Chapter 1: Macroeconomics and Life
Learning objectives
1. Explain the concept of scarcity
2. Explain opportunity cost and marginal decision making
3. Explain incentives
4. Explain efficiency
5. Distinguish between correlation and causation
6. Characteristics of good economic models
7. Distinguish between positive and normative analysis
The basic insights of economics
- Economics is the study of how people manage resources
- Microeconomics = how industries and firms manage resources
- Macroeconomics = study of the economy on a regional, national, international level
- People experience rational behavior = make choices that will best obtain their goals
4 Qs of economics
1. What are the wants and constraints of those involved
2. What are the trade offs
3. How will others respond
4. Are resources being allocated in the best way possible
● Scarcity
- The condition of wanting more than we can get
- We expect people to work to what they want but they are constrained by limited
resources (not everything is limited -> think knowledge)
- Analysis what people what and their constraints
● Performance and decision making
- Every decision involves weighing the tradeoffs
- Potential benefits are easy to see
- Costs are not so easy
- The cost includes the opportunity you must now give up for something that you
might have enjoyed otherwise
Opportunity cost
- True cost of your choice
- It is equal to the value to you of what you have to give up ir order to get something else
- Helps us think more about trade offs
- Can be expressed as a dollar value
Marginal decision making
- Rational people make decisions on the margin
- They compare the additional benefits of a choice against the additional costs
- Sunk costs are costs that have already been incurred and cannot be recovered
- They should not have an impact on your marginal decision
-
Trade offs play an imp role in business decisions about what goods and services to
produce
● Incentives
- As trade-offs change so will peoples choices
- An owner must consider how others will respond
- Asking this gives us a complete picture of how a particular decision affects the
world
- People respond to incentives -> + = more likely // - = less likely
- Nothing happens in a vacuum -> you can’t change just one thing in the wrd w/o
eliciting a response from others
- Asking how others will respond prevents bad decisions by predicting the
undesirable side effects
- Collateral = possession pledged by a borrower to a lender
● Efficiency
- Are resources being used in the best way possible and is the outcome fair and
ethical
- Efficiency = max productivity and ensuring ppl get what they most want + need
given the available resources
- When the economy is efficient there is no way to make it better w/o making it
worse for someone else
- Resources are being used to create the greatest total economic value
Partial implications of efficiency
- If a good idea exists why isnt anyone else doing it?
- If you think the idea is good and no one is doing it think back to the first three q’s
- If these questions don’t discourage you then its possible the economy is not working
under normal circumstances
- 4 reasons for why a circumstance may not be normal
1. Innovation : the idea simply is brand new
2. Market failure: ex your idea won’t work because it will be to easy for others to
copy it or a bigger company already has the market for it sewn up
3. Intervention : sometimes a powerful force (gov.) will intervene in the economy
baring transactions to take lace as normal
4. Unprofitable idea: its just a bad selling idea
An economist’s Problem solving tool box
- Analysis require the combo of theory with observations and to put them through tough
scrutiny before making conclusions
● Correlation and causation
- Caution needs to be taken when assuming what happens because of what
- If there is a consistent relationship between 2 events or variables = correlation
- Same time and same direction = +
- 1 increases and 1 decreases = - No consistency = no correlation
- Correlation =/= causation -
- Causation is when one event brings out another
- Correlation and causation don’t always go straightforward
Correlation without causation
- Ex sell in may and go away is a saying about stocks implying they grow the most
november to april
- This however shows no plausible cause and effect relationship -> it happens to be
correlated but there is no logical reason making it the cause
Omitted variables
- Some events are only correlated because of a relationship with a third factor
Reverse causation
- When two events happen together it can be hard to tell which caused which
- Ex if u take ur raincoat out and then it rains you might assume grabbing your coat
caused the rain but in reality the anticipation of rain caused you to grab your jacket
- Always know how to explain why two events are related
● models
- Simplified representation of a complex situation
- Allows us to focus our attention on the most imp parts
- Most basic model is the circular flow model -> shows how transactions work
together and highlights the imp patterns
- An economic model approximates what happens in the real economy
- The best lead us to clearer answers about complicated questions and help us
devise policy to achieve desirable goals
- A good model should do 3 things
1. predicts cause and effect
2. Makes clear assumptions
3. Describes the real world exactly
- Models are tested by observing what happens in the real world and collecting data which
is then used to verify or reject the model
● Positive and normative analysis
- A statement that makes a factual declaration about how the world acc works =
pos statement
- A stat. about how the world should work is called a normative statement
Chapter 2: specialization and exchange
Learning objectives
1. Construct a production possibilities graph and describe what causes shifts in production
possibilities curves
2. Define absolute and comparative advantage
3. Define specialization and why people do it
4. Explain how the gains from trade follow from comparative advantage
● Production possibilities
- Using a tool called production possibilities frontier can help us come to concl.
Drawing the production possibilities frontier
- If you have 2 possible items to be produced the ratio of A:B can be found and the point
plotted on a graph
- By filling enough point we can create a line or curve that is the production possibilities
frontier (PFF)
- This line represents all the possible combination of outputs making use of all available
resources
- This helps us answer the first question of wants and constraints we want A & B and the
line shows us where are constraints are
- Production cannot happen outside the frontier as there are not enough resources or time
- It also shows us the trade offs: 1 worker can make 1 A or 2 B
- The opportunity cost of A is 2 B
- The opportunity cost of B is ½ A
- The opportunity cost is represented by the slope (if the slope is -2 means the cost of 1 A
is 2B)
- Can make this more nuanced by including more resources such as land and material as
more resources are added the opportunity cost of the good increases
- The slope of the curve will increase (steeper)
● Choosing among production possibilities
- Choosing a point inside the frontier means it can get more of A more B or both by
using all available workers (inefficient because it does not use all resources)
- Once at the frontier it will have to give up some or A or some of B
- If they lie on the frontier it is an efficient point by getting the most output from all
available resources
- Economies aren’t always efficient but it is a reasonable starting assumption
- We know they are likely to choose a point on the frontier but not what point
- The decision depends on the needs of people
● Shifting the production possibilities frontier
- What happens when the economy changes? Ex new innovations leaded to faster
production
- We can change the rate of production of A to double
- If A changes but not B the curve changes
Absolute and comparative advantage
● Absolute advantage
- If a producer can generate more output than others given the amount of
resources they have the absolute advantage
● Comparative advantage
- When a producer can make a good at a lower opportunity cost then other
producers
- Ex if by making A they only lose 2 B, whereas when others make A they lose 4B
- Can have comparative advantage without having absolute advantage
- Impossible to have the comparative advantage at everything
Why trade?
- Both parties can consume more when they specialize
●
●
●
●
Specialization
- If each party focuses on producing what they have comparative advantage over
they can produce more
Gains from trade
- When parties specialize they only end up with 1 thing so they must trade to get
other needs
- Gains from trade is when there is an exchange of goods or services
- Because of the trade each country’s consumption increase to a point that was
previously unachievable
- When trading a party cannot charge more then the opportunity cost the other
party would incur for the project
- But also must receive enough to cover its opportunity cost of making the product
Why might people not want specialization and trade?
- National heritage
- Security
- Quality control and ethics
Comparative advantage over time
- occurs when technology and the industry advances -> instead of hand sewing
machines sew
- When you lose comparative advantage in one aspect you gain in another
- High wage jobs replace low wage jobs
Chapter 3: Markets
Learning Objectives
1. Identify the defining characteristics of a competitive market.
2. Draw a demand curve and describe the external factors that determine demand.
3. Distinguish between a shift in and a movement along the demand curve.
4. Draw a supply curve and describe the external factors that determine supply.
5. Distinguish between a shift in and a movement along the supply curve.
6. Explain how supply and demand interact to drive markets to equilibrium.
7. Evaluate the effect of changes in supply and demand on the equilibrium price and
quantity.
Markets
- An “invisible hand” coordinates the complex economic interactions
- Private individual;s make the decisions = market economy
●
●
What is a market?
- Refers to the buyers and sellers who trade a particular good or service not to a
physical location
What is a competitive market?
