, that we make economic decisions.

Diminishing marginal utility refers to the marginal utility of each additional unit of a good having less value than the previous unit. For example, the marginal utility of an additional slice of bread to a person with few slices will be great. But the marginal utility of an extra slice of bread to a person with many slices will be small.

Diminishing marginal utility is a very common assumption in economics, but it is not universally assumed. It corresponds to convexity of the indifference curves.

Marginalism and Schools of Economic Thought

Neo-classical Economics

Neo-classical economists derive demand curves from indifference curves, of which one assumption is diminishing marginal utility. Although the scarcity of factors of production is still thought to be important, individual demand and the marginal benefits that they would obtain from a good is seen as the driver of the whole process and the ultimate source of economic value.

Austrian School

The Austrian School accepts marginalism more completely, making a clear break from the factor-input theories of value. They used marginal utility as a starting point: for example, the supply of labor reflects the subjective marginal utility of leisure (and the marginal disutility of work).

Austrian economists formulated the law of marginal utility in a period when psychologists were much interested in the Weber-Fechner law of sensation. The Weber-Fechner law states that in order that the intensity of a sensation may achieve an arithmetic progression, the stimulus itself must achieve a geometric progression. For example, in a quiet environment, humans will notice even a small increase in noise level, but when the given noise level is already loud, humans will need a much larger increase in order to perceive a difference.

Von Wieser's seminal essay on "Natural Value" appeared in 1889. In 1890, the American psychologist William James wrote his Principles of Psychology and offered an interpretation of the Weber-Fechner law that may also shed a lot of light on marginal utility in von Weiser's sense. James saw the Weber-Fechner law as a rough generalization as to the friction in the neural machinery.

"If our feelings [of weight, sight, sound, etc.] resulted from a condition of the nerve molecules which it grew ever more difficult for the stimulus to increase, our feelings would naturally grow at a slower rate than the stimulus itself," he wrote. "An ever larger part of the latter's work would go to overcoming the resistances, and an ever smaller part to the realization of the feeling-bringing state."

Whatever the neurological basis, the result of diminishing marginal utility is that rather than having a lot of one good or a lot of another one, one prefers having some of both. In the case of perfect substitutes this result does not apply (since the two products are essentially the same), in the case of perfect complements it applies most.

Marxist School

Karl Marx died before marginalism became the accepted interpretation of economic value and neoclassical economics replaced classical political economy. His theories were based on the labor theory of value, which distinguishes between utility and use value.

Some economists strongly influenced by the Marxian tradition such as Oskar Lange, Wlodzimierz Brus, and Michal Kalecki have attempted to integrate the insights of classical political economy and neo-classical economics. Important reasons for this were that Marx lacked a sophisticated theory of prices, and neo-classical economics lacked a theory of the social frameworks of economic activity.

Marxists often criticise capitalism for its "commodity fetishism" or the "illusions created by competition" arguing that capitalists dominate the working class and exploit them. They argue that although individual economic visions and decision-making play a role in Marx's theory, he thought that it was necessary to understand the totality of capitalist social relations (in volume I of his Das Kapital) before it was possible to understand this consciousness and action (in volume III of that book). Some Marxists argue that on one level there is no conflict between marginalism and Marxism: one could employ a marginalist theory of supply and demand within the context of a "big picture" understanding of capitalist exploitation of labor.

Income, generally defined, is the money that is received as a result of the normal business activities of an individual or a business. For example, most individuals' income is the money they receive from their regular paychecks.

In business and accounting, income (also known as profit or earnings) is, more specifically, the amount of money that a company earns after paying for all its costs. To calculate a company's income, it starts with its amount of revenue, deducts all costs, including such things as employees' salaries and depreciation, and the number that results is its income, which may be a negative number. This money is typically reinvested in the business, paid in corporate tax and used to pay the owners (the shareholders) a dividend.

All public companies are required to provide financial statements on a quarterly basis. The statement of income is an important part of this. Some companies also provide a more rosy financial report of their income, with pro forma reporting, or, EBITDA reporting. Pro forma income is an estimate of how much the company would have earned without including the negative effect of exceptional "one-time events", supposedly in order to show investors how much money the company would have made under normal circumstances if these exceptional, one-time events had not occurred. Critics charge that, in most cases, the "one-time events" are normal business events, such as an acquisition of another company or a write off of a cancelled project or division, and that pro forma reporting is an attempt to mislead investors by painting a rosy financial picture. Besides that, when discussing results with analysts and shareholders CEOs and CFOs have a tendency to do even more "hypothetical accounting". EBITDA stands for "earnings before interest, taxes, depreciation, and amortisation", and is also criticised for being an attempt to mislead investors. Warren Buffett has criticised EBITDA reporting, famously asking, "Does management think the tooth fairy pays for capital expenditures?"

It is common for some other companies, such as real estate investment trusts, to present reports using a standard called FFO, or funds from operations. Like EBITDA reporting, FFO ignores depreciation and amortization. This is widely accepted in the industry, as real estate values tend to increase rather than decrease over time, and many data sites report earnings per share data using FFO.

In economics, income is the constraint to unlimited consumer purchases. Consumers can purchase a limited number of goods. The basic equation for this is I = Px × x + Py × y, where Px is the price of good x, x is the quantity of good x, and I is the income (Py and y are similar to Px and x). If you need to examine more than two goods, you can add more on. This equation tells us two things. First, if you buy one more of good x, you get Px/Py less of good y. Here, Px/Py is known as the rate of substitution. Secondly, if the price of x changes, then the rate of substitution changes. This causes demand curves to slope down.

The distribution of income within a society can be measured by the Lorenz curve and the Gini coefficient.

National income, measured by statistics such as the Net National Income (NNI), measures the total income of all individuals in the economy. For more information see measures of national income and output.

In economics, profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue -- total cost method relies on the fact that profit equals revenue minus cost, and the marginal revenue -- marginal cost method is based on the fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost.

Basic Definitions

Any costs incurred by a firm may be classed into two groups: fixed cost and variable cost. Fixed costs are incurred by the business at any level of output, including none. These may include equipment maintenance, rent, wages, and general upkeep. Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category. Fixed cost and variable cost, combined, equal total cost.

Revenue is the total amount of money that flows into the firm. This can be from any source, including product sales, government subsidies, venture capital and personal funds.

Average cost and revenue are defined as the total cost or revenue divided by the amount of units output. For instance, if a firm produced 400 units at a cost of 20000 USD, the average cost would be 50 USD.

Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to quantity output. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to linear interpolation. Calculus is capable of providing more accurate answers if regression equations can be provided.

Total Cost-Total Revenue Method

To obtain the profit maximizing output quantity, we start by recognizing that profit is equal to total revenue minus total cost. Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph. Finding the profit-maximizing output is as simple as finding the output at which profit reaches its maximum. That is represented by output Q in the diagram.

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Profit Maximization - The Totals Approach

There are two graphical ways of determining that Q is optimal. Firstly, we see that the profit curve is at its maximum at this point (A). Secondly, we see that at the point (B) that the tangent on the total cost curve (TC) is parallel to the total revenue curve (TR), the surplus of revenue net of costs (B,C) is the greatest. Because total revenue minus total costs is equal to profit, the line segment C,B is equal in length to the line segment A,Q.

Computing the price at which to sell the product requires knowledge of the firm's demand curve. The price at which quantity demanded equals profit-maximizing output is the optimum price to sell the product.

