1 economics 516 fall 2005 dan goldhaber. 2 chapters 1 and 2: introduction and review of supply and...
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Economics 516
Fall 2005
Dan Goldhaber
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Chapters 1 and 2: Introduction and Review of Supply and Demand
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Why Study Economics?• Economic concepts and training help to sharpen thinking about:– Relevant alternatives– Under what conditions market interventions are likely to be useful– Policy options, effects, and implications
• Many of the simplifications (e.g. human behavior) used in economic theory are useful for clarification of complex issues
• Some of the types of questions economics can help answer:
– Would rent control result in more affordable rental units?– How much should water cost?– What should bus fares be (and should they cover the full cost)?– What is the underlying assumption about a society that opts to provide food stamps instead of cash assistance?
– Why does I-5 get so congested?
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Thinking Like An Economist
• Economics - The study of the allocation of scarce resources– Basic assumption is that people are reasonably rational and seek to maximize utility
– Exchanges take place (assuming no duress) because they make individuals better off
– Positive and normative analyses - economics is useful in making positive, but not for normative, assessments
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Costs• Opportunity costs consist of the value of our best forgone alternative action.– Every action we take has an associated opportunity cost because we could be doing something else.• Example: The cost of enrolling in the MPA program includes tuition, fees, etc., but also the lost wages we would have earned if we would have worked instead of attending.
– Opportunity costs = explicit (monetary) costs + implicit (time) costs
• Sunk costs are costs that already have been incurred and cannot be recovered regardless of any action we may take.
• Example: If you spent $1000 repairing your radiator last week and this week you total your car, you wish you wouldn’t have just spent that money last week but there’s nothing you can do to recover it.
• Marginal costs are costs that depend on the next action taken
• Example: You are trying to decide whether to go to a movie or to spend those two hours captivated by your economics text.
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Is Economic Theory Perfect?
• Basic assumption is that market participants are goal oriented (utility maximization), but:
• No, people don’t always function like “Homo Economicus”:– E.g. tipping on the road, contribution to charities, etc.
• But, the Homo Economicus caricature does help us understand economic systems, and most people do function with a degree of self-interest– Seemingly selfless behavior may also be in one’s self interest
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Limitations of Rational Consumer Model
• Time preferences
• Independence of utility
• Imperfect information
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Supply and Demand
• Law of demand - observation that people demand more of a product when the price of that product is lower, ceteris paribus– Demand curves therefore have a negative slope
• Law of supply - observation that firms will produce and offer more of a product when the price of that product is higher– Supply curves therefore have a positive slope
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Market Equilibrium
• The intersection of demand and supply curves determine the equilibrium price and quantity in the market– Price does not determine supply and demand in the market, rather it is supply and demand that determine price (in the absence of any intervention)
– Prices set above equilibrium lead to excess supply, and those set below equilibrium lead to excess demand
• Prices serve as a signal in the market for rationing and allocating goods– In the short run price directs resources/products to those who value them most (are willing to pay) - rationing function
– In the long run price acts to direct resources away from production of less desirable goods towards those more in demand
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Shifts vs. Movements of Supply and Demand Curves
Shifts of demand curve• Income• Prices of substitutes or complements
• Tastes/preferences• Population• Expectations
Shifts of supply curve• Technology• Input/factor prices• Number of suppliers• Natural conditions (weather)
• Expectations
• Shift of supply curve is movement along the demand curve• Shift of demand curve is movement along the supply curve
Learn the differences between changes in demand/supply and changes in quantity demanded/supplied!
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Market Equilibrium
Supply Shift Demand Shift
Q
P
Q
Ps0
s1
d0
d1
s
d
p1
p0
Q0 Q1
p0
p1
Q0 Q1
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Elasticity• Price elasticity of demand is a measure of how sensitive consumers are to changes in price, p = %Q/%P
= (Qd/Q)/ (P/P)– Three measures of price elasticity:
• Elastic, p > 1• Inelastic, p < 1• Unit elastic, p = 1
– Elasticities vary among goods– Elasticity is key to determining who pays for taxes/shifts in demand/supply curves
• Price elasticity of supply is a measure of the responsiveness of quantity supplied to changes in price
• Income elasticity of demand is a measure of how responsive consumers are to changes in income
• Cross-price elasticity of demand is a measure of how much a change in the price of good X affects the demand for good Y
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Consumer Surplus
• The differential between what one was willing to pay for a purchase and what one actually had to pay for that purchase
P*
Q
PConsumer’s surplus
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What Do We Know About Equilibrium Price/Quantity
When Things Change?• If only one curve - the supply or the demand - shifts, we can tell what happens to both equilibrium price and quantity (i.e. they go up/down)
• If both supply and demand shift in the same direction, we can tell what happens to equilibrium quantity but not to equilibrium price
• If both supply and demand shift in opposite directions, we can tell what happens to equilibrium price but not to equilibrium quantity
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The Algebra of Supply and Demand
Demand : P 100 20QD
Supply : P = 25 +5QS
100 20QD 25 5QS
EQUILIBRIUM QS QD
100 20Q 25 5Q Q 3
From the Demand and Supply equations:P = 100 - 20(3) = 40P = 25 + 5(3) = 40
(1)
From (1):
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Non-Market Clearing Price Policies
• Price Ceiling: Prices are not allowed to rise above a certain level
• Price ceilings create excess demand, or shortages
• Price Floor: Prices are not allowed to fall below a certain level
• Price floors create excess supply, or surpluses
PriceCeiling
Demand Demand
Supply
Supply
PriceFloor
QdQs QsQd
Shortage
Surplus
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Algebra of Non-Market Clearing Policies
Demand : P 100 20QD
Supply : P = 25 +5QS
• Government imposes P = 30
30 100 20QD QD 3.5
30 25 5QS QS 1
•
QD QS Shortage of 2.5 units
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Chapter 3: Theory of Consumer Behavior
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Indifference Curves and Budget Constraints
• Individuals seek to maximize utility by allocating income across a range of purchases subject to the constraints of their budgets
• Indifference curves represent all the different allocations of purchases where an individual is equally satisfied– Shape of the indifference curves describe whether goods are goods or bads
– We usually assume diminishing marginal utility implies convex indifference curves• Perfect substitutes and perfect complements are special cases
– Intersecting indifference curves represent inconsistent behavior
• Budget constraints determine the allocations of purchases available to consumer and the budget line describes the maximum that can be purchased if consumer expends all his/her income
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Indifference Curves
Convex shape indicates diminishingMRS
U1
U2
U3
Good X
Good Y
Utility increases moving up indifference curves in the northeast direction (U1<U2<U3)
Slope of indifference curves indicatesMRS
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The Marginal Rate of Substitution (MRS)
• The MRS at any point on the IC represents the amount of one good (on the vertical axis) that a consumer is willing to trade for another (the good on the horizontal axis) to make her/him indifferent (same utility function) between two allocations– The absolute value of the the slope of the IC at a given point
• The MRS is (usually) different at different points on the IC because of the law of diminishing marginal utility (marginal utility declines as consumption of a good increases)
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Budget ConstraintsGood Y
Good X
I
Py
I
Px
Intercepts where all income isSpent on one good or the other
Budget line shows all consumption baskets that are possible with the
given income
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Utility Maximization With Constraint
U2
U1
U3
Apples
Oranges
O*
A*
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Perfect Substitutes
U1U2
U3
Land O’ Lakes Butter
Darigold Butter
Note: Indifference curves have a slope of -1 (i.e. a one-to-one trade off)
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Perfect Complements
U1
U2
U3
Left Shoes
Right Shoes
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Effect of a Income Change:
Normal Goods
apples
All other goods
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Effect of a Income Change:
Inferior Goods
Spam
All other goods
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How Much of Each Good Should a Consumer Purchase
to Maximize UtilityApples Oranges
20
35
47
55
61
65
67
Total Utility
Marginal Utility
Marginal Utility/dollar
Total Utility
Marginal Utility
Marginal Utility /dollar
20
15
12
8
6
4
2
15
27
36
39
41
42
42
15
12
9
3
2
1
0
1
2
3
4
5
6
7
10
7.5
6
4
3
2
1
10
8
6
2
1.33
0.67
0
Apples= $2.00/lb
Oranges=$1.50/lb
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The Effect of Changes in Price on DemandApples Oranges
20
35
47
55
61
65
67
Total Utility
Marginal Utility
Marginal Utility/dollar
Total Utility
Marginal Utility
Marginal Utility /dollar
20
15
12
8
6
4
2
15
27
36
39
41
42
42
15
12
9
3
2
1
0
1
2
3
4
5
6
7
8
6
4.8
3.2
2.4
1.6
.8
10
8
6
2
1.33
0.67
0
Apples= $2.50/lb
Oranges=$1.50/lb
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Sample Problem
Assume both demand and supply have constant slopesQuestions:1 What are the demand and supply equations?2 What are the equilibrium quantity and price
levels?3 What are the new equilibriums if the product is
found to be good for your health such that demand at every price increases by 10?