- Fully informed price-taking buyers and sellers easily trade a standardized good or
service
- No individual sellers has a power to change the market price
-
A buyer or seller who cannot effect the market price = price taker
Both buyers and sellers are price takers
Any two units have the same features and are interchangeable = standardized
goods
Have full information about the price and features of the goods being bought and
sold
There are no transaction costs
Don’t need to pay for anything for the privilege of buying or selling in the market
Very few markets are perfectly competitive
Demand
- Describes how much of something people are willing and able to buy
- Amount of good that buyers in a market will purchase at a given ppricve during a
specified period = quantity demand
- Inverse relationship between price and quantity demanded = quantity demand
- When all else is held equal quantity demand rises as price falls -> nothing other then the
price changes
- This describes the underlying reality of individual people's decisions
- If benefits stay the same and opportunity cost goes down -> trade offs look a lot better
- incomes , expectations, and tastes = non-price determinants of demand
● Demand curve
- Demande is represented as a table = demand schedule
- Shows quantity of goods or services willing to purchase at various prices
- Demand curve visually displays demand schedule
- Represents consumers willingness to buy
- Quantity = x -axis
- Price = y-axis
- Downward slope = inverse relationship: price and quantity
● Determinants of demand
- Demand curve works if everything is held constant demand
- If everything is not held constant the curve will shift
- Downward curve reflects the trade offs between (1) the benefits they receive (2)
the opportunity cost they face
- Consumer preferences are the personal likes and dislikes -> more or less
inclined to purchase a good
- Some preferences are constant
- Others change over time in response to external events or fads
Prices of related goods
- Substitutes and complements affect demand
- Substitutes = similar enough purpose
- Complements = consumed together : if the price for one increases the demand for the
other decreases
- If they purchase less of the first they want less of the second
- If price of one decreases the demand of the other increases
Incomes
- Normal goods = increase in income = increase in demand
- Decrease in income = decrease in demand
- Inferior goods = income increases = demand decreases
- Inferior goods are typically replaced with more expensive goods
Expectations
- Changes in consumers expectations abt the future prices (or other) can affect demand
- If they expect prices to fall = postpone purchase
- Expected drop in price = demand decreases
- Expect rise in $ = purchase immediately = demand increase
Number of buyers
- Increase of buyers = increase demand
- Decrease in buyers = decrease in demand
● Shifts in the demand curve
- The entire curve shifts (L/R) horizontally because non-price determinants affect
the quantity demanded at each price
- Economy grows = income rises = more demand
- Economy falls = decrease demand = shift to left
- Shifts in the demand curve are caused by changes in the non-price determinants
of demand
- To find the quantity that consumers will want to purchase at the new price wee
move along the existing curve from the old price to the new price
- Change in one of the non-price determinants = increase/decrease in demand =
shift of the entire curve
- Movement along = change in price = increase/decrease in quantity demanded
Prices of related goods
- Determines supply because -> affects the opportunity cost of production
- By choosing to produce more A you lose the profits from B
- If the price of B increases so does the lost profit
Technology
- Improved tech means less resources are needed to make something
- Production costs are lower
- Producers are willing to supply more
Price of inputs
- Price of input rises = production cost rises = quantity produced decreases
Expectations
- Suppliers expectations about prices determine supply
Number of sellers
- Number of sellers is a fixed part of the curve
- Sellers supply more if price is high
- There are non-price factors that cause sellers to change
- Ex. licensing requirements -> if strict = less sellers / if dropped = more sellers
● Shifts in the supply curve
- A change in one of the non-price determinants increases or decreases supply
- Increase = shifts curve right
-
●
●
●
Decrease = shift curve to the left
Very specific terminology is used to distinguish between a shift and a movement
Change in one of the non-price determinants of supply causes and
“increase/decrease in supply” = shift of the entire supply curve
- Change in price causes an “increase/decrease in the quantity supplied” =
movement along the curve
Market equilibrium
- When markets work well the quantity supplied exactly equals the quantity
demanded
- This happens at a equilibrium point
- The price at this point is the equilibrium price and the quantity is equilibrium
quantity
- Also known as the market clearing price
- Describes how markets function
Reaching equilibrium
- Sellers set prices by trial and error and based off past experience
- Incentives faced will naturally drive the market towards equilibrium
- When quantity supplied is higher than quantity demanded = surplus or excess
quantity supplied
- When quantity supplied is less than the quantity demand = shortages or excess
quantity demand
- At any price above or below equilibrium sellers will increase or decrease the price
Changes in equilibrium
- To determine the effect on market equilibrium of a change in a non-price factor
1. Does the change affect demand? (inc/dec)?
2. Does the change affect supply? (inc/dec)?
3. How does the combination of changes in supply and demand affect the
equilibrium price and quantity?
Shifts in both supply and demand
- Both demand and supply can change at the same time ex. Cost to produce can lower &
the product can be made better
- The equilibrium point will rise as both factors independently make it rise
- When supply and demand shift together it is possible to predict either the direction of the
change in quantity or the direction of the change in price without knowing how much the
curve shifts
Chapter 4: Elasticity
Learning Objectives
1. Calculate price elasticity of demand using the mid-point method.
2. Explain how the determinants of price elasticity of demand affect the degree of elasticity.
3. Calculate price elasticity of supply using the mid-point method.
4. Explain how the determinants of price elasticity of supply affect the degree of elasticity.
5. Calculate cross-price elasticity of demand, and interpret the sign of the elasticity.
6. Calculate income elasticity of demand, and interpret the sign of the elasticity.
What is elasticity?
- Measure of how much consumers and producers respond to a change in market
conditions
- Can be applied to supply or demand
- Used to measure responses to a change in the price of goods or related good or change
in income
- Allows us to anticipate how others will respond
- Price elasticity of demand & price elasticity of supply
- Describe how the quantity demand and quantity supplied change when the price of a
good changes
- Cross-price elasticity of demand describes what happens to the quantity demand of A
when the price of B changes
- Income elasticity of demand ; how much the quantity demand reacts to changes in
consumers incomes
Price elasticity of demand
- Size of change in the quantity demand of a good/service when its price changes
- Measure of consumers sensitivity t price changes
- Buying = highly influenced by price = more elastic
- Small change in price causes a large change in the quantity demanded
● Calculating price elasticity of demand
- Price elasticity is the percentage change in the quantity
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃
𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
-
To calculate the change -> mid-point method
Find the change relative to a point midway between the two points
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 =
𝑄2−𝑄1
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝑄
𝑄2−𝑄1
=
𝑄2+𝑄1
2
-
The denominator (mid point average) is equal to the sum of the two quantities divided by
2
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 =
𝑃2−𝑃1
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑓 𝑃
=
𝑃2−𝑃1
𝑃2+𝑃1
2
-
Full equation for price elasticity of demand is
𝑄2−𝑄1
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
(𝑄2+𝑄1)/2
(𝑃2−𝑃1)
(𝑃2+𝑃1)/2
●
What does the answer mean?
For a 1 percent decrease in price , X increase in demand
For 1 percent increase in price , X decrease in demand
Price elasticity of demand will always be a negative number because price and quantity
move in opposite directions
This number is often written as an absolute value
Determinants of price elasticity of demand
- Consumers are more sensitive to price changes for some goods and services
then for others
- Many factors determine responsiveness
- Substitutes, relative need, relative cost, time needed to adjust to price changes
Availability of substitutes
- Substitutes are goods that are distinguishable but have similar uses
- If close substitutes are available, demand for the good will be more elastic
Degree of necessity
- When it is a necessity even if the price rises it will still be bought to maintain a level of
comfort
- Demand for socks for home heating is not very elastic
- Demand for luxury like a vaycay is more elastic
Cost relative to income
- If a small amount of their income is spent on a good = demand for the good = less elastic
- Good costs large portion of income = demand = more elastic
Adjustment time
- More elastic time in the long run than in the short term
- Adjusting to price takes time
Scope of the market
- Everything is relative to how you define the market
- Does the good in a market have more or less substitutes etc
● Using price elasticity of demand
- Don’t know the exact price elasticity of the demand
- Placing goods in several broad categories helps facilitate real pricing decisions
without full info
- Demand = perfectly elastic = curve is horizontal
- Demand = perfectly inelastic = curve is vertical
- Elastic, inelastic, unit-elastic
- Absolute value > 1 = elastic
-
Absolute value < 1 = inelastic
Absolute value = 1 = unit elastic (1:1 ratio)
-
-
-
Knowing the elasticity lets the manager determine if a price increase will cause
total revenue to rise or fall
- An increase in precise affects revenue in 2 ways
1. Quantity effect - decrease in revenue that results from selling fewer units
of the good
2. Price effect - increase in revenue that results from receiving a higher price
for each unit sold
When demand is elastic a price increase = total revenues fall = quantity effect outweighs
the price effect
Demand = elastic = price increase causes a proportionally larger decrease in quantity
demand
When demand is inelastic = percentage change in price is larger than the % change in
quantity demanded = price effect outweighs the quantity effect
Inelastic = purchase less when price rise = change in quantity demand will be
proportionally less than the change in price
Elasticity varies along the curve
-
Demands tend to be more elastic when the price is high and more inelastic when the
price is low
Ex. between points A and B have a difference of 2$ but between points A and C the
difference is 5$ even though the slope is the same
Price elasticity of demand
- The size of change in the quantity supplied of a good or service when its price changes
- Measures producers responsiveness to change in price
● Calculating price elasticity of supply
-
𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
- 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 =
(𝑄2−𝑄1) / (
𝑄1+𝑄2
2
)
𝑃 +𝑃
(𝑃2−𝑃1) / ( 1 2 2 )
-
Price elasticity of supply is described using 3 categories
Elastic = absolute value > 1
Inelastic = absolute value < 1
Unit-elastic = absolute value = 1
Perfectly elastic = quantity supplied can be anything at a given price and 0 at any
other price
- Perfectly inelastic = quantity is always the same
- Price elasticity of supply is always positive because quantity supplied moves in
the same direction as the price
● Determinants of price elasticity of supply
Availability of inputs
- Some goods can easily be expanded with more inputs
- Ex. bakery makes more bread by buying more flour
- Not always the case cant make more picasso paints cuz hes dead
- Elasticity of supply depends on elasticity of supply of inputs
- If producing more than the initial amount costs more due to difficulty of
getting supplies a producer will not want to make more
Flexibility of the production process
- Easiest way to adjust quantity of good A is to draw production capacity away from good
B
- Can be easy ex farmer just switches seeds
- Can be hard ex if ur a specialty part maker you may need new machinery
Adjustment time
- Supply is more elastic over long periods than over short periods
- Producers can make more adjustments over long periods
Other elasticities
- Quantity of goods is sensitive to more than just price
● Cross price elasticity of demand
- Describes how demand of good A changes if the price of good B changes
-
If you have 2 substitutes and good A rises in price good B will rise in demand
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝐴 𝑑𝑒𝑚𝑎𝑛𝑑
𝑐𝑟𝑜𝑠𝑠 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝐴 𝑎𝑛𝑑 𝐵 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐵
- When two goods are substitutes their cross-price of demand is positive
- Increase in price of 1 = increase in demand of the other
- Can also be negative
- When 2 goods are complements = negative
- Ex. coffee and cream; if people want coffee, they want cream
- Strong complements = large neg number
● Income elasticity of demand
- Describes how much the quantity demand changes in response to a change in
consumers incomes
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
- 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
- For normal goods ; income elasticity is positive
- Demand increases as incomes rise
- If a good is a necessity income elasticity will be positive but less than 1
- If the good is a luxury it will be positive and larger then 1
- Can be a negative number
- Happens with inferior goods, because demand decreases as incomes increase
Chapter 5: Efficiency
Learning Objectives
1. Use willingness to pay and willingness to sell to determine supply and demand at a given
price.