Marginal Cost-Marginal Revenue Method

If total revenue and total cost figures are difficult to procure, this method may also be used. For each unit sold, marginal profit equals marginal revenue minus marginal cost. Then, if marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals marginal revenue. This intersection of marginal revenue (MR) with marginal costs (MC) is shown in the next diagram as point A. If the industry is competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal line at a price determined by industry supply and demand. Average total costs are reprsented by curve ATC. Total economic profits are represented by area P,A,B,C. The optimum quantity (Q) is the same as the optimum quantity (Q) in the first diagram.

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Profit Maximization - The Marginal Approach

If the firm is operating in a non-competitive market, minor changes would have to be made to the diagrams.

Modes of Operation

It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered.

A firm is said to be making an economic profit when its average total cost is less than the price of the product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.

A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output.

If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it was to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose equivalent of its entire fixed cost.

If the price is below average variable cost at the profit-maximizing output, the firm is said to be in shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost.

Perfect competition is a model in economic theory. It describes a hypothetical market form in which no producer or consumer has the market power to influence prices in the market. This would lead to an outcome which is efficient, according to the standard definition in economics (Pareto efficiency). The analysis of perfectly competitive markets provides the foundation of the theory of supply and demand.

Assumptions of perfect competition

Perfect competition requires five parameters to be fulfilled:

  1. Atomicity -- there are a large number of small producers and consumers on a given market, each so small that its actions have no significant impact on others, firms are price takers.
  2. Homogeneity -- that goods and services are perfect substitutes.
  3. Perfect and complete information -- all firms and consumers know the prices set by all firms.
  4. Equal access -- all firms have access to production technologies, and resources (including information) are perfectly mobile.
  5. Free entry -- any firm may enter or exit the market as it wishes (see Barriers to entry).

In such a market, the price would move instantaneously to equilibrium.

Results of a Perfectly Competitive Market

This model is in most cases only a distant approximation of real markets, with the possible exception of certain large street markets. In general, few, if any of the conditions listed above will apply in real markets. For example, firms will never have perfect information about each other, and there will always be some transaction costs. In a perfectly competitive market, there will be both allocative and productive efficiency. Productive efficiency occurs when the firm produces at the lowest point on the average total cost curve, implying it cannot produce the goods for any cheaper. This is shown on the diagram - the horizontal demand curve touches the ATC (average total cost) curve at the lowest point. This would be achieved in perfect competition, as if any firm was not doing this another firm would be able to undercut it by selling products at a lower price. Allocative efficiency occurs when price is equal to marginal cost, as the good is available to the consumer at the lowest possible price. This is also achieved in perfect competition.

In contrast to a monopoly or oligopoly, it is impossible for a firm in perfect competition to earn abnormal profit in the long run, that is to say that a firm cannot make any more money than is necessary to cover its losses. If a firm is earning abnormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit.

Examples of Perfect Competition

Some say that agriculture, with a large amount of suppliers, relatively inelastic demand, and almost perfectly substitutable product is an approximation to the perfect competition model. This may be/have been true in some places and times, but in modern economies it is not. For example, in the global agriculture market, agricultural subsidies are provided to US and European (via the CAP) farmers whose products are exported (dumped) at prices below the cost of production. Any form of government intervention such as subsidies warps the market, meaning that perfect competition does not occur. Buying a farm (of even renting one, together with equipment) is a rather substantial barrier to entry!

Perhaps the closest thing to a perfectly competitive market would be a street market with many small stalls selling identical smallholding-sourced food produce. As perfect competition is a theoretical absolute, there are no examples of a perfectly competitive market.

This article is about the state of a player in economics. For the Parker Brothers board game, see Monopoly (game).

In economics, a monopoly (from the Greek monos, one + polein, to sell) is defined as a persistent market situation where there is only one provider of a kind of product or service. Monopolies are characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods.

Monopoly should be distinguished from monopsony, in which there is only one buyer of the product or service; it should also, strictly, be distinguished from the (similar) phenomenon of a cartel. In a monopoly a single firm is the sole provider of a product or service; in a cartel a centralized institution is set up to partially coordinate the actions of several independent providers (which is a form of oligopoly).

Forms of monopoly

Monopolies are often distinguished based on the circumstances under which they arise; the main distinctions are between a monopoly that is the result of law (government-granted monopoly and government monopoly) alone; one that arises from the cost structure of the industry (natural monopoly); and one that arise by other means (eg one firm simply outcompeting all other firms; illegal behaviour; etc). Advocates of economic liberalism assert that a more fundamental way of classifying monopolies is to distinguish those that arise and exist due to violation of the principles of a free market (coercive monopoly) from those that arise and are maintained by consistently outcompeting all other firms.

Legal monopoly

A monopoly based on laws explicitly preventing competition is a legal monopoly or de jure monopoly. When such a monopoly is granted to a private party, it is a government-granted monopoly; when it is operated by government itself, it is a government monopoly or state monopoly. A government monopoly may exist at different levels of government (eg just for one region or locality); a state monopoly is specifically operated by a national government.

An example of a "de jure" monopoly is AT&T, which was granted monopoly power by the US government, only to be broken up in 1982 following a Sherman Antitrust suit.

Natural monopoly

Main article: Natural monopoly

A natural monopoly is a monopoly that arises in industries where economies of scale are so large that a single firm can supply the entire market without exhausting them. In these industries competition will tend to be eliminated as the largest (often the first) firm develops a monopoly through its cost advantage. In these industries monopoly may be more economically efficient than competition, although because of potential dynamic efficiencies this is not necessarily clear-cut.

Natural monopoly arises when there are large capital costs relative to variable costs, which arises typically in network industries such as electricity and water. It should be distinguished from network effects, which operate on the demand side and do not affect costs. Counter-intuitively, the case of a monopolization of a key source of a natural resource is not considered a natural monopoly, because it is based on the running down of natural capital rather than the amortization of an investment in physical or human capital.

Whether an industry is a natural monopoly may change over time through the introduction of new technologies. A natural monopoly industry can also be artificially broken up by government, although (eg electricity liberalization, eg Railtrack) the results are at best mixed. Advocates of free markets, such as libertarians, assert that a natural monopoly is a practical impossibility, and, given that a monopoly is a persistent rather than a transient situation, that there is no historical precedent of one ever existing. They say that the idea of "natural monopoly" is mere theoretical abstraction to justify expanding the scope of government, and that it in the case of nationalization or deprivatization it is the government intervention itself that creates a monopoly where one did not actually exist.

Local monopoly

A local monopoly is a monopoly of a market in a particular area, usually a town or even a smaller locality: the term is used to differentiate a monopoly that is geographically limited within a country, as the default assumption is that a monopoly covers the entire industry in a given country. This may include the ability to charge (to some extent) monopoly pricing, for example in the case of the only gas station on an expressway rest stop, which will serve a certain number of motorists who lack fuel to reach the next station and must pay whatever is charged.

Monopolistic competition

Main article: Monopolistic competition

Industries which are dominated by a single firm may allow the firm to act as a near-monopoly or "de facto monopoly", a practice known in economics as monopolistic competition. Common historical examples arguably include corporations such as Microsoft and Standard Oil (Standard's market share of refining was 64% in competition with over 100 other refiners at the time of the trial that resulted in the government-forced breakup). Practices which these entities may be accused of include dumping products below cost to harm competitors, creating tying arrangements between their products, and other practices regulated under antitrust law.