P Qd Qs
40 5 15
20 15 5
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Chapters 4: Individual and Market Demand
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Price-Consumption Curve
10 20
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P=$2P=$3P=$7
7
3
2
10 20
Price
Quantity of butter
butter
margarine
Demand for butter
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Price-Consumptioncurve
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Link Between Indifference Curve Budget Constraint Model and Demand Curve
• The utility-maximizing quantities at each price level trace out the individual’s demand curve
P=$5P=$10P=$15
$5
$10
$15
9 12 15 9 12
15Q Q
P
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From Individual to Market Demand
• Market demand is made up of the sum of individual demands
D1 D2 D3
D4
Total Demand
15 30 25 1080
p p p p p
Q Q Q Q Q
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Income-Consumption and Engel Curves
apples
OrangesIncome
apples
I = 75I = 100
I = 50
1000 2000 2900
50
75
100
1000 2000 2900
Income-ConsumptionCurve
Engel Curve
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Normal and Inferior Goods
• Normal good - one whose quantity demanded rises as income rises
• Inferior good - one whose quantity demanded falls as income rises
Normal good
Inferior goodNormal good
Normal good
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Effect of a Price Change on Utility
• Compensating Variation: The minimum change in income at the new prices that would make the consumer as well off as they were before the price change
• Equivalent Variation: The minimum change in income at the old prices that would make the consumer as well off as they are after the price change
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Compensating Variation
Compensating Variation
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Equivalent Variation
Equivalent Variation
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Income and Substitution Effects
• The total impact of a price change on the demand for a product can be broken into the income and substitution effects– Income effect - the component of the total effect of a price change that results from the associated change in real purchasing power (quasi income)
– Substitution effect - the component of the total effect of a price change that results from the associated change in the relative attractiveness (relative price) of the good in question
• Giffen good is one for which the total effect of a price increase/decrease is to increase/decrease the demand for that good (counter intuitive effect)– Substitution effect is always in the same direction so a Giffen good is a strongly inferior good, so strongly inferior that the income effect is larger than the substitution effect
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Effect of a Price Change: Normal Good
apples
All other goods
Income effect
Substitution effect
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Effect of a Price Change: Inferior Good
Spam
All other goods
Income effectSubstitution
effect
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Effect of a Price Change: Giffen Good
Potatoes
All other goods
Income effect
Substitution effect
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Price Elasticity
• Price elasticity of demand - the percentage change in the quantity demanded that results from a 1 percent change in its price
• Always less than zero by Law of Demand
• The value of price elasticity tells whether demand is elastic, inelastic, or unitary elastic– Elastic– Inelastic– Unitary Elastic
%Q
%P
Q
P
P
Q
1
slope
P
Q 0
1
1
1
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Graphical Depiction of Price Elasticity
10
9
2
1
1 2 9 10
1 Q
P
P
Q
(2 1)
(9 10)
9
2
9
2
2 Q
P
P
Q
(10 9)
(1 2)
2
9
2
9
Elastic
Inelastic
Price
Quantity
demand
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Elasticity Along a Demand Curve
Elastic
Inelastic
Price
Quantity
demand
Unitary Elastic
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Other Elasticities
• Income elasticity of demand - the percentage change in the quantity demanded that results from a 1 percent change in income (Y)
• Cross-price elasticity - the percentage change in the demand for good X that results from a 1 percent change in the price of good Y
%Q
%Y
Q
Y
Y
Q
xy %Qx
%Py
Qx
Py
Py
Qx
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What Determines Price Elasticities
• Substitution possibilities - greater number of substitutes makes goods more elastic
• Budget share - greater share of expenditures accounted for by the product, the more elastic
• Direction of income effect - normal goods will have higher price elasticities than inferior goods b/c the income effect reinforces the substitution effect
• Time - the longer the time period in question, the greater the price elasticity
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Price Elasticity and Total Revenue(Elastic)
Price
Quantity
Gains in total revenue from lowering the price
Losses in total revenue from lowering the price
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Price Elasticity and Total Revenue
(Inelastic)Price
Quantity
Gains in total revenue from lowering the price
Losses in total revenue from lowering the price
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Chapters 5: Using Consumer Choice Theory
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Returning to the Conceptof Consumer Surplus
• Consumer surplus is a dollar measure of the extent to which a consumer (or many) benefits from participating in a transaction– Assuming that transactions occur voluntarily (implying that those engaging in them are better off than had the transactions not occurred), consumer surplus represents the difference in what one was willing to pay for a product/service and what one actually had to pay to obtain that product/service
• The concept of consumer surplus is key to evaluating public policies such as taxation/subsidization, price ceilings/floors, etc.
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Consumer Surplus
P*
Q
PConsumer’s surplus
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Algebra of Consumer Surplus
10
12
20
Consumer surplus before tax =
Consumer surplus after tax =
Change in C.S. after tax =
8 10
12 (20 10)10 50
12 (20 12)8 32
50 32 [(12 10)8] [1/2(12 10)(8 10)] 18
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Price Elasticity and Consumer Surplus
Elastic Demand
Inelastic Demand
S0
S1
Loss in C.S. for elastic demand
Loss in C.S. for inelastic demand
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Calculating Loss in Consumer Surplus
• Loss in Consumer Surplus
(P Q) .5(P Q)
P
Q
Q
Demand
Supply0
Supply1
Q
P
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Taxation
Tax RevenueLoss in C.S.
Loss in P.S.
Deadweight Loss
Q
P
D
S
ST
58
Taxation on the Supply Side
D1
S1
S2
A B
CF
E D
Pc
Pno tax
Pp
Pc = Price paid by consumer Pp = Price received by producer
G
• Lost P.S. = FCDE• Lost C.S. = ABCF• Tax Revenue = ABDE • Deadweight Loss = BCD• Tax Paid By Consumer=ABFG• Tax Paid By Producer = FGDE
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Taxation on the Demand Side
D1D2
S
A B
C
D
E
FPno tax
Pc
Pp
• Lost P.S. = FCDE• Lost C.S. = ABCF• Tax Revenue = ABDE • Deadweight Loss = BCD• Tax Paid By Consumer=ABFG• Tax Paid By Producer = FGDE
Pc = Price paid by consumer Pp = Price received by producer
G
60
Algebraic Example of Taxation
• The government imposes a $0.404/pack cigarette tax– What is the total amount of the tax?
