Econ Exams PDF

Economics 1. Study of decision making 2. Study of organization/allocation of resource 3. Study of strategic interaction (Game theory, how do people act and what are their strategies) 4. Study of material prosperity and development/growth Ten Principles of Economics 1. People fa...

Economics 1. Study of decision making 2. Study of organization/allocation of resource 3. Study of strategic interaction (Game theory, how do people act and what are their strategies) 4. Study of material prosperity and development/growth Ten Principles of Economics 1. People face trade-offs (E.g. what do they pick at the grocery store, which one is better value? Efficiency vs equity) 2. The cost of something is what you give up for it (E.g. the money you pay for snacks could have paid for something else, and walking to the grocery store has an opportunity cost where you could have worked instead) 3. Rational people think at the margin (People think about marginal benefits and costs to doing things) 4. People respond to incentives (Given a sale or tax, economic activity can change) 5. Trade can make people better off (Let’s say I need medicine, while you need food, we can trade to make it a mutually beneficial opportunity) 6. Markets are usually a good way to organize economic activity (Markets keep things competitive, where everyone is interested in their own goals, leaving prices to stabilize themselves) 7. Governments can improve market outcomes (Governments can offer tax and subsidies depending on how they want to control behavior) 8. A country’s standard of living depends on its ability to produce goods and services (Living standards are tied to productivity, how efficiently a country can produce) 9. Prices rise when the government prints too much money (Inflation happens when the government decides to inject too much money into the economy, causing demand to be greater than the short run supply can keep up, leading to higher prices) 10. Society faces short-run tradeoff between inflation and unemployment (When inflation goes up, unemployment goes down as firms are trying to keep up with demand and vice versa) 4 Additional Points (Boettke, 2024)  1. The hard truth of economics: decisions require tradeoffs (incentives or disincentives affect behavior) 2. An appreciation for spontaneous order: how to design institutions (The rules, norms or institutions determine the incentives people face) 3. There is hope: Economics can show the way out of problems, the solutions to society’s issues 4. Economics is an ally to compassion: Emphasizes how exchange and competition leaves everyone better off - The Invisible Hand: Force observed by Adam Smith regarding the self-regulating nature of the free market. Individuals seeking to further their own goals unintentionally push society to its most optimized state. Economic Models - Circular Flow: Visual model showing how money flows through the market from firms to households and vice versa - - Production Possibility Frontier: Combination of production output that an economy can produce with the current resources  - Basic terms: - Opportunity costs: The value of the next best alternative that is lost when making a decision - I buy 2 pizzas in the 2000s instead of 10,000 bitcoins, I just gave up generational wealth to be fatter. - Absolute advantage: Comparison among producers of a good, where one entity can produce more of a good with the same resources or produce the same amount with fewer resources. - We both have 2 days on MasterChef to create a multi-course meal with the same basic food products. You only create 3 meals by that time, and I create 6. Therefore, I have an absolute advantage. - Comparative advantage: Comparison among producers of a good, where one entity can produce a good at a lower opportunity cost than another. - We run insurance companies, and I specialize in ski accidents, while you specialize in general practices. If you decide to focus on ski accidents, you sacrifice a significant opportunity to grow in the general practices market, where your expertise or efficiency is stronger. Meanwhile, my opportunity cost for  specializing in ski accidents is lower because I’m not as efficient in general practices. Therefore, I have a comparative advantage in the ski market as I can operate at a lower opportunity cost. - Specialization: trade allows an entity to focus on things that they have a comparative advantage in, benefiting everyone as the economy becomes more efficient. Types of Statements - Positive: Statements that describe the world as it is (objective, empirical, observation) - Grass is green, water is wet, toast is heated bread - Normative: Statements that prescribe how the world should be (opinion, policy, belief) - Dolphins should be green, Trump should dress like an orange, Joe Rogan should be Dana White for Halloween Policy Debates - Result of disagreements - Validity of positive statements - Difference in values or preferences of normative views - Difference in direction or magnitude of policy effects Supply and Demand - Supply and Demand are concepts used to characterize market behavior - Market: Place a group of buyers and sellers interacting for a good, service or resource - Buyers determine demand - Sellers determine supply - Types of markets: 1. Perfectly competitive market (homogenous goods, price taking behavior) 2. Monopolistic competition (Differentiated