Large corporations often attempt to monopolize markets through horizontal integration, in which a parent company consolidates control over several small, seemingly diverse companies (sometimes even using different branding to create the illusion of marketplace competition). Such a monopoly is known as a horizontal monopoly. A magazine publishing firm, for example, might publish many different magazines on many different subjects, but it would still be considered to engage in monopolistic practices if the intent of doing this was to control the entire magazine-reader market, and prevent the emergence of competitors.

A monopoly arrived at through vertical integration is called a vertical monopoly. A common example is vertical integration of electricity distribution with electricity generation, which is common because it reduces or eliminates certain costly risks.

Coercive monopoly

Main article: coercive monopoly

A coercive monopoly is one that arises and whose existence is maintained as the result of any sort of activity that violates the principle of a free market and is therefore insulated from competitive forces that would otherwise be a potential threat to its superior status. The term is typically used by those who favor laissez-faire capitalism.

Economic analysis

Primary characteristics of a monopoly

  • Single Seller
A pure monopoly is an industry in which a single firm is the sole producer of a good or the sole provider of a service. This is usually caused by a blocked entry.
  • No Close Substitutes
The product or service is unique in ways which go beyond brand identity, and cannot be easily replaced (a monopoly on water from a certain spring, sold under a certain brand name, is not a true monopoly; neither is Coca-Cola, even though it is differentiated from its competition in flavor).
  • Price Maker
In a pure monopoly a single firm controls the total supply of the whole industry and is able to exhert a significant degree of control over the price, by changing the quantity supplied. In subtotal monopolies (for example diamonds or petroleum at present) a single organization controls enough of the supply that even if it limits the quantity, or raises prices, the other suppliers will be unable to make up the difference and take significant amounts of market share.
  • Blocked Entry
The reason a pure monopolist has no competitors is that certain barriers keep would be competitors from entering the market. Depending upon the form of the monopoly these barriers can be economic, technological, legal (basic patents on certain drugs), or of some other type of barrier that completely prevents other firms from entering the market.

Monopolistic pricing

In economics a company is said to have monopoly power if it faces a downward sloping demand curve (see supply and demand). This is in contrast to a price taker that faces a horizontal demand curve. A price taker cannot choose the price that they sell at, since if they set it above the equilibrium price, they will sell none, and if they set it below the equilibrium price, they will have an infinite number of buyers (and be making less money than they could if they sold at the equilibrium price). In contrast, a business with monopoly power can choose the price they want to sell at. If they set it higher, they sell less. If they set it lower, they sell more.

If a monopoly can only set one price it will set it where marginal cost (MC) equals marginal revenue (MR) as seen on the diagram on the right. This can be seen on a supply and demand diagram for the firm. This will be at the quantity Qm and at the price Pm. This is above the competitive price of Pc and with a smaller quantity that the competitive quantity of Qc. The profit the monopoly gains is the shaded in area labeled profit.

As long as the price elasticity of demand (in absolute value) for most customers is less than one, it is very advantageous to increase the price: the seller gets more money for less goods. With an increase of the price the price elasticity tends to rise, and in the optimum mentioned above it will for most customers be above one. A formula gives the relation between price, marginal cost of production and demand elasticity which maximizes a monopoly profit: Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle \frac{P}{MC} = \frac{1}{1 + 1 / e}} (known as Lerner Index).

The economy as a whole loses out when monopoly power is used in this way, since the extra profit earned by the firm will be smaller than the loss in consumer surplus. This difference is known as a deadweight loss.

Calculating monopoly output

The single price monopoly profit maximisation problem is as follows:

The monopoly's profit is its total revenue less its total cost. Let the price it sets as a market response be a function of the quantity it produces (Q) Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle P(Q)} and let its cost function be as a function of quantity Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle C(Q)} . The monopoly's revenue is the product of the price and the quantity it produces. Hence its profit is:

Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle \Pi\ = P(Q).Q - C(Q)}

Taking the first order derivative with respect to quantity yields:

Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle \frac{d \Pi\ }{dQ} = P'(Q).Q + P(Q) - C'(Q)}

Setting this equal to zero for maximisation:

Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle \frac{d \Pi\ }{dQ} = P'(Q).Q + P(Q) - C'(Q)=0}

Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle \frac{d \Pi\ }{dQ} = P'(Q).Q + P(Q)= C'(Q)}

i.e. marginal revenue = marginal cost, provided

Failed to parse (MathML with SVG or PNG fallback (recommended for modern browsers and accessibility tools): Invalid response ("Math extension cannot connect to Restbase.") from server "https://wikimedia.org/api/rest_v1/":): {\displaystyle \frac{d^2 \Pi\ }{dQ^2} = P''(Q).Q + (Q+1).P'(Q) +P(Q) - C''(Q) < 0} (the rate of marginal revenue is less than the rate of marginal cost, for maximisation).

This procedure assumes that the monopolist knows exactly which is the demand function. For a discussion on a monopolist who does not know it, see http://www.economicswebinstitute.org/essays/monopolist.htm where a free software is available as well.

Monopoly and efficiency

In standard economic theory (see analysis above), a monopoly will sell a lower quantity of goods at a higher price than firms would in a purely competitive market. In this way the monopoly will secure monopoly profits by appropriating some or all of the consumer surplus, as although the higher price deters some consumers from purchasing, most are willing to pay the higher price. Assuming that costs stay the same, this does not lead to an outcome which is inefficient in the sense of Pareto efficiency; no-one could be made better off by shifting resources without making someone else worse off. However, total social welfare declines compared with perfect competition, because some consumers must choose second-best products.

It is also often argued that monopolies tend to become less efficient and innovative over time, becoming "complacent giants", because they don't have to be efficient or innovative to compete in the marketplace. Sometimes this very loss of efficiency can raise the potential value of a competitor enough to overcome market entry barriers, or provide incentive for research and investment into new alternatives. The theory of contestable markets argues that in some circumstances (private) monopolies are forced to behave as if there were competition, because of the risk of losing that monopoly to new entrants, or because of the availability in the longer-term of substitutes in other markets. For example, a canal monopoly in the late eighteenth century United Kingdom was worth a lot more than in the late nineteenth century, because of the introduction of railways as a substitute.

Some argue that it can be good to allow a firm to attempt to monopolize a market, since practices such as dumping can benefit consumers in the short term; and once the firm grows too big, it can then be dealt with via regulation. (This is a rather optimistic view of how effectively regulation can substitute for competition.) When monopolies are not broken through the open market, often a government will step in to either regulate the monopoly, turn it into a publicly-owned monopoly, or forcibly break it up (see Antitrust law). Public utilities, often being natural monopolies and less susceptible to efficient breakup, are often strongly regulated or publicly-owned. AT&T and Standard Oil are debatable examples of the breakup of a private monopoly. When AT&T was broken up into the "Baby Bell" components, MCI, Sprint, and other companies were able to compete effectively in the long-distance phone market and started to take phone traffic from the less efficient AT&T.