– What percentage of the tax is paid by the consumers?
– What percentage of the tax is paid by the producers?
– What is the total deadweight loss of the tax?
$0.404 9,996 $4030.38
$0.40 9,996 $3,998.4 99% of Tax
$0.004 9,996 $39.98 1% of Tax
.5 ($0.404 4) $0.81
QD 10,040 10P
QS 6000 1000PSupply and Demand Before Tax
61
Burden of Taxation: Elastic Demand
Loss in C.S.
Loss in P.S. D
SST
Q
P
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Burden of Taxation: Inelastic Demand
Loss in C.S.
Loss in P.S.
Q
P
D
S
ST
63
Algebra of Taxation: Elastic and Inelastic
Demand
Supply : QS 850 P
Elastic Demand : Qd (e ) 1450 5P
Inelastic Demand : Qd (i) 1000 .5P
• Government imposes tax of $60
Supply Tax : QST 790 P
Elastic Demand : P eT 110, QeT 900 C.S. 9250
Inelastic Demand : P iT =140, QiT 930 C.S. 38,400
• Two demand curves (elastic & inelastic) have the same initial equilibrium price and quantity
P* 100, Q* 950
64
Bias in Consumer Price Index
• Substitution Bias: The CPI does not take into account the fact that consumers will change their consumption basket as relative prices change. (Substitution Effect)
• Quality Change: The CPI holds a basket of goods as fixed, when in fact the quality of some of the goods may be changing dramatically over time (e.g. the efficacy of pharmaceuticals)
65
CAFÉ Standards for Automobiles
• Justification for government intervention– Imperfect information about long-term benefits– Imperfect capital markets– Externalities (pollution and national security) - estimated to be 12 cents per gallon
• Government solution - regulations governing average fleet mileage– Fines imposed on those who don’t meet government standard
• (Possible) consequences– Increased lobbying expenditure– Increased fleet sales– “Rebound Effect”
66
Graphical Depiction of CAFÉ Standards
Quantity of Automobiles
Price of Automobiles
Supply without CAFÉ Standards
Supply with CAFÉ Standards
Demand for automobiles
PC
QC
PE
QE
Marginal Social Cost (MSC)
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Alternative Way to Meet Objective: Tax and Rebate
Amount of rebate
Gasoline
$
68
Strip Club Moratorium
• Justification for government intervention: negative externalities
• Government solution - restrict the number of strip clubs in Seattle to 4 (existing) clubs
• (Possible) consequences– Higher prices– Economic profits– Possible loss of consumer surplus
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Graphical Depiction of Strip Club Moratorium
market supply
market demand
Quantity of strip clubs
Price
Regulated
Supply = S 1
Regulated
Supply = S 2
Ps
QS
PE
QE
70
Intertemporal Choice
• Just as consumers make decisions over the purchase of different combinations of goods, they make decisions about whether to purchase goods today or in the future
• We can examine consumer preferences over intertemporal choice using the tradition IC framework– Intertemporal ICs show combinations of current/future consumption for which consumers are indifferent
– The marginal rate of time preference (MRTP), which is the slope of the Intertemporal IC, shows the rate at which the consumer is willing to trade off consumption today versus consumption tomorrow
– Consumers may exhibit positive, negative, or neutral time preference (most exhibit positive)
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Factors Affecting Time Preferences
• Inidividual preferences
• Uncertainty about future events
• Value of anticipated future utility/disutility
• Preferences for a rising consumption standard
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Graphical Illustration of Time Preferences
C1C1 C1
C2 C2 C2
Impatience Neutrality Patience
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Intertemporal Budget Constraint
• The intertemporal budget constraint is determined by r, the interest rate
• Assuming consumers can borrow freely, the intertemporal budget constraint is represented by:
C1 C2
1 rY1
Y2
1 r
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Intertemporal Optimality
C1
C2
Y1 (1+r) + Y2
Y1+Y2(1+r)-1
C1*
C2*
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Changes in the Interest Rate and Optimality
Y1+Y2(1+r1)-1Y1+Y2(1+r0)-1
Y1 (1+r0) + Y2
Y1 (1+r1) + Y2
• Interest rate falls from r0
to r1
• Interest rate begins at r0
76
Algebraic Example of Intertemporal Choice
If James earns $50,000 this year and will earn $60,000 next year, what is the maximum interest rate that would allow him to spend $100,000 this year?
What is the minimum interest rate that would allow him to spend $115,000 next year?
$50,000$60,000
1 r$100,000 r .2
$50,000(1 r) $60,000 $115,000 r .1
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Homo Economicus?
• Some people may function as perfect examples of Homo Economicus, but most only approximate this behavior– We are satisfiers not maximizers, but this is rational!
• Limitations of rationality– Asymmetric treatment of gains and losses (K-T value function)– Failure to appropriately ignore sunk costs– Judgmental heuristics and biases
• Availability• Representativeness• Anchoring and adjustment
• So long as people practice “bounded rationality” economic theory is useful
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Kahneman-Tversky Value Function
Losses Gains
Value
V(gain)
V(loss)
loss
gain
V(loss) V(gain)
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Sunk Costs
• James and AJ have the same preferences for movies. They’re both eager to see the latest summer blockbuster but work different schedules: James can only attend the matinee ($3.50) and AJ can only attend the evening show ($9.00). Halfway through the movie they both realize they hate it. Which is more likely to walk out?
• K-T value function helps explain failure to ignore sunk costs!
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K-T Value Function and the Market
• Sellers, gift givers, etc. can “manipulate” consumers by:– Segregating gains (e.g. separate lottery wins)– Combining losses (e.g. state and fed tax delinquency notices)
– Offsetting small loss with a larger gain (e.g. lottery and ink drop)
– Segregating small gains from large losses (e.g. car rebate)
• We see examples of all of these practices above in the marketplace
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Graphical Depiction of K-T Practices
1000
1000
A manufacturer offers a $1000 rebate on a car
purchase
82
Judgmental Heuristics (Rules of Thumb)
• Availability - memory research shows that it is easier to recall an event the more vivid, sensational, or recent it is– As a consequence, we often put too much weight on these type of events (e.g. murders and suicides in NYC, “r” as first or third letter)
• Representativeness - we often overstate the importance of representative events– Judgments about muggings– Regression to the mean– Sophomore/SI jinx
• Anchoring and adjustment - we often overstate the importance of the anchor (e.g. which is larger 1x2x3…x9 or 9x8x7…1)
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Chapters 6 & 19.1 & 19.2: Exchange Efficiency, and Prices
84
General and Partial Equilibrium Analysis
• Partial equilibrium analysis - the study of how individual markets function in isolation– Ceteris paribus– What we’ve been doing!
