Chapter 1 - Scarcity And Choice (What’s in economics for you)
•
Scarcity - Arises because of limited time, money, and energy = problem
o Can never gave all wants satisfied = smart choices of what to go after vs. what to
give up
•
Economics - How individuals, businesses, and government make the best possible
choices to get what they want, and how those choices interact in markets
•
Opportunity Cost - The cost of the best alternative given up
o Because of scarcity every choice involves a trade-off → you have to give
something up to get something else
o The true cost of any choice is an opportunity cost
o Opportunity cost is more important than money cost
▪ Ex. Sleep vs. Studying
▪ Money cost = nothing
▪ Ex. Tuition is same for either choice = doesn’t change
benefit-cost comparison for studying or sleeping
▪ Opportunity cost → sleep and not studying = lower grades = a
lower chance getting into medical school = economics opportunity
cost
▪ Ex. Win a free Cuba vs. hard client with a million dollar contract
▪ Money cost = nothing / free → FREE trip to Cuba
▪ Opportunity cost of going to Cuba is a million dollars
•
Smart choice = the value of what you get must be greater than the value of what you
give up = get > give up
•
Smart choices change as benefits change
o Ex. Sleep vs. Studying
▪ Well prepared for test = sleep isn’t going to cost much (lower marks)
▪ Not well prepared for test = sleep will lose you many marks
o Ex. Free trip to Cuba
▪ Trip might not be worth it to lose sale but free trip
o Incentives → rewards and penalties
o More likely to choose actions with rewards (positive incentives) and avoid actions
with penalties (negative incentives)
•
When the economy slows down, incentives to quit school decrease because it’s harder
to find a job (unemployment) and opportunity costs of going to school decrease
•
Gains from trade
o Opportunity cost and comparative advantage are key to understand why
specializing and trading makes us better off
o
o
o
o
o
o
o
With voluntary trade, each person feels that what they get is of greater value than
what they give up
Absolute Advantage - The ability to produce a product or service at a lower
absolute cost (money cost) than another producer
Comparative Advantage - The ability to produce a product or service at a lower
opportunity cost than another producer
Opportunity Cost = Give UpGet
Comparative advantage = key to mutually beneficial gains from trade
Trade makes individuals better of when each:
▪ Specializes in producing a product or service with comparative advantage
(lower opportunity cost)
▪ Trades for the other product or service
Production Possibilities Frontier (PPF) graph shows maximum combinations of
products or services that can be produced with existing inputs
▪ Ex. Jill and Marie’s Production Possibilities
Possibility
Bread (Loaves/Month)
Wood (Logs/Month)
A
50
0
B
40
20
C
30
40
D
20
60
E
10
80
F
0
100
▪
▪
▪
Mutually Beneficial Gains From Trade → Specialization → Jill can
now consume 80 logs of wood and 20 loaves of bread, a
combination that was impossible before trade
X : Inefficiency
▪ Not using resources at maximum
▪ Poor leadership
▪ Economic recession
▪ Fools
Y : Hope / Impossible Combinations
▪ Need more resources, technology, and education for
economic growth
Marie’s PPF
Possibility
Bread (Loaves/Month)
Wood (Logs/Month)
A
40
0
B
30
5
C
20
10
D
10
15
E
0
20
▪
▪
▪
▪
Mutually Beneficial Gains From Trade → Specialization → Marie
can consume 20 logs of wood and 20 loaves of bread, a
combination that was impossible before trade
X : Inefficiency
▪ Not using resources at maximum
▪ Poor leadership
▪ Economic recession
▪ Fools
Y : Hope / Impossible Combinations
▪ Need more resources, technology, and education for
economic growth
Opportunity Costs for Jill and Marie
Opportunity Costs of 1 Additional...
Loaf of bread
Log of Wood
Jill
Gives up 2 logs of wood
Gives up ½ loaf of bread
Marie
Gives up ½ logs of wood
Gives up 2 loaf of bread
Comparative
Advantage
Marie has comparative advantage
(lower opportunity cost) in bread
making
Jill has comparative advantage
(lower opportunity cost) in wood
chopping
o
o
o
o
•
▪ Specialization in graphs
Specialization (according to comparative advantage) and trade allows each
trader to consume outside of the PPF, an impossible combination without trade
▪ All arguments for freer trade are based on comparative advantage
Even if one individual has absolute advantage in producing everything at lower
cost, differences in comparative advantage allow mutually beneficial gains from
specializing in trading
Specialization allows one to consume more than if they were self-sufficient and,
therefore, an improved standard of living
Gains from trades → comparative advantage → specialize in what you do best
→ trade for the other product
Thinking like an economist
o
o
o
o
o
o
The circular-flow model, like all economic models, focuses attention on what’s
important for understanding and shows smart choices by households,
businesses, and governments interact in markets
An economic model - Simplified representation of the real world, focusing
attention on what’s important for understanding
▪ Ex. PPF of Jill and Marie → no exchange rate, politics, transportation
costs, etc. → not essential for understanding
Circular flow model of economic life reduces complexity of the Canadian
economic to 3 sets of players who interact in the markets : households,
businesses, and governments
Circular flow model :
Inputs are productive resources → labour, natural resources, capital equipment,
entrepreneurial ability
Inputs are used to produce products and services
o
Governments set rules of the game and choose to interact in any aspect of the
economy
•
Models for microeconomics and macroeconomics
o The 3 Keys summarize the care of microeconomics, providing smart choices in
all areas of life
o Microeconomics - Analyzes choices that individuals in households, individuals in
businesses, and governments make, and how those choices interact in markets
o Macroeconomics - Analyze performance of the whole Canadian economy and
global economy, the combined outcomes of all individual microeconomic choices
o Differences :
▪ Trees (micro) vs. forest (macro)
▪ Smart choices for you (micro) vs. smart choices for all (macro)
▪ Macro = look at the big picture
•
3 Keys Model For Microeconomics → 3 keys to smart choices
1. Choose only when additional benefits are greater than opportunity costs
2. Count only additional benefits and additional opportunity costs
3. Be sure to count all additional benefits and costs including implicit costs and
externalities
o “Margin” = “Marginal” = “Additional”
o Marginal Benefits - Additional benefits from the next choice
o Marginal Opportunity Costs - Additional opportunity costs from the next choice
o Implicit costs - Opportunity costs of investing your own money and time
o Negative (or Positive) Externalities - Costs (or Benefits) that affect others
externally to a choice or a trade
•
Is economics a science?
o Science - Asystematic enterprise that builds and organizes knowledge in the
form of testable explanations and predictions about the universe
o Economics uses quantitative expression in mathematics and concise statements
of its models in axioms and derived “theorems” so it looks a lot like the models of
science from physics
•
Economic models assume all other things not in the model do not change
o Mental equivalent of controlled experiments in laboratory
•
Positive statements
o About what is
o Can be evaluated as true or false by checking facts
o Ex. ↑ Gas price = ↓ Gas quantity used = ↑ Global warming
•
Normative Statements
o About what you believe should be
o Involve value judgements
o Cannot be factually checked
o
Ex. To ↓ global warming, we ought to/should :
▪ ↑ Gas prices
▪ Subsidize clean energy sources
Chapter 2 - Coordinating Demand And Supply
•
Weighing benefits, costs, and substitutes
o Your willingness to buy a product or service depends on your ability to pay,
comparatives benefits and costs, and the availability of substitutes
•
Preferences - Your wants and their intensities
•
Demand - Consumers’ willingness and ability to pay for a product/service
o For any choice, what you’re willing to pay or give up depends on
▪ Cost
▪ Availability of substitutes
•
Smart choices are marginal choices
o Key 2 states “count only additional benefits and additional costs”
o Additional benefits mean marginal benefits - not total benefits - and marginal
benefits change the circumstances
•
Marginal Benefit
o Additional benefit from a choice
o Changing with circumstances
▪ Ex. Stuck in a dessert → First drink = life saving, but the 10th drink will be
less satisfying; with each additional unit,the satisfaction (marginal benefit)
diminishes
•
Marginal Benefits explained the diamond / water paradox
o Willingness to pay depends on marginal benefit, not total benefit
o Water is abundant, marginal benefit is low
▪ Need for life, but price is low
o Diamonds are scarce, marginal benefit is high
▪ Don’t need it to live
o Value of a product or service is determined at the margin
▪ What you’re willing to pay for water is what the last drink of water is worth
to you
▪ What you’re willing to pay for diamonds is what the last diamond was
worth to you
•
The Law Of Demand
o The demand curve combines 2 forces - switch to substitutes, and willingness and
ability to pay - determining quality demand, and can be read as a demand curve
and as a marginal benefit curve
•
Quantity Demanded - The amount you actually plan to buy at a given price
•
Market Demanded - The sum of demands of all individuals willing and able to buy a
particular product or service
•
Law Of Demand - If the price of a product or service rises, quantity demanded
decreases; other things remain the same
o $ ↑ = Quantity Demanded → other things remain the same
•
Demand Curve - Shows relationship between price and quantity demanded; all other
things remain the same
o Ex. Market Demand for Water
Row
Price ($/m )
Quantity Demanded (000’s of m /month)
A
$1.00
5
B
$1.50
4
C
$2.00
3
D
$2.50
2
E
$3.00
1
3
3
▪
▪
Demand Curve
▪ Downwards slope from top left to bottom right
▪ At lower prices, the quantity demanded is a larger number; at
higher process, the quantity demanded is a smaller number
2 ways to read a demand curve
▪ Demand Curve
▪ Read over and down
▪ From any prive go over to the demand curve and down to
the quantity demanded
▪ Marginal Benefit Curve
▪ Read up and over
▪ Rom any quantity on the horizontal axis, go up to the
marginal benefit curve and over to the price
•
What can change demand?