Historical examples


Until common salt (sodium chloride) was mined in quantity in comparatively recent times, its availability was subject to the vagaries of climate and environment. A combination of strong sunshine and low humidity or an extension of peat marshes was necessary for winning salt from the sea — the most plentiful source — by solar evaporation or boiling. Mines and inland salt springs being scarce and often located in hostile areas like the Dead Sea or the salt mines in the Sahara desert, they required well-organised security for transport, storage and highly monopolised distribution. Changing sea levels flooded many of these sources during certain periods and caused salt "famines" and communities were left to the mercy of those who monopolised these few inland sources. The "Gabelle", a notoriously high tax levied upon salt, resulted in the French Revolution and is possibly the most cruel example in recent history. Anyone was allowed to purchase salt; however, strict legal controls were in place over who was allowed to sell and distribute salt. Advocates of laissez-faire capitalism, such as the Austrian school, maintain that a salt monopoly would never develop without such government intervention.

In economics, a market failure is a situation in which markets do not efficiently organize production or allocate goods and services to consumers (for example, a failure to allocate goods in a way some see as socially or morally preferable). To economists, the term would normally be applied to situations where the inefficiency is particularly dramatic, or when it is suggested that non-market institutions would provide a more desirable result. On the other hand, to many, market failures are situations where market forces do not serve the perceived "public interest". Here, the focus is on the economists' theories of market failure.

Economists use model-like theorems to explain or understand such cases. The two main reasons that markets fail are:

  • the inadequate expression of costs or benefits in prices and thus into microeconomic decision-making in markets.
  • sub-optimal market structures

In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. (It has also been called asymmetrical information and markets with asymmetrical information). Typically it is the seller that knows more about the product than the buyer, however, it is possible for the reverse to be true: for the buyer to know more than the seller.

Examples of situations where the seller usually has better information than the buyer are numerous but include used-car salespeople, stockbrokers, real estate agents, and life insurance transactions.

Examples of situations where the buyer usually has better information than the seller include estate sales as specified in a last will and testament.

This situation was first described by Kenneth J. Arrow in a seminal article on health care in 1963 entitled "Uncertainty and the Welfare Economics of Medical Care," in the American Economic Review.

George Akerlof later used the term asymmetric information in his 1970 work The Market for Lemons. He also noticed that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. It is even possible for the market to decay to the point of nonexistence.

Because of information asymmetry, unscrupulous sellers can "spoof" items (like software or computer games) and defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much for a given item.

An externality occurs in economics when a decision (for example, to pollute the atmosphere) causes costs or benefits to stakeholders other than the person making the decision. In other words, the decision-maker does not bear all of the costs or reap all of the gains from his action. As a result, in a competitive market too much or too little of the good will be consumed from the point of view of society. If the world around the person making the decision benefits more than he does (education, safety), then the good will be underconsumed by individual decision makers; if the costs to the world exceed the costs to the individual making the choice (pollution, crime) then the good will be overconsumed from society's point of view.


External costs and benefits.

To most economists, the problem of an externality usually concerns the results of market activity. Economists see voluntary exchange as mutually beneficial to both parties in an exchange. On the other hand, either the consumption of a product (perfume, nice clothes) or its production may have external effects — as in the diagram. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so free. The left-hand-side of the diagram shows consumption externalities (such as those of perfume), while the right-hand-side shows production externalities (such as those produced by a perfume factory).

From the perspective of a social planner or welfare economics, this will result in an outcome that is not socially optimal. From the perspective of anybody affected by the externality, it is either a negative factor in their lives (as with obnoxious smell or pollution) or a boon (as with the other's pretty clothes). In the first case, the person who is affected by the negative externality (air pollution) will likely see it as violating his freedom to breathe freely. It might even be seen as trespassing on their lungs, violating their property rights. Thus, an external cost can easily pose an ethical or political problem. Alternatively, it might be seen as a case of poorly-defined property rights.

An external benefit, on the other hand, may increase the availability of choices for — and thus the amount of freedom of — the beneficiaries with no cost to them. (In effect, it's a "free lunch" for them.) They may thus resist the ending of such beneficial externalities along with any associated inefficiencies.

The value of the effects of the externality are likely not something that can be easily calculated in a technocratic way by economists or social planners, since they reflect the ethical views and preferences of the entire population. Instead, for countries believing in popular sovereignty, some sort of democratic method is needed to attach values to the external costs and benefits.

Sometimes, laissez-faire economists such as Friedrich von Hayek and Milton Friedman refer to externalities as "neighborhood effects" or "spillovers". But it should not be thought that all externalities are small, spilling over only in the "neighborhood." For example, the burning of fossil fuels affects the entire "neighborhood" of the Earth, and according to many encouraging global warming.

Going outside the broadly-defined liberal political tradition, Marxists see externalities of all sorts (including pecuniary ones – see below) as ubiquitous, the rule rather than the exception. Production is socialized or totally interdependent. On the other hand, under capitalism, property rights, the appropriation of income, and the making of economic decisions are largely individualized. In order to solve this contradiction between socialized production and individual decision-making, Marxists often call for democratic economic planning, as a key part of socialism.(cf. Frederick Engels, "Socialism: Utopian and Scientific")

Types of externalities

Examples of these kinds of externalities include:

  • Pollution by a firm in the course of its production which causes nuisance or harm to others. This is an example of a negative externality, external cost, or external diseconomy.
  • In a business trying to cut costs, the mail department asks each employee to pick up their own mail from the mailroom. The mail department decreases its costs, but the company suffers inefficiency. The employees' extra time is the mailroom's external cost.
  • The harvesting by one fishing company in the open sea depletes the stock of available fish for the other companies. Over-fishing may result. This is an example of a common property resource, sometimes referred to as the Tragedy of the commons.
  • An individual planting an attractive garden in front of his house may benefit others living in the area. This is an example of a positive externality, beneficial externality, external benefit, or external economy. Goods with positive externalities are known as Merit goods.
  • An individual buying a picture-phone for the first time will increase the usefulness of such phones to people who might want to call him or her. This may lead to the general acceptance of these phones. This is an example of a network externality.

In contrast:

  • A property tycoon buying up a large number of houses in a town, causing prices to rise and therefore making other people who want to buy the houses worse off (perhaps by excluding them from the housing market), is not causing an externality, because the effect is through prices, and is considered part of the normal functioning of the market. Alternatively, these effects are sometimes called "pecuniary externalities", with externalities as defined above called "technological externalities." This article considers only the latter.

Externalities are important in economics because they may lead to inefficiency (see Pareto efficiency). Because the producers of externalities do not have an incentive to take into account the effect of their actions on others, the outcome will be inefficient. There will be too much activity that causes negative externalities such as pollution, and not enough activity that creates positive externalities, relative to an optimal outcome. As noted, external costs also can imply political conflicts, rancorous lawsuits, and the like. This may make the problem of externalities too complex for the concept of Pareto optimality to handle.

Many of the most important externalities in the economy are concerned with pollution and the environment. See the article on environmental economics for more discussion of externalities and how they may be addressed in the context of environmental issues.

Externalities in supply and demand

The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the externality can be monetized (valued in terms of money). An extra supply or demand curve is added, as in the diagrams below. One of the curves is the private cost that consumers pay as individuals for additional quantities of the good (in competitive markets, the marginal private cost) and the other curve is the true cost that society as a whole pays for production and consumption of increased production the good (the marginal social cost).

Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as effective demand in the market.

Negative externalities

The graph below shows the effects of a negative externality. For example, the steel industry is assumed to be selling in a competitive market – before pollution-control laws were imposed and enforced (e.g. under laissez-faire). The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the cost of the smoking stacks and water pollution. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit.