2. Calculate consumer surplus based on a graph or table.
3. Calculate producer surplus based on a graph or table.
4. Calculate total surplus based on a graph or table.
5. Define efficiency in terms of surplus, and identify efficient and inefficient situations.
6. Describe the distribution of benefits that results from a policy decision.
7. Define and calculate deadweight loss.
8. Explain why correcting a missing market can make everyone better off.
Willingness to pay and sell
●
●
- All potential buyers have a maximum price they will pay
- The max price = willingness to pay
- Each seller has a willingness to sell = minimum price they are willing to sell for
- Seller wants to sell as high above this minimum as possible
Willingness to pay and the demand curve
- Willingness to pay can be plotted on a graph buyers/quantity on the x-axis / price
on the y-axis
- Each buyer's willingness to pay is driven by different motivations ; what are the
trade offs?
- Willingness to pay can be represented as the moment where the benefits of
spending money on A is equal to the benefit of spending on B (opportunity cost)
- Curve is a downwards slope
Willingness to sell and the supply curve
- Willingness to sell is represented by a positive curve
- Willingness to sell is determined by trade offs faced (opportunity cost of sale)
Measuring Surplus
- Surplus is a way of measuring who benefits from transactions and by how much
- If you buy something for less or sell for higher its good
- Surplus is the difference between the price a buyer/seller is willing to trade and the
actual price
- The difference is the extra value the buyer/seller gets from the transaction
● Consumer Surplus
- If your willingness to pay is $500 but you only pay 160$ ; surplus = $340
- Consumer surplus is the area under the curve
- Measuring consumer surplus tells us how much better or worse off buyers are
when the price changes
● Producer Surplus
- Want to increase the distance between the price they are willing to trade and the
actual price
- Producer surplus is the net benefit that a producer receives from the sale of a
good (difference between willingness to sell and actual price)
- Tells how much better or worse sellers are when prices change
● Total Surplus
- To find total surplus the consumer and producer curves need to be plotted
together and their intersection point needs to be found (equilibrium)
- Total consumer surplus = area under the curve and above equilibrium price
- Total producer surplus = area under the curve and below the equilibrium price
Total surplus = consumer + producer surplus
- Total surplus is the value created by the market
- Total surplus cannot be less then 0 or else people would not buy
- In the market both people are winners
Using Surplus to Compare Alternatives
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●
●
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In a competitive market equilibrium will occur naturally
Market Equilibrium and Efficiency
- Equilibrium is the point which buyers match sellers
- Also point at which total surplus is maximized
- When price is above or below the equilibrium total surplus decreases
- A higher or lower price will cause fewer trades to take place
- The market is efficient when it is at equilibrium
Changing the Distribution of total surplus
- When price is changes there is a reassignment of surplus from consumers to
producers or vice versa
Price is raised = sellers gained some well-being at the expense of the buyers
- Price = lowered buyers gained some well-being at the expense of sellers
- This transfer = reduced total surplus
- When an artificially high price is introduced = bad for consumer surplus
- Consumers loose surplus
- Producers; loose surplus from transactions but gain more surplus from the higher
price
- These two effects compete to see if the surplus increases or decreases
- When prices are lower then the market equilibrium the opposite occurs
- Fewer transactions take place (less willing to sell) so both parties loose surplus
- When transactions do take place consumers gain surplus and producers loose
surplus
- Sometimes governments will impose minimum and maximum prices
Deadweight loss
- What happens to the surplus?
- It “disappears”
- Deadweight loss = loss of total surplus that results when the quantity of good is
bought and sold below the equilibrium quantity
- Deadweight loss = total surplus at market equilibrium (before intervention) - total
surplus after market intervention
- Also calculate the area of the triangle on the graph
Missing Markets
- When people want to make exchanges but cannot we are missing opportunities
for mutual benefit
- ƒMarket is missing ; no place for potential buyers and sellers to exchange a good
- When quantity is below the equilibrium
- Means total surplus is lower than it could be
- Can be missing for a variety of reasons ; public policy (bans) / lack of accurate
info or communication / lack of technology
- Can increase total surplus by creating new markets
Chapter 6: Government Intervention
Learning Objectives
1. Calculate the effect of a price ceiling on the equilibrium price and quantity
2. Calculate the effect of a price floor on equilibrium price and quantity
3. Calculate the effect of a tax on the equilibrium price and quantity
4. Calculate the effect of subsidy on the equilibrium price and quantity
5. Explain how elasticity and time period influence the impact of a market intervention
Why Intervene
● Three reasons to intervene
Correcting Market Failures
- Market does not always work efficiently
- There may be 1 producer who has no competition and may charge a crazy price
- When efficient competitive markets fail to hold = market failure
- Intervening in this case can increase total surplus
Changing the distribution of surplus
- Efficient markets maximize total surplus ; but this may seem unfair
- If the market is efficient ; wages still may drop so workers are below the poverty line
while their employers are wealthy
- Gov. may intervene by imposing a minimum wage
- Change the distribution of surplus
Encouraging or Discouraging Consumption
- Some products for whatever reason are considered bad; alcohol , drugs, stc
- Gov. will use taxes to discourage people from buying
- Minimizing the cost on others is also sometimes the goal
- Can use subsidies to encourage good consumption ex public funding to schools
● Four real world interventions
1. Mexican families have tortillas as a staple; what happens if the gov,. sets a
minimum price to keep them affordable
2. Farming is risky ; to support a farmers income gov. sets a min. legal price to
which goods can be sold; what happens when there’s a min, set price for milk
3. Many struggle with health conditions from poor nutrition; response was banning
some bad foods; what happens if the gov taxes all bad food?
4. What would happen if instead of setting a max price the gov. of mexico
subsidizes tortillas
- When going through these, think of pos. And normative analysis
Price Controls
- What do you do if you live somewhere that food prices are rising?
- Set price control
- Setting a price control hold the price of a good up or down as the market shifts
- 2 types ceiling and floors
● Price ceilings
- Maximum legal price at which a good can be sold
- This ensures everyone can afford their basic needs
- Mexico government has a set ceiling price for tortillas
- Ex. $0.50 at 50 mill kg
- If prices rise and the gov sets a new max of $0.25 what happens?
-
-
●
Consumers want to buy more tortillas, but producers want to sell less
The ceiling creates a shortage of tortillas
This means total surplus will also fall since we have moved away from
equilibrium
Deadweight loss = total loss of surplus because the quantity of a good is below
the market equilibrium
One thing we can’t tell from a graph is if consumer surplus will increase or
decrease ; this depends on the slope of supply and demand curves
- Consumers lose surplus from trades that no longer take place ; but ones that do
take place gain more surplus
- Looking at the graph we can tell the goal was achieved (net increase for
consumers) (area 2 is larger then area1)
- Was this change worth while? Normative q.
- Another thing to consider is how are the scare tortillas being distributed?
- Coupons? To ensure everyone gets their fair share of tortillas?
- First come first serve? Forces people to waste time in lines
- Also the issue of preferentials and bribery
- Rent-seeking behavior = when the person in charge of allocation is bribed
- Can also lead to things like black markets and create corruption
- Does not always affect market outcome
- Is ceiling is set above the equilibrium it is a non-binding ceiling
In this case equilibrium price and quantity will prevail
- Although they are typically binding when first implemented (the whole point) shifts
in the market after render them no binding
Price floors
- Minimum legal price at which a good can be sold
- Typically will happen in canada on agricultural goods
- Keeps farmers in business ensuring food b y ensuring them a livable wage
- Ex. the gov puts in places a price floors so the price of milk cannot be lower than
3$
- At this price dairy farmers will want to up production but consumers will want to
consume less
- This creates an excess amount of milk
-
-
-
This leaves ½ happy ½ sad producers ; ½ will be able to sell their milk at a higher
cost but ½ cannot sell it because its in excess
consumers are unhappy because they are getting less milk for more $
Can also calculate dead weight loss
This changes the distribution of surplus in favor of producers
Whether its an overall win is dependent on if the area gained is bigger then
deadweight area
Is this a worthwhile change? To decide you need to look at how the extra surplus
is being distributed? Is it an equal distribution? Or are some producers more
favored?
