1. THE LOGIC OF
MAXIMIZING BEHAVIOR
Learning Objectives
1. Explain the maximization assumption that
economists make in explaining the behavior of
consumers and firms.
2. Explain and illustrate the concepts of marginal
benefit and marginal cost and supply them to
understanding the marginal decision rule.

Economists assume that:
◦ Tastes and preferences are fixed and given, and
play a large role in decision making.
◦ Consumers make choices that give them the
greatest , satisfaction —they maximize their
satisfaction or benefit.
◦ Utility is the technical term in economics for
benefit, satisfaction, or usefulness, so consumers
MAXIMIZE Utility.
3

Marginal benefit or Marginal utility: the
extra utility derived from consuming one
more unit of a good or service.
change in total utility
marginal utility 
change in quantity
The same formula for “marginal benefit”
4
Economic Profit
• The difference between total revenue and
total cost
1.1 The Analysis of
Maximizing Behavior
•
•
•
•
•
Net benefit is the total benefit of an activity minus
its opportunity cost.
Marginal benefit is the amount by which an
additional unit of an activity increases its total
benefit.
Marginal cost is the amount by which an additional
unit of an activity increases its total cost.
The marginal decision rule states that if the
marginal benefit of an additional unit of an activity
exceeds the marginal cost, the quantity of the
activity should be increased. If the marginal benefit
is less than the marginal cost, the quantity should
be reduced.
A constraint is a boundary that limits the range of
choices that can be made.
Diminishing Marginal Benefit
• At some point the marginal benefit of any
activity or any product diminishes as we
continue doing one more
– Eating 1 burger when hungry
– 2nd burger
– 3rd burger
– 4th burger……
1 hour STATS study vs 2nd hour,
3rd, 4th, 20th ????
The Benefits of
Studying
Economics
Note: On Marginal benefit and
marginal cost curves we mark
the value at the midpoint.
The marginal benefit of 1 hour of
study here is shown at 18 points
Notes: 5 hours budgeted for study of both Econ and
Accounting. MB of both given as expected gains for
each hour allotted to each subject.
The Marginal Benefits of
Studying Accounting
The Marginal Benefits and Marginal
Costs of Studying Economics
Reminder: On Marginal
benefit and marginal
cost curves we mark
the value at the
midpoint.
The marginal benefit of
1 hour of study here is
shown at 18 points
The marginal cost of 1
hour is 0 points
The Benefits and Costs of Studying
Economics
The Marginal Benefit Curve and
Total Benefit
Deadweight Loss
• The loss in net benefits resulting from a failure
to carry out an activity at the most efficient
level
Using Marginal Benefit and Marginal Cost
Curves to Determine Net Benefit
Using Marginal Benefit and Marginal Cost
Curves to Determine Net Benefit
Using Marginal Benefit and Marginal Cost
Curves to Determine Net Benefit
2. MAXIMIZING IN THE
MARKETPLACE
Learning Objectives
1. Explain what is meant by an efficient allocation
of resources in an economy and describe the
market conditions that must exist to achieve
this goal.
2. Define consumer and producer surplus.
3. Discuss the relationship between efficiency and
equity.
2. MAXIMIZING IN THE
MARKETPLACE
•
Efficient allocation of resources is when the net
benefits of all economic activities are maximized.
2.1 Achieving Efficiency
•
The role of property rights
–
Property rights are a set of rules that
specify the ways in which an owner can use a
resource.
•
•
An exclusive property right is a property right
that allows its owner to prevent others from using
the resource.
A transferable property right is a property right
that allows the owner of a resource to sell or lease
it to someone else.
Demand and Supply and the
Efficiency Condition
2.2 Producer and Consumer
Surplus
•
•
Consumer surplus is the amount by which the
total benefits to consumers from consuming a good
exceed their total expenditures on the good.
Producer surplus is the difference between the
total revenue received by sellers and their total
cost.
Consumer and Producer
Surplus
Net Benefit: The Sum of Consumer
and Producer Surplus
2.3 Efficiency and Equity
•
•
•
In a market that satisfies the efficiency condition, an
efficient allocation of resources will emerge from
any particular distribution of income
Different income distributions will result in different,
but still efficient, outcomes
Whatever distribution society chooses, an efficient
allocation of resources is still preferred to an
inefficient one
3. MARKET FAILURE
Learning Objectives
1. Explain what is meant by market failure and the
conditions that may lead to it.
2. Distinguish between private goods and public goods and
relate them to the free rider problem and the role of
government.
3. Explain the concepts of external costs and benefits and
the role of government intervention when they are
present.
4. Explain why a common property resource is unlikely to be
allocated efficiently in the marketplace.
Market Failure
• Occurs when private decision makers in the
marketplace fail to achieve an efficient
allocation of scarce resources
Market Failures
As Explanation of roles for Government
in the economy
1.
2.
3.
4.
5.
Imperfect Information
Externalities
Public Goods
Lack of Competition
Business Cycles
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Imperfect Information

Imperfect information leads to market failures that
cause inefficiency.

False information

Asymmetric information
Either the buyer or seller has
more or better information
than the other
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28
Imperfect Information

Some solutions:

Market Based Solutions: Brand names,
franchises, and product warranties

Government
Solutions:
Requiring full and
correct disclosure.
(Food labels, stock
prospectuses, etc.)
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29
Externalities

Externalities are the costs or benefits
of a transaction that are borne by
someone not directly involved in the
transaction.

Real efficiency occurs only when all
the costs and all the benefits accrue
to the buyer and seller
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
External Benefits (Positive externalities) when
someone outside the transaction is receiving
benefits from the transaction.
◦ If buyers are not receiving all benefits, they will demand
less than is optimal.
◦ If sellers are not receiving all the benefits from the sale,
they will not produce as much as is optimal.
◦ Examples: New large business in a declining neighborhood,
Education, Landscaping and painting a formerly unkempt
property, Immunizations
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
External costs
(Negative Externalities): when
someone outside the transaction is incurring costs
related to the transaction.
◦ If buyers are not bearing all the costs of the purchase, they will
demand too much.
◦ If producers are not bearing all the
costs of production, then they will
produce too much.
◦ Example: Pollution by a manufacturer,
Second hand tobacco smoke, Smog
and traffic congestion from my choice
to drive alone.
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External Costs


Government imposes costs
Government regulates to internalize external
costs.
◦ Examples: Smog fees, mandated pollution
controls, banns on indoor smoking etc
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

Government produces or subsidizes the
production/consumption of the good.
Government requires the consumption of
the good
◦ Examples: required immunizations, public
education, student aid, tax breaks to businesses
that locate in run-down areas
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Public Goods*

Public Goods are goods whose consumption
by one person does not diminish the quantity
or quality available to other consumers.
Specifically, they:
–
–
Can be jointly consumed (jointness)
Individuals can simultaneously enjoy
consumption of same product or service.
Are non-excludable (non-exclusion)
Consumption of the good cannot be restricted to
the customers who pay for it.
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36
Characteristics of a Public Good
• Non-excludability
• If it is produced for some, it is available to all. There is
no way to exclude non-payers.
• No one enjoys a private property right to the public
good.
• Functioning Private Property Rights require:
•Exclusivity
•Transferability
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Characteristics of a Public Good
• Without private property rights:
• People have an incentive to try free ride:
• Free rider: a person who receives the
benefits of the good without helping to pay
for it.
• Because of the Free Rider Problem, too little
will be produced; efficiency is not achieved.
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Examples of Public Goods
• Examples of public goods:
• National defense
• Forest fire protection
• Broadcast radio and television
stations
• Clean air
• Unpolluted ground water
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Public Goods and Market
Failure

Government production

Government subsidized production

Marketization: Sometimes markets develop ways
of providing public goods (e.g. use of advertising
to support radio and television).
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 Goods
owned collectively or not
owned at all.
◦ Examples: Public Parks, Public
highways and roads, Wildlife, River
water or underground water.
◦ Common Property Goods DO NOT
have Jointness or Non-exclusivity.
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
Common Property goods tend to be
under-produced & over-consumed.
◦ Solutions:
 Marketize them like buffalo in the
Midwest
 Regulate their use like wildlife
 Government production &
maintenance like city streets and city
parks
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
Sellers may gain by restricting output and raising
price.
◦ Too few units will be produced.
◦ Consumers may not be able to get needed goods.

Monopoly: a market with only one producer
◦ Example: utility companies

Oligopoly: a market with only few producers (who
may operate jointly as a monopolist through a
cartel).
◦ Example: OPEC

Monopsony: a market with only one buyer
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Restricting Supply to Raise Prices
Price
S2
S1
P2
P1
D
Q2 Q1
Quantity
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
Anti-trust laws; ban collusion and anticompetitive behavior

License and regulate monopolies

Government provision of the good
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


Cycles of Expansion and Contraction create
inefficient outcomes:
Expansion, when too rapid or extreme leads to
over-production or over-consumption of certain
types of goods
Contraction, especially when they lead to recession
lead to unemployment of Capital and Labor.
Unemployment is not efficient.


Market Response: natural market responses
correct for business cycles in time.
Government Responses to Recession:
◦ Stimulate demand by Fiscal Stimulus – ie; cut taxes
or increase spending
◦ Monetary Stimulus – ie; increase money supply or
decrease interest rates

Government Responses to Excessive
Expansion: Reign in inflation
◦ Fiscal Contraction – ie; increase taxes or reduce
government spending
◦ Monetary Contraction – ie; reduce the money supply
or increase the interest rate
Public Choice Analysis
• Public Choice Theory: Proposes that government activity in
the economy has little to do with market failures.
• Public Choice theory suggests that government may be
brought in to benefit specific individuals or groups.
• People may seek government intervention to improve their
own profit in comparison to the market outcome.
• This is referred to as rent-seeking—the use of resources
to transfer wealth from one individual to another without
increasing production or total wealth.
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


Self-interest directs public sector activity,
just as it directs market activity.
Government actions (like price ceilings or
floors) are often enacted for political gain,
not as a remedy for economic inefficiency.
Government action is likely to create
market failure or reduce efficiency.
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3.2 Public Goods
•
•
•
A public good is a good for which the cost of exclusion is
prohibitive and for which the marginal cost of another
user is zero.
A private good is a good for which exclusion is possible
and for which the marginal cost of another user is
positive.
Free riders are people or firms that consume a public
good without paying for it.
3.4 Common Property
Resources
•
Common property resources are
resources for which no property rights
have been defined
The difficulty with common property
resources
•
–
Individuals may not have adequate
incentives to engage in efforts to preserve or
protect them