o Quantity Demand changes on;y with change in price
o All other influences on consumer choice change demand
•
Demand is a catch-all term summarizing all possible influences on consumers’
willingness and ability to pay for a particular product or service
o Increase in demand
▪ Increase in consumers’ willingness and ability to pay
▪ Rightward shift of demand curve
o Decrease in demand
▪ Decreases in consumers’ willingness and ability to pay
▪ Leftward shift of demand curve
o Increase Demand Curve Ex. → More Consumers Increase the Market Demand
for Water
Price
($/m )
Quantity Demanded (000’s
of m /month)
Quantity Demanded with more households
(000’s of m /month)
$1.00
5
10
$1.50
4
9
$2.00
3
8
$2.50
2
7
$3.00
1
6
3
3
3
•
Demand changes with changes in
o Preferences
▪ Ex. Advertising gets you to buy more at any given price willingly and able
to = ↑ in demand
o Income
▪ ↑ in income = ↑ in normal goods = ↑ in demand
▪ Normal Goods - Goods where demand ↑ when income ↑
▪ ↑ in income = ↓ in inferior goods
▪ Ex. Public transit for driving a car, shoppers drug mart running
shoes for better (now) affordable shoes
▪ If income ↓ = can’t afford anything else ; Inferior product ↑ = income ↓
▪ Ex. Buy Mac & Cheese over (expensive) restaurants
o Number Of Consumers
▪ ↑ number of consumers = sum of all individuals demand curves of all
individual consumers = a bigger number at any given price = ↑ demand
o Expectations Of Future Prices
▪ Ex. Expect gas prices to ↑ on the weekend (in the future) = buy today
before $ ↑ = ↑ demand today
o Price Of Related Goods
▪ Substitutes
▪ Goods to be used in place of each other
▪ Ex. Different apps, wine for beer / alcohol
▪ Ex. $ ↑ for wine = more willing to buy beer at any given
price
▪ ↑ in $ of substitute = ↑ in demand for other product
▪ Complementary
▪ Ex. Hamburgers & hamburger buns, hotdogs & fries
▪ Price of one of those changes = affect the demand for the
other related complementary product
▪ Ex. ↓ in $ of hamburger bun = ↑ demand of hamburger and
hamburger bun
↓ in $ of complement = ↑ in demand of complementary
product
Ex. Demande increases with
▪ ↑ in preferences
▪ ↑ in prices of a substitute
▪ ↓ in prices of a complement
▪ ↑ in income for normal goods
▪ ↓ in income for inferior goods
▪ ↑ in expectations for future prices
▪ ↑ in number of consumers
Ex. Decrease in demand = reverse for all ⬆ examples given
▪
o
o
•
Changes in Quantity Demanded
o Change in price of the product itself = moves along the curve
•
Change in demand
o One of the other variables change = shift demand curve
•
Law of Demand & Changes in Demands
o
The Law of Demand - The quantity demanded of a product or service
Decreases if :
Increases if :
Price of the product or service rises
Price of the product or service falls
Changes in Demand - The demand for a product or service
Decreases if :
Increases if :
Preferences decrease
Preferences increase
Price of a substitute falls
Price of a substitute rises
Price of a complement rises
Price of a complement falls
Income decreases (normal goods)
Income increases (normal goods)
Income increases (inferior goods)
Income decreases (inferior goods)
Expected future price falls
Expected future prices rise
Number of consumers decrease
Number of consumers increase
Chapter 3 - Law Of Supply
•
Costs are opportunity costs
o Businesses must pay higher prices to obtain more of an input because
opportunity costs change with circumstances
o The marginal costs of additional inputs (like labour) are ultimately opportunity
costs → the best best alternative use of input
•
Marginal Cost - Additional opportunity cost of increasing quantity supplied
o “Marginal” = “Additional”
•
Marginal cost changes with circumstances] Ex. Offered $15/hour and give up gaming
time to be willing to work those many hours in the week, but asked to work additional
hours for $30/hour or $45/hour, the time you give up in the rest of your life becomes
increasingly valuable
o Ex. Valuable time = time to study, sleep, for friends and family
o Give up most valuable time last
•
Business P.O.V. → To buy inputs, businesses must pay the price matching best
opportunity cost of the input of the owner (labour and labourers)
•
Key 2 relation → Additional benefits and costs → SUNK COSTS DON’T MATTER FOR
FUTURE CHOICES
o Sunk costs that cannot be reversed are NOT part of opportunity costs
o Sunk costs DON’T influence smart, forward-looking decisions
•
Sunk Costs - Past expenses that cannot be recovered
o Sunk costs are the same no matter which fork in the road you take, so no
influence on smart choices
o NOT part of opportunity costs to consider when making forward-looking choices
o Ex. “You just paid for bus fare. A friend in a car pulls up and offers a ride. Explain
how you would decide on staying on the bus or taking the ride, and the influence
of the paid fare on your choice.”
▪ Either choice made, the money is gone
▪ Smart choice : more fun and/or faster friend = GO WITH FRIEND
▪ Sunk cost shouldn’t matter in making a smart choice
o Ex. Dropping a course and no tuition refund
▪ Lost the money for tuition = sunk cost → doesn’t change for either choice
▪ Pass course = BENEFIT
▪ Fail course = lost money and fail on grade point average
•
As you give up time to work, marginal cost ↑; Give up least valuable alternate first
•
The Law Of Supply
o If the price of a product or service rises, quantity supplied increases
o Businesses increase product when higher prices either create higher profits or
cover higher marginal opportunity costs of production
o Price offered = time supplied ↑
o Ex.
Supply of hours worked
Price
(minimum willing to accept per hour)
Quantity Supplied
(hours of work per price)
$15
10 - 20
$30
35
$45
55
•
Supply - Businesses’ willingness to produce a particular product or service because
price covers all opportunity costs
o Cover all costs and have a return profit
•
Quantity Supplied - Quantity you actually plan to supply at a given price
•
Marginal Opportunity Cost - Complete term for any costs relevant to smart decision
o All opportunity costs are marginal costs and all marginal costs are opportunity
costs
•
Ex. Paola’s Parlour Production Possibilities Frontier
Combination
Fingernails (Full Set)
Piercings (Full Body)
A
15
0
B
14
1
C
12
2
D
9
3
E
5
4
F
0
5
o
o
o
o
o
o
o
o
Assumption is that all of Paola’s staff are not equally skilled / good at doing
fingernail sets
Assumption is that all of Paola’s staff are equally skilled / good at doing piercings
but some are better than others at fingernail sets
If Paola starts at producing all fingernail sets and wants to increase her outputs
of piercing, switch out the worst person at fingernail sets
▪ Amount of fingernail sets given up is 1 to get the first additional piercing
Move from B to C = gain 1 more piercing → switch second worst fingernail set
producer (staff person)
▪ Opportunity cost = 2
Move from C to D = gail 1 more piercing
▪ Opportunity cost ↑ to 3 fingernail sets because she needs to move the
better fingernail set painters out of fingernails and into piercings
Move from E to F
▪ Very last person (Paola herself) to switch = the best fingernail painter =
highest opportunity cost of 5 fingernail sets given up
Graph illustrates increasing opportunity cost of piercings which is from the staff
not all being equally good at producing fingernail sets → ↑ opportunity cost as ↑
output (supply of piercings)
▪ Opportunity Cost = Give UpGet
Paola’s Parlour Marginal Opportunity Costs
•
General Rule : Increasing marginal opportunity costs arise because inputs are not
equally productive in all activities
o Ex. In business with specialized people, in machinery
o Where inputs are equally productive in all activities, marginal opportunity costs
are constant
•
Law Of Supply - If the price of a product or service rises, quantity supplied increases
•
Market Supply - Sum of supplies all businesses willing to produce a particular product /
service
•
Marginal Opportunity Cost Of Additional Piercings Measured In Fingernail Sets
Marginal Opportunity Costs Of Additional Piercings
(Fingernail Sets Given Up)
Quantity Supplied
(Piercings)
1
1
2
2
3
3
4
4
5
5
•
Marginal Opportunity Cost Of Additional Piercings Measured In $
Price (Marginal Opportunity Cost Of Minimum Willing
To Accept)
Quantity Supplied
(Piercings)
$20
1
$40
2
$60
3
$80
4
$100
5
•
Market Supply Of Piercings
Row
Price (Marginal Opportunity Cost Or Minimum willing
To Accept Per Piercings)
Quantity Supplied
(Piercings)
A
$20
100
B
$40
200
C
$60
300
D
$80
400
E
$100
500
o
2 ways to read a supply curve :
▪ Read as a supply curve
▪ For any price on the vertical axis, go over to the supply curve and
down to the quantity supplied
▪ Read as a marginal cost curve
▪ From any quantity on the horizontal axis, go up to the marginal
cost curve and over to price
•
Supply Curve - Shows relationship between price and quantity supplied, other things
remain the same
o ↑ $ = ↑ Quantity Supplied
o Drawn upward sloping from left to right; at higher proces, the quantity supplied is
a larger number
o 2 ways to read a supply curve
▪ As a supply curve
▪ Read over and down from price to quantity supplied
▪ As a marginal cost curve
▪ Read up and over from quantity supplied to price
o A marginal cost curve shows the minimum priced businesses will accept that
covers all marginal opportunity costs of production
▪ Businesses need to be shown the money to cover all marginal and
opportunity costs. As output ↑, opportunity cost ↑ = Businesses need to
be shown incentive of a higher price in order to be willing to supply that
greater quantity
•
What changes supply?
o
o
Quantity supplied is changed only by a change in price
Supply is changed by all influences on business decisions
•
Supply is a catch-all term summarizing all possible influences on a business’ willingness
to produce a particular product or service
o Increase in supply - Increase in business’ willingness to produce → rightward
shift of the supply curve
o Decrease in supply - Decrease in business’ willingness to produce → leftward
shift of the supply curve
•
Increase in market supply of piercings
Price
(Marginal Opportunity Cost or
Minimum Willing To Accept Per
Piercing)
Quantity Supplied
(Before Technology
Improvement)
Quantity Supplied
(After Technology
Improvement)
$20
100
300
$40
200
400
$60
300
500
$80
400
600
$100
500
700
o
•
Rightward shift = increase in supply curve
Supply changes with changes in
o Technology
▪ Ex. Technology improvement
▪ Improvement in technology = increase in supply = rightward shift
o Environment
▪ Ex. Environmental change helping pollution
▪ Weather affects agricultural crops
▪ Good weather (sun, rain) and great growing season =
business at any given price will supply a greater quantity
than they would before
o Prices of input
▪ Ex. Fall in price of an input
▪ If all all wages go down as a business, that means at any given
price going to be willing to supply a greater quantity of a product
because wages are lower, the price of the product is the same
and you’ll be making a higher profit
▪ Marginal cost reading → to produce any given unit, you use to
need to receive price x, but since wage costs are lower, you’ll take
x - # and earn the same amount of profit
o Price of related products or services
▪ Ex. Fall in price of a related product or service
▪ Related product or service → a business has certain quantities of
inputs (workers, equipment) and those inputs produce different
outputs
▪ The different outputs are related for that business because
the business can choose to produce either of those
outputs with its inputs
▪ Ex. Paola’s Parlor → Makes piercings and fingernail sets =
piercings and fingernail seats are related products for
Paola’s Parlour
▪ Paola Produces piercings and nail sets; the price of nail sets falls.
What is Paola going to do (from a business P.O.V.)?