The ones unfavored would have excess loss and waste
The gov in this case may choose to buy ALL the extra milk using tax payers $
(not good)
Not always binding but may become binding in response to the market
Taxes and Subsidies
- A way for the gov to make money to pay for its public programs
- Used to correct market failure and discourage or promote production
● Taxes
- How does a country fix obesity from unnatural foods?
- Implement a high tax on artificial foods, with the tax either the buyer or seller
must pay extra money to the government raising the price
- This will discourage the production and consumption of the food
A tax on sellers
- Does tax on sellers affect supply?
- Yes supply decreases when there is a tax imposed it means the seller will
lose x$ on each transaction to counter that they need to raise the price so
the tax burden is split between them and the buyer
- If there's curve 1 and curve 2 with new tax the amount supplies at spot
.50 on curve 2 is the same amount supplies at spot .20 on curve 1 (if .30
tax increase)
- Does it affect demand?
- No demand is the same
- Stays the same because tax does not change the non-price determinants
- BUT the quantity demanded may change due to the change in price
- Does it affect market equilibrium?
- Equilibrium price rises and quantity demand falls
- New curve causes the equilibrium point to move up along the demand
curve
- At the new point price is higher and quantity demanded is lower
- At a new equilibrium the seller does not keep all the money they now need to pay
a portion to the gov
- This creates a tax wedge = difference paid by buyers and the price the sellers
receive
-
-
Tax causes deadweight loss and redistributes surplus
The redistribution is harder to follow
Both producers and consumers loose surplus
This time it does not disappear it goes towards the goverment
A tax on buyers
- When this happens the outcome is exactly the same
- The only difference is that the demand curve moves instead of the supply curve
-
Does it affect the supply curve
- No because tax does not change the incentives producers face no
ono-price determinants are changed
- Does it affect the demand curve
- Yes demand decreases
- Does it affect market equilibrium
- Equilibrium price and quantity both fall
- New demand curve is farther down the supply curve ; equilibrium price
falls
- Also creates a tax wedge
- And gives the gov. Tax revenue
Who bears the burden of a tax
- The outcome of tax does not depend on who pays it
- Either way the cost is shared its just a matter of who bears more of it
-
●
Never usually split evenly
Relative tax burden borne by buyers and sellers is called the tax incidence
It is determined by relative elasticity of supply and demand curves
Price elasticity describes how much the quantity supplied or demand changes in
response to a change in price
- Tax effects the price so the responsiveness of supply and demand will determine
the tax burden
- The side that is more price elastic will adjust to price changes and will shoulder
less of the tax burden
- If demand if relatively more elastic many consumers will give up their product ;
meaning producers pay a higher share of the tax
- If demand is less elastic consumers will keep buying even for more $ ; buyers
pay a higher share of tax
- Tax burden will always be the same no matter what side its on
- Policy makers have very little control over how the tax burden is shared
Subsides
- Reverse of a tax
- Government pays extra to a producer or a consumer
- This gives benefits without causing a shortage or excess quantity
- What would happen if tortillas are subsidied?
- Price per 0.70 ; now there's a .35 subsidy
Buyers and sellers will react in the opposite way they respond to a tax
- w/ subsidy quantity supplied and demanded increase and the government
spends money
-
Does it affect the supply curve (sellers)
- Yes supply increases
- w/ a subsidy the real price a producer receives is higher then the market
price
- The new supply curve is drawn 0.35 below the old one
- Affect the demand curve (sellers)
- No demand stays the same because consumers are not directly affected
by the subsidy
- Affect the market equilibrium (sellers)
- Equilibrium price decreases and equilibrium quantity increases
- Equilibrium quantity with new supply curve increases as consumers move
down the demand curve
- A subsidy benefits both buyer and seller increasing total surplus within the
market
- Imposes a cost on the government and ultimately on taxpayers
- Is the subsidy worth it depends on if the opportunity cost (what the gov, and tax
payers could have done with the money other wise)
- Effects of the subsidy are the same regardless if its paid to the consumers or the
producers
- The benefits of the subsidy are split between the two groups in accordance to
relative elasticity
- In summary subsidies have the following effects
1. Equilibrium quantity increases (encourgaing production and consumption)
2. Buyers pay less and sellers receive more (amount forms a wedge)
3. Gov, has to pay for the subsidy (cost = amount of subsidy x new
equilibrium quantity)
4. Subsidy causes a deadweight loss
Evaluating Government Interventions
- To decide if policy makers have achieved their goal ; need to asses the effects of each
intervention included unintended ones
- Key effects;
- Price controls have opposing effects on the quantities supplied and demanded =
shortage or excess
- Taxes and subsidies move the quantities supplied and demanded in the same direction =
new equilibrium point
-
●
Taxes discourage people from buying and selling a particular good, raise gov. Revenue,
impose a cost on both buyers and sellers
Subsided encourage people to buy and sell a particular good, cost the gov. money and
provide benefits to both buyers and sellers
How big is the effect of a tax or subsidy
- How much will the equilibrium change? Can the effect be predicted ahead of time
-
Supply = inelastic
Demand = inelastic
-
Taxes causes the
equilibrium quantity yo
decrease (slightly)
Buyers and sellers keep
trading
-
-
Demand = more elastic
Supply = less elastic
-
When the supply curve is
.20 higher ; change in
quantity is much larger
-
Supply = elastic
Demand = inelastic
-
Suppliers are highly
responsive to the cost of tax
; quantity changes more
-
Supply = elastic
Demand = elastic
-
Quantity goes down the
most
To make predictions the price elasticity must be known ; use that info to see who will
bear more of the burden or receive the benefit
●
Long run versus short run impact
- Sometime the full effect of a price control is not seen until the long run
- Ex. if the price floor on gasoline was imposed; in the short run the demand might
not change very much
- In the short demand and supply are not very elastic , price floor results in only a
small excess
- Elasticity is often greater over a long period of time
- If the goal of a price floor on gas is to reduce pollution ; over the long run the gas
used will decrease
Chapter 7: Consumer Behavior
Learning Objectives
1. Explain how revealed preferences indicate which goods or activities gie a person the
most utility
2. Show how the budget constraint affects utility maximization
3. Show how a change in income affects consumption choices
4. Show how a change in price affects consumption choices and distinguish between the
income and substitution effects
5. Outline the ways in which utility is influenced by outside perceptions
6. Describe how people get utility from altruism and reciprocity
The basic idea of utility
- The challenges of gift giving highlight a point that is crucial to economic analysis
- 20$ isn't valuable but it represents the things you can buy for 20$
● Utility and Decision making
- Think about : wants and constraints
-
What people want are independent of their constraints
How do we decide which one of our wants to make a reality
Utility is the measure of the amount of satisfaction a person derives from
something
- People buy things based on if they think it will give them the most utility - utility
maximization
● Revealed preference
- Utility is hard to measure
- We observe what people actually do and assume that as rational individuals
they’re doing what gives them the most utility
- Revealed preference: determination of other people's utility through observation
- Put more weight in what people do rather than what they say
● Utility Functions
- To think about how people make choices economics use a utility function
- Formula for calculating the total utility that a particular person derives from
consuming a combination of goods and services
- Each combination a person could consume is a bundle
- The functions is a map that connects each possible bundle to the corresponding
level of utility that a person gets from consuming it
- Measurements are relative not absolute
- The numbers are not a measure but a rank of how much utility 1 thing has over
another
Marginal utility
- The change in total unity that comes from consuming one additional unit of a good or
service is called marginal utility
- Ex. eating the 1st scoop of ice cream = very yummy, 2nd = less yummy / the marginal
utility from the second scoop is a little lower then the marginal utility of the first
- The additional utility gained from consuming successive units tends to be smaller then
the utility gained from the previous unit ; diminishing marginal utility
- Its most noticeable in food because we have a physical reaction to additional
consumption
- Can diminish so much it becomes negative
●
When the marginal utility is zero you have maxed out the total utility you can get
For most cases your never in a negative
Maximizing Utility Within constraints
- You often do more than one thing in a day but how do you pick your activities
- Marginal utility helps by calling attention to the trade offs
- Spending the day is about choosing the combination of goods and activities that
will maximize utility within the limits of time and money available
- A rational utility maximizer will try to optimize the constraints by spending their
resources on the bundle of goods and activities that will give them the highest
possible utility
- Can represent possibilities on a line = budget constraint line
- Composed of all possible combinations of goods or services purchasable
-
-
To maximize utility the choice selected has to be on the budget line
Responding to changes in incomes and prices
- Incomes change all the time
● Changes in income
- When an income increases more bundles of goods and services become
affordable
- When income decreases fewer bundles are affordable
- These changes are represented by shifting the entire budget line
- The slope stays the same because the ratio of the prices of the two goods has
not changed
●
Changes in price
- 2 important affects ; income affect and substitution effect
- Normal goods = goods where demand increases as income increases
- Inferior goods = demand decreases as income increases
- A price decreases causes the budget line to rotate outward
- It rotates because for good A you can now get more but spend the same cash,
but for good B the price is the same and the quantity is the same
Income effect
- Describes the change in consumption that results from increased effective wealth due to
lower prices
- Meaning: if you pay 15$ for a ticket but they now cost 10$ ; everytime you buy one your
5$ richer
Substitution effect
- Describes the change in consumption that results from a change in the relative price of
goods
- If good A becomes cheaper relative to good B it will be subsitututed for good B
-
The opportunity cost of concerts and movies has changed when good A cost 15$ and
Good B 30$ the opportunity cost of B was 2 A ; when the price of A decreases the cost
of B increases to 3A
- Some people may still choose to buy more of a good when the price increases if it is a
Veblen good
- Veblen goods = quantity demanded is higher when prices are higher because they have
bragging rights associated
Utility and society