File:Negative externality.jpg
Supply & Demand with external costs

If the consumers only take into account their own private cost, they will end up at price Pp and quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased only as long as the marginal social benefit exceeds the marginal social cost. The result is that a free market is inefficient since at the quantity Qp, the social benefit is less than the societal cost, so society as a whole would be better off if the goods between Qp and Qs had not been produced. The problem is that people are buying and consuming too much steel.

This discussion implies that pollution is more than merely an ethical problem; it is more than just "greedy" (profit-maximizing) firms. The problem is one of the disjuncture between marginal and social costs that is not solved by the free market. There is a problem of societal communication and coordination to balance benefits and costs. This discussion also implies that pollution is not something solved by competitive markets. In fact, a monopoly might be able to use some of its excess profits to be benevolent and internalize the externality (pay the cost of the pollution). More likely, a monopoly would artificially restrict the quantity supplied in order to maximize profits. This would actually benefit society in this situation because it would mean less pollution than in the competitive case. Perfectly competitive firms have no choice but to produce according to market incentives (private costs): if one decides to internalize external costs, it implies higher costs than those of competitors and likely exit from the market. So some collective solution is needed, e.g., government intervention banning or discouraging pollution (by means of economic incentives such as taxes), or an alternative economy such as participatory economics.

Beneficial externalities

The graph below shows the effects of a positive or beneficial externality. For example, the industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit of getting the vaccination is less than the marginal social or public benefit by the amount of the external benefit, i.e., the fact that if one person gets the vaccination, others are less likely to get the smallpox even if they themselves are not vaccinated. This marginal external benefit of getting a smallpox shot is represented by the vertical distance between the two demand curves. Assume that there are no external costs, so that social cost equals individual cost.

Supply & Demand with external benefits

If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity Qs. These latter again reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered market is inefficient since at the quantity Qp, the social benefit is greater than the societal cost, so society as a whole would be better off if more goods had been produced. The problem is that people are buying too few vaccinations.

The issue of external benefits is related to that of public goods, i.e., goods where it is difficult if not impossible to exclude people from benefits. The production of a public good has beneficial externalities for all (or almost all) of the public. As with external costs, there is a problem here of societal communication and coordination to balance benefits and costs. This also implies that pollution is not something solved by competitive markets. The government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If the government does this, the good is called a merit good.

Externalities and the Coase theorem

Ronald Coase argued that individuals could organise bargains so as to bring about an efficient outcome and eliminate externalities without government intervention. The government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the "Coase Theorem," requires that

  1. Property rights are well defined;
  2. the number of people involved is small; and
  3. bargaining costs are very small.

Only if all three of these apply will individual bargaining solve the problem of externalities.

Thus, this theorem does not apply to the steel industry case discussed above. For example, with a steel factory that trespasses on the lungs of a large number of individuals with its pollution, it is difficult if not impossible for any one person to negotiate to be compensated for this transgression. It may extremely expensive even for all individuals to negotiate with the steel firm, especially since some individuals may be tempted to be "free riders," benefiting from the negotiations without paying any costs. Thus, most economists see the need for government to be involved with big external costs, to regulate the firm while paying for the regulation with taxes.

The case of the vaccinations also does not fit with the Coase Theorem. The firms of the vaccination industry would have to get together to bribe large numbers of people to have their shots. Individual firms would be tempted to "free ride" and not pay the cost of these bribes. In many cases, it is simpler to involve the government.

This does not say that the Coase theorem is totally irrelevant. For example, if a logger is planning to clear-cut a forest in a way that has a negative impact on the nearby resort, it is quite possible that the resort-owner and the logger could get together to agree to a deal. For example, the resort-owner could pay the logger not to clear-cut -- or could buy the forest. In terms of the examples that started this entry, telling someone that her perfume is offensive may easily lead to its being replaced, while praising the clothes of the fancy dresser may encourage the wearing of similar clothes in the future. Of course, none of these bargains may work out as well as desired.

Also, the central government may not be needed. Traditional ways of life may have evolved as ways to deal with external costs and benefits. Alternatively, democratically-run communities can agree to deal with these costs and benefits in an amicable way.

A tax is a compulsory charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (e.g., tribes, secessionist movements or revolutionary movements). Taxes could also be imposed by a subnational entity.

Taxes may be paid in cash or in kind or as corvée labor. In modern capitalist taxation systems, taxes are designed to encourage the most efficient circulation of commodified goods and services and are levied in cash. In kind and corvee taxation are characteristic of traditional or pre-capitalist states and their functional equivalents. The means of taxation, and the uses to which the funds raised through taxation should be put, are a matter of hot dispute in politics and economics, so discussions of taxation are frequently tendentious.

Public finance is the field of political science and economics that deals with taxation.

A history of taxation

Political authority has been used to raise capital throughout history. In many pre-monetary societies, such as the Incan empire, taxes were owed in labor. Taxation in labour was the basis of the Feudal system in medieval Europe. King Solomon of the Old Testament pointed to the need for taxes to be applied for civil purposes (1 Kings 4:7; 9:15; 12:4), and these amounts were increased during times of foreign occupation.

In more sophisticated economies such as the Roman Empire, tax farming developed, as the central powers could not practically enforce their tax policy across a wide realm. The tax farmers were obligated to raise large sums for the government, but were allowed to keep whatever else they raised. Many Christians have understood the New Testament to support the payment of taxes, through Jesus's words "Render unto Caesar the things that are Caesar's". It is even recognized as a duty whether as a "telos" on merchandise or travelers (Matthew 17:25), an annual "phoros" on property tax (Luke 20:22;23:2), a "kensos" or poll tax (Matthew 22:17, Mark 12:14), or the tribute money of a temple-tax (Matthew 17:24-27). Other Christians, such as Christian anarchists, hold a contrary interpretation.

There were certain times in the Middle Ages where the governments did not explicitly tax, since they were self supporting, owning their own land and creating their own products. The appearance of doing without taxes was however illusory, since the government's (usually the Crown's) independent income sources depended on labour enforced under the feudal system, which is a tax exacted in kind.

Many taxes were originally introduced to fund wars and are still in place today, such as those raised by the American government during the American Civil War (1861-1865) and the telephone tax instigated at the start of World War I (War Tax Revenue Act of 1914). Income tax was first introduced into Britain in 1798 to pay for weapons and equipment in preparation for the Napoleonic wars and into Canada in 1917 as a "temporary" tax under the Income War Tax Act to cover government expenses resulting from World War I.

Purposes and effects of taxation

Funds provided by taxation have been used by states and their functional equivalents throughout history to carry out the functions such as:

Most modern governments also use taxes to fund welfare and public services, such as:

Colonial states and moderning states have also used cash taxes to draw or force reluctant subsistence producers into cash economies.

Governments use different kind of taxes and vary the tax rates:

  • to distribute the tax burden between individuals or classes of the population involved in taxable activities, such as business,
  • to redistribute resources between individuals or classes in the population. Historically, the nobility were supported by taxes on the poor; modern social security systems are intended to support the poor, the disabled or the retired by taxes on those who are still working,
  • to influence the macroeconomic performance of the economy (the government's strategy for doing this is called its fiscal policy) (see also tax exemption),
  • to modify patterns of consumption or employment within an economy, by making some classes of transaction more or less attractive.