goods, many sellers) 3. Monopsony (One buyer determining price) 4. Oligopoly (Few sellers compete) 5. Monopoly (One seller determines price) Demand  - Factors determining demand: - Price - Number of resources available to spend - Preferences/tastes - Price of substitute - Social norms - Expectations - Number of buyers - What is the demand chart made of? - Demand curve: Relation between price of good and how much the consumer is willing to pay - Quantity demanded: Amount of a good a consumer is willing to pay at given price - Market demand: Sum of all individual demands for a good or service - Important Terms: - Law of demand: All things held constant; quantity demanded falls when price rises - Income: Money or financial benefits received; changes consumption behavior based on price - Diminishing marginal returns: additional units of a good provide smaller increase in benefits to the buyer (Eating too many snacks makes you feel sick) - Changes in demand: Increasing or decreasing the quantity demanded at every price (shift of demand curve) Types of Goods - Normal Good: Other things equal, an increase in income leads to an increase in demand (Cars, high quality food, luxury watches) - Inferior Good: Other things equal, an increase in income leads to a decrease in demand (Instant noodles, used clothes, public transportation) - Substitute Goods: Two goods that can be swapped between (Increase in price leads to increase in demand of substitute) - Smoking vs Vape - Compliment Goods: Two goods that can be used in combination (Increase in price of one lead to decrease in demand of the compliment) - Bread and butter Supply - Factors determining supply: - Input price - Technology - Expectations - Number of sellers - What is the supply chart made of? - Supply curve: Relationship between the price of a good and the quantity supplied - Quantity Supplied: Amount of a good that sellers are willing and able to sell - Market supply: Sum of supplies of all sellers - Important terms - Law of supply: Other things equal, as price rises, quantity supplied rises - Diminishing Marginal Returns: If productivity falls with each additional input, each additional marginal unit is more costly to produce - Changes in Supply: Changes increasing or decreasing the quantity supplied at every price Markets - Equilibrium: Situation where price reaches a point where quantity supplied = quantity demanded. - Equilibrium price: Price balancing quantity supplied and demanded - Equilibrium quantity: quantity supplied and demanded at equilibrium price - Market conditions - Surplus: Quantity supplied is greater than quantity demanded - Shortage: Quantity supplied is less than quantity demanded - Law of Supply and Demand: Price of a good adjusts to bring quantity demanded = quantity supplied  - Changes in Equilibrium (Just draw a graph and see, it's much easier no need to memorize) - Elasticity - Measures how buyers and sellers respond to a change in price - % change in quantity / % change in price - Point method: - % Change in quantity = (new quantity - original quantity)/original quantity * 100 - % Change in price = (new price – original price)/original price * 100 - Midpoint method: - - Factors that affect responsiveness - Addiction - Income - Price of substitutes - Availability of substitutes - Time horizon  - Definition of the market (specific vs general goods (specific are less likely to be substituted)) - How elastic is it? - Absolute value of elasticity > 1, it is elastic (quantity moves more than price) - Absolute value of elasticity < 1, it is inelastic (price moves more than quantity) - Absolute value of elasticity = 1, it is unit elastic (quantity moves the same amount as price) Revenue Implications - Total revenue is quantity * price Other terms: - Cross – price elasticity of demand: % change in quantity of good 1 / % change in price of good 2 Supply Elasticity - Supply tends to be more elastic in the long run - Quantitative responses measures how the quantity changes based on the effects of a change - Same rules apply to elasticity of supply and demand Tax Incidence - The burden of the tax is divided between consumers and producers, depending on how elastic each is to respond to the change - If inelastic supply and elastic demand, the producer will bear most of the tax incidence - If elastic supply and inelastic demand, the consumer will bear most of the tax incidence Markets and Economic policy - Concerns in markets - Equity concerns (Who has the ownership) - Sustainability concerns (How does it damage the environment) - Externalities (Unintended problems) - Solutions - Price ceiling: A legal maximum price that can be charged for a good or service, set below the equilibrium price to make goods more affordable. (Rent control, Water prices, food price) - Price floor: A legal minimum price that must be paid for a good or service, set above the equilibrium price to ensure fair income for producers or workers. (Minimum wage, interest laws, agriculture subsidies) - If price ceiling is above equilibrium, it is not binding, if it is below the equilibrium, it is a binding constraint - If the price floor is below equilibrium, it is not binding, if it is above the equilibrium, it is a binding constraint Welfare - Consumer Surplus: Amount of willingness to pay exceeds price paid (they could have paid more for the product) - Producer Surplus: Amount received