- Utility can help us think about envy, status, kindness, and a range of other emotions
- Ex. Oxfam : when you buy a goat in the name of someone else and it helps the
impoverished ; you and the person in the name of the donation feel good about helping
someone, the person in need gets help
- People can get utility from various sources that tie together both psychology and
economics
● Utility and Status
- Utility comes from 2 sources ; direct effect , other peoples reactions
- Overall utility is a mix of outside perceptions and inner preferences
- Utility can be related to status as some people get more utility from showing off
how wealthy they are and so they buy expensive things
Frames of reference
- Case A : you can make 36k at a job where the average salary is 40K
- Case B: make 34k at a job where 30k is the average
- Most people would choose B (80%) because you have the satisfaction of knowing that
you make more than the rest of your coworkers
- Utility may depend on who you compare yourself with
- If you compare yourself with peers you may get more satisfaction then comparing
yourself to wealthy
● Utility and Altruism
- People who help others with no obvious benefit behave altruistically
- Altruism = motive for action in which a person's utility increases simply because
someone else's utility increased
- An action can produce utility for a multiple of different reasons
- “We assume people are rational and act in their self interest” does not mean they
are being selfish they are just acting in a way that maximizes their utility
● Utility and Reciprocity
- People may get utility from punishing bad behavior and rewarding good behavior
- People get utility from rewarding kindness with kindness in return even if there
nothing in it for them = reciprocity
- Reciprocity = responding to another's action with a similar action
- Can also occur with bad treatment
- People will engage in bad reciprocity even if it means losing out
Chapter 12: The Costs of Production
Learning Objectives
1. Define total revenue, total cost, and profit
2. Explain the difference between fixed and variable costs and give example
3. Explain the difference between explicit and implicit costs & examples
4. Calculate economic and accounting profit and explain the importance of the difference
5. Define marginal product and show why there is diminishing marginal product
6. Define and graph tota; cost, average cost and marginal cost
7. Explain why firms face different costs in the long run than in the short run
8. Understand what economies and diseconomies of scale are and their implications for
production decisions
The Building Blocks Of Business: Revenues, Costs, and Profits
- Making a profit is the central goal
- Some may want social and environmental impacts but at the end of the day profit
● Profit is revenue minus cost
- Revenue = amount a firm receives from the sales of all goods and services
- Total cost = amount a firm pays for all the inputs that produce goods and
services
- Can be 1 time expenses or ongoing expenses
- Profit = total revenue - total cost
- Revenue = quantity x price
- (quantity x price) is repeated and added together for each sold item
● Fixed and variable costs
- Fixed costs = don’t depend on the quantity of the output produced
- Can be a one time payment or ongoing
- Variable costs = depend on the quantity produced
- Cost includes; raw materials, labour
● Explicit and implicit costs
- Explicit costs = require a firm to spend money comprised of fixed and variable
costs
- Costs used to operate daily
- Implicit costs = costs that represent forgone opportunities ; opportunities that
could have generated revenue
- Ex. a company uses a warehouse to store goods, they could have rented it out
and made 4k the 4k is an implicit cost
● Economic and accounting profit
- Accounting profit = total revenue - explicit costs
- Only looking at explicit costs can be misleading
- Economic profit = total revenue - explicit costs - implicit costs
- Investors are more interested in economic profit
Production Function
- The relationship between inputs and outputs
● Marginal product
-
-
The marginal product = is the increase in output that that is generated by an
additional unit of input
Diminishing marginal product = the marginal product of an input decreases as the
quantity of the input increases
Can be shown graphically ; employees x-axis, quantity y-axis; marginal product
is represented by the slope of the total production curve
At low levels of output the curve becomes steeper as people are added
Curve flattens when diminishing output kicks in
-
Can also graph the number of goods each person adds
Also can show the average number of product produced per worker
Average product = total production / number of workers
-
- Marginal product connect to marginal decision making
- Compare the marginal product of an input to its marginal cost
Cost Curves
- When a firm increases its outputs by increasing its input it incurs costs
- Cost of an input does not lesson at the point of diminishing marginal product
● Total, average, and marginal costs
Total and average costs
- Total cost = fixed cost + variable cost
- Average fixed cost (AFC) = fixed cost / quantity
- Average variable cost (AVC) = variable cost / quantity
-
-
Average total cost (ATC) = total cost / quantity
Graphically;
Fixed cost will always be constant
Variable cost will initially be less steep (reflecting marginal product)
Average costs : graphically
Average fixed cost curve trends downward ; fixed cost remain the same as quantity
produced increases / so fixed cost per unit of production decreases
AVC curve is u-shaped ; initially slopes downward (increasing marginal product) then
trends upward (diminishing marginal product)
- An important stat is the average total cost which is also u shaped
Marginal Cost
- What additional cost will incur by producing one additional unit
- Marginal cost = change in total cost / change in quantity
- Also u shaped curve
- If the marginal cost of increasing production by 1 unit is less then your current average
total cost then producing the extra unit will decrease your average cost
- If the marginal cost of increasing production by 1 unit is more than your average cost
then the extra unit will increase your average cost
-
Production in the Short Run and the long run
- Supply is more flexible over longer periods of time
● Costs in the long run
- A fixed cost depends on the timescale
- In the short run the cost of a lease is fixed but in the long run it is not fixed
- You can have a lease for a while and then decide when its up to downsize
- How long is the long run?
- The long run is how long it would take for a firm to vary all of its costs if it wanted
to
- As of right now we have been looking at short run curves
●
Economies and diseconomies of the scale
- When firms plan for the long run they consider the scale at which they want to
operate
- Returns to scale describes the relationship between the quantity of output and
average total cost
- A small firm may find that operating on a large scale enables it to lower its
average cost
- This firm is said to be facing economies of scale
- Ex. a lot of places charge less for bulk buys
- But there may be a point in which increasing scare leads to higher average costs
- When increasing a firms scale starts to raise its average costs = diseconomies of
scale
- In between the extremes there are various sales without higher or lower costs =
constant returns to scale
- When a firm can achieve economies of scale by expanding its long run ATC
slopes down ; ATC decreases as output increases
- When a firm faces diseconomies the curve slopes up ; ATC increases and output
increases
- The long run ATC curve is a flat portion in the middle ; it represents various diff.
Levels of output at which there is a constant return to sale
-
A long run ATC curve covers a much greater range of output then its short run
In the short run all firms are stuck on the smaller curve ; constrained by limited
capacity of fixed inputs
By increasing / decreasing its scale a firm can move along the curves
Chapter 13: Perfect Competition
Learning Objectives
1. Describe the characteristics of a perfectly competitive market
2. Calculate average marginal and total revenue
3. Find a firm's optimal quantity of output
4. Describe a firm's optimal quantity of output
5. Describe a firm's decision to shut down and to exit the market and explain the difference
between these choices
6. Draw a short-run supply curve for a competitive market with identical firms
7. Draw a long-run supply curve for a competitive market with identical firms and describe
its implication for profit-seeking firms
8. Explain why a long-run supply curve might slope upwards
9. Calculate the effect of a shift in demand on a market in long-run equilibrium
A Competitive Market
- How firms make product decisions
- Firms are operating in a competitive market
- What are the wants and constraints
● Characteristics of a competitive market
- Buyers and sellers are fully informed price takers
- Goods are standardized
Individuals can’t affect the going price
- If your the only vender of a good you can charge as high as you want
- If your one customers with lots of sellers you can offer a low price
- Most buyers and sellers can not set their own price
- In a perfectly competitive market there is so much competition buyers and sellers can
not set their own price
- Opposite of a price taker is having market power ; being able to noticeably affect the
market
Goods and services are standardized
- Standardized goods are interchangeable ; meaning all producers have to sell at market
price
- Not the case in real life ; brands, quality, characteristics all vary
- Not standardized, producers can charge different prices
- Natural resources are typically considered standardized
- Goods like gold and oil are known as commodities
- No information asymmetries in a perfectly competitive market - everyone knows what
they are trading
Firms can freely enter and exit
- The extent to which firms can enter and exit explains some differences among markets
- Ex. roasted plantains is easy to start, a oil rig is not
- The entry requirements for crude oil make it easy for the firms to collude and keep prices
high ; fails the price-taking requirement of a perfect competition
● Revenues in a perfectly Competitive Market
-
In a perfectly competitive market ; producers are able to sell as much as they
want without affecting the market price
- Ex. you live in a town and setting up a plantain roasting enterprise
- Total revenue ; comes from only one thing so total revenue = price x quantity
- Also need to consider 2 other types of measurement
- Average revenue = total revenue / quantity sold
- Any firm selling 1 product, average revenue is equal to the price of the good
- Marginal revenue = revenue generated by selling an additional unit of a good ;
in this example is it the market price because its a 1:1 ratio
- For a firm in a competitive market marginal revenue is equal to the price of the
good
Profits and Production Decisions
● Deciding how much to produce
- How much to produce to maximize profits
- In a perfect competition ; revenue and cost per plantain are determined by factors
outside of its control
- Only factor they can control is production quantity
- A firm should keep producing for as long as marginal cost is less than
marginal revenue; it should stop producing as soon as the two are equal
- Ex ;
-
-
Output
Marginal rev
Marginal cost
Marginal profit
2
1k
600
400
3
1k
800
200
Increasing production from 2 ->3 makes sense because there is still a positive
marginal profit
-
-
Output
Marginal rev
Marginal cost
Marginal profit
4
1k
1k
0
5
1k
1.2k
-200
By producing 5 the firm is losing money so it should stick to 4
The profit maximizing quantity is the one at which the marginal revenue of
the lat unit is exactly equal to the marginal cost
-
●
The point at which marginal rev. and marginal cost meet = profit-maximizing
quantity to produce
- What if the price product can be sold at drops?