• Partial equilibrium analysis ignores:– Spillover effects - a change in equilibrium in one market may affect other markets too
– Feedback effects - a change in equilibrium in a market that is caused by events in other markets that, in turn, are the result of an initial change in equilibrium in the market under consideration
• General equilibrium analysis - study of economic outcomes when one simultaneously considers the the interconnected system of markets– Here we are not making ceteris paribus assumptions
85
A Simply Exchange Economy• An Edgeworth box is a useful tool to help understand general equilibrium in a simply exchange economy with two consumers– Provides an understanding of the value of exchange– Defines points of optimality for the economy
• Edgeworth box allows us to judge different allocations between individuals in an economy– An allocation “A” is superior to an allocation “B” if at least one individual prefers “A” to “B” and all others are at least as happy with “A” as “B”• “A” is said to be Pareto superior to “B”
• Pareto optimality (efficiency) - set of allocations (between individuals) where it is impossible to make one person better off without making at least some others worse off– Contract curve defines the set of Pareto optimal points - all voluntary contracts must lie on the contract curve
• Inefficient - the condition under which, though a reallocation of resources at lease one person could be made better off w/o making anyone else worse off
86
Edgeworth Box
Adam’s quantity of food
Adam’s quantity of clothes
Beth’s quantity of food Beth’s quantity of clothes
Contract Curve
Adam’s indifference curves
Beth’s indifference curves
87
An Example of a Disequilibrium Relative
Price Ratio
80
60
60
80
200 220
200220
Adam
Beth
Food
Food
Clothes
Clothes
Pf = Pc
88
The Invisible Hand & Welfare Theorems
• The first theorem of welfare economics also known as the Invisible Hand Theorem states that “An equilibrium produced by competitive markets will exhaust all possible gains from exchange”
– Adam Smith
– Every competitive equilibrium allocation is efficient
• The second theorem of welfare economics says that, under relatively unrestricted conditions, any allocation on the contract curve can be sustained as a competitive equilibrium– May require reallocation of initial endowments
• Cautions:– These theorems apply, but only under certain conditions
• We will discuss later whether/when they exist– These theorems do not imply that individuals would not prefer different equilibrium points, in general they would, but they are the best that individuals can do given their initial endowments
89
The Inefficiency of Taxes/Subsidies in General
Equilibrium• Taxes or subsidies in an economy change the relative price ratio between goods, which leads to
• In equilibrium consumers will still have a common value of MRS, and producers will still have a common value of MRTS, but inefficiency arises from the fact that producers and consumers see different price ratios– Consumption decisions are based on gross prices (prices inclusive of taxes and subsidies)
– Production decisions are based on net prices (prices received by producer after tax is paid or subsidy received)
90
Would the World Be Better Without Taxes?
• Not necessarily because:1. The optimums produced from a competitive economy
only apply under certain conditions– We will discuss some of the exceptions to these
conditions shortly
2. As a society we might care about other things in addition to efficiency, such as equity, human rights, etc.
• Still, in general, we limit the inefficiency caused by taxation if we impose taxes that keep price distortions to a minimum– E.g. same tax rate applied to all products, or a
head tax
91
Chapters 7: Production
92
Production
• Any activity that creates present or future activity
• We assume an input output relationship defined by the production function defining a relationship by which inputs are combined to produce output– Q = F(K, L, E)
• K = capital, L = labor, E= Entrepreneurship
93
Fixed and Variable Inputs
• Two types of inputs, variable and fixed– Variable inputs are those whose quantity can be relatively easily altered
– Fixed inputs are those whose quantity cannot be altered within a given time period
• Short-run - the longest period of time during which at least one of the inputs used in production cannot be varied
• Long-run - shortest period of time required to alter the amounts of every input– Note that all inputs are variable in the long run
• Note that neither the short or long run is defined by specific time periods, and that the short and long runs may be different for different production processes
94
Law of Diminishing Marginal Returns
• Total product - Q = F(K,L), omit E for simplicity• Marginal product - change in total product with a change of one of the inputs, holding constant all others
– MP = MPL
• Note production function implies diminishing marginal returns
– Law of Diminishing Marginal Returns - increase in output from an increase in a variable input, ceteris paribus, must eventually decline
• Average product - average product produced with a given level of input– APL = Q/L
KK
Q
L
Q
L
95
Numerical Example of Production
(in the Short Run)
Labor Total Product
Average Product
Marginal Product
1 10.00 10.00 10
2 14.14 7.07 4.14
3 17.32 5.77 3.18
4 20.00 5.00 2.68
5 22.36 4.47 2.36
6 24.49 4.08 2.13
7 26.46 3.78 1.96
8 28.28 3.54 1.83
9 30.00 3.33 1.72
10 31.62 3.16 1.62
11 33.17 3.02 1.54
12 34.64 2.89 1.47
Q 10K .5L.5 (in short run K = K =1)
96
Graphical Representation of Production (in the Short
Run)
Total Product
Slope = Marginal Product at L*
Slope = Average Product at L*
L*
Q
L
97
Relationship Between Production Curves
APL
MPL
Q F(K ,L)
Q
L
L
Q
98
Relationship Between Production Curves
APL
MPL
Q F(K ,L)
Q
L
L
Q
Q10 - Q9
99
Production in the Long run
• In the long run all factors of production can be varied
• Isoquant represents the set of all input combinations that yield a given level of output– The production equivalent of an indifference curve
• Marginal rate of technical substitution (MRTS) is the rate at which one input can be exchanged for another without altering the total level of output– MRTS around a point A
MPLA
MPKA
K
L
dK
dL qq0
100
Graphical Representation of Marginal Rate of Technical
SubstitutionK
L
K
L
MRTS K L
101
Returns to Scale
• The proportional change in production that occurs with a given change in all inputs defines the returns to scale– Constant returns to scale if Q = F(K, L) = F(K, L)– Increasing returns to scale if Q = F(K, L) > F(K, L)
– Decreasing returns to scale if Q = F(K, L) < F(K, L)• In theory we should never observe decreasing returns to scale
• Note that decreasing returns to scale has nothing to do with diminishing marginal returns
102
Returns to Scale on the Isoquant Map
Q=30
Q=240
Q=180
Q=400
Q=360
Q=300
Q=420
1 2 3 4 5 6 7 8
16
14
12
10
8
6
4
2Q=90
L
K
103
Chapters 8: Costs of Production
104
Cost Definitions
• Total cost (TC) = all costs of production– If r is the cost of capital (rental cost), and w is the wage, then TC = rK + wL
– Average total cost (ATC) = total cost/quantity produced
• Fixed cost (FC) = costs that do not vary with the level of output produced– Average fixed cost (AFC) = fixed cost/quantity produced
• Variable cost (VC) = costs that vary with the level of output produced– Average variable cost (AVC) = variable cost/quantity produced
• Marginal Cost (MC) = change in TC with a 1 unit change in output
TC = FC + VCATC = AFC + AVC
MC = .