The resource taken from the public through taxation is always somewhat greater than the amount which can be used by the government. The difference is called compliance cost, and includes for example the labour cost and other expenses incurred in complying with tax laws and rules.

The collection of a tax in order to spend it on a specified purpose, for example collecting a tax on alcohol to pay directly for alcoholism rehabilitation centres, is called hypothecation. This practice is often disliked by finance ministers, since it reduces their freedom of action. Some economic theorists consider the concept to be intellectually dishonest since in reality money is fungible. Furthermore, it often happens that taxes or excises initially levied to fund some specific government programs are then later diverted to the government general fund. In some cases, such taxes are collected in fundamentally inefficient ways, for example highway tolls.

Some economists, especially neo-classical economists argue that all taxation distorts the market and results in economic inefficiency. They have therefore sought to identify the kind of tax system that would minimise this distortion. A theory is that the most economically neutral tax is a tax on land. A government's primary duty is to maintain and defend title to land, and therefore it should collect most of its revenues for this unique service. Since governments also resolve commercial disputes, especially in countries with common law, this doctrine is often used to justify a sales tax or value added tax. Others (e.g. libertarians) argue that most or all forms of taxes are immoral due to their involuntary (and therefore eventually coercive/violent) nature. The most extreme anti-tax view is anarcho-capitalism, in which the provision of all social services should be a matter of voluntary private contracts.

Tax rates

Taxes are most often levied as a percentage, called the tax rate, of a certain value, the tax base (how much income and assets one has, earns, spends, inherits, etcetera). An ad valorem tax is one where the tax base is the value of a good, service, or property. Sales taxes, tariffs, property taxes, inheritance taxes, and value added taxes are different types of ad valorem tax. An ad valorem tax is typically imposed at the time of a transaction (sales tax or value added tax (VAT)) but it may be imposed on an annual basis (property tax) or in connection with another significant event (inheritance tax or tariffs). An alternative to ad valorem taxation is an excise tax, where the tax base is the quantity of something, regardless of its price: for example, in the United Kingdom, a tax is collected on the sale of alcoholic drinks that is calculated by volume and beverage type rather than the price of the drink.

An important distinction when talking about tax rates is to distinguish between the marginal rate and the average rate. The average rate is the total tax paid divided by the total amount the tax is paid on, while the marginal rate is the rate paid on the next dollar of income earned. In a [progressive] tax system, these can be very different. For example, if income is taxed on a formula of 5% from $0 up to $49,999, 10% from $50,000 to $99,999, and 15% over $100,000, a taxpayer with income of $175,000 would pay a total of ((.05*50,000)+ (.10*50,000) + (.15*75,000)), or $18,750. His average rate would be 10.7%, but his marginal rate would be 15%.

Progressive and regressive taxation

An important feature of tax systems is whether they are flat (the percentage does not depend on the base, hence the tax is proportional to how much you earn, have, or spend), regressive (the more you have the lower the tax rate), or progressive (the more you have the higher the tax rate). Progressive taxes reduce the tax burden of people with smaller incomes, since they take a smaller percentage of their income. Regressive taxes are less common but not unknown.

Direct and indirect taxation

Taxes are sometimes referred to as direct or indirect. The meaning of these terms can vary in different contexts, which can sometimes lead to confusion. In economics, direct taxes refer to those taxes that are collected from the people or organizations on whom they are ostensibly imposed. For example, income taxes are collected from the person who earns the income. By contrast, indirect taxes are collected from someone other than the person ostensibly responsible for paying the taxes.

From whom a tax is collected is a matter of law. However, who pays the tax is determined by the market place and is found by comparing the price of the good (including tax) after the tax is imposed to the price of the good before the tax was imposed. For example, suppose the price of gas in the U.S., without taxes, were $2.00 per gallon. Suppose the U.S. government imposes a tax of $0.50 per gallon on the gas. Forces of demand and supply will determine how that $0.50 tax burden is distributed among the buyers and sellers. For example, it is possible that the price of gas, after the tax, might be $2.40. In such a case, buyers would be paying $0.40 of the tax while the sellers would be paying $0.10 of the tax.

In law, the terms may have different meanings. In US constitutional law, for instance, direct taxes refer to poll taxes and property taxes, which are based on simple existence or ownership. Indirect taxes are imposed on rights, privileges, and activities. Thus, a tax on the sale of property would be considered an indirect tax, whereas the tax on simply owning the property itself would be a direct tax.

The distinction can be subtle, but it is important under US law, since the United States Constitution formerly required that direct taxes be apportioned according to population. That is, if one state had twice the population of another state, then the direct tax revenue from that state must be exactly twice that from the other state. In 1895, the US Supreme Court interpreted the income tax as a direct tax when applied to income from property, and struck down the tax as a result. The federal government then had no income tax until the Sixteenth Amendment was ratified, which removed the apportionment requirement for income taxes.

Economics of taxation

Figure 1: Equilibrium

Figure 1 indicates a good without any government interference. This good could represent anything from apples to zippers. At this equilibrium quantity Q1 of the good are sold at price P1. The consumer and producer surplus are both high.

Figure 2: With a tax

Figure 2 shows the introduction of a very simple tax. The tax charges a flat fee whenever a consumer wishes to purchase the good. The price thus rises to P2, and since fewer consumers wish to purchase the good at the higher price, the quantity produced falls to Q2. The government receives the amount of the tax for each unit sold, and this amounts to the region shown in grey. This is the amount of revenue the government receives for this tax.

Note that in this situation the price of the good to consumers only increases by half the amount of the tax, the other half of the tax is borne by the producer. Thus both consumer and producer surpluses shrink by equal amounts. For many goods this is not the case. Who bears the cost of the tax is determined by the elasticity of the good. For inelastic goods like cigarettes, and gasoline almost all of the tax is paid by the consumer.

Figure 3: Net Societal Loss

The tax is not a simple transfer of wealth from producers and consumers to government. A permanent loss of surplus occurs, shown in orange. This loss is often called dead weight loss which is is a permanent loss to sociey as if some of the goods (Q1 to Q2) were destroyed.

However, because this model greatly simplifies the economics of taxation, governments must weigh many other factors when choosing a tax system. The size of the dead weight loss usually increases exponentially with regards to the size of the tax meaning a broad small tax (sales tax) would normally have less negative impact than a narrow large tax (taxing a particular good heavily).

Types of taxes

Income tax

Income tax is commonly a progressive tax because the tax rate increases with increasing income. For this reason, it is generally advocated by those who think that taxation should be borne more by the rich than by the poor, even to the point of serving as a form of social redistribution. Some critics characterize this tax as a form of punishment for economic productivity. Other critics charge that income taxation is inherently socially intrusive because enforcement requires the government to collect large amounts of information about business and personal affairs, much of which is considered proprietary and confidential.

The crucial invention permitting the reliable collection of high income taxes was direct withholding of taxes from payrolls by employers; this works because most people in modern societies are salaried workers. This reduces the perceived burden of the tax, because employees never handle the money. Direct withholding also discourages cheating, because it requires the collaboration of employers, and as there are fewer employers than employees, the government's enforcement efforts can be deployed more effectively. However, direct withdrawal also has some drawbacks: it puts part of the burden of processing taxes on the employer, and it also complicates matters when the employee is in a situation where he or she should pay significantly less or more than what is expected from its salary (because of tax-deductible expenses, or side revenues). Direct withholding is the method of collection of choice in most countries implementing income taxes, with the exception of France, where direct withholding is periodically discussed, but has so far not been implemented.