- Firm can no longer create profit no matter the quantity sold
- Sometimes a firm cannot quickly exit the market ; fixed costs such as rent will still
need to be paid
Deciding when to operate
- How low would the market price have to all before deciding to produce nothing
- The MC curve intersects AVC and ATC at their lowest points
- The fixed costs (total cost - variable) must be paid no matter what production is
- In a perfectly competitive market ; market price = firms average revenue
- If average revenue remains above average total cost; total revenue will be higher
then total cost and the firm will make profits
- If market price is below A^TC there is no level of output that makes a profit
- Do we stop production in this case?
- Depends on if we are looking at the short run or the long run
- In the short run; variable costs are 0$ but fixed costs remain unchanged
- Therefore fixed costs are irrelevant in deciding whether to shut down
production in the short run
- Decision depends on variable cost of production
- Is market price is lower than ATC but higher than AVC the firm should still
continue to produce in the short run
- Firm should produce where market price interests the MC curve ; loss-minimizing
level
- Shut down if P<min(AVC)
-
-
At any price above where AVC meeting MC (shutdown point) the firm will
produce the quantity where price intersects MC Curve
Profit maximizing quantity is one at which marginal cost = marginal revenue ; in a
perfectly competitive market marginal revenue = price
In the long run decisions are made differently
In the long run all costs become variable
To determine wether to exit ; consider if the average revenue is greater then the
average total cost
If the market price is less than the lowest point on the ATC curve the firm
should exit the market for good
Exit if P < min (ATC)
-
Firm will decide if the price is likely to remain low in the long run
-
-
If the price is determined to go back up they may only halt production
momentarily
Behind the Supply Curve
● Short run supply
- Short run - number of firms in the market is fixed
- Total quantity of a good is supplied at a given price is the sum of the quantities
that each individual producer is willing to supply
- Assume all else is the same
- There is 100 producers all with the same supply curve total quantity supplied is
the sun of quantities that each firm supplies
●
Long run supply
- In the long run firms can enter and exit freely
- More firms will enter a market if the existing firms are making a profit
- Economic profit = revenues are higher then total costs
- Total costs include opportunity costs - ex money they could have made if they
invested elsewhere
- ATC also includes opportunity cost
- Economic profits mean there is money to be made ; firms will want to be included
- If more firms enter the total quantity offered for sale increases
- Meaning whole supply curve shifts to the right
- As supply increases but demand stays constant the market equilibrium moves to
a lower price and higher quantity
- Profits = revenues - cost
- As market price falls so do revenues and so do profits
- As long as economic profits are still positive more firms will enter
- Eventually after enough have entered the market price will be so low economic
profit is equal to 0 ; P =ATC
- No longer an incentive to enter the market
- If price falls below ATC a firm may still make accounting profits but it will have
negative economic profits
-
It can make more by pursuing other opportunities so it will exit
When a firm exits the supply curve shifts left new lower quantity and higher price
= more profit ; continues until economic profit is 0
Firms earn zero economic profit
- The business may still be making an accounting profit
- Firm can not earn greater accounting profit by choosing to operate in a different marker
Firms operate at an efficient scale
- To understand this all three rules need to be brought together
- Gives us P = MC + ATC ; all 3 lines intersect at one point
- When A firm is operating at this point it is operating at its efficient scale
Supply is perfectly elastic
- For economic profits to be 0 ; price must equal the minimum of ATC
- If anything causes the equilibrium to move away the neg or pos profits will determine to
exit or enter
- In the long run price is the same at any quantity
- Supply curve is horizontal - perfectly elastic
- In the long run a price of a good will never change
● Why the long run market supply curve shouldn’t slope upwards but does
- Removes the assumption that all firms have the same cost structure
- Some firms are more efficient than others at converting inputs into outputs
- In the long run the supply curve will shift upward because price has to rise to
entice new firms to enter and increase the total quantity supplied
- Price is equal to the minimum of the ATC for only the least-efficent firm in the
market
- Every firm has the same ATC prices will also change inthe long run because over
time the average total cost itself may change
-
●
Ex innovation that enables production at a lower cost
Meaning MC and ATC curves will lower
In turn increasing profits meaning new firms meaning more supply = lower price
Responding to shifts in demand
- If there is a shift in demand caused by (ex.) change in price of a substitute good
causing the sub to cost more
- Meaning people buy more plantains - shift the demand curve to the right
- Short run demand shift to the right = higher quantity is traded for a higher price
- Higher price means making economic profit = incentive for more firms to enter
- As more firms enter supply curve shifts right
- Equilibrium price slides down the new demand curve until it reaches the long run
curve
- At that point there is no economic profit being made
-
Chapter 14: Monopoly
Learning Objectives
1. List several reasons that monopolies exist and explain how each causes barriers to entry
2. Explain why a monopolist is constrained by demand
3. Calculate the profit maximizing production price and quantity for a monopolist
4. Calculate the loss in total social welfare associated with a monopoly
5. Describe the pros and cons of common public policy responses to monopoly
6. Explain why a firm has an incentive to use price discrimination when possible
Why Do monopolies exist
- When a company faces no competition at all
- A perfect monopoly controls 100%
- A monopoly of power if they control slightly less then 100%
- Lack of a close substitute is essential part of the definition of a monopoly
- Set your own price and people have no choice but to pay it
● Barriers to entry
- Forces of competition are usually stacked against one firm gaining that much
power
- When 1 firm charges a high amount another usually comes along and undercuts
it
- There are barriers preventing oters from doing this
Scarce resources
- Most straightforward barrier is scarity in resources
Economies of scale
- In some industries economies of scale are so powerful that competition between two or
more firms simply don’t make sense
- Infrastructure is too costly to replicate
- Ex. electricity
- Natural monopoly
- Market in which a single firm can produce at a lower cost than multiple firms the entire
quantity of output demanded
- High fixed costs create an effective barrier to entry
- Governments usually get involved in natural monopolies to try and protect the public
from abuse
Government intervention
- Gov may create or sustain monopolies
- Gov has created a monopoly on alcohol
- Say they will use the monopoly to benefit the public interest
- Can also create monopoly for state-owned firms
- Though legal prohibition against other firms entering the market or by subsidizing
enough private companies cannot compete
- Can also create or support private monopolies through regulation of intellectual property
rights
-
Ex. pharmacies companies can patent a drug and others cannot make a generic version
or works of art are protected from illegal distribution
- Plus side: gives firms an incentive to invest in research that lead to products to enrich
peoples lives
- Neg: drive down consumer surplus by setting higher prices
Aggressive tactics
- Buying up other companies who want to enter the market
- Predatory pricing - temporarily slashing prices until rival local stores are forced out of
business
- Some tactics are welcomed by smaller firms
- Ex. google buys up smaller promising looking inventions in technology to keep a
monopoly ; purchase benefits the smaller firm
How monopolies work
- Monopoly wants to maximize profits
- Does not face the constraint that production decision cannot effect market price
- Instead constrained by the demand curve
● Monopolists and the demand curve
- Each firm faces a horizontal demand curve ; demand curve for the market as a
whole slope downward
- Each firm is assumed to be too small for its production decisions to affect the
market price
●
- As the only producer a monopolist faces a downward slop
- It can choose to sell at any price without worry of getting undercut
- Still constrained by market demand
- How will consumers react to a high price?