▪ Nail sets = less profitable → can’t get as much in the
market place
▪ Spend more inputs and devote more inputs into producing
piercings
o Expected future prices
▪ Ex. Fall in expected future prices
▪ Can produce stuff today or in the future
▪ If you know that in the future, the priced you’re going to get for
your product is lower, you’re going to produce more today as you
possibly can when you can sell at a higher price
▪ ↑ in supply today
o Number of businesses
▪ Ex. Increase in the number of businesses
▪ More businesses at any given price, the quantity supplied in the
market will be larger
•
Change in Quantity Supplies
•
Change in Supply
•
Law of Supply And Changes In Supply
o
The Law of Supply - The quantity supplied of a product or service
Decreases if :
Increases if :
Price of the product or service falls
Price of the product or service rises
Changes in Supply - The supply for a product or service
Decreases if :
Increases if :
Environment change harms production
Environment change helps production
Price of an input rises
Price of an input falls
Price of a related product or service rises Price of a related product or service falls
Expected future prices rises
Expected future prices falls
Number of businesses decreases
Number of businesses increase
Technology improves
Chapter 4 - Coordinating Demand And Supply
•
What is a market?
o Markets connect competition between buyers, competition between sellers, and
cooperation between buyers and sellers.
o Government guarantees of property rights allow markets to function
•
Market - Interactions between buyers and sellers
•
Markets Mix
o Competition - Between buyers ; Between sellers
o Cooperation - Between buyers and sellers
•
Voluntary exchanges between buyers and sellers happen only when both sides end up
better off
•
Property rights - Legally enforceable guarantees of ownership of physical, financial, and
intellectual property
o Ex. No property rights = people take your product / service without paying = no
incentive to continue producing
o Essential for markets to function
•
Governments sets rules of the game, defining, and enforcing property rights necessary
for free and voluntary exchange
•
Price signals from combining demand and supply
o When there are shortages, competition between buyers drive prices up
o When there are surpluses, competition between sellers drive prices down
•
Market Demand And Supply For Piercings
Price
Quantity Demanded
Quantity Supplied
Shortage (-) OR Surplus (+)
$20
1200
200
- 1000
$40
900
400
- 500
$60
600
600
0
$80
300
800
+ 500
$100
0
1000
+ 1000
•
Prices are the outcome of a market process of competing bids (from buyers) and offers
(from sellers)
•
Frustrated Buyers - Market price too low
o Shortage (Excess Demand) - Quantity demanded exceeds quantity supplied
o Shortages create pressure for prices to rise
o Rising prices provides signals and incentives for businesses to increase quantity
supplied and for consumers to decrease quantity demanded, eliminating the
shortage
•
Frustrated Sellers - Market price too high
o Surplus (Excess Supply) - Quantity supplied exceeds quantity demanded
o Surpluses create pressure for prices to fall
o Falling prices provides signals and incentives for businesses to decrease
quantity supplied and for consumers to increase quantity demanded, eliminating
the surplus
•
Market-Clearing Or Equilibrium Prices
o Market-clearing or equilibrium prices balance quantity demanded and quantity
supplied,coordinating smart choices of consumers and businesses
•
The price that coordinates the smart choices of consumers and businesses has 2 names
:
o Market-Clearing Price - Price that equalizes quantity demanded and quantity
supplied
▪ The price that clears the market
▪ Demanders and suppliers all match up
▪ Quantity Demanded = Quantity Supplied
▪ No on is frustrated
▪
▪
o
Buyers get what they want
Sellers find an amount of consumers they feel is acceptable
Equilibrium Price - Price that balances forces of competition and cooperation, so
that there is no tendency for change
•
When equilibrium is reached, price signals in markets create incentives, so that while
each person acts only in self-interest
o Interaction coordinated through Adam Smith’s Invisible Hand
▪ Invisible Hand pushes independent choices in a direction to equilibrium or
market-clearing that turns out to be good for everybody
o Result is the miracle of markets → continuous, ever-changing production of
products and services we want
▪ Don’t want = don’t make money = fall off the map
▪ Miracle of markets occur because price serves as signals to consumers
and businesses to make smart choices
•
When there are imbalances between quantity demanded and quantity supplied, prices
adjust, which then changes the incentives for individuals’ self-interest decisions; that
then take those decisions, moving prices, moving quantities, until the markets settle at
the market-clearing or equilibrium price, or quantity demanded = quantity supplied
•
What happens when demand and supply change?
o When demand or supply curve change, equilibrium prices and quantities change
o The price changes cause businesses and consumers to adjust their smart
choices
o Well functioning markets supply the changed products and services demanded
•
Original Equilibrium Price And Quantity in Bacon Market
•
Rise In Price Of Input (Pig Feed) In Bacon Market
•
Increase In Preferences (From Epic-Meal-Time) In Bacon Market
•
Economists Do It With Models
o Price and quantity changes are the result, not the cause, of economic events
o Thinking like an economist means analyzing a situation using comparative statics
▪ Comparing equilibriums
o Start with one equilibrium situation (intersection of demand and supply, other
things remain the same_
▪ Change one other thing / variable
▪ Compare resulting equilibrium situation (intersection of demand and
supply after the change) in terms of price and quantity
•
Demand changes due to a change in
o Preferences
o Income
o
o
o
Number of consumers
Expected future prices
Price of related products (substitutes and complementary)
•
Increase In Demand
•
Decrease In Demand
•
Increase in demand causes a(n)
o Rise in equilibrium
o Increase in quantity supplied
•
Decrease in demand causes a
o Fall in equilibrium
o Decrease in quantity supplied
•
Supply changes due to a change in
o Environment
o Technology
o Price of inputs
o Price of related products
o Number of businesses
o Expected future prices
•
Increase In Supply
•
Decrease In Supply
•
Increase in supply causes a(n)
o Fall in equilibrium price
o Increase in quantity demanded
•
Decrease on supply causes a(n)
o
o
Rise in equilibrium price
Increase in quantity demand
•
Review Of Comparative Statics
o Price of quantity changes are the result, not the cause, of economic events
o Thinking like an economist means analyzing or a situation using comparative
statics
o Start with one equilibrium situation (intersection of demand and supply, other
things remain the same); then change one other thing / variable, and compare
resulting equilibrium situation (intersection of demand and supply after the
change) in terms of price and quantity
•
When both demand and supply change at the same time
o Can predict change in equilibrium price or equilibrium quantity
o But without information about the relative size of shifts in demand and supply
curves, cannot predict the other equilibrium outcome
•
Effects Of Combined Changes In Demand And Supply
1. Increase in both demand and supply
2. Decrease in both demand and supply
3. Increase in demand and decrease in supply
4. Decrease in demand and increase in supply
•
Effects In Changes In Demand Or Supply
Change
Shifts Of Curve
Effects On Equilibrium
Price
Quantity
↑ in demand
Demand shifts →
↑
↑
↓ in demand
Demand shifts ←
↓
↓
↑ in supply
Supply shifts →
↓
↑
↓ in supply
Supply shifts ←
↑
↓
↑ in demand & ↑
in supply
Demand shifts → &
Supply shifts →
Need exact #s to
predict outcome
↓
↓ in demand & ↓
in supply
Demand shifts ← &
Supply shifts ←
Need exact #s to
predict outcome
↑
↑ in demand & ↓
in supply
Demand shifts → &
Supply shifts ←
↑
Need exact #s to
predict outcome
↓ in demand & ↑
in supply
Demand shifts ← &
Supply shifts →
↓
Need exact #s to
predict outcome
•
Consumer Surplus, Producer Surplus, And Efficiency
o An efficient market outcome has the largest total surplus, prices just cover all
opportunity costs of production and consumers’ marginal benefit = businesses’
marginal costs
•
Reading demand curves as marginal benefit & marginal cost curves reveals concepts of
o Consumer Surplus - Difference between amount a consumer is willing to pay,
and the price actually paid
▪ Area under marginal benefit curve but above market price
o Producer Surplus - Difference between amount producer is willing to accept and
the price actually received
▪ Area below market price but above marginal cost curve
•
Marginal Benefit & Consumer Surplus
•
Marginal Cost & Producer Surplus
•
Efficient Market Outcome - Coordinates smart choices of businesses & consumers so
o Consumers buy only products and services where marginal benefit is greater
than price
o Product and services produced at lowest cost; prices just covers all opportunity
costs of production
o Products and services go to consumers most willing and able to pay
o Total Surplus (consumer surplus + producer surplus) is at a maximum
•
Maximum Total Surplus For Efficient Market
•
Inefficient Outcomes
o Deadweight Loss - Decrease in total surplus compared to an economically
efficient outcome
o For an inefficient outcome, subtract deadweight loss so total surplus is less than
for economically inefficient outcome
•
Inefficiency When Marginal Benefit (MB) Is Not Equal To Marginal Cost (MC)
1. Inefficiency Of Producing Too Little
2. Inefficiency Of Producing Too Much
Chapter 5 - Elasticity (Just How How Badly Do You Want It)
•
Second most important concept in economics
o Just how badly do you want it?
o Crucial for business pricing decisions, government tax policy and who pays taxes
•
Price Elasticity
o Elasticity measures how responsive quantity demanded is to a change in price
•
Elasticity
o Price Elasticity of Demand - Measured by how much quantity demanded
responds to a change in price
▪ Formula : Price Elasticity of Demand = % change in quantity demand%
change in price
▪ Inelastic Demand VS. Elastic Demand
▪ Inelastic Demand (For Insulin)
Big ↑ in price = Small response in quantity demanded (↓)
Ex. If you’re diabetic, you need insulin to live = going to
always prioritize a constant (or close to) quantity no matter
the price
Elastic Demand (For Blue Earbuds)
▪
▪
▪
Small ↑ in price = Huge response in quantity demanded (↓)
Ex. If you’re not diabetic, you don’t need insulin to live =
not going to prioritize a constant (or close to) quantity no
matter the price = stop buying it
Price Elasticity of Insulin
▪ Ex. Suppose the price went up 100% (doubled) → %
change in price = 100% and the % decrease in quantity
demanded = 2%
▪ Big increase in price and very small response in
quantity demanded
▪
▪
▪
Price Elasticity of Demand = % change in quantity
demand% change in price= 2100= 0.02
▪
▪
▪
Inelastic Demand - Small response in quantity demanded when
price rises
▪ Ex. Demand for insulin by a diabetic
▪ Elasticity < 1 (or 0 < Elasticity < 1)
▪ Low willingness to shop elsewhere (even when price ↑)
Elastic Demand - Large response in quantity demanded when
price rises
▪ Ex. Demand for blue earbuds
▪ Elasticity > 1
▪ High willingness to shop elsewhere
Extreme Elasticities of Demand
▪ Perfectly Inelastic Demand - Price elasticity of demand
equals zero ; quantity demanded does not respond to
change in price
▪ Vertical demand curve
▪
▪
•
No matter what happens to price, no matter how
much it ↑, there is absolutely no response, no
change in the quantity demanded
Perfectly Elastic Demand - Price elasticity of demand
equals infinity ; quantity demanded has infinite response to
change in price
▪ Horizontal demand curve
▪ At that price, consumers will buy whatever is
available, but if price prices, no matter how matter
small, then the quantity demanded falls to zero
The price elasticity of demand is influenced by :
o Availability of Substitutes
▪ More substitutes = more elastic demand
▪ Most important
Ex. If you’re diabetic, there aren’t many substitutes for insulin. So when
price ↑ , you have no choice but to buy that price if you want to buy insulin
(Unless you want poor, poor substitutes that are available)
▪ Ex. Blue earbuds have many substitutes (white earbuds, blck earbuds,
red earbuds). So if the price of blue earbuds ↑, there are many substitutes
to switch to. Thus, it’s very easy to respond to an ↑ in price for something
like blue earbuds by shopping elsewhere for buying many of the available
substitutes
Time to Adjust
▪ Longer time to adjust = more elastic demand
▪ When you’re a consumer and the price of something foes up, you
can switch to substitutes, but sometimes, not so quickly
▪ Ex. Drive to work and don’t have an easy transit route to get to
work. If the price ↑,
▪ Short-run = stuck
▪ Long run = more time → if price of gas ↑ enough, with
more time, you might :
▪ Buy a hybrid car (which reduces your quantity
demanded of gas)
▪ Move closer to a transit route to work
▪ With time you can adjust to the price rise and that quantity
adjustment can lead to a more dramatic change in quantity
demanded as you have more time to respond
Proportion of Income Spent
▪ Greater proportion of income spent on a product / service = more elastic
demand
▪ Ex. Ex. Consumption of salt
▪ Price of salt goes up by 100%, doubles from $1 to $2 a box, how
much is the quantity demand going to change?