Where income tax is not collected at source, it may become easier to cheat by lying about one's affairs. The government may then require that employers report the amounts they pay to employees.

Income tax, in addition to income, generally takes into account a variety of factors. Certain expenses, such as work-related expenses, donations to charities etc..., may be tax-deductible: that is, they are subtracted from the taxable revenue. Investments in some impoverished areas or industrial sectors may be encouraged through tax breaks (reduced rates). Donations to charities may be partly subtracted from the tax, in an original form of subsidy. Because of various exemptions, rebates etc..., income tax codes tend to be complicated. In some countries such as the United States, individuals often hire the service of a tax accountant so as to find the best way to reduce their tax.

Income tax fraud is a problem in most, if not all, countries implementing an income tax. Either one fails to declare income, or declares nonexistent expenses. Failure to declare income is especially easy for non-salaried work, especially those paid in cash. Tax enforcement authorities fight tax fraud using various methods, nowadays with the help of computer databases. They may, for instance, look for discrepancies between declared revenue and expenses along time. Tax enforcement authorities then target individuals for a tax audit – a more or less detailed review of the income and tax-deductible expenses of the individual.

Income tax may be collected from legal entities (e.g., companies) as well as natural persons (individuals), although, in some cases, the income tax on legal entities is levied on a slightly different basis than the income tax on individuals and may be called, in the case of income tax on companies, a corporation tax or a corporate income tax.

Retirement tax

Some countries with social security systems, which provide income to retired workers, fund those systems with specific dedicated taxes. These often differ from comprehensive income taxes in that they are levied only on specific sources of income, generally wages and salary (in which case they are called payroll taxes). A further difference is that the total amount of the taxes paid by or on behalf of a worker is typically considered in the calculation of the retirement benefits to which that worker is entitled. Examples of retirement taxes include the FICA tax, a payroll tax that is collected from employers and employees in the United States to fund the country's Social Security system; and the National Insurance Contributions (NICs) collected from employers and employees in the United Kingdom to fund the country's national insurance system.

These taxes are sometimes regressive in their immediate effect. For example, in the United States, each worker, whatever his or her income, pays at the same rate up to a specified cap, but income over the cap is not taxed. A further regressive feature is that such taxes often exclude investment earnings and other forms of income that are more likely to be received by the wealthy. The regressive effect is somewhat offset, however, by the eventual benefit payments, which typically replace a higher percentage of a lower-paid worker's pre-retirement income.

Capital gains tax

A capital gain tax is the tax levied of the profit realised upon the sale of an asset. In many cases, the amount of a capital gain is treated as income and subject to the marginal rate of income tax.

If such a tax is levied on inherited property then it can act as a de facto probate or inheritance tax.

Corporation tax

Corporation tax is a tax on corporate earnings (and often includes capital gains) of a company. Earnings are generally considered gross revenue less expenses. However, corporate expenses that relate to capital expenditures are rarely deducted in full (such as the entire cost of a company truck) and are often deducted over the useful life of the asset purchase. Generally, industrialized countries also use a regressive rate of tax upon corporate income.

Poll tax

A poll tax, also called a per capita tax, or capitation tax, is a tax that levies a set amount per individual. The earliest tax mentioned in the Bible of a half-shekel per annum from each adult Jew (Ex. 30:11-16) was a form of poll tax. Poll taxes are regressive, since they take the same amount of money (and hence, a higher proportion of income) for poorer individuals as for richer individuals. Poll taxes are difficult to cheat.


Unlike an ad valorem tax, an excise is not a function of the value the product being taxed. Excise taxes are based on the quantity, not the value, of product purchased. For example, in the United States, the Federal government imposes an excise tax of 18.4 cents per US gallon (4.86 ¢/L) of gasoline, while state governments levy an additional 8 to 28 cents per US gallon.

Purposes and effects of excises

Excises on particular commodities are frequently hypothecated. For example, a fuel excise is often used to pay for public transportation, especially roads and bridges and for the protection of the environment. A special form of hypothecation arises where an excise is used to compensate a party to a transaction for alleged uncontrollable abuse: for example, a blank media tax is a tax on recordable media such as CD-Rs, whose proceeds are typically allocated to copyright holders. Critics charge that such taxes tax blindly those who make legitimate and illegitimate usages of the products; for instance, a person or corporation using CD-R's for data archival should not have to subsidize the producers of popular music.

Excises (or exemptions from them) are also used to modify consumption patterns. For example, a high alcohol excise is used to discourage alcohol consumption, relative to other goods. This may be combined with hypothecation if the proceeds are then used to pay for the costs of treating illness caused by alcohol abuse. Similar taxes may exist on tobacco, pornography, etc..., and they may be collectively referred to as sin taxes. A carbon tax is a tax on the consumption of carbon-based non-renewable fuels, such as petrol, diesel-fuel, jet fuels and natural gas. The object is to reduce the release of carbon into the atmosphere. In the UK, vehicle excise duty is an annual tax on vehicle ownership.

Sales tax

Sales taxes are a form of excise levied when a commodity is sold to its final consumer. They are generally held to discourage retail sales. The question of whether they are generally progressive or regressive is a subject of much current debate. People with higher incomes spend a lower proportion of them, so a flat-rate sales tax will tend to be regressive. It is therefore common to exempt food, utilities and other necessities from sales taxes, since poor people spend a higher proportion of their incomes on these commodities, so such exemptions would make the tax more progressive. The classic way of cheating on sales tax is to ask a merchant or service provider for a cash discount. The merchant pockets the cash and writes off the merchandise to shrinkage and the state fails to get the tax.


An import or export tariff (also called customs duty or impost) is a charge for the movement of goods through a political border. Tariffs discourage trade, and they may be used by governments to protect domestic industries. A proportion of tariff revenues is often hypothecated to pay government to maintain a navy or border police. The classic way of cheating a tariff is smuggling.

Value added tax

A value added tax (sometimes called a goods and services tax, as in Australia and Canada) applies the equivalent of a sales tax to every operation that creates value. To give an example, sheet steel is imported by a machine manufacturer. That manufacturer will pay the VAT on the purchase price, remitting that amount to the government. The manufacturer will then transform the steel into a machine, selling the machine for a higher price to a wholesale distributor. The manufacturer will collect the VAT on the higher price, but will remit to the government only the excess related to the "value added" (the price over the cost of the sheet steel). The wholesale distributor will then continue the process, charging the retail distributor the VAT on the entire price to the retailer, but remitting only the amount related to the distribution markup to the government. The last VAT amount is paid by the eventual retail customer who cannot recover any of the previously paid VAT. Economic theorists have argued that this minimises the market distortion resulting from the tax, compared to a sales tax. However, VAT is held by some to discourage production.

VAT was historically used when a sales tax or excise tax was uncollectible. For example, a 30% sales tax is so often cheated that most of the retail economy will go off the books. By collecting the tax at each production level, and requiring the previous production level to collect the next level tax in order to recover the VAT previously paid by that production level, the theory is that the entire economy helps in the enforcement. In reality, forged invoices and the like demonstrate that tax evaders will always attempt to cheat the system.

Property taxes

A property tax is usually levied on the value of property owned, usually real estate. Property taxes may be charged on a recurrent basis, or upon a certain event.