- If all else equal quantity demanded falls as price rises
- Monopoly can choose any price-quantitiy combination but it must be on the curve
Monopoly revenue
-
Total revenue earned at each price is price x quantity sold
As price increases quantity sold decreases
Total revenue first rises and then falls
Total revenue increases on sections of the demand curve where demand price is
elastic
Average revenue - found by dividing total revenue by quantity sold
Average revenue = price
Marginal revenue is the revenue generated by selling each additional unit
Marginal revenue = total revenue (@ certain quantity) - total revenue (when
quantity is one unit lower)
In a competitive market a firm can sell as much as it wants without changing the
market price
BUT in a market dominated by a monopoly by producing an additional unit the
market price drop
Quantity effect - total revenue increases due to money brought in by the sale of
an additional unit
Price effect - total revenue decreases because all units sold now bring in a lower
price than they did before
Price effect always works opposite of quantity effect
Marginal revenue in a monopoly market is always less than the price except
for the first unit sold
For the first unit average revenue and marginal revenue are both equal to the
price
Average revenue is equal to price @ any quantity ; AR curve is the same as MD
curve
MR cuve is below AR curve because it is always less
-
Marginal revenue can sometimes be negative
Negative MR means that the price effect has become bigger than the quantity
effect ; each additional unit decreases revenue
- Point where MR curve crosses the x-axis = revenue - maximizing quantity
Maximizing profits by picking price and quantity sold
-
The profit maximizing quantity of output for a monopoly is the point at which the MR
curve interests the MC curve
If the MR of a unit is higher then MC the unit brings in more money then it costs to
produce = profit
If MR is lower then MC unit costs more then it brings in = less profit
Quantity below the point = more profit earned by selling 1 more
-
Quantity above the point = earn more profit by selling less
Monopolies profit maximizing price is higher then marginal costs = key to know how
monopolies earn positive economic profits in the long run
Profit = (P-ATC) X Q
If profit is greater then ATC profits will be positive even in the long run
- Profit = area of the shaded box
- Height = difference/distance between the profit-max price and average total cost
Problems with monopoly and public policy solutions
● The welfare costs of monopoly
- Ability to keep a price high and quantities low hurts society
●
- In a monopoly consumer surplus is smaller
- Total surplus is not maximized
Public policy responses
- Range of poicys to break up monopolies, prevent new ones, ease the effect
Competition act
- Administered and enforced by federal competition bureau
- 4 purposes ; promote efficiency and adaptability of canadian economy / expand
opportunities for canadian participation in world markets / Ensure small and medium
sized enterprises have an equitable opportunity to participate in the canadian economy /
provide consumers with competitive prices and product choices
- Has definitions of criminal offenses and civil reviewable matters
- Criminal office act prohibits things like ;
- Conspiracy ex. Cartel
- Bid-rigging ; collusion of bidders to win a bid
- Pyramid selling ; recruits members via a promise of payments or services for enrolling
others
- Price maintenance ; where manufacturer and distributors agree that the distributors will
sell the manufacturer product at certain prices
- Tied selling ; the illegal practice of providing a service or product on the condition that a
customer purchases some other product or service
- Exclusive marketing ; distribution arrangement when only certain retailers are given the
option of carrying a product in store
- Abuse of dominance ; when a dominant firm engages in conduct that in intended to
eliminate or discipline a competitor or to deter future entry by new competitor that results
in less competition
- Canadian gov has rejected mergers to prevent monopolies such as the merger of the big
banks
- In recent years it has slowed back on its stoppage of mergers
Public ownership
- To solve the issue of monopolies a natural monopoly is run as a public agency
- Public ownership means the governments are supposed to serve the public interest
rather than maximise profit
- Ex. canada post and via rail
- A public owned monopoly can set lower prices, lower than a monopoly price but still
higher than average total cost ; still some deadweight loss
-
-
Even a public ownership has problems
Politicians may feel pressure to lower prices even further
May also make business decisions on the basis of political concerns
Loss of profit motive could reduce the motivations to improve efficiency
If an inefficient monopoly cannot provide a service people want to pay it can cover its
losses from revenue from taxes
Regulation
- if policy makers don't want to go all the way to public ownership a common intermediate
step is to regulate the behaviours of all natural monopolies
- Ex. setting a control on the prices monopolies can charge
- By capping ATC can force monopolies to earn 0 economic profits, reducing deadweight
loss
- Does not alway work ; firms don’t give accurate information making it hard to form new
policies
Vertical splits
- Splitting an industry adds competition
- Divides the original firm into companies that operate at different points in the production
order
- Ex. supply of energy is a monopoly but generation is not
No response
- Doing nothing may be preferred if a regulation is too difficult to create or manage
effectively
- If gov intervention leads to corruption or political mishandling
Market power and discrimination
● What is price discrimination
- Charging different customers different prices for the same good
- Discriminates customers based on their willingness to pay
- Ex. using your student card to get a discount
- Cannot charge different prices in a perfectly competitive market
- When a firm gains a high degree of market power it looks to exploit willingness to
pay
- Ex. theaters w/ matinee shows being cheaper
- More monopoly = more price discrimination
- By price discriminating a company can earn more money as it doesn’t exclude
groups who may want to pay less, while also upcharging those who don’t mind
paying more
-
Perfect price discrimination
- In reality there are not three even groups of people willing to pay a certain price, there
are millions
-
- If a company can price discriminate perfectly the firms profits are biggest
- There is no consumer surplus because they all pay exactly what they are willing
- All producer surplus
- No deadweight loss - efficient market
Price discrimination in the real world
- Its hard to identify who the customer is ; are they actually a student?
- Many products can be resold ; buy at student discount then resell for profit
- Must be a way of punishing these people
- Impossible to read the minds of people to determine how much they are willing to pay
-
Chapter 18: Externalities
Learning Objectives
1. Explain how external costs and benefits affect the trade offs faced by economic decision
makers
2. Calculate the effect of a negative externality on market price and quantity and measure
the resulting change in surplus
3. Describe how individuals could reach a private solution to externality and explain why
this doesn’t always occur
4. Show how a tax or subsidy can be used to counteract an externality and explain why this
doesn’t always occur
5. Show how a tax or subsidy can be used to counteract an externality and discuss the
pros and cons of such a solution
6. Show how quantity regulations and tradable allowances can be used to counteract an
externality
What are externalities
- Causes associated with a choice you make
- Ex. when buying a car it has benefits to you and withdrawals
- Pollution caused by burning gas to drive = externality -> imposes a cost on people other
then the driver
● External costs and benefits
- Costs such as gas, parking, wear and tear are costs borne by the driver
- Cost falls directly on the economic decision maker = private cost
- Cost of pollution or any other imposed without compensation on someone other
then the person who incurred it = external cost
- Private cost + external cost = sum cost
- If you host a party ; food, drink = private cost annoyance felt by neighbors from
loud noise = external cost
- Can also be private and external benefits
- Private + external benefits = social benefits
- External benefits and external costs = externalities
- Cost = negative externality
- Benefit = positive externality
- Size of benefit or cost depends on many factors
- For simplicity assume they are constant and predictable
- Network externality = effect that an additional user of a good or participant in an
activity has on the value of that good or activity for others
Can be positive or negative
● Negative externalities and the problem of too much
- Negative externality poses a cost on a third party
- Negative externalities occurring when a good or service is produced = production
externality
-
Negative externalities occurring when a good or service is consumed =
consumption externality
Negative production externalites
- Ex. manufacturing a car for a company only costs labor and materials but for society the
cost is pollution
- Private cost to the company is less than to society as a whole
- To add the external cost associated with car production need to quantify how much
damage is being imposed each time
-
At private equilibrium the market creates deadweight by not accounting for external costs
Equilibrium price is when the private supply curve and the market demand curve interact
When the negative external cost is accounted for the efficient quantity of care produced
falls
- Efficient price rises
- Social cost of manufacturing a car is higher then the private cost
- Socially efficient equilibrium in the market reflects the external costs in addition to the
benefits and costs to the buyers and sellers
- Cost of too many cars = deadweight
- Deadweight loss reduces economic surplus to society
Negative consumption externality
- Ex driving a car
- Pollution and environmental damage are external costs - cost looks smaller to the
individual then to society
- Because the individual cost is smaller people drive “too much”
● Positive externalities and the problem of too little
- Also reduce total surplus
Positive consumption externality
- Third party benefit
-
-
-
If external benefits are worth 500$ ; 500 is the amount combined from the amount your
neighbours are willing to pay to avoid having your shabby looking house lowering the
tone of the neighborhood
Difference between private trade-off and social trade-off is represented by adding a new
demand curve
Forcing others to paint their house for external benefits matches the effect of a subsidy
Equilibrium price and quantity is at the interaction of private supply curve and private
demand curve
- Net cost to society is shown in deadwight loss
- Underproducing a good or service reduces economic surplus and generates a
deadwight loss
- Positive consumption externality results in “too little” house painting
Positive production externality
- Third party benefit that occurs when a good or service is being produced
- Ex. power plants produce unexpected positive externality
- Power plants in florida produce hot water and its released into the ocean - creates a
good habitat for manettes
- Increased number of manatees and their habitats is a positive
- If regulations force the power plant to improve the manatee habitat ; how much power
should the plant produce?