TC
Q
dTC
dQ
105
Numerical Example of Costs (1)
Labor Total Product
Marginal Product of Labor
Total Fixed Cost
Total Variable Cost
Total Cost
Average Total Cost
Marginal Cost
0 0 --- 100 0 100 --- ---
1 10.00 10.00 100 50 150 15.00 5.00
2 14.14 4.14 100 100 200 14.14 12.07
3 17.32 3.18 100 150 250 14.43 15.73
4 20.00 2.68 100 200 300 15.00 18.66
5 22.36 2.36 100 250 350 15.65 21.18
6 24.49 2.13 100 300 400 16.33 23.43
7 26.46 1.96 100 350 450 17.01 25.48
8 28.28 1.83 100 400 500 17.68 27.37
9 30.00 1.72 100 450 550 18.33 29.14
10 31.62 1.62 100 500 600 18.97 30.81
11 33.17 1.54 100 550 650 19.60 32.39
12 34.64 1.47 100 600 700 20.21 33.90
106
Numerical Example of Costs (2)
Labor Total Product
Marginal Product of Labor
Total Fixed Cost
Total Variable Cost
Total Cost
Average Total Cost
Marginal Cost
0 0 --- 2000 2000 --- ---
1 40 52.50
2 100 22.00
3 190 12.11
4 270 8.89
5 340 7.35
6 400 6.50
7 450 6.00
8 490 5.71
9 520 5.58
10 540 5.56
11 550 5.64
12 555 5.77
107
Graphical Representation of Relationship Between Diminishing Marginal Returns and Increasing
Marginal Cost
MC
AVC
MPL
APL
L
L
108
Graphical Representation of All Costs
FC
AFC
MC
ATC
AVC
TC
VC
r1
r2
FC
Q
Q
$/Q
$/L
109
Costs in the Long Run and the Optimal Input
Combination• Isocost line - a set of input bundles each of which costs the same amount– The production equivalent of a budget line– The slope of the isocost line is the negative of the input price ratio (-w/r if labor is on the x-axis and capital is on the y-axis)
• Maximum output for a given input cost is a point where isoquant is just tangent to the isocost line– Also the point of minimum cost for a given level of output
110
Production Optimality
• If isoquant is tangent to isocost line at optimum, we know that:– Slope of isoquant = slope of the isocost line
and
– Slope of isoquant = MRTS = (-K/ L) = (-MPL/MPK)
and– Slope of isocost line = (-w/r)
therefore
– (-MPL/MPK) = (-w/r) and (MPL/w) = (MPK/r)
• Economic interpretation is that firms should hire inputs to the point where the marginal output per dollar is the same for all inputs– Were this not the case, firm could increase output and reduce cost - would not be at an optimum
111
Graphical Representation of Production Optimality
L
K
Q = Q1
Isocost LineSlope = -w/r
Isoquant
L*
K*
112
Optimality: Cost Minimization
L
K
L*
K*
Q=100
TC=$2000
TC=$1750
TC=$1500
113
Optimality: Profit (Output) Maximization
L
K
L*
K*
Q=100
Q = 80Q = 90
TC = $1500
114
Effects of a Change in Input Prices: Cost
Minimization
L
K
Q=100
115
Output Expansion Path
TC1/w TC2/wTC2/w
TC1/r
TC2/r
TC1/r
Q1
Q2
Q3
Expansion Path
116
Long Run ATC Curve
SMC1
SMC1
SMC1
LMC
LATC
ATC1
ATC3
ATC2
117
Chapters 9: Perfect Competition
118
Perfect Competition
Assumptions:• Free Entry• All buyers and sellers have perfect information• Many firms producing a homogenous product• Factors of production are perfectly mobile in the long run
Implications:• Firms are “price takers,” that is, they cannot sell anything above the prevailing market price
• The firm’s supply curve will be the portion of their marginal cost curve above their average total cost curve
• In the long run, economic profits are zero
119
Perfect Competition: Numeric Example
Quantity
ATC MC ∏(P=22)
∏(P=4)
4 6 10 64 -8
6 8 14 84 -24
8 10 18 96 -48
10 12 22 100 -80
12 14 26 96 -120
120
Total Revenue and Total Cost TC
TR
TR TC
Fixed Cost
(-) Fixed Cost
121
Perfect Competition: Zero Profit
Demand =Price =Marginal revenue
wheat
Price/Marginal Revenue Marginal cost
Average total cost
Supply curve
122
Perfect Competition: Negative Profit (losses)
Demand =Price =Marginal revenue
wheat
Price/Marginal Revenue Marginal cost
Average total cost
losses
123
Perfect Competition: Positive Profit
Demand =Price =Marginal revenue
wheat
Price/Marginal Revenue Marginal cost
Average total cost
Profits
124
Perfect Competition: Labeling
Curves/Optimums/Profit/Loss
A B C D E
G H I
J K L
M
N O P Q R
S
T
U
V
W
F
125
Supply/Shutdown Decision
• Competitive firms will, in the short run, supply products so long as price must equal marginal cost on a rising portion of the MC curve, and it must exceed the minimum value of the AVC curve
MC
AVCSupply
Shut Down
P
Q
126
Short-Run Competitive Industry Supply Curve
MC1 MC1 S = MC1 + MC2
10 5 10 4 5 10 204 5
127
Elasticity of Supply
• Price elasticity of supply - the percentage change in quantity supplied that occurs in response to a 1 percent change in product price
– Short-run competitive industry supply curve will always be upward sloping because of the law of diminishing marginal returns implying elasticity of supply is always positive
S QS
P
P
Q
dQ
dP
P
Q
128
Algebra of Market and IndividualFirm Output
• A market consists of 100 firms. For each firm,
• Total market supply is given by
• If market demand is given by
• Then the profit for each firm is given by
• Profit in the market is equal to
TC Q2 2Q100
ATC Q 2 100 /Q
MC 2Q 2
QiS .5P 1 for P 2
100Qis 100(0.5P 1) QS 50P 100
Qd 2210 5P
TR TC 4220 20(20 2 100 /20) 300
100 i 100300 30,000
129
Chapters 10: Using the Competitive Model
130
Efficiency of Competitive Equilibrium
• Competitive markets result in allocative efficiency - a condition in which all possible gains from exchange are realized
• Competitive equilibrium leaves no room for mutually beneficial exchange– Consumers would certainly pay less than equilibrium price, but no producer would sell for less
– Producers would certainly accept more than equilibrium price, but no consumer would pay more
– The cost to produce the last unit of output (the MP of the last unit) equals the price paid
131
Producer Surplus I
Producer Surplus for the Firm
P*
AVC
MC MC
Q* Q*
Producer Surplus II
Alternative Measures of Producer Surplus
132
Aggregate Producer Surplus
S MC
D
P*
Producer Surplus
133
Total Surplus
D
S
P*
Price
Quantity
Consumer Surplus
ProducerSurplus
Q*
134
Loss of Surplus Due to Market Interventions
P
S
D
S
Loss
ConsumerSurplus
ProducerSurplus
ConsumerSurplus
ProducerSurplus
ProducerSurplus
ConsumerSurplus
LossLoss
Fixed SupplyTaxPrice Ceiling
135
Adjustments in the Long Run
Profit
Profit
Zero profit
Q
MC
D
P
P1
P2
P3
Qi
P
136
Burden of Taxation
• ADAM - P. 271
137
Deadweight Loss of an Excise Tax
• ADAM, p. 274
138
Chapters 16.1-16.5, 17.1-17.4, 18.1, 18.2: Input & Labor Markets, Wages &
Rent
139
Input Demand Curve of aCompetitive Firm
• Input demand shows the total quantity of the input that will be demanded at various prices
• Input demand will depend on the marginal value product (MVP), which is the extra revenue a competitive firm receives by selling the additional output generated when employment of an input is increased by 1 unit– For a competitive firm, MVP = MPL * P (this is b/c output price is constant for a competitive firm)
– It makes sense for a firm to hire to the point where MVP = w, w = MPL*P and therefore w/MPL = P
140
Competitive Firms Demand for Labor: All Inputs
Variable• When all inputs are variable, an input’s MVP curve shifts with changes in the employment of other inputs– A lower wage rate causes the firm to substitute toward labor and away from capital
• Input demand is a “derived demand” reflecting the fact that industry demand for an input ultimately derives from consumers’ demand for the final product produced by that input– ADAM, please add Figure 16.3 & definition + show the substitution & output effects of an input price change (p. 447)
141
Competitive Industry Demand for Labor
• ADAM, add figure 16.4
142
Elasticity of an Industry’s Demand Curve for an Input
• Elasticity of input demand is the sensitivity of input demand to changes in input cost
= (%input demand)/(%input cost)• Four major determinants of the
elasticity of an industry’s demand for an input1. Elasticity of the final product2. The substitutability of one input for
another in production3. The supply of other inputs4. Time period
143
Supply of Inputs
• ADAM, FIGURE 16.5
144
Equilibrium in Input Markets
• ADAM, SPLIT SLIDE - FIGUREs 16.6 & 16.7
145
Income Leisure Choice of the Worker
• ADAM, FIGURE 17.1
146
Supply of Hours of Work
• ADAM, FIGURE 17.2
147
A Backward Bending Labor Supply Curve?