A common type of property tax is an annual charge on the ownership of real estate, where the tax base is the supposed value of the property. For a period of over 150 years from 1695 a window tax was levied in England, with the result that you can still see listed buildings with windows bricked up [1] in order to save their owner's money. A similar tax existed in France, with similar results.

The two most common type of event driven property taxes are stamp duty, charged upon change of ownership, and inheritance tax, which is imposed in many countries on the estates of the deceased.

In contrast with a tax on real estate, a land value tax is levied only on the unimproved value of the land.

When real estate is held by a higher government unit or some other entity not subject to taxation by the local government, the taxing authority may receive a payment in lieu of taxes to compensate it for some or all of the foregone tax revenue.

Transfer taxes

Historically, in many countries, a contract needed to have a stamp affixed to make it valid. The charge for the stamp was either a fixed amount or a percentage of the value of the transaction. In most countries the stamp has been abolished but stamp duty remains. Stamp duty is levied in the UK on the purchase of shares and securities, the issue of bearer instruments, and certain partnership transactions. Its modern derivatives, stamp duty reserve tax and stamp duty land tax, are respectively charged on transactions involving securities and land. Stamp duty has the effect of discouraging speculative purchases of assets by decreasing liquidity. Taxes on currency transactions are known as Tobin taxes.

See also: transfer tax, stamp duty

Inheritance tax

Some believe that inheritance taxes do not have any harmful effect on the economy and may even be beneficial as they encourage consumer spending by the elderly. However, they are also believed to discourage productivity and to disrupt the continuity of family-owned businesses.

See also: allodial, death tax, estate tax, Pigovian tax

Wealth (net worth) tax

Main article: wealth (net worth) tax

Some countries' governments will require declaration of the tax payers' balance sheet (assets and liabilities), and from that ask for a tax on net worth (assets minus liabilities), as a percentage of the net worth, or a percentage of the net worth exceeding a certain level. The tax is in place for both "natural" and in some cases legal "persons".

Personal property tax

In many jurisdictions (including many American states), there is a general tax levied periodically on residents who own personal property within the jurisdiction. Vehicle and boat registration fees are subsets of this kind of tax.

Usually, the tax is designed with blanket coverage but with large exceptions for obvious things like food and clothing. Household goods are exempt as long as they are kept or used within the household. However, any otherwise non-exempt object can lose its exemption if regularly kept outside the household. Thus, tax collectors often monitor newspaper articles for stories about wealthy people who have lent art to museums for public display, because the artworks have then become subject to personal property tax. And if an artwork had to be sent to another state for some touch-ups, it may have become subject to personal property tax in that state as well.

Who pays

In the United States, the Congressional Budget Office produces a number of reports on the share of all federal taxes paid by taxpayers of various income levels. Their data for 2002 shows the following: (Table 2)

  • The top 1% of taxpayers by income pay 33% of all individual income taxes, and 22.7% of all federal taxes.
  • The top 5% of taxpayers pay 54.5% of all individual income taxes, and 38.5% of all federal taxes.
  • The top 10% of taxpayers pay 67.4% of all individual income taxes, and 50% of all federal taxes.
  • The top quintile pays 82.5% of all individual income taxes, and 65.3% of all federal taxes.

Their numbers also show, that when broken down by quintile, the social insurance taxes are regressive on an effective tax rate basis only for the highest quintile, though that quintile pays the largest share of social insurance taxes (44%). (Table 1)

Historical taxation levels

Quite a few records of the government tax collection in Europe since at least the 17th century are still available today. But the taxation levels are hard to compare to the size and flow of the economy since production numbers are not as readily available. The government expenditures and revenue in France during the 17th century went from about 20 million livres in 1600 to about 60 million livres in 1650 to about 150 million livres in 1700 when the government debt had reached 1.6 billion livres.

The taxation as a percentage of production of final goods may have reached 15%-20% during the 17th century in places like, France, the Netherlands, and Scandinavia. During the war filled years of the eighteenth and early nineteenth century tax rates in Europe increased dramatically as war became more expensive and governments became more centralized and adept at gathering taxes. This increase was greatest in England, Peter Mathias and Patrick O'Brien found that the tax burden increased by 85% over this period. Another study confirmed this number, finding that per capita tax revenues had grown almost six-fold over the eighteenth century, but that steady economic growth had made the real burden on each individual only double over this period before the industrial revolution. Average tax rates were higher in Britain than France the years before the French Revolution, but they were mostly placed on international trade. In France the taxes were lower but the burden was mainly on landowners, individuals, and internal trade and thus created far more resentment.

Taxation as a percentage of GDP is today (2003) 56.1% in Denmark, 54.5% in France, 49.0% in the Euro area, 42.6% in the United Kingdom, 35.7% in the United States, 35.2% in The Republic of Ireland, and among all OECD members an average of 40.7%. (OECD national accounts) (Forbes magazine)

Historical forms of taxation

In monetary economies prior to fiat banking, a critical form of taxation was seigniorage, the tax on the creation of money. Seigniorage has been replaced by central banking.

Other obsolete forms of taxation include:

  • scutage - paid in lieu of military service; strictly speaking a commutation of a non-tax obligation rather than a tax as such, but functioning as a tax in practice
  • tallage - a tax on feudal dependents
  • tithe - a tax, or more precisely a tax-like payment, (one tenth of one's earnings or agricultural produce), paid to the Church (and thus too specific to be a tax in strict technical terms even though appearing as one to the payer)
  • Aids - During feudal times Aids was a type of tax or due paid by a vassal to his lord.
  • Danegeld - medieval land tax originally raised to pay off raiding Danes and later used to fund military expenditures.
  • Carucate - tax which replaced the danegeld in England.
  • Tax Farming - the principle of assigning the responsibility for tax revenue collection to private citizens or groups.

Some principalities taxed windows, doors or cabinets to reduce consumption of imported glass and hardware. Armoires, hutches and wardrobes were invented to evade taxes on doors and cabinets.

Today the most complicated taxation-system is the German one. Three quarters of the world's taxation-literature refers to the German system. There are 118 laws, 185 forms and 96000 regulations (only one comment to taxation covers 2671 pages). The administration spends 3.7 billion Euro just to collect income tax.

Morality of taxation

Many say that activities funded by taxes are beneficial to society and that progressive taxation used in most modern countries is a net benefit to the majority of the population. Others disagree. But as payment of tax is not optional, some people hold that taxation is tantamount to theft. This view is most common among political schools of thought such as libertarianism and anarcho-capitalism, which accuse governments of levying taxes through a system of coercion. However most libertarians, particularly minarchists, recommend taxation as a necessary evil as long as only enough money is taken as is necessary for a government to maximize the protection of liberty.

Many maintain that taxation is not theft since government is the party performing the act, and moreover that if there is a democracy in place, then it is society as a whole that decides (through the government) what the level and form of taxation is. The American Revolution's "No taxation without representation" slogan took this view. Others assert that the moral stature of any act, such as slavery or the taking of a person's property without his consent, is not contingent upon its legality or who is performing it or whether a majority approves of it.

There are several justifications that are offered for compulsory taxation. Taxation of business is justified with the claim that business necessarily involves use of publicly established and maintained economic infrastructure, and businesses are in effect charged for this use. Compulsory taxation of individuals, such as income tax, is based on similar arguments to those for universality of law, territorial sovereignty, and the social contract.

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