by a producer in excess of cost (profit and opportunity cost) - Economic profits: Amount received over the opportunity cost - Total surplus: Consumer surplus + Producer surplus - Deadweight loss: Loss of total surplus due to market inefficiency when the equilibrium is not reached (Tax, subsidies, price controls) - Laffer curve: Relationship between tax rates and government revenue, implies that theres an optimal tax rate that will generate the most revenue for the government - Insights about market outcomes  1. Free markets allocate quantity supplied of goods to buyers to value them the most 2. Free market allocates quantity demanded of goods to sellers who produce at the lowest cost 3. Free market produces a quantity of goods that maximizes producer and consumer surplus (equilibrium) - Theorems of Economics 1. The allocation of goods resulting from a competitive market is efficient 2. An efficient outcome can occur when redistributing resources and then letting the market function by itself International Trade - Benefits - Variety - Lower cost through specialization and comparative advantages - Increased competition (innovation, lower price, efficiency) - Diverse ideas - Arguments against international trade - Jobs argument (Taking away domestic jobs) - National Security argument (National safety concerns) - Infant industry Argument (New domestic industries outcompeted and shutdown) - Unfair competition Argument (Domestic producers cannot compete with margins) - Protection as a bargaining chip Argument (Using International trade as a leverage in negotiations such as tariffs) - Cases of international trade 1. World price > domestic price (country becomes an exporter) 2. World price < domestic price (country becomes an importer) - Policies to protect from international trade - Support domestic industry (Subsidies, tax relief, programs) - Protect domestic labor force (Tariffs, labor laws, unions)  - Protect incentive for innovation (Copyright laws, patents, monetary benefit) - Tariff: A tax on goods produced abroad and sold domestically - Quotas: Limit on how much of a good can be imported Firms - Are a unit of organization, whose job is to: 1. Transforms inputs into outputs 2. Technology is represented by a production function 3. Produces homogenous commodity - Key terms: - Cost of production: Cost of producing a good or service with given technology - Output produced and Selling: Price of good given to the market based on market conditions and consumer willingness to pay - Industrial organization: Study of how firms' decisions regarding price and quantity and prices depend on the market conditions they face - Industry: A group of firms producing the same product or similar products (Shoes, Cars, Perfume) - The goal of firms is to maximize profit based on their market - Firms' costs: - Total Revenue: Amount a firm receives for the sale of its good or service - Total Cost: Combined costs of a firm's inputs in production - Profit: Leftover funds after you subtract total cost from total revenue - Fixed costs: Costs that don’t vary with quantity of output - Variable costs: Costs that vary with quantity of output - Average total costs: Total cost/quantity of output - Average fixed costs: Fixed cost/quantity of output - Average variable costs: Variable cost/quantity of output - Marginal costs: Increase in total cost from an additional unit of production - Sunk cost: Cost that has been committed and cannot be recovered  - Types of costs: - Explicit: Out of the pocket expenses that a firm incurs when operating - Implicit: Opportunity costs associated with a firm’s operation (unseen costs) - How do Economists vs Accountants look at these costs? - Economist: Economic profit, Implicit costs, and Explicit costs - Accountant: Accounting profit split and Explicit costs - Accountants only look at the literal costs while economists factor in lost opportunities - Efficient scale: Quantity of output that minimizes the average total cost - Firm Profits - Breakeven analysis: understanding effect of change in quantity of firm profits - Breakeven point is the point where total revenue = total cost - Economies of scale: Property where long run average total cost falls as the quantity of output increases - Diseconomies of scale: Property where long run average total cost rises as the quantity of output increases - Constant returns to scale: Property where long run average total cost stays the same as quantity of output rises Monopoly - A monopoly is a market with a single producer, and an insurmountable barrier to entry - This can be due to many factors: - Patents (Right to produce) - Large, fixed cost (Need a lot of capital to start (e.g., airlines)) - Legislation (Government contract or license to produce) - There are many different types of reasons monopolies are created:  1. Monopoly Resource: A key resource is owned by a firm (oil wells, diamond mines, forests) 2. Government - created monopolies: Government gives exclusive rights to a firm to produce goods for them (Lockheed Martin, OLG Lottery, Canada Post) 3. Natural Monopolies: A single firm can produce output at a lower cost/efficiency relative to their competitors (Google, Amazon, Meta) - Why are monopolies created? - Economic profit is the main incentive drawing firms to enter a market or continue production - In an equilibrium, the entry and exit of firms reduces the economic