• ADAM, FIGURE 17.3
148
Why Do Wages Differ?
• If wage rates differ across occupations and there is free entry and exit from/into occupations, shouldn’t we see individuals leave the low wage occupation (shifting supply to the left) and enter the high wage occupation (shifting supply to the right), equalizing wages across occupations. So why do wages differ across individuals and occupations?
1. Compensating wage differentials2. Differences in human capital3. Differences in ability
149
Minimum Wages
• ADAM, FIGURE 18.1 split, one with the floor above equilibrium and one with the floor below equilibrium
150
Burden of Social Security Tax
• Social security is financed by a payroll tax composed of two equal-rate levies, one collected from employers and one collected from employees (about 7.6% on each for the first $80K of income), so who really pays for this tax
• ADAM, BURDEN OF Soc Sec Tax - add split slide graphs with differently sloped supply curves (p. 505)
151
Chapter 11: Monopoly
152
Monopoly
Assumptions:• Restricted entry• One firm produces a distinct productImplications:• A monopolist firm is a ‘price setter,’ that is, they
can affect the market price and set it to maximize their profits (demand curve slopes downward)– Profit maximizing output occurs where MC=MR (like
perfect competition), but price is above MC• Economic profits are positive in the long run• A monopolist sets price and quantity simultaneously
and therefore does not have a true supply curve• The monopolist’s profit-maximizing output will not be
socially optimal
153
Sources of Monopoly
• Various sources of barriers to entry, such as:– Exclusive control over natural resources– Economies of scale
• Natural monopoly has a constantly downward sloping LRATC curve
– Patents/trademarks– Network economies– Government licenses or franchises– Product differentiation
154
Monopoly: Numeric Example
Q P TR MR TC MC ATC Profit
0 100 0 0 200 200 200 -200
10 90 900 90 420 22 42 480
18 80 1440 67.5 660 30 36.67
780
24 70 1680 40 900 40 37.5 780
28 60 1680 0 1108 52 39.57
572
30 50 1500 -90 1240 66 41.33
260
155
Monopoly
Marginal cost
demand
Marginalrevenue
Q*
P*
Price/Marginal Revenue
widgets
Inefficiencyor deadweight loss
Average total cost
profits
156
Algebra of Marginal Revenueand Elasticity
• Marginal Revenue
• Recall: Price Elasticity of Demand
• Therefore,
Q
P
P
Q
MRQ 0P0
P
QQ0
MRQ P 11
157
Monopolist Profit-Maximizing Markup
P MC
P
1
158
• A monopolist faces the following demand and marginal cost curves
• What is the profit-maximizing price it will charge? What is the total profit? What is the size of the inefficiency?
Algebra of Monopoly Optimums
QD 1000 5P, MC 40
159
Two-Plant Monopoly
Market 1 Market 2 Total
P2
P1
Q1 Q2
MC
Q1 + Q2
MR1 + MR2
MC*
160
Total Revenue: Monopoly v. Perfect Competitor
Total RevenueTotal Revenue
Slope = P*
TR = P*Q
Perfect Competitor Single-Price Monopoly
161
Monopoly v. Perfect Competitor
Monopoly• Price setter• MR is declining and below demand curve
• Equilibrium price is set above MC
• Economically inefficient
Perfect Competitor• Price taker• MR is constant
• Marginal cost pricer
• Economically efficient
162
Chapters 12: Product Pricing with Monopoly Power
163
Price Discrimination
• Price discrimination is the practice of charging different prices in different markets for the same basic product
• Price discrimination is practiced as a method to maximizing total profit by charging prices that are closest to the highest that each customer (market) are willing to pay
• Perfect price discrimination (first degree price discrimination) occurs if monopolist is able to charge exactly what each consumer is willing to pay
SMCATC
D
Q1 Q2 Q3
P1
P2
P3
EconomicProfit
164
Three Necessary Conditions for Price Discrimination
1. Some degree of market power2. Seller must have some means of
approximating what different buyers are willing (the maximum) to pay for each unit of output
3. Seller must be able to prevent resale (or arbitrage) of the product
165
Algebra of Monopoly Optimums with Perfect Price
Discrimination
QD 1000 5P, MC 40
• A monopolist faces the following demand and marginal cost curves
• If the firm can perfectly price discriminate, what is the price it will charge the person with the lowest willingness to pay? What is the total profit?Profit Condition: Demand = MR = MC200-Q/5 = 40, Q = 800, P = $40
Profit = 1/2 *(160*800) = $64,000
166
Algebra of Monopoly Optimums with Segmented
Markets• Adam, please put in an example like p. 336
167
Intertemporal Price Discrimination & Peak-Load
Pricing• Adam, please add in graph and numeric example - p. 347-349
168
Chapters 13 & 14: Imperfect Competition & Game Theory
169
Reality: Imperfect Competition
• Perfect competition and monopoly represent idealized market structures that rarely exist– These are useful in showing tendency and direction, but in the real world the payoff to an action often depends not only on the action itself, but also on how it relates to actions taken by others
– Read the 3 economist, 3 lawyer parable on page 455, it’s funny (particularly if you are an economist)
• Game theory is a useful tool to use to analyze likely outcomes when individual payoffs depend on the actions of others– Three elements of game theory: 1) the players, 2) the list of possible strategies, and 3) the payoffs associated with each combination of strategies
170
Algebraic Example of Game Theory in the Marketplace
MEXICO OIL
VENEZUELA PETROLEUM
Cooperate
(P=5)
Cheat(P=4)
Cooperate
(P=5)
Cheat(P=4)
V 100
M 100
V 75
M 75
V 150
M 25
V 25
M 150
171
Oligopoly
Assumptions:• Restricted entry• Few firms producing Implications:• The actions of one oligopoly firm will affect the prices
and profits of the other firm(s) in the market• There are several possible hypotheses about how oligopoly
firms behave• May collude and act as a monopoly• May compete against each other and drive prices to the perfectly
competitive level• May compete, but arrive at equilibrium somewhere between the monopoly
and perfectly competitive prices
• The exact structure of the oligopoly likely depends on the products they are producing and the degree of product differentiation
172
Cournot Duopoly Model
• Two firms in the market that sell identical products• Each firm assumes that the other will keep production
levels fixed regardless of their own production• Each firm has a “reaction function” that determines of
the optimal level of output given the other firm’s output
Q1
Q2
Firm 2’s reaction function
Firm 1’s reaction function
a/3b
a/3b
173
Bertrand Model
• Two firms in the market that sell identical products• Each firm assumes that the other will keep prices fixed
at the current level regardless of the price they set• Each firm’s best strategy is to sell just below the
price of the other firm so that they can capture the entire market demand
• The firms will continue to reduce the price until it reaches the competitive market price
174
Stackelberg Model
Q1
Q2
• Two firms in the market that sell identical products• The market consists of a “leader” and a “follower”• The follower is a naïve Cournot duopolist• The leader will choose its quantity level by taking into
account how that will affect the follower’s response
a/2b
a/4b
Firm 2’s reaction function
Firm 1’s reaction function
175
Comparison of Oligopoly Models
···
·
Monopoly