- To know how much power to produce need to measure the value of manatee habitat
- How much would people pay to preserve manatee populations
- In an unregulated market power plants and consumers do not care about the external
benefit
- Will produce “to little”
Private solution to externalities
- Transform external cost and benefits to private costs and benefits
- Private individuals may be able to deal with externalities restoring efficiency to the
market on their own
- Ex your friend is eating tuna and the bad smell is annoying you, you can pay them to not
eat the sandwich
- You paying them to not eat it solves the externality
-
Market failure ; when actions of private individuals and firms are insufficient to ensure
efficient markets
- Individuals will pursue mutually beneficial trades with other individuals - no mutually
beneficial trade should go unexploited
- When we add up all actions of self-interested individuals every opportunity to gain
surplus had been exploited ad total surplus is maximized
- There must be mutually beneficial trades witig to be exploited
- The idea that individuals can reach an efficient equilibrium through private trades even in
the presence of an externality is called the coase theorem ; key assumptions ; people
can make enforceable agreements to pay one another , there are no transaction costs
- These assumptions very often do not hold true
- There comes a point where coordination and enforcement are higher then surplus lost =
not worth it
- Private solution yields an efficient outcome - surplus - maximizing quantity of gas is
bought and sold ; distribution of the surplus is different; instead of drivers paying others
to compensate for pollution ; citizens pay drivers to not drive ; citizens are better off
under externality but not as well off as when the drivers had to pay them
- Coase theorem does not say we have to be fair but we must maximize surplus
- Q. of politics, law, and philosophy than economics to decide who pays whom to solve a
market failure
- People usually not only care about reaching an efficient equilibrium but also ow we get
there and who benefits
Public solution to externalities
- Public solutions are often easier then private
- Most common remedies are taxes and subsides
● Taxes and subsidies
Countering negative externality with a tax
- A tax meant to counter the effect of a negative externality = pigovian tax
- Include carbon, gas taxes and “sin” taxes such as alcohol nad cigs
- The effect of the tax is to increase the effective price hat is paid for the good; which
creates a new demand curve below the original
-
Can also show the effect by adding a new supply curve above the original
-
Not a perfect solution
Not always easy to set the tax at the right level
If the tax is set too low, market will move closer to efficient equilibrium but remain
inefficient
- If taxes is too high market will overshoot and new equilibrium will be too low and
inefficient
- Effective at transferring surplus from consumers and producers ; no guarantee the gov
can or will do anything to help the people bearing the external cost
- Revenue collected fro mtaxes can sometimes be used as compensation but often is not
Capturing a positive externality with a subsidy
- Subsidy can help capture the benefits of positive externalities
- If the gov fins painting a house creates 500$ worth of external benefits it will offer 500$
subsidies to paint your house
-
Subsidy does not create equal fairness
The distribution of surplus depends on where the government gets the money to pay for
the subsides
May seem “fair” if it was fro property taxes, but total surplus is max if it comes from
general taxes
Public policies that use subsidies are less noticeable then taxes but very widespread
Solving a positive externality through subsidies requires quantifying the external cost or
benefit
Is its too low the surplus will be too low ; too high and the total surplus will not be
maximized because the increase in benefits will be less than the cost
Quotas and tradable allowances
●
Quotas
- If we know the socially optimal quantity of something then why not regulate quantity (set
a quota)
- Limiting total consumption does not make the market efficient
- The reasons why the “magic hand” works is because it allocates resources to those with
the greatest willingness to pay for them
- A tax allows the market to sort itself out a quota does not
Tradable allowances
- Why not set a quota then allow firms to buy and sell their quota allowances?
- Production or consumption quota that can be bought or sold = tradable allowance
- The tradable allowance is bought and sold among private parties
● Targeting externalities with public policey
-
Chapter 19: Public goods & common resources
Learning Objectives
1. Define different types of goods in terms of rivalry and excludability
2. Describe the free rider problem and its consequences
3. Explain how and when problems with public goods can be effectively solved by social
norms, gouvernement provision and expansion of property rights
4. Describe the tragedy of the commons and its consequences
5. Explain how and when problems with common resources can be effectively solved by
social norms gouvernement regulation and expansion of property rights
Characteristics of goods
- When a good is excludable it is possible for sellers to prevent its use by those who have
not paid for it
- When a good is rival in consumption one persons consumption prevents or decreases
others ability to consume it
- Most of the goods so far are private goods
● Excludable goods
- Excludability allows owners to set an enforceable price on a good
- Non-excludable - street lamp ; onces its there you can’t stop people from using it
- Can be a matter of degree
- Ex bridges can be made excludable by adding toll booths
● Rival in consumption goods
- Has to do with whether a good is used up once someone consumes it
- When 1 fish is caught it cannot be recaught by another
- Knowledge and technology are non-rival ; once something has been invented
everyone can take advantage of it
- Also a matter of degree
● Four categories of goods
- Private goods: both excludable and rival - usually allocated efficiently by
competitive markets
- Public goods: opposite of private goods ; neither excludable nor rival
- Common resources: not excludable but rival
- Artificially scarce goods: are excludable but not rival
Public Goods
● The free-rider problem
- Caused by non-excludability leading to an undersupply of a public good
- When a good is easily excludable what people pay for it may not necessarily
reflect the real value they place on it
- When this happens the good will be undersupplied compared to efficient quantity
- Very common problem
- If given the opportunity people will free ride
- Free riders enjoy positive externalities from others choices to pay
- It is not possible to exclude free-riding residents from enjoying the benefits
● Solution to the free rider problem
- Free rider problem leads to market failure ; undersupplied goods
- The undersupply can be remedied by ;
❖ Changing the social norms related to the good or service
❖ Make somebody responsible for the provision of a certain quantity of the
good or service
❖ Make the good or service more excludable by assigning property rights
- The many possible solutions fall under 3 categorises
● Social norms
- Big cities can pay to have people keep public spaces clean
- In a smaller town they stay clean based on expectations and potential
disapproval of the community ; if you don’t litter its probably because you were
taught its not a nice thing to do
- The free rider problem is a problem of trade offs ; people are able to enjoy the
benefits of something without paying the corresponding costs
- Strong social norms can help rebalance the trade offs by imposing costs on
people who litter etc
- Costs don’t have to be $$ social disapproval or guilt or conflict in your community
can be costs
-
●
Gouvernement provision
- To combat the undersupply of goods it is common for the government to step in
and provide a good directly
- Some people argue about when the government should provide these or force
others to pay ; either way there are two questions; what is the right amount of
public good to supply ? who will pay?
- In a functioning market people will buy a good up to the point where the marginal
benefit they enjoy from the last unit is equal to the marginal cost of the unit
- If the benefit was greater then the cost they could increase their utility by buying
more
- If cost was more the the benefits thay could increase their utility by buying less
- The marginal social benefit is the sum of the marginal benefit gaines by ach
individual user
- Harder to find irl ; how does the gov know the value citizens place
- When asking citizens they will overstate the marginal benefit they receive ;
expecting the gov to pay for it
- Instead the gov tries to conduct a cost-benifit analysis when deciding how much
of a public good to supply
- Making a best guess at what the marginal social benefit of an additional unit will
be
- Economic research can help with this
- Second issue it figuring out how to pay for gov provision of public goods
- Who will pay depends in part on how easy it is to exclude people who don’t pay
- It is possible to make the good excludabe ex monitor and enforcing payments
- Services used by all citizens are harder to exclude and are typically funded
through general tax revenue
● Assigning property rights
- Private goods are excludable and rival ; solution to free rider is to make a public
good excludable
- 1 way is to monitor use and enforce payments
- 2nd way is to give individua;s or firms the right to use or sell a public good by
assigning property rights
- Public goods like knowledge are made excludable through patents and
copyrights
- Protection like this incentivises people to undertake research that will create new
knowledge
Common resources
- The issue with common resources is that they are overconsumed
● The tragedy of the commons
- Common goods are not excludable but are rival
- This means the good gets “used up” every time someone accesses it
- Demand is characterised by inefficiently high demand and dwindling quantity
- Leads to the “tragedy of the commons” the depletion of a common resource due
to individually rational but collectively inefficient overconsumption
-
-
Equilibrium quantity is both individually rational and collectively inefficient
Individually rational ; on the plus - high value of good, no cost to acquire cost equipment, time, risk as a result hunters will hunt more than they would if they
had to pay someone for the good
Collectively inefficient ; using a common resource imposes a negative externality
on others
● Solution to the tragedy of the commons
Social norms
- When there is trust that others are going to reciprocate and be trustworthy including their
officials they will be highly cooperative
- Some specific principles make community based solutions to common resource
problems more effective ;
- Clear distinctions between who is and is not allowed to access the resource
- The participation of resource users in setting the rules for use
- The ability of users to monitor one another
Government regulation: bans and quotas
- Making something illegal is simply one way of changing the tradeoffs that people face by
creating costs for breaking the ban or exceeding quotas
- The cost rule breakers face depends both on the punishment associated with rule
breaking and on the likelihood of being caught and punished
- If the punishment is not severe or the chance of getting caught is low the cost may not
be high enough to change the trade off
- Bans and quotas often fail where it is difficult or costly to monitor and punish rule
breakers
Property rights: privatisation
- Privatisation helps introduce excludability and assign responsibility costs and benefits
the public aspect helps counteract remaining externalities
- Assigning property rights over commons resources is far from simple
- Especially when the resources is already being used ; its difficult to decide who owns
what ; no one wants to be the person that has to reduce their consumption
Property rights: Tradable allowances
- Governments can institute private property rights through the use of tradable allowances
or permits
- Quotas can control total quantity but don’t necessarily allocate supplies in the most
efficient way
- Can result in undesirable side-effects such as damaging extraction methods or rushes to
get as much of a resource as possible before hitting the quota
- A cap is set on the total quantity of the resource that can be used and shares of that total
are allocated to individuals or firms
- After the initial allocation people can buy or sell
- Trading ensures the resource is allocated to those with the highest willingness to pay ;
while limiting overall quantity to an efficient level
-
The people who own shares now have private property rights ; and an incentive as
owners to make sure that the common resource does not get overused
Because the depletion of common resources imposes a negative externality tradable
permits are also useful in allocating common resources