▪ Salt is salt and not that big of a deal, not a lot of money =
you just pay the difference
▪ Ex. Automobiles
▪ If the price of automobiles went up 100%, some
percentage change, but if the price of an automobile goes
from $25,000 to $50,000, there’s a bigger proportion of
income than the $1 to $2 spent on salt = respond
differently
▪ Higher the proportion of income that you spend on a product, the
more elastic the demand is going to be for that product, the more
price sensitive you are
According to Law of demand, ↓ price = ↑ quantity demanded → relation to % ↑/↓
in price or quantity demanded
▪
o
o
o
•
Elasticity and Total Revenue
o Elasticity determines business pricing strategies to earn maximum total revenue
→ cut prices when demand is elastic and raise prices when demand is inelastic
•
Total Revenue - All money a business receives from sales
o Total Revenue = Price Per Unit Quantity Sold = P Q
o
o
•
For businesses facing elastic demand (> 1), price cuts increase tidal revenue
▪ Make it up in volume
For businesses facing inelastic demand (< 1 OR 0 < E < 1), price rises increase
total revenue
▪ No available substitutes for consumers = have to pay
As you move down a straight line demand curve, elasticity changes and is not the same
as the slope
o Elasticity goes from elastic, to unit elastic, to inelastic
o Total revenue increases, reaches a maximum when elasticity equals 1 (unit
elastic = 1) then decreases
o Elasticity and Total Revenue
o
Ex. Concession stands at movie theatres charge high prices for popcorn, drinks,
and other refreshments. This pricing strategy increases total revenue. What does
that imply about the price elasticity of demand for refreshments in movie
theaters? What theatre policy helps make this demand elastic or inelastic?
▪ Inelastic demand → $↑ and no / little sensitivity in quantity demanded
▪ Policy → We can’t bring in our drinks and food = eliminates cheap
substitutes = more willing to pay higher prices
•
Price of Elasticity of Supply
o Elasticity of supply measures the responsiveness of quantity supplied to a
change in price , and depends on the difficulty, expense, and time involved in
increasing production
•
Elasticity of Supply - Measures how much quantity supplied responds to a change in
price
o Formula : Price Elasticity of Supply = % change in quantity supplied% change in
price
o Recall : Law of Supply → ↑ price = ↑ quantity demanded → relation to % ↑/↓ in
price or quantity demanded
o Inelastic Supply - Small response in quantity supplied when price rises
▪ Price ↑ = more profitable → businesses encouraged to ↑ production,but
how quickly, or by how much, can they increase their output of this now
more profitable product / service?
▪ Difficult to increase if it takes a long time to get new output
▪ Elasticity = inelastic
▪ Difficult and expensive to increase production
▪ Ex. Supply of Gold
▪ Price of gold ↑, gold mining companies can’t instantly increase the
quantity of gold they bring to the market = not a quick response
▪ Elasticity of Supply < 1 (OR 0 < E < 1)
o Elastic Supply - Large response in quantity supplied when price rises
▪ Easy and inexpensive to increase production
▪ Price ↑ = instantly there’s more available by suppliers on the market
▪ Ex. Snow-Shovelling services
▪ Anybody can get into the business with a shovel or pick-up truck
so that if people are willing to pay more, if price ↑, for the services
= quick response in the quantity supplied
▪ Elasticity of Supply > 1
o Extreme Elasticity of Supply
▪ Perfectly Inelastic Supply
▪ Price elasticity of supply = 0
▪ Vertical supply curve
▪ Quantity supplied does not respond to change in price
▪
Perfectly Elastic Supply
▪ Horizontal supply curve
▪ Price of elasticity of supply = infinity
▪ Quantity supplied has an infinite response to change in price
•
Elasticity of supply is influenced by
o Availability of Additional Inputs
▪ More available inputs = more elastic supply
▪ Ex. If you can instantly get more workers, put more snow shovels on the
ground, then elasticity of supply is more elastic
o The Time Production Takes
▪ Less time production takes = more elastic supply
▪ The shorter time production takes, the easier it is to ramp up output and
bring it to the market
▪ Ex. Gold mining
▪ Gold mining takes a long time to ramp up new production, hence
it’s more inelastically supplied
o Elasticity of supply allows more accurate predictions of future outputs and prices,
helping businesses avoid disappointing customers
•
More elasticities of demand
o Elasticity measures explain the responsiveness of quantity demanded to
changes in prices of related products and income, and the division of a tax
between buyers and sellers
•
Cross Elasticity of Demand - Measures responsiveness of a demand for a product or
service to a change in price of a substitute or compliment
o Formula : Price Elasticity of Supply = % change in quantity demanded% change
in price of a substitute or compliment
o If products are unrelated = Price change Product A has no effect on consumers’
demand for Product B = Zero change in quantity demanded of product B
o Ex. Blue And White Earbuds
▪ Blue earbuds → denominator
Blue earbuds % change ↑ = huge ⊕ change in demand for white
earbuds
Cross elasticity of demand is a positive number for substitutes ー The larger the
number, the :
▪ Larger the change (increase) in demand
▪ Larger the rightward shift of the demand curve
▪ Closer the products or services are to perfect substitutes
▪ Rightward shift in demand curve
Cross elasticity helps measure the magnitude of the shift of the demand curve →
Bigger the shift of the demand curve = bigger the shift of the demand curve
Cross elasticity of demand is a negative number for compliments. The larger the
number, the :
▪ Larger the change (decrease) in demand
▪ Larger the leftward shift of the demand curve
▪ Closer the products or services are to perfect complements
▪ Leftward shift in demand curve
▪ Ex. Hamburger + Hamburger Buns
▪ Price of hamburgers ↑ = hamburgers + hamburger buns are more
expensive = people buy fewer = ↓ in demand for hamburger buns
▪
o
o
o
•
Income Elasticity of Demand - Measures responsiveness of the demand for a product or
service to a change in income
o Formula : Price Elasticity of Supply = % change in quantity demanded% change
in income
▪ Positive for normal goods
▪ ↑ in income = ↑ demand for normal goods
▪ Negative for inferior goods
▪ ↑ in income = ↓ for inferior goods
o Income for inelastic demand
▪ Income elasticity is less than 1 but greater than 0 (0 < E < 1)
▪ % change in quantity is less than % change in price
▪ Normal goods that are necessities
o Income elastic demand
▪ Income elasticity greater than 1 (> 1)
▪ % change in quantity is greater than % change price
▪ Normal goods that are luxuries
•
Tax Incidence and Government Tax Choices
o Who pays a tax depends on elasticities of demand and supply?
▪ The more inelastic the demand, they buyers pay, and the more inelastic
supply, the more seller pays
•
Tax Incidence - Division of a tax between buyers and sellers ; depends on elasticities of
demand and supply
•
Who pays GST / HST → businesses or consumers?
o
Ex. A Sales Tax on Businesses
▪
▪
o
•
New equilibrium is up by $10
The $20 tax
▪ $10 from consumers
▪ $10 from suppliers
In general,
Tax Revenues
▪
o
•
Tax Revenue = Area = $20 x 40 units = $80 of tax revenue government
collects from sales tax
The more inelastic demand and supply are, the greater the tax revenue for the
government
▪ For maximum revenue, government try to tax products and services with
inelastic demands and suppliers
Elasticity and tax incidents
When Demand Is...
Perfectly Inelastic
Tax Incients
Buyers pay all of a tax
Inelastic
Buyers pay more of a tax
Elastic
Sellers pay more of a tax
Perfectly Elastic
When Supply Is...
Perfectly Inelastic
Sellers pay all of a tax
Tax Incidents
Sellers pay all of a tax
Inelastic
Sellers pay more of a tax
Elastic
Buyers pay more of a tax
Perfectly Elastic
Buyers pay all of a tax
Chapter 6 - Government and Policy Choices (What Gives When Prices
Don’t)
•
Market Demand and Supply For Piercings
Price Quantity Demanded Quantity Supplied Shortage (-) OR Surplus (+)
$20
1200
200
-1000
$40
900
400
-500
$60
600
600
0
$80
300
800
500
$100
0
1000
1000
•
Do Prices OR Quantities Adjust?
o When the government fixes prices, the smart choices of consumers and
businesses are not coordinated
o Quantities adjust to whichever is less ㄧ quantity supplied or quantity demanded
•
Market gasoline with Storage
Price
Per
Litre
Quantity Demanded
(Millions of litres per
month)
Quantity Supplied
(Millions of litres per
month)
Shortage (-) OR Surplus
(+) (Millions of litres per
month)
$0.80
95
35
-60
$1.00
85
55
-30
$1.20
75
75
0
$1.40
65
95
30
$1.60
55
115
60
•
When a price is fixed below market-clearing
o Shortages develop → quantity demanded > quantity supplied
o Consumers are frustrated
o Quantity sold = Quantity supplied only
•
When a price is fixed above market-clearing
o Surpluses develop → quantity supplied > quantity demanded
o Businesses are frustrated
o Quantity sold = Quantity demanded only
•
When prices are fixed, quantities adjust to whichever is less ㄧ quantity supplied or
quantity demanded
•
Governments can fix prices, but can’t force businesses (or consumers) to produce (or
buy) at the fixed price
o
o
•
Businesses can reduce output or more resources elsewhere → price fixed too
low
Consumers can reduce purchases or buy something else → price fixed too high
Price Ceilings - The maximum price set by government, making it illegal to charge at a
higher price
o Rent controls fix rents below market-clearing levels, and quantity adjustment
takes the unintended form of apartment shortages
o Ex. Rent Controls
o Rent Controls sometimes justified by Robin Hood Principle → take from the rich
(landlords) and give to the poor (tenants)
o Ex.