Cournot
Stackelberg
Bertrand/Perfect Competition
a
a/2
a/2b a/b
176
Monopolistic Competition
• Differentiated products• Many sellers• Free entry• Each seller faces a downward-sloping demand curve
UnderCuts Cheap Snips Dean Suarez Salon
177
Classic Prisoner’s Dilemma
CLYDE
SquealRemain Silent
BONNIESqueal
12 years for B12 years for C
0 years for B20 years for C
Remain Silent
20 years for B0 years for C
1 year for B1 year for CPayoff to an action often depends not only on the action itself, but also on how it relates
to actions taken by others
178
Game Theory
• Nash equilibrium - the combination of strategies in are such that neither player has any incentive to change given the strategy of others
• Players in games may have dominant or non-dominant strategies– Dominant strategy - when a player has a strategy in a game that produces better results regardless of the strategy chosen by other players (opponents)• Each player may have a dominant strategy, but the result of each player exercising their dominant strategy may be less beneficial for the players (e.g. price wars) and/or society as a whole
– Non-dominant strategy - when at least one player does not have a dominant strategy, rather the best strategy for that player is dependent on what others choose• Nash equilibrium may occur even if a player does not have a dominant strategy b/c one (or more players) bases decision on what others will do
179
Nash Equilibrium: Dominant Strategy
PEPSI
Advertise
Don’t Adverti
se
COKE
Advertise
C: $100 mP: $100 m
C: $250 mP: $25 m
Don’t Adverti
se
C: $25 mP: $250 m
C: $200 mP: $200 m
180
Nash Equilibrium: Non-Dominant Strategy
ADIDAS
Advertise
Don’t Advertis
e
NIKE
Advertise
N: $100R: $100
N: $135R: $200
Don’t Advertis
e
N: $50R: $125
N: $140R: $115
181
Chapters 15 & 19.7: Using Noncompetitive Market Models &
Regulation
182
Graphical Depiction of Efficiency Loss Due to Single-Price Monopoly
LAC=LMCEconomic Profit
ConsumerSurplus
EfficiencyLoss
Q* QC
183
Regulation of (Natural) Monopoly
• State ownership and management (e.g. elected boards)– Downside is weakened incentives for profit leading to X-
inefficiency (when firms fail to attain maximum output for a given combination of inputs)
• Rate of return regulation - prices are set to allow monopolist to earn a set (competitive) rate of return on invested capital– Downside is that regulators can’t be sure of the
competitive rate (if rate is set too high then price is too high, if set too low then monopolist will eventually go out of business)
• Exclusive contracting (with natural monopoly) - have competition for who gets to be the exclusive contractor
• Enforcement of antitrust laws - effort to prevent monopolies from forming (note that this is not effective for natural monopoly)
184
Causes of Economic Inefficiency
• Market power - firms with market power do not marginal cost price (P>MC) – As a consequence, the relative price in the industry where there is market power, call it Pp/Pc > MCp/MCc, where Pc and MCc are the price and marginal cost in a perfectly competitive industry• Implies that more of the market power good should be produced and less of the perfectly competitive good since consumers would like to trade for more of it
• Imperfect information - consumers may not know how much utility they will get from consumption of a good
• Externalities/public goods - consumption/production of a good might impact other than the consumer/producer, but this impact is not taken account of in the production/consumption so the market does not lead to efficient allocation
185
Chapters 20: Public Goods, Externalities, & Government
186
Tragedy of the Commons
Number of cars on the bridge (in thousands)
Average commute time along the bridge
Total commute time via the bridge (in thousands of minutes)
Marginal time cost of one more car taking the bridge
Monetary cost to individuals of taking the bridge
Net Monetary benefit of individuals taking the bridge instead of the monorail
1 15 min 15 15 $ 3.00 $ 3.00
2 15 min 30 15 $ 3.00 $ 3.00
3 15 min 45 15 $ 3.00 $ 3.00
4 17.5 min 70 25 $ 3.50 $ 2.50
5 20 min 100 30 $ 4.00 $ 2.00
6 22.5 min 135 35 $ 4.50 $ 1.50
7 25 min 175 40 $ 5.00 $ 1.00
8 27.5 min 220 45 $ 5.50 $ 0.50
9 30 min 270 50 $ 6.00 $ 0.00
10 32.5 min 325 55 $ 6.50 $ -0.50
11 35 min 385 60 $ 7.00 $ -1.00
Commuters in West Seattle have to get downtown to work. Suppose they can either get there by driving alone in their car via the West Seattle bridge or by taking the monorail. Travel on the monorail always takes 30 minutes regardless of how many people ride. The bridge, on the other hand, begins to get congested if more than three thousand cars travel at a time. Assume that each commuter values their time at $ 12.00 per hour.
187
Analysis of Common Property Problem
• How much would West Seattle be willing to pay to build a monorail that would get them downtown in 30 minutes?
• Given that the monorail does exist: Left to their own devices, how many commuters travel the bridge and how many commuters take the monorail?
• What is the socially efficient number of commuters on the bridge and the monorail?
• How much would Seattle need to subsidize monorail riders to achieve the socially efficient ridership?
188
Externalities
• An externality is when the production or consumption of a good has an impact (may be positive or negative) on others in the market– There are, in theory, eight possible types of externalities:
1. Positive, consumer-consumer2. Positive, producer-producer3. Positive, producer-consumer4. Positive, consumer-producer5. Negative, consumer-consumer6. Negative, producer-producer7. Negative, producer-consumer8. Negative, consumer-producer
• Positional externalities - externalities that arise when rewards or sanctions are determined not by absolute position (e.g. performance), but by one’s position in society
189
Coase Theorem
• Externalities exist because property rights are not assigned for all goods
• Coase Theorem states that when the parties affected by externalities can negotiate costlessly with one another, an efficient outcome results no matter how the law assigns responsibility for damages– Law often doesn’t assign responsibility– Affected parties can never negotiate completely costlessly; sometimes the costs of negotiation are quite high
190
Interventions to Deal with Externalities
• Taxation of negative externalities
• Subsidization of positive externalities
• Assignment of property rights
191
Intervention to Deal with Negative Externalities: Fixing the Tragedy of the
Commons
C*
MC
AC$ 6
$ 4Tax/Toll
Cost of Taking Bridge
# of cars
192
Intervention to Deal with Negative Externalities: Fixing the Tragedy of the Commons from Benefit Side
C*
0
Net Benefit of Using Bridge
MarginalBenefit
AverageBenefit
$2.00
193
Alternative Intervention to Deal with Negative
Externality• Two neighbors live across the street from each other. The neighbor on
the east side of the street wants to build a second story onto his house. The one on the west side doesn’t want the morning sunrise to be blocked. The city has given the East Side neighbor the permit for the addition.
• How much would the West Side neighbor be willing to pay her neighbor not to build the addition?
• How much would the West Side neighbor be willing to pay if she had to pay a lawyer $250 to negotiate the agreement?
East Side Neighbor Builds
Gains to East Side Neighbor
$1,000
Damage to West Side Neighbor
$1,400
194
Intervention to Deal with Negative Externalities
Demand (MV)
Individual MC
Social MC
Q0QE
P0
PE TAX
195
Intervention to Deal with Positive Externalities
Individual Marginal Benefit
Social Marginal Benefit
SUBSIDY
MC
Quantity
Price
196
When Is The Market Less Likely to Be Efficient
• When markets are less competitive
• In the case of externalities– May be positive or negative– May occur on production or consumption side
• In the case of public goods
• In the case of asymmetric/poor information
197
Public Goods
• Public goods are those goods that, to a greater or lesser degree, possess two key traits, nondiminishability and nonexcludability (a special case of externalities)– A nondiminishable good is one for which one persons consumption of a good has no effect on the amount of it available to others (MC = 0)
– A nonexcludability good is one for which it is not possible to prevent consumers (paying or nonpaying) from consuming that good
• Two types of public goods– Pure public good is one that has a high degree of nondimishability and nonexcludability (e.g. national defense)
– Collective good is has a high degree of nondiminishability, but may have excludible properties (e.g. roads)
• Public goods may be provided by either the government or the private sector
198
Optimal Quantity of Public Goods
• Aggregate willingness to pay curve (like the aggregate demand curve) is the vertical sum of individual’s willingness to pay curves
• Optimal quantity of a public good is the quantity, Q*, corresponding to the intersection of aggregate willingness to pay and marginal cost curves with the proviso that the total cost of producing Q* does not exceed the total amount that the public would be willing to pay
• The fact that the optimal quantity of public goods may differ from person to person suggests “Tiebout” sorting associated with local provision of public goods
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Public Goods: Graphical Example
Aggregate Willingness to Pay Curve
MC
A* = 8
A* = 5
A* = 13
Q*=10
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Provision of Public Goods
• Funding by donation– Suffers from free rider problem
• Sale of by-products - e.g. commercial TV
• Creating excludability techniques - cable TV
• Legal/private contracts - e.g. condo/home association
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Public Goods: Numeric Example
• A town has 100 people with identical preferences for a fireworks display.
• Each person has a willingness to pay P=40-.2Q
• How much would the town be willing to pay for 100 shells at their fireworks display?
• The aggregate willingness to pay is P = 4000 - 20Q
• The town is willing to pay $2000 or $20 each.
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Government Interventions to Try to Create Efficient Resource Allocation
• Control over pricing– e.g. The setting of rates for natural monopolies
• Information, licensure, certifications, etc.– e.g. FDA, FAA
• Regulations governing production techniques– e.g. mandating smokestack scrubbers
• Taxation/subsidies– e.g. cigarette tax
• Creation of “new” markets– e.g. pollution credit markets
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Another Key Role for Government: Income Redistribution
• As a society we may care not only about efficiency (pretty much everything we’ve been talking about), but also equity– The two may be linked if utility functions are interdependent (my utility depends on your utility)
• Rawlsian pre-birth lottery - thought experiment on what constitutes a just distribution of income– What should the distribution of income (& rewards for work/talent) look like for those behind the veil of ignorance?• Risk aversion suggests that social safety net acts as pre-birth insurance policy
• Methods of Redistribution– Welfare programs– Negative income tax– Jobs programs
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Public Choice
• Major way we make policy is through majority voting, where the median voter (the voter whose ideal outcome lies above the ideal outcomes of half the voters) determines the outcome
• But there are some unpalatable properties of majority voting, including– Intransitivity-
• With more than 2 choices, the least preferable choice may be selected if the voters are split between the most preferred choices
• Majority voting may sometimes imply so the order of the votes may be very important
• Allows for agenda manipulation (we see this all the time in politics)
– Lack of consideration of strength of preference
A B,B C,C A
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And the Winner Is…The Loser
• A city has the choice between four mayoral candidates: Tara, Sarah, Wendy and Amy. Amy was recently added to the ballot when her corporate fraud conviction was overturned on a technicality
• When asked, 74% of the citizens list Amy as their last choice out of the four candidates. However, in deciding between the candidates A,B, and C they are evenly split.
• When they vote, the final tally will be: Tara 24.67%
Sarah 24.67% Wendy 24.67%
Amy 26%
• Amy Wins!
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And the Winner Is…Who Knows?
• Three people are voting on three alternatives. The orders of their preferred choices are listed below.
• This group prefers Johnson over Duritz and Zavala over Johnson, but prefers Duritz over Zavala. If these elections are run sequentially, then the order in which they are done will determine the outcome.
Meghan Cory Jon
Johnson 1 2 3
Duritz 2 3 1
Zavala 3 1 2
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We’re All Winners!
Johnson
DuritzJohnson
Johnson
Zavala
Duritz
DuritzZavala
Zavala
Zavala
Johnson
Zavala
Duritz
Duritz
Johnson
Congratulations Mayor Zavala!
Er…Congratulations Mayor Duritz!
Wait…Congratulations Mayor Johnson!
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Extra Topics
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Economics of Information
• Thus far we have assumed all economic entities have perfect information when making decisions - this is obviously a gross simplification
• We generally worry more about information flows between adversaries (those with conflicting goals) than those with common goals b/c there is goals in common - there’s an incentives problem
• Signaling: the conveying of credible information - signals work better when:– They are costly to fake (costly to fake principle)– Disclosure of favorable qualities creates an incentive for individuals to disclose unfavorable ones (full disclosure principle)
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Information Problem: Adverse Selection & Moral
Hazard• If individuals have different attributes(i.e. they are heterogeneous), they will have different incentives to engage in economic trades (e.g. the purchase of insurance)– Adverse selection is the process whereby the less desirable potential trading partners are the ones who volunteer for trades
• We often see the problem of adverse selection arise with insurance when insurers cannot accurately distinguish between the good and bad insurance risks– A consequence of adverse selection is differential prices charged to individuals with different characteristics(statistical discrimination) based on attributes other than the attribute (e.g. careful driving) we care about most - related to arguments over national health care
• Insurance against losses may lead to an altering (inefficient type) of behavior referred to as moral hazard
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Inefficiency Associated with Imperfect Information
• Assume that teenage boys make up 10% of drivers and that they cause an average of $1000/year in auto accidents where all other drivers cause an average of $100/year.
• Imagine that a law is passed that prohibits insurance companies from charging different rates based on personal characteristics.
• If all drivers are required by law to have insurance, what is the minimum premium insurance companies would charge for all drivers?
• If drivers are not required to have insurance, who would opt to buy insurance (assume they are risk neutral)?
• In the above case, what is the premium the insurance would end up charging?
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Choice Under Uncertainty
• In the real world we make choices (economic transactions) based on uncertain payoffs– Thus, we calculate the expected value of alternative transactions in order to make decisions• Expected value is the weighted average of all possible outcomes associated with a choice
• Von Neumann-Morgenstern expected utility model is the formal model whereby individuals are assumed to choose the alternative that brings the highest expected utility– Expected utility of a gamble (virtually everything is a gamble at one level or another) is the expected value of utility over all possible outcomes
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Concavity of Utility Function and Risk Aversion
Suppose a person gets utility only from the level of their wealth (W). These specifications have very different implications for the expected change in utility for a risky endeavor.
• Risk Neutral: Utility= aW
• Risk Aversion: Utility= W1/2
• Risk Loving: Utility = W2
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Expected Utility Problem
• Suppose U=W1/2
• You currently have wealth of $900 but have a 50% chance of losing $800 of it
• What is the maximum you would be willing to pay for an insurance policy that protects you from this risk?
Expected Utility without Insurance
E(U) E(.5U(100) .5U(900)) .5(1001/ 2) .5(9001/ 2) 20
Willingness to Pay for Insurance
U(W - i) = 20
U(900 i) 20 (900 i)1/ 2 20
i 500
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Graphical Depiction of Expected Utility Problem
900500100
10
30
20
400
Income
Utility