profit to 0 - Restriction competition allows the hope of economic profit to serve as an incentive to take on large, fixed costs or research and development - How does a monopoly control the market? - Monopolies have great influence over the market, as they are the price makers, facing the entire demand curve by themselves. - The monopoly can pick any point on the demand curve, but cannot choose anything off it - They will choose the point that maximizes their profits (revenue – expenses maxed) - Revenue calculations - Total Revenue = P * Q - Average Revenue = TR/Q - Marginal Revenue = Change in Total Revenue / Change in Quantity - When monopolies increase amount sold: 1. The output effect: The more quantity sold, increases total revenue 2. The price effect: The price falls, so P is lower, decreasing total revenue - Depends on elasticity of demand  - Monopolist must lower the price to sell additional and previous units. Therefore, they lose revenue on previously sold units (i.e., selling at 4000 units goes to 5000 units, they reduce price, and 4000 units makes less revenue now) - How to maximize profit as a monopolist: - Choosing quantity and price where MC = MR - MC > MR (Incurring losses) - MC < MR (Losing out on profit) - If Price > ATC, the firm makes a profit - Welfare effects of a monopoly: - The welfare effect is compared by measuring the output of a monopolist vs social planner - Competitive markets yield the greatest welfare, so we can compare the monopoly with it - Deadweight loss is measured at the points where MC = MR up to the point where Demand = MC - A monopoly’s profit comes from a transfer of surplus from the buyer to the seller - The main issue concerns that monopolies sell below an amount that maximizes surplus - This comes from an inefficiently low quantity or inefficiently high price Monopoly Solution - Price is usually higher in a monopoly, and quantity is lower - This profit can be used to cover large, fixed expenses and provide incentive for profits - Price discrimination: Practice of selling the same good for different prices for different customers - Types of price discrimination 1. First Degree  - Each person pays their willingness to pay 2. Second Degree - Consumer pays different amounts depends on quantity 3. Third Degree - Diverse types of consumers - Revelation problem: An individual’s best interest sometimes is not to reveal their personal information, such as willingness to pay. - Monopoly solutions: - A monopolist can consider submarkets within the larger market, enabling them to sell a larger quantity and gain more producer surplus, reducing deadweight loss - Monopolists can charge an entry fee to minimize deadweight loss and maximize consumer surplus - How can the government respond? 1. Making monopolized industries more competitive (Giving incentive to enter market) 2. Regulating behavior of monopolies (Inspections, fines, legislation) 3. Turning private monopolies into public enterprises (Making it government owned, like Bank of Canada, Canada Post, CBC) 4. Doing nothing - How can the Canadian government respond? 1. Government can respond to inefficiencies resulting from market power and monopoly through legislation that encourages competition and discourages monopolistic practices - Competition law in Canada is enforced by the Competition Bureau, a unit within the Federal Government’s industry, Canada - Benefit of greater efficiencies as an outcome of mergers are called synergies (economies of scale) 2. Another way is by regulating the behavior of monopolists  - Common for natural monopolies, where they restrict the price that can be charged (price ceiling) - Government agencies are responsible for regulating their prices - How should governments set prices for natural monopolies? - Issues with MC pricing: 1. Negative profits 2. Zero incentive to reduce cost - If the government takes over the natural monopoly, negative profits is not as bad as when it is a private corporation due to taxes (Example: some years, buses barely break even or lose money for the government) - What is the most viable solution? - Each previous policy has downsides, which is why some economies argue the best thing to do is nothing at all, but place an emphasis on innovation and reducing cost Imperfect Competition - Types of competition 1. Perfect Competition: Homogeneous goods, price takes behavior, no barrier to entry 2. Monopoly: Single producers, demand takes behavior (price set by monopoly), insurmountable barrier to entry - Monopsony: Single buyer (Example: Governments only ones buying military weapons from Lockheed Martin, Boeing, General Dynamics) 3. Oligopoly: Differentiated goods sold by few producers, price takes behavior, high barrier of entry 4. Monopolistic competition: Available close substitutes (differentiated goods), many things such as quality, price, brand and etc take behavior, low barrier of entry 5. Duopoly: Two firms selling goods, almost insurmountable barrier of entry - Issues with small amount of sellers  1. Collusion: Agreements between competing firms about prices and quantity (Lightbulb) 2. Cartel: Group of firms acting in their own benefit Duopoly - Without cooperation, firms have an incentive to undercut prices and reduce profits (like prisoner’s dilemma) - Bertrand paradox: With two firms, market can have perfectly competitive outcome (Firms compete against each other in