Market for Two-Bedroom Apartments
Market for Two-Bedroom Apartments with Rent Controls
o
o
o
•
Rent controls have unintended consequences
▪ Create housing shortages, giving landlords the upper hand over tenants
▪ Subsidize well-off tenants willing and able to pay market clearing rents
▪ Inefficiency, reducing total surplus below market-clearing amounts
Alternative policies to help the homeless that do not sacrifice market flexibility
▪ Government income subsides
▪ Government-supplied housing
All policies have opportunity costs
▪ Be sure to look for unintended consequences of policies that have good
intentions
Price Floors - Minimum price set by government that makes it illegal to pay a lower wage
o Maximum wage laws fix wages above market-clearing levels, and quantity
adjustment takes the unintended from unemployment
o Circular Flow Of Economic Labour markets are input markets
▪
▪
o
o
o
o
o
Households own all inputs
In input markets,
▪ Households = Suppliers
▪ Businesses = Demanders
Ex. Minimum Wage Laws
Ex. The price of labour
Living Wage
▪ Estimated at $20 / hour
▪ To allow individuals in a large Canadian city to live above the poverty line
Unintended consequences of minimum wage above market-clearing wage
▪ Quantity of labour supplied by households is greater than quantity of
labour demanded by businesses
▪ Creates unemployment
Market for unskilled labour with a minimum wage
o
o
o
o
o
o
o
How much unemployment is created by raising minimum wage depends on
elasticity of business demand for unskilled labour
▪ When demand is inelastic and businesses have fewer substitutes for
labour, small response in decrease quantity demanded
▪ When demand is elastic and businesses can easily substitute machines
for people, large response in decreased quantity demanded
Minimum wages help the working poor if gains of workers who keep their jobs
with higher incomes are greater than loss of workers who lose jobs and income
In output markets, Q P = Total Revenue ; Q = Quantity, P = Price
In input markets, Q P = Income For Workers ; Q = Hours Worked, P = Wage
Rate
Increased wage (P) → Increased income (Q P) if labour demand is inelastic
Increased wage (P) → Decreased income (Q P) if labour demand is elastic
Alternative policies to help the working poor that don’t sacrifice market flexibility
▪ Training programs to help unskilled workers get higher-paying jobs
▪ Wage supplements
•
All policies have opportunity costs
o Be sure to look for unintended consequences before making up your mind about
policy choices
•
Trade-offs between efficiency and equity
o Well functioning markets are efficient, but not always equitable
o Governments may smartly choose policies that create more equitable outcomes,
even though the trade-off is less efficient
•
Efficient, well- functioning markets provide the products and services we value most,
which means outputs go to those most willing and able to pay
•
Efficient market outcomes may not be fair or equitable
•
Efficient market outcome
o Coordinates smart choices of business and consumers
o Outputs are produced at lowest cost (prices just cover all opportunity costs of
production)
o Consumers buy products and services providing the most bang per buck
(satisfaction) (marginal benefit is greater than price)
•
Maximum Total Surplus for Efficient Market
•
Consumers who don’t buy at Equilibrium market-clearing price are either
o Unwilling → because benefit is less than price (even though they could afford to
buy)
o Unable to pay → Even though they are willing to buy (marginal benefit is greater
than price)
•
Allowing markets to operate without government interaction is a choice with an
opportunity cost → unfairness or inequity
•
Economists tend to agree about efficiency but disagree about fairness
•
Trade-off between efficiency and equity
o Compare U.S.A. market-driven health care with Canadian universal governmentrun health care
▪ Canadian-style government health care - more equitable but less efficient
▪ U.S.A-style private market outcome = more efficient but less equitable
▪
Health-care waiting lists are a quantity adjustment when prices are fixed
too low
•
Government may make smart policy choices that
o Create more equitable outcomes, even though the trade-off is less efficiency
o Create more efficient outcomes, even though the trade-off is less equity
•
What economics can and cannot do for you
o Once you choose to support a political position or social goal based on your
values, political economic thinking helps identify the smartest choices to
efficiency achieve that goal
•
Positive (Empirical) Statements - About what is
o Can be evaluated as true or false by checking facts
•
Normative Statements - About what you should believe should be ; involve value
judgements
o Efficiency versus equity choices are normative
•
Two Definitions of Equity
o Equal Outcomes - At the end, everyone gets the same amount
o Equal opportunities - At the start, everyone has the same opportunities, but the
outcomes can be different
•
Politics of Equity
o For any political choice, weigh benefits against opportunity costs, including
unintended consequences
o Equal Outcomes
▪ Politicians on political left
▪ Redistribution of incomes towards equity : skeptical about equal
opportunities
▪ Equity prioritizes over efficiency
o Equal Opportunities
▪ Politicians on political right
▪ Unequal outcomes are fair results of personal differences
▪ Efficiency prioritizes over equity
Chapter 7 - Opportunity Costs, Economic Profits / Losses, Miracle Of
Markets : Finding The Bottom Line
•
3 Keys Model to smart choices
1. Choose only when additional benefits are greater than additional opportunity
costs
2. Count only additional benefits and additional opportunity costs
3. Be sure to count all additional benefits and costs, including implicit costs and
externalities
•
Accounting profits and hidden opportunity costs
o Accounting profits equal revenues minus all obvious costs, including depreciation
o Accounting profits miss the hidden opportunity costs of a business owner’s time
and money
•
Obvious Costs (Explicit Costs) - Costs a business pays directly
o Ex. Pay for hydro, rent, labour costs
•
Accountants count all obvious business osts and include depreciation
o Decrease in the value of equipment over time because of wear and tear and
because it becomes obsolete
o Yearly Depreciation Costs = price of equipment# of years it lasts
•
Accounting profits
o Accounting Profits = Revenues - Obvious Costs
▪ Obvious Costs include depreciation, labour costs, raw materials, hydro,
etc.
•
Accountant’s One-Year Business Plan For Wahid’s Web Wonders
•
Implicit Costs - Hidden opportunity costs of what a business could earn elsewhere with
time and money invested
o
o
o
o
o
o
Opportunity cost of time → best alternative use of business owner’s time
▪ Best alternative employment that one could have earning money instead
of spending the year in their own business
▪ Ex. Working for someone else and they would pay $38,000 / year
→ $38,000 is the opportunity cost of one’s time in their own
business
▪ The most one could have earned working for a year
elsewhere
Opportunity cost of money → best alternative use owner’s money invested in the
business
▪ Ex. Putting $40,000 for the year into business ($20,000 equipment,
$20,000 other expenses), what else could one have earned with that
$40,000
Most include compensation for Risk
▪ Risk associated with investment
▪ Different kinds of investments = different risks
▪ Put money into savings account or bank = least risky / risk free
▪ Invest in a business → risk associated
▪ May expect a certain return but no guarantee
Ex. For $40,000 investment
Bank Interest = 5%
Wahid’s Risk Premium = 15% above bank interest rate
Wahid is equally pleased with
a.
$2,000 guaranteed from the bank
• 5% bank investment
b. $8,000 expected return from business investment
• 5% Bank Investment + 15% Risk Premium = 20%
If both were 5%, the best choice is (a), the $2,000 guaranteed from the bank
since it’s a safer risk
Invest in business → expect a greater return than the guaranteed from the bank
Risk Premium
▪ To avoid bank investment, need to expect to receive the % from the bank
+ extra % for the risk associated with any business
•
Risk compensation depends on attitude towards risk
o Risk-loving investor does not require much compensation for taking risks
o Risk-averse (Risk avoiding) investor requires high compensation for taking risks
•
Normal Profits and Economic Profits
o Smart business decisions return at least normal profits ㄧ What a business
owner could earn from the best alternative uses of their time and money
o There are economic profits over and above normal profits when revenues are
greater than all opportunity costs of production, including hidden opportunity
costs
•
Normal profits
o Compensation for business owner’s time and money
o
o
o
Sum of hidden opportunity costs (implicit costs)
What a business owner must earn to do well as the best alternative use of time
and money
Average profits in other industries
•
Economic Profits = …
o Economic Profits = Revenues - ALL Opportunity Costs
o Economic Profits = Revenues - (Obvious Costs + Hidden Opportunity Costs)
o Economic Profits = Revenues - (Obvious Costs + Implicit Costs)
o Economic Profits = Revenues - (Obvious Costs + Normal Profits)
•
Economics subtract hidden opportunity costs when calculating profits ㄧ accountants do
not
o Economic profits are less than accounting profits
•
Economic Losses - Negative economic profits
o If revenues are less than all opportunity costs it’s not a smart decision, and
business owner would be better off in alternative uses of time and money
o With economic losses, business owner earns less than normal profits, or less
than average profits in other industries
•
Economist’s One-Year Business Plan For Wahid
o
The brackets for “($11 000)” = ⊖ = Loss
▪ Best to invest elsewhere
o
Counting implicit costs = Key 3
•
How economic profits direct the invisible hand
o The simplest rule for smart business decisions is “Choose only when economic
profits are positive”
o When businesses pursue economic profits, markets produce the products and
services consumers want
•
Alternative Profit Scenarios for Wahid’s Web Wonders
Scenario
One
Revenues
$60 000
$71 000 $80 000
Total Obvious Costs
$25 000
$25 000 $25 000
Total Hidden Costs
$46 000
$46 000 $46 000
Accounting Profits
$35 000
$46 000 $65 000
Economic Profits
($11 000)
•
Two
$0
Three
$9 000
Economic Profits & Losses
o Signal smart business decisions
o Economic Losses
▪ Businesses contract and leave industry
▪ Supply decreases
▪ Pushes prices up until prices just cover opportunity costs of production
▪ Economic profits = 0
▪ A RED light
o Break Even point
▪ Businesses just earning normal profits
▪ Market equilibrium
▪ Zero economic profits / losses
▪ No tendency for change
▪ A YELLOW light
o Economic Profits
▪ Businesses expand and enter industry
▪ Supply increases
▪ Pushing prices down until prices just cover all opportunity costs of
production
▪ Economic profits = 0
▪ A GREEN light
•
Short-Run Market Equilibrium - Quantity demanded equals quantity supplied, but
economic losses or profits lead to changes in supply
•
Long-Run Market Equilibrium - Quantity demanded equals quantity supplied, economic
profits = 0, no tendency for change
o Price consumers willing and able to pay just covers businesses’ opportunity costs
of production, including normal profits
•
Short-Run and Long-Run Market Equilibrium
o Economic Losses and Decreased Supply Lead to Long-Run Market Equilibrium
(Scenario #1)
o
Economic Profits and Increased Supply Lead to Long-Run Market Equilibrium
(Scenario #3)
▪
P is the long-run equilibrium price at which economic profits are zero
L
•
Difference between short-run and long-run market equilibrium is additional time it takes
for supply changes to adjust economic profits to zero
•
Economic profit / losses are key signals directing businesses to produce products and
services consumers want
o Changes in economic profits trigger :
▪ Changes in supply
▪ Changes in prices
▪ Moving industry from short-run market equilibrium to long-run market
equilibrium
Chapter 8 - Monopoly To Competition And In Between
•
Price Makers and Price Takers
o Businesses aim for monopoly’s economic profits and price-making power
o Competitors usually push businesses towards the normal profits and price taking
of perfect competition
•
Monopoly - Only seller of product or service; no substitutes available
o Demand curve is steep and inelastic
•
Market Power - Business’ ability to set prices
•
Price Maker - Monopoly with maximum power to set prices (market power)
•
Monopoly’s Inelastic Demand
•
Businesses can set any price, but can’t force consumers to buy
o Even monopoly process markets must live by law of demand
•
Perfect Competition - Many sellers producing identical products or services
o Demand curve is horizontal and perfectly elastic at the market price
o Price Taker
▪ Price Taker - Business with zero power to set price
•
Perfectly Elastic Demand for an individual business in perfect competition
•
Examples :
o Price Makers
▪ Photocopier (Xerox copier)
o Price Takers
▪ Wheat farmers → can’t differ price since consumers go elsewhere + can’t
lower prices since it’ll result in economic loss
•
Market Structure
o Pricing power depends on competitiveness of a business’ market structure ㄧ
available substitutes, number of competitors, barriers of entry of new competitors
ㄧ and on elasticity of demand
•
Market Structure ㄧ Characteristics affecting competition and pricing power
o Available substitutes
o Number of competitors
o Barriers to entry of new competitors
•
Broader Definition of Market - More substitutes and competitors, more elastic demand,
less pricing power
o Ex. Smartphones
▪ Willing to buy any smartphone → broad choice of type and price
•
Narrower Definition of Market - Fewer substitutes and competition, more inelastic
demand and more pricing power
o Ex. Smartphones
▪ For a specific type of smartphone → Eliminated potential substitutes and
eliminated potential competition and more stuck to pay price that that
particular business is charging
•
Market Structure Examples
o Vegetables → Can be bought and come from anywhere
▪
▪
▪
Willing to buy from anywhere
▪ A lot of choices = more competition and more substitutes
▪ U.S.A., Canada, Peru, local, etc.
Just Canadian
▪ Ruled out a lot of substitutes = narrowed definition of market =
taken away option that might have been cheaper
Locally (Extreme)
▪ Big narrowing of market
▪ Pay a much higher price because there’s less competition and
fewer substitutes to consider
•
Product Differentiation - Attempt to distinguish product or service from those of
competitors
o Reduces competition and substitutes, and increases pricing power
o Can be actual differences or perceived differences
▪ Convince you that particular product is better / cooler
▪ If no difference (in actuality), you think differently of their product
o Advertising = trying to differentiate a product
•
Pricing power and number of competitors
o Fewer competitors = more pricing power
o More competitors = less pricing power
•
Barriers To Entry - Legal or Economic barriers that prevent new competitors from
entering a market
o Legal Barriers - Patents and copyrights are exclusive property rights to sell or
license creations
▪ Necessary incentive for innovations
▪ Ex. Xerox, Apple’s iPhone
▪ Original company spends millions of dollars coming up with the product,
put them on the market, a competitor buys it, reverse engineers it, builds
a competitive product, but charge a lower price because they didn’t have
to cover though R&D costs
▪ That company or anyone who comes after would never have an
incentive to invest in research or development again
▪ Expires after a certain amount of time to protect the interests of
consumers
▪ Once the business has paid for its initial investment, then it’s only fir that
there should be competition → price comes down that consumers will
benefit from
o Economic Barriers - Economies of scale : Average total cost of producing
decreases as quantity (scale) of production increases
▪ Advantage of bigness
▪ When a business gets a sufficient scale of output, they can reduce their
average total cost, how much it costs per unit of output
▪ A competitor coming in as a fresh start usually starts small = average
costs are higher
Can’t easily enter a market that has advantages in the form of economies
of scale
▪ Businesses try and ramp u[ to scale very quickly because it will
prevent somebody from coming in at a small scale, at which it’s
easier to come in, and instead force them to come in at a very
large scale
▪ Takes a lot of investment and risk, and much less likely to
happen
▪ Important for protecting economic profits over time
Average total cost = Total cost per unit of output
▪
o
•
Higher pricing power = more inelastic demand
o Consumers have few substitutes or strong brand loyalty
•
Lower prices = more elastic demand
o Consumers have many substitutions or no bran loyalty
•
Oligopoly and monopolistic competition
o
There are 4 main market structures : Monopoly, oligopoly, monopolistic
competition, and perfect competition
•
Oligopoly - Few big sellers control most of the market
o Ex. Gaming Hardware
▪ Ex. Microsoft, Windows, Nintendo, Sony → Similar but slightly
differentiated products
▪ Big and have a lot of market power, but have a few other big
competitors
▪ Ex. Pepsi and Coke → big and similar
•
Monopolistic Competition - Many small businesses make similar but slightly
differentiated products or services
o Slightly differentiated = a little bit of pricing power
o Ex. Restaurants
▪ All serve food but have distinctive identities
o Ex. Dry Cleaners
▪
o
•
Dry cleaners are dry cleaners but have some reputation for services or
better hours or being more careful
Ex. Florists, hair salon
Market Structure and Pricing Power
Market
Structure
Characteristic
Monopoly
Oligopoly
Monopolistic
Competition
Perfect
Competition
Pricing Power
Price Maker
(Maximum
Pricing Power)
Price Maker
(Much Pricing
Power)
Price Maker
(Limited Pricing
Power)
Price taker (No
Pricing Power)
Product
Substitutes
No Close
Substitutes
Differentiated
Substitutes
Slightly
Differentiated
Substitutes
Many Perfect
Substitutes
Number of
Sellers
1
Few
Many
Greatly Many
Barriers to
Entry
High
Medium
None
None
Elasticity of
Demand
Inelastic
Inelastic
Elastic
Perfectly
Elastic
o
In moving across range of market structures from monopoly to perfect
competition
▪ Pricing power moves from price maker to price taker
▪ Availability of substitutes foes from none to many
▪ Number of sellers goes from one to great many
▪ Entry barriers go from high to low
▪ Elasticity of demand goes from low to high
•
How do businesses compete?
o Businesses actively compete for monopoly’s economic profits and pricing power
o This process of creative destruction drives competitors who don’t adequately
respond out of business while unintentionally improving productivity and luxury
standards for all
•
Competition - Active attempt to increase profits, and gain market power of monopoly
o Cutting costs
▪ Ex. Walmart, Costco
o Improving quality and product innovation
▪ Ex. Apple
o
o
o
Advertising and Brand Loyalty
▪ Luxury products and differentiation
▪ Ex. Kanye West’s Yeezy, Prada, Micheal Kors
▪ Expensive advertising and established images
Eliminating competition
▪ Merger → combine with another company
▪ Ex. Leon’s and The Brick
Building barriers to entry
▪ Ex. Starbucks locations
▪ Ex. House cleaning products → Tide, Ivory, Gain, Downy, Cheer
▪ Big competitors
▪ Made by the same companies
•
* Shrinkage = steal *
•
A market economy provides extraordinary economic freedom to make business
decisions, to invest and spend as we please, to choose our occupations
o As sellers who depend on markets to earn a living, we must play by the market’s
competitive rules
•
Creative Destruction - Competitive business innovations generate economic profits for
winners, improve living standards for all, but destroy less productive or less desirable
products and production methods
o Ex. Blacks photography store to close
▪ Printed photos at stores
▪ Technology goes digital = don’t need to print at these stores = people
lose jobs and investors lost money because Blacks went out of business
▪ Technology changes and competitive change leading to creative
destruction
o Elimination of VCRs, DVDs, SDs, typewriters
o Responsible for moving jobs offshore
▪ Ex. Computer programming and call centres moved from Canada to India
o Joseph Schumpeter’s theory of competitive innovations
▪ Competition drove the ever-changing and ever-more-productive market
economy
▪ Business’ competitive actions “incessantly revolutionize the economic
structure from within, incessantly destroying the old one, incessantly
creating a new one
▪ Essential fact about capitalism
▪ Theory suggests that competitive forces weed out companies that do not
innovate
•
Capitalism
o Karl Marks and Fredrick Engles (1848) describing the rise of capitalism (that
began in 1700s with industrial revolution)
o Rise of market economy = economies’ economic growth in living standards, and
products and services
o
o
o
o
o
o
o
Capitalism → delivering goods
…”[it’s] created more massive and more colossal productive forces than have all
preceding generations together”
Incredible productivity from creative destruction
No one’s guaranteed survival in market economy = must compete
Competition (from business’ P.O.V.) takes the form of innovations that cut costs,
increase productivity, and increase our standards of living
Heart of why markers deliver products and services consumers value the most
Competition and creative destruction propel growth of market economies, AND
market structure and competition determine a business’ ability to set prices (to be
a price maker rather than a price taker)
Chapter 9 - Pricing For Profits
•
Marginal Revenue
o Marginal revenue equals price for price takers and is less than price for price
makers
o Smart businesses choose actions when marginal revenue is greater than
marginal cost
o Key 2 : Additional Benefits and Costs
▪ Count only additional benefits and additional opportunity costs
•
Marginal Revenue - Additional revenue from selling one more unit (or from one more
sale)
o How much revenue for an additional sale?
o How much additional sales / revenue if I stay open an extra hour? Is it worth it?
o Marginal revenue depends on market structure(how competitive an industry is)
and whether business is price taker or price maker
▪ Marginal revenue = Price for price-taking businesses in perfect
competition
▪ Marginal revenue < Price for price-making businesses in other market
structures
o Demand = marginal Revenues for price takers (perfect competition)
▪
•
Advantage of being a price taker : Can sell as much as you want at the
going price ; you don’t have to lower your price to try to sell more → small
player
One Price Rule (for other market structures) - Products easily resold have a single price
in the market
o When a price-making business lowers price, must lower price on all its units sold,
not just new sales
o Reason why marginal revenue < price for price makers
o Ex. Salesman charges high price for rich and lower price for poor → if product
can be resold, whoever buys it at a lower price might resell at an intermediate
price to one of the rich people for higher price = competition and resale among
consumers = eventually force price back to average
o
o
Ex. Suppose that diamonds are selling for $1,000 ini Vancouver and $500 in
Halifax
▪ An entrepreneur could go to Halifax and buy diamonds at $500 in Halifax
and sell them for $1,000 in Vancouver (or a little less) = increase in
demand in Halifax market = push up price of diamonds there
▪ Bring supply to Vancouver market = push down the diamonds there
▪ Competitive forces will eventually force price of diamonds to some single
price across the two markets
▪ Adjust for minor detail costs (ex. transportation)
▪ Product can be resold = A single price
Demand and Marginal Revenue for Price Makers with On-Price Rule
▪
Marginal Revenue < Price since you need to drop price on all units sold,
not just the last unit sold
•
Marginal Cost
o As output increases, marginal cost increases for businesses operating near
capacity or when businesses’ additional inputs cost more
o Marginal cost is usually constant for businesses not near capacity
•
Increasing and Constant Marginal Costs
o Increasing Marginal Cost
▪
o
As quantity increases the price the business needs to receive, which is
related to the cost of producing an additional output, is increasing
▪ Ex. Paola’s Parlour switching workers from nails to piercings and
unskilled labour = increasing marginal cost
▪ Differences in productivity of inputs
▪ Increasing marginal costs due to the differences in
productivity of inputs
Constant Marginal Cost
▪
As output increases, the cost of each additional unit is the same
▪
▪
Ex. Suppose you’re selling seats on an airplane, by how much do your
costs go up for each passenger you add
▪ Hardly increase at all
▪ Additional weight of passenger increases fuel consumption a little
bit a few snack → additional cost of each passenger doesn’t
change
Ex. Movie theatre seats
▪ Marginal cost of increasing your audience by 1 is the same for all
additional units
•
Diminishing Returns - As output increases, decreasing productivity increases marginal
costs
o Ex. Oil Drilling → As you drill a well, to get additional oil, you must dig deeper
and deeper ; the deeper you go, the greater the costs are
▪ Barrels after will be more expensive at the margin then at the beginning
o Ex. Busy kitchen and Adding more cooks → “Too many cooks in the kitchen”
▪ Busy kitchen and adding more workers, up until you get to the capacity of
the kitchen, people will be productive and add value to production
▪ As you add more people, people get in the way and productivity
decreases
•
Business operating near capacity or shifting to more expensive inputs, having increasing
marginal costs to increase output
o Ex. If you have all your workers working full time, and you want to increase
output, and then you need to pay them overtime, you have increasing marginal
costs
o Marginal costs tends to increase
•
Businesses not operating near capacity have constant marginal costs to increase output
o Easier to increase output without increasing marginal cost → constant marginal
cost
•
Marginal revenue greater than marginal cost
o A smart business decision for maximum economic profits involve both quantity
and price decisions
o The quantity decision is : Produce all quantities for which marginal revenue is
greater than marginal cost
o The price decision is : Set the highest possible price that allows you to sell that
quantity
o Key to maximum profit is to focus on marginal revenues, not on total revenues
and total costs
•
Ex. You’re working too many hours at your part-time job (which pays $10/hour) and your
economics marks are suffering. Your father wants you to do better in school, but
recognizes your need for cash. He offers you a deal : For every 1% increase in your
mark on the next test, he will pay you $6. You estimate :
o
o
o
o
o
One additional hour of studying will raise your mark 5%
A second hour of studying will raise your mark 4%
A third hour of studying will raise your mark 3%
A fourth hour of studying will raise your mark 2%
A fifth hour of studying will raise your mark 1%
If all you are trying to do is make the most money, how many hours should you study?
→ 4th hour
Additional Hours
of Studying
Marginal Revenue = %
Increase in marks x $6
Marginal (Opportunity)
Cost of Not Working
Smart
Choice
1st
5% x $6 = $30
$10
Study
2nd
4% x $6 = $24
$10
Study
3rd
3% x $6 = $18
$10
Study
4th
2% x $6 = $12
$10
Study
5th
1% x $6 = $6
$10
Work
•
Recipe for Maximum Profits :
1. Look at the quantity decision
▪ Increase in quantity yields increase in profits if marginal revenue is
greater than marginal cost
▪ Stop increasing quantity when marginal revenue is less than marginal
cost
2.
Once you choose a target quantity (maximum economic profits), look at
the price decision
▪ Set highest price that allows sale of target quantity
o Paola’s Marginal Revenues and Marginal Costs for Nose Piercings
o
Marginal Revenue and Marginal Cost
•
Intersection of Marginal Revenue (MR) curve and Marginal Cost (MC) curve is the key to
the recipe for maximum profits
•
Fixed Costs - Do not change with the quantity of output produced
o Rent and insurance are examples of fixed costs
o Fixed costs include normal profits
•
Price Discrimination recipes for higher profits
o
o
o
Price Discrimination is a bnusiness strategy that divides consumers into groups
Businesses increase profits by lowering the price to attract additional pricesensitive customers (elastic demand) , without lowering the price to others
(inelastic demand)
Ex. Cell phone providers charges different prices for daytime and evening, and
weekend minutes but the cost for the providers are exactly the same to produce
•
Price Discrimination (Dynamic Pricing) - Charging customers different prices for the
same product or service
•
Price discrimination brekas the one-price rule
o Possible only when businesses can
▪ Prevent low-price buyers reselling to high-price buyers
▪ Control resentment among high-price buyers
•
Price driscrimination examples :
o Airline tickets
▪ Can pay different prices for tickets based on when you buy them, what
conditions you bought them on, do you stay over Saturday, did you buy
them in advance?
▪ Cost of the seat of the airline seat for the passenger is the same
▪ Strategy of different prices for people
▪ Make more prices
o Seniors and children get charged different prices for movies, dinners, transit
fares
▪ Same cost to the company but a different price to different consumers
•
Most examples of price discrimination involve services which cannot easily be
o Ex. Cell phone minutes, movie tickets
•
Price discrimination increases profits by separating market into groups
o For elastic demand group (lower willingness to pay) charge lower price
o For inelastic demand group (higher willingness to pay) charge higher price
o Set price for each group allowing sale of all quantities with marginal revenue
greater than marginal cost
▪ Ex. Cell phone minutes
▪ Need to be available during business hours (9am - 5pm)
▪ Phone bills = write off against revenues → cost of doing business
▪ Consumers don’t need a lot of phone calls between 9am - 5pm
and you might not mind getting a discount not calling a lot during
then, but instead, calling during the evening and making texts
during then
▪ Phone companies set up phone plans for consumers (with
discounts)(elastic demand) and business people (inelastic
demand) have to pay (= no discounts)
•
Price distrimination is perceived to be unfair
o Consumers get discounts, coupons → everyone has a chance to find them
o Businesses offer rebates
▪ Most consumers don’t return rebates = businesses charge a higher price
•
Dynamic Pricing - Price discrimination that contuinuously adjusts for many variables
affecting willingness to pay
o Made possible by technology advancements including software algorithms that
analyze data, predict future demand, and adjust prices to match
o Used for event tickets, restaurant reservations, Uber surge pricing, Airbnb pricing
o Ex. Theatre prices
▪ Use to charge same price for any seat, anytime of the year, any time
▪ Now depending on the day of the week, season, popularity of the show,
location of the seat, charging different prices based on different
consumers willingness to pay
o Has become socially acceptable
o Airline ticket pricing, hotels, in almost every walk of life
o Ex. Disney Broadway Shows
▪ Have a data set and a proprietary software, an algorithm, that takes
information about past sales and uses to predict maximum that people
are willing to pay and then adjusts ticket prices accordingly
▪ Same bums in same seats but with very different prices
▪ Comparison of the Lion King and Wicked
▪ Lion king is an older show = has much lower maximum ticket
prices
▪ Using its algorithm, Disney has been able to out-gross Wicked because
they are getting the most possible from every consumer in a way that
wouldn’t be possible without these advances in software and modelling
algorithms different people are willing to pay
▪ Advantage : Consumers are able to get bargains if you’re willing to fit into
those groups or categories when there is less willingness to pay
▪ Businesses reduce prices for those groups and for those events
•
Market structure and Efficiency
o Maximum profits bring efficiency for perfect competition, but inefficiency for
market structures with price-making power
•
Perfect competition, with price-taking businesses, is an efficient market structure
o Businesses just earn normal profits ーeconomic profits are zero
o Maximum total surplus (consumer surplus + producer surplus)
•
All other market structures, with price-making businesses, are inefficient
o With some inputs, businesses reduce output and raise price
o
Businesses earn economic profits
•
Total surplus is less than perfect competition because of deadweight loss from reduced
output
•
Efficient of Price Takers and Price Makers
o Efficiency of Perfectly Competition
o
Inefficiency of Market Structure with Price Makers
•
There are benefits to market structures with price-making power and economic products
o Product variety
o Economic profits finance innovations and creative destruction, improving living
standards for all
o Differential pricing creates some more affordable options
•
Compare additional costs and additional benefits. There is always a trade-off
Chapter 10 - When Markets Fail (Natural Monopoly, Gaming,
Competition, And Government)
•
Market Failure and Natural Monopoly
o Natural monopolies are a market-failure challenge for policy makers ー gain the
low-cost efficiencies of monopoly’s restricted output and higher price
•
Market Failure - When markets produce outcomes that are inefficient or inequitable or
markets fail to produce the positive outcomes for society that we normally expect them
to
•
Economies Of Scale - Average total costs decrease as quantity of output increases
o Ex. Cable companies → Government makes 1 cable company a monopoly
▪ The biggest cost of providing cable services is the network (underground
and overground cables that supply the services to each house → start up
/ fixed cost = big
▪ Marginal cost = small → hooking up additional customers
▪ Flipping a server switch, stringing last piece of cable to the
household
▪ Most of the cost = fixed cost
▪ Fix cost to be smaller number per customer (total average cost) = have a
lot of customers = reduced total average cost
▪ Problem with competition :
▪ Each competitor has to rebuild the same network → huge fixed
costs → competition = half as many customers → Average Total
Cost (ATC) increases with competition
▪ Only a single seller can achieve lowest ATC
o Ex. Cable TV, utilities (electricity, water, gas)
•
Natural Monopoly - Economies of scale allows only a single seller to achieve lowest
average total cost
o Natural monopoly is one cause of market failure
o Ex. Ex. Cable TV, utilities (electricity, water, gas)
•
Government policies for natural monopoly
o Public Ownership
▪ Crown Corporations (in Canada)
▪ Publicly owned businesses in Canada → single seller and publicly
owned
▪ Ex. CBC, VIA Rail, Provincial utilities
▪ Achieve economies of scale, but lack of competition weakens
incentive to reduce costs or innovation
o Regulations
▪ Rate of return regulation
▪ Set price allowing regulated monopoly to just cover average total
costs and normal profits
▪
▪
o
o
Problem : Incentive to exaggerate reported costs
Government grants private company monopoly, but regulate
prices that the monopoly can charge to try and kind of profits and
earn the same kind of profit they would earn anywhere else in the
sector
▪ Cat and mouse game
▪ Government to monopoly : Provide this service. Whatever
your costs are, we will allow you an x percent rate of return
rate of profit on top of you costs
▪ Economics is about incentive → provider incentives guaranteed % rate of return on anything you spend costwise = try to burn up costs since the more costs you have,
the more you’re going to get by the way of profits
▪ Government regulators do not observe costs directly and use rate
of return regulation
▪ Ex. Businesses (ALL businesses) like to entertain clients to get goodwill
with clients. Business buys an expensive box at the Air Canada Centre
for business development → Becomes a cost you build into your base →
The government, with rate of return regulation, gives you a profit of that
cost
▪ Mostly that private base us used for people who work for that
corporation (CEO & other executives) → not a cost of doing
business but pass it off that way because of incentive that rate of
return
▪ Incentive to exaggerate reported costs = inefficiency = Problem
Want to gain efficiencies because of economic scale but avoid inefficiencies of
restricted output and higher price
No perfect solutions
•
Prisoner’s Dilemma and Cartels
o Strategic interaction among competitors complicates business decisions, creating
2 smart choices ー one based on trust and the other based on lack of trust
•
Game Theory - Mathematical tool for understanding how players make decisions, taking
into account what they expect rivals to do
•
Prisoner’s Dilemma - Game with 2 players who must make a strategic choice, where
results depend on the other player’s choice
o ** Jail and prisoners’ confess or don’t confess with partners and years in jail. One
on one with officers → Tell = shorter sentence ; Don’t tell = longer sentence **
o 2 smart choices based on trusting or not trusting your partner
o Everyone acts in their own self- interest & interest of everyone in the group =
trust = best outcome
o Prisoner’s Dilemma of Bonnie and Clyde
▪
▪
▪
o
If other player cannot be trusted, smart choice = cheat / confess
If other player can be trusted, smart choice = cooperate / deny
Nash Equilibrium - Outcome of a game in which each player makes the
best choice, given the choice of the other
▪ All players in Prisoner's Dilemma driven to Nash equilibrium outcome
where everyone cheats / confesses
Summary of the Prisoner’s Dilemma
▪ Each player (prisoner) is motivated to cheat (confess) → based on selfinterest
▪ Both would be better off if they can trust each other to cooperate (deny)
▪ Tension between Nash equilibrium outcome (no trust) and better joining
outcome (trust)
▪ With complication of trust / no trust, there are 2 smart choices
▪ Explains gas station cycle of high prices (cooperation) and price wars
(cheat)
•
Cartels, Collusion, Cheating, Competition Law, Caveat Emptor
o Governments use laws and regulations to try to promote competition, discourage
cartels, and protect the public from dangerous practices
•
Collusion - Conspiracy to cheat or deceive others
•
Cartel - Association of suppliers formed to maintain high prices and restrict competition
o Ex. OPEC (Organization of Petroleum Exporting Countries), Chocolate Cartel
(Hershey, Nestlé, Mars), Quebec Maple Syrup Cartel
▪ OPEC
▪ Formed in 1970s
▪
o
A collusive agreement where all the producing countries agreed to
restrict their output
▪ Drove up the world price of oil and increased profits for everybody
who was involved in the cartel
▪ Face a constant threat of their members cheating
▪ In their self-interest if they don’t trust each other to cheat and
reduce prices and break the power of the cartel
Customers lose out
•
Problem : Desirable competitor behaviour is hard to distinguish from undesirable
collusive behaviour
o Desirable Competitive Behaviour - Always an active attempt to increase profits
and gain the power of a monopoly
o Leon’s buys domestic rival The Brick in $700M deal
▪ Combined Leon’s and The Brick → leon’s bought out The Brick
▪ Reduction in competition
▪ SOunds like collusion (because of the reduction in competition) but
there’s actual business reasons
▪ Objective to take on Walmart and Target
•
“People of the same trade seldom meet together, even for merriment and diversion, but
the conversation ends in a conspiracy against the public or in some contrivance to raise
prices” - Adam Smith
o Key for good social outcomes = channel self-interest in a constructive way
•
Competition laws originated in late 1800s following Axel, coal, railroad cartels, coffin
industry
o First anti-combines law in 1889
o Modern Competition Act in 1986
o Minimize competition
•
Competition Act : “To maintain and encourage competition in Canada in order to
promote the efficiency and adaptability of the Canadian economy”
o Maintain and encourage in the best interest of the Canadian economy
o Prevent anti-competitive business behaviour
•
Current concerns with multinational technology companies (Google, Amazon, Facebook,
Apple) based on network effects (demand side) instead of economies of scale (supply
side) → Advantage of having more consumers
o They’re all about collecting dada
o Give away products or services for free (free shipping, free services) and don’t
make money on products or services but make money in the data they acquire
by having a large network of customers
•
Competition Act rouses expected costs to business of price fixing (prison time, fines,
legal prohibitions) relative to expected benefits )profits)
o Criminal Offences
▪ Price fixing, bid rigging, false / misleading advertising
▪ Punished by prison time, fines
▪ Whistleblower protection for confessing
o Civil Offences
▪ Mergers, abusing dominant market positions, lessening competition
▪ Punished by fines, legal prohibitions
•
Competition Tribunal for civil offences weighs costs of lessening competition against
benefits of increased efficiencies
o Ex. Leon’s and The Brick
o Key #1 → Additional Benefits > Opportunity costs
•
If mergers that reduce competition also provide economies of scale, may be approved
for promoting “efficiency and adaptability”
•
Caveat Emptor = “Let the buyer beware” - Buyer alone is responsible for checking
quality of product before buying
o Not much government action → not government’s responsibility to make sure
products are good, it’s the consumers’
o Word will get out if product is bad and discipline of the market (competition) will
rectify the situation and eliminate bad products
•
Certain products (nuclear power, medicines, poisonous insecticides) are regulated by
the government because the average consumer cannot know the products quality
•
Major forms of government regulation in Canada
o Government departments
o Agencies and boards
o Professional Associations
o Businesses’ self-interest = cut corners = lower quality at lower price / cost to
make = unsafe
•
Market failure or government failure?
o The public-interest view of government regulation suggest that government
actions improve market-failure outcomes while the capture view suggests that
government actions produce government failures
•
Public-Interest View - Government regulation eliminates waste, achieves efficiency,
promotes the public interest
•
Capture View - Government regulation benefits regulated business, not the publicinterest
o Ex. Canadian Dairy board
▪ Established to promote stable prices for Canadian Dairy farmers and a
stable supply of products but over the years, the Dairy Bored kept prices
high, protecting the profits and business positions of Canadian Dairy
farmers and producers at the expense of Canadian consumers
▪ Evidence → Arrest of Canadians trying smuggle cheese from the U.S.A
because if you’re a small pizzeria, by smuggling cheese from the U.S.A.
where the prices are much more competitively set and lower, you could
save $50,000/year rather than what you have to pay for cheese in
Canada
o Business lobbying (Evidence)
▪ They want to affect any legislation that passed in a way that provides
business interests, as opposed to anybody else's interests
o Most economies agree the Competition Act serves the public-interest well
•
Market Failure - When markets provide inefficient or inequitable outcomes
•
Government Failure - When regulations fail to serves public interest interest
•
Market outcome, even with monopoly power, better than regulation if significant
government failure
•
Government outcome, with public interest regulation, better than market outcome if
significant market failure
•
Economic thinking can’t make normative policy choices, but can answer the positive
question, “Will government improve market failures outcomes, or will government action
fail with worse outcomes than market outcome?” → Trade off
Chapter 11 - Externalities, Carbon Taxes, Free Riders, And Public
Goods : Acid Rain on Others’ Parade
•
Market failure with externalities
o When externalities exist, prices don’t reflect all social costs and benefits ;
markets fail to coordinate private smart choices with social smart choices
•
Negative Externalities (External Costs) - Costs to society from your private choice that
affects others, but that you don’t pay
o Ex. Second-hand smoke, pesticides, loud music from neighbour while you’re
trying to sleep, pollution as a byproduct of industrial production, traffic jams
•
Positive Externalities (External Benefits) - Benefits to society from your private choice
that affect others, but that others do not pay you for
o Ex. Vaccinations (protect yourself and reduce likelihood of spreading to those
who don’t get vaccinations), house renovations (property value of your house of
other nearby houses on the street increase), public transit (reduces pollution),
education
•
Externalities occur when clear property rights are missing
o Tragedy Of The Commons - The overuse and depletion of a resource that no one
can be excluded from because of missing property rights
▪ Ex. 16th century England → Land for cattle for a village was held in
common
▪ No one held property rights on that common area
▪ If my cows are grazing on the common land, it reduces the
amount of grass for anybody else’s cows but because nobody
owns the land privately, everybody is going to try to use the land
as much as possible to graze their own cows, leading to tragedy
of the commons
▪ Ex. Overfishing → The collapse of the East Coast and Fishery →
Extreme
▪ No one had property rights over the fish in the sea ー or clear
property rights
▪ Everybody tried to get as much fish as they could and the fish
stocks were depleted to the point where they were in danger of
not being able to sustain themselves
•
Free Riders - Those who consume products or services without paying
o Ex. People who get services from seeing a lighthouse don’t have to pay for the
construction of a lighthouse but they benefit from seeing the beacon
o Ex. Student Group work
▪ Weak students end up doing nothing but end up getting a decent mark
because the move smarter students, or more responsible students, in the
group do all work
▪ Weaker students free ride on the activities of others
▪
No clear property rights in a group in terms if who participates and how
does the credit get allocated
•
When externalities exist, prices don’t reflect all social costs and benefits, and market fail
to produce efficient outcomes
o Instead markets produce
▪ Too many products and services with negative externalities
▪ Ex. Second-hand smoke, pollution, traffic james
▪ Too few products and services with positive externalities
▪ Ex. Vaccination, eduction
•
Negative externalities and efficient pollution
o For an efficient market outcome when there are negative externalities choose the
quantity of output where marginal social cost equals marginal social benefit
•
“Efficient pollution” balances the additional environment benefits of lower pollution
opportunity costs of reduced living standards”
•
Socially desirable amount of pollution (according to economists) is not zero
o At some point, additional opportunity costs of reducing pollution are greater than
additional benefits of lower pollution
▪ Key #1 : Additional benefits vs. opportunity costs
•
When there are externalities, smart choice rule is : Choose the quantity of output where
marginal social cost = marginal social benefit
•
Marginal Social Cost (MSC) =Marginal Private Cost (MC) + Marginal External Cost
o Marginal External Cost = Price of preventing or cleaning up to others external to
the original activity
▪ Ex. Air pollution = the cost of eliminating the source of air pollution, or the
cost of remedying the damage done once the pollution has already
occured
o Takes into account all costs, not just to the individual concerned but to broader
society
•
Marginal Social Benefit (MSB) = Marginal Private Benefit (MB) + Marginal External
Benefit
o Marginal External Benefit = Price of the value or savings to others external to the
original activity
▪ Ex. Taking the transit reduces our pollution and saves somebody else
from having asthma would be something you would need to measure in
same way as an external benefit
•
Demand, Supply, And Negative Externalities In the Pulp Market
•
Markets overproduce products and services with negative externalities
o Price is too low because it does not incorporate external costs
•
Policies to internalize negative externalities
o If polluters are forced by government to pay the marginal external costs of their
pollution, this internalise the externalities / costs into private choices, creating
sociaal smart choices
•
WIthout property rights to the environment, businesses have incentives to save money
and improve profits by ignoring external costs like pollution and global warming
•
Government can remedy market failures from externalities by creating social property to
the environment, making pollution illegal, and penalizing polluters
•
Emissions Tax - Tax to pay for the external costs of emissions
o Carbon Tax - Emissions tax on carbon-based fossil fuels
o Smart carbon tax = marginal external cost of damage from emissions
•
Internalize The Externality - Transform external costs into costs the producer must pay
to the government
•
Pulp Market with $30/Tonne Emissions Tax
•
Cap-and-Trade System - Limits quantities of emissions business can release into
environment
o Government auctions off pollution permits to highest bidders
o Total quantity of emissions allowed by permits = emissions target
o Businesses buy and sell emissions permits ; Permit price becomes private costs
(internal cost) to business reflecting marginal external cost of pollution
•
Carbon taxes and emissions permits give pollution a price reflecting marginal external
cost of damage, so smart private choices become smart social choices
•
Carbon taxes and cap-and-trade systems may be inequitable, hurting lower-income
consumers most
o
Governments offer subsidy or rebate programs, usually to people a the bottom
end of the income distribution
•
Differences
o Carbon taxes swet price of emissions and the market adjusts quantities
o Cap-and-trade systems set quantities and the market adjusts prices
•
Free riders and public goods
o With positive externalities, buyers and sellers are not paid for the external
benefits their exchange creates. The market-clearing price is too high for buyers
to be willing to be willing to buy the socially best quantity of output, and too low
for swellers to be willing to supply
•
Positive Externalities (Externalities Benefits) - Benefits to society from your private
choice that affect others but not that others do not pay for you
o Extreme forms → Public Good - Provide external benefits consumed
simultaneously by everyone ; no one can be excluded
▪ Public goods like lighthouse and national defenses are extreme examples
of positive externalities
▪ Free Rider - Someone who does not have to pay for external benefits
▪ Never privately profitable → never get somebody, unless they are a
sucker, to pay for construction of a lighthouse because you might wait
until somebody else pays for it (be the free rider and benefit from the
beacon)
•
With positive externalities, smart social quantity of output is at intersection of marginal
social benefit and marginal social cost curve
•
Because of free rider problem
o Markets underproduce products and services with positive externalities
o No single price can coordinate smart individual choices and smart social choices
o Market-clearing price is too high for buyers to be willing to buy and too low for
sellers to be willing to supply
•
Demand, Supply and Positive Externalities in a Private Post-Secondary Education
Market
•
Education has enormous positive externalities
o When you get a degree, you benefit privately because you’re going to have a
higher lifetime income
o Rest of society benefits as :
▪ Businesses don't have to train you in the same way because you’ve got a
certain basic communication skills
▪ People who are educated end up relying less on social assistance
because they have better jobs → saves money down the road
▪ Those educated tend to be more law abiding = saves money on prisons,
policing, and other kinds of social costs
•
Subsidies for the public good
o When there are positive externalities, government subsidies can get everyone to
voluntarily choose the socially best quantity of output where marginal social
benefit equals marginal social cost
•
Government policy tools to get all to voluntarily choose output where marginal social
benefit = marginal social cost
o Public Provision - Government provision of products or services with positive
externalities, financed by tax revenue
▪ Ex. Educational services (primary and secondary levels)
o Subsidy - payment to those creating positive externalities
▪ Ex. Educational services (post-secondary level)
•
Smart subsidies (= value of marginal external benefits) and public provision remove the
disconnect between prices for buyers and sellers, leading to voluntary choice of output
best for society
Post-Secondary Education Market With $3000 Subsidy To Schools