price war to drive prices does to equal marginal cost) - Even with coordination, there is an incentive to cheat (keep all profit to themselves, while competitors get nothing) - Competition increases gains from trade - It is illegal for firms to collude for anti-competition (gang of oligopoly) - This leads to a result: Nash Equilibrium - An equilibrium where everyone chooses their best option given the choices that all others choose Oligopoly - Firms in an oligopoly’s strategy to maximize profit produce quantity more than monopolies - Competitive price < Oligopoly Price < Monopoly price - If the oligopoly does not form a cartel, they must decide how to produce and sell 1. Output effect: Price is above marginal cost of production, therefore every additional unit grants a profit 2. Price effect: Raising production will increase total amount sold, lowering the profit on previous units sold - Considering these factors, if output effect > price effect, owner will raise production due to profits. If price effect > output effect, owner will decrease production due to loss in profits. - Firms in an oligopoly will adjust production until price and output effects balance out - Game Theory: Study of strategic interaction Game Theory - We can look at situations as a game 1. Who are the players? 2. What are the rules? 3. What are the payoffs? (for taking risk or using a strategy to be rewarded) - Why use game theory? - Understand human behavior and develop hypotheses about behavior - Empirical data - Experimental data - Find people’s preferences - Find people’s beliefs and thought processes - Characteristics of games: - Strategic Dependence: Payoff of action depends on actions of others - Common Knowledge: Everyone knows that everyone knows (common rules, who the players are, what are the pay offs) - Types of games: - Chance - Skill - Strategy - Can be a combination - Prisoner’s Dilemma: A game that demonstrates that cooperation is hard to maintain even when it is mutually beneficial. Although both staying silent is the most beneficial option for both, one is more inclined to put their self-interests ahead and confess - Dominant Strategy: The best strategy for a player in a game, regardless of what other players do - Reason Oligopolies have trouble maintaining monopoly profits: - The monopoly outcome is jointly rational, to maximize profits. Oligopolies have an incentive to cheat one another to profit - Governments can improve market outcomes: - Government can encourage competition among the oligopoly for allocation of resources to be closer to social optimum - Judges have refused to enforce agreements restraining trade among competitors (reducing quantities, raising prices, price-fixing). Competition Act section 45.1 of the act). - Activities that are subject to criminal/civil prosecution: - Bid-rigging - Price discrimination - Resale price maintenance - Predatory pricing - Monopolistic competition characteristics long run equilibrium 1. As in a monopoly market, Price > MC 2. As in a perfectly competitive market, Price = ATC - Difference between monopolistic comp vs perfect comp 1. Excess capacity 2. Markup - Sources of inefficiency - Markup of price over marginal cost (profit for firm) - Number of firms may not be ideal (competition sometimes leads to inefficiency) - The product variety externality - The business stealing externality Inequality and Distribution of Income - Poverty is linked to inequality and distribution of income - - The Lorenz Curve: Depicts distribution of income (Right skewed, the top 1% hold 46% of wealth) - Horizontal is the % of population arranged by income - Vertical is the % of income earned - Diagonal is if there was an equal distribution of income - Distance from the diagonal to the Lorenz Curve represents inequality in a society - Slope of Lorenz Curve is the rate at which income or wealth accumulates as you get richer - Marginal contribution: Incremental share of wealth added to the culminative wealth - Gini Coefficient: Is the ratio of the area between the Lorenz Curve and the 45- degree diagonal line and the area below the Lorenz Curve - - How does inequality affect things? - Diminishing marginal utility (additional value from increased consumption) from income raises potentially raises welfare (people do not have to do jobs they hate or struggle to afford life) - Externalities: Health, Crime, Social unrest, education... - Effect on social capital: (Society values such as trust, respect, reciprocity) - Efficiency: Resources are being allocated in the most effective way, and output is created at the lowest cost - Pareto Efficiency: Situation resources are allocated in a way where no individual cannot be better off with making someone else worse off. (If I win, we all win) - Equity: Distribution of society’s resources among individuals or groups  - John Rawls: is primarily concerned with how society should allocate resources and opportunities fairly, ensuring that the distribution is just, particularly for the disadvantaged. - Lance Walster: looks at how human capital (the value individuals bring to society through their education and skills) impacts both their personal success and the larger economy. He emphasizes the role of social structures in determining who has access to opportunities that enhance human capital. Causes of Inequality - Types of Inequality - Income (wage per unit of time) - Assets (generating passive wealth) - Equality of opportunity (Rawls, Roemer) (Just access to opportunities, high class vs lower class) - Luck / Chance: Personal or economic - Change in demand (Trends dying down or hyping up) - Shift in budget line (Change in price or disposable income of consumers) - Imperfect institutions - Access to education - Credit market (lending money to individuals with no credit history) - Inequality relation to productivity - Cobb – Douglas production function: (amount produced vs amount inputted) - Wages: (1 − 𝛼) (𝐾/L) ^ 𝛼 (calculate overall production) - Pervasiveness (Tendency to happen to a group) of inequality - Economic mobility: Intergenerational movement along the wealth chart - Intergenerational elasticity: Measures deviation of earnings across generations (%change in income of sons / %change in income of fathers)  - Institutions - Educational institutions - Credit institutions - Social Institutions Systems that tackle inequality: - Utilitarianism: Government chooses policies to maximize total utility in society - Liberalism: Government chooses policies deemed just as evaluated by an impartial observer - Libertarianism: Government enforces crimes and enforce voluntary agreement but doesn’t redistribute income - Condorcet Paradox: Majority-rule voting can lead to inconsistent or cyclical preferences at the societal level, even if individual preferences are consistent. (E.g., we like Pizza more than Ice cream, but we like Ice cream more than hot dogs, but we like hot dogs more than Ice cream, therefore can’t come to a rational decision of what to choose) - What to choose as a society - Unanimity: If everyone prefers an option, choose it - Transitivity: If A is better than B and the B is better than C, then A > C - Independence: Ranking between A and B should not depend on relation to C - Non dictatorial: One person should get their preference regardless of what others pick - Arrows Impossibility Theorem: There is no method for aggregating preferences that satisfies all these conditions - Median Voter Theorem: When a policy is chosen based on majority voting, the option preferred by the median voter will be chosen - Labour Markets: - Factors of Production: 1. Land 2. Capital  3. Labour - The demand for a factor of production is derived demand (e.g., need land or money to start a business) - Two factors determining quantity of labor demanded: 1. Firm is competitive in the market 2. Firm is profit maximizing - The Production function: Relationship between quantity of inputs to make a good and quantity of output - Marginal Product of Labor: Increase in output with every additional unit of labor - Diminishing marginal product: marginal product of input decreasing as quantity of input increase (e.g., 10 workers in a store, inefficient planning for use of 1 oven) - Value of marginal product: marginal product times price of the output - Factors affecting labor market demand curve 1. Output price (Value of product in society) 2. Technological change (Less need if process is more efficient) 3. Supply of other factors - Labor supply is the tradeoff between leisure and work - Upwards sloping labor supply curve means increase in wage leads to increase in quantity of labor supply - Downwards sloping labor supply curve means increase in wage leads to decrease in quantity of labor supply - Factors affecting the labor market supply curve - Changes in tastes (Less or more people want to be doctors) - Changes in alternative opportunities (If for example farmers began making more money than a doctor, many will flock to that) - Immigration (Increase in number of individuals seeking a job, flooding the labor supply market, especially for low skill – capped work) - Behavior of wages in competitive markets: 1. Wages adjust for supply and demand for labor 2. Wages = marginal product of labor 3. Change in supply or demand of labor leads to a change in the equilibrium wage and marginal product by the same amount - Other factors of production - Capital: Equipment, tools, machinery, and building used to produce goods and services (e.g., Uber driver uses their car) - Factors determining how much owner of land and capital should earn: 1. Purchase price of land or capital: Price paid upon agreement to own factor of production indefinitely (buying out a ranch for farm business) 2. Rental price: Price person pays to use the factor of production for a limited time (renting a mill to produce products for farm business) - The price paid for the factor of production is the value of marginal product of the factor - Therefore, changes in the supply of the factor of production leads to changes in the VMP (Marginal product * price of output) - Competitive market discrimination - In comp markets, all types of people are assumed to be treated the same - Difference in education - Difference in industries - Wage differences are attributed to differences in productivity or opportunity cost (changes in labor supply and demand) - Wage discrimination affects earnings of marginalized groups - Groups overrepresented in those among poverty (Children, disabled individuals, refugees) - Discrimination affects how poor people are, and who will be poor - This also affects distribution of individuals across industries (Women in stem, racially discriminated groups in high finance roles, women in caregiving positions)  - Institutions and access (Opportunity to pursue education) - Incentives - If there is discrimination in an industry, the discriminated group may be less prone to enter the market - Types of discrimination - Skill, education, qualifications - Social characteristic, group membership (men, women, Asians, etc...) - Price discrimination (Charge different amount to different people on willingness to pay or other factors) - Prejudice: dislike, distaste, or misperception based on innate characteristics (ethnicity, gender, skin color, etc...) - Discrimination: Employment, wage, and promotion practices resulting in workers with equal production being treated differently due to unrelated characteristics - Side effects of discrimination - Efficiency losses (Qualified people leave industry) - Information revelation (Harder to judge an individual’s true talent) - Social concerns (Values in society such as respect, fairness, reciprocity) - Taste based discrimination (perceived reduction in marginal productivity) - Statistical/Informational discrimination (Belief about type of worker based on prejudice) - Solutions to these issues - Competition: Drives out producers who are discriminatory as all higher level talent flock to fairer companies - Intervention: Regulations that change the structure of the company Information Problems  - Information is often hidden about the item being sold, concerning the quality of the goods. - Outcomes rarely rely on the known observables, but also the hidden information. - There is Asymmetric Information - Sellers know the quality better than buyers. - Workers understand the work required more than the employer. - Differences in information are called information asymmetry. Moral Hazard - Moral Hazard is the tendency of an individual to engage in risky or undesirable behavior because they do not bear the full consequences of their actions, often due to a safety net, protection, or guarantee provided by another party. - An Agent is a person who performs tasks or makes decisions on behalf of another person, the principal, based on a pre-agreed contract or understanding. - A principal is a person or entity for whom an agent performs tasks or makes decisions, under an agreed-upon arrangement or authority. Case of Moral Hazard - Employment relationship - Employer: principle - Employee: agent - Imperfectly managed agents have an incentive to lessen their responsibilities while being paid. - Solutions to agents slacking off: 1. Better monitoring 2. High wages (Less incentive due to risk of unemployment and proper compensation) 3. Commission (Incentive to do more) 4. Delayed Payment (Verification of output) 5. Contracting and regulation 6. Norms and trust  - Cost of Solutions: - Remedies for hazards are costly - Monitoring cost - Output contingent wages are risky to employees - Delayed payment is costly to the employee - Efficiency costs on information problems (resources could be better directed elsewhere e.g., development) Incentive Implications - Workers have an incentive to withdraw from responsibilities if input is not contingent to output - Create a situation where people who input the most and do the best, they get rewarded as such - Grades as incentive - Equity theory (The more u put in, the more you get out) - Signal extraction problem - Challenge in distinguishing meaningful indicators of the outcome from sources like knowledge and effort, apart from chance and other external factors Adverse Selection - Adverse selection is a situation where unobserved or hidden information about certain variables leads to an imbalance in a transaction, making the opportunity less desirable or riskier for the less-informed party. - Examples - Used cars - Stock market - Insurance - Information problems can create a market failure 1. Low price leading to less high-quality goods being sold 2. Since buyers know that they will buy less - Efficiency effects:  - Passing inspections for quality takes time and money, incurring cost to the producer which they can pass to the buyer Signaling - Signaling is when one party conveys private or otherwise unobservable information to another party, typically to reduce information asymmetry and convey qualities or intentions that are not directly observable. - Other Types of Signals: - Branding and reputation - Certificates - College Degree - Each is costly to the individual sending the signal Screening - Screening is when an uninformed party requests privileged information from informed party - Examples: - Insurance screening - Loan screening - Rental screening - How to screen (Identify key characteristics correlated with risk): 1. Gender 2. History and Experience 3. Grades 4. Health 5. Employment 6. Family Regulation  - Asymmetric information can cause the government to act - Private markets can deal with this issue on their own, with signaling and screening - When governments step in, they rarely have more info than private parties, they are not perfect - Examples of regulation to fix information issues: - Certificates, licensing, inspection - Workplace safety legislation - Consumer protection legislation - Educational accreditation Efficiency - Cost of information problems: - A group pays higher rates due to behavior of outliers - Goods not accurately represented, making the consumer bear the cost - Effort not equally shared across organization, concerns over trust and fairness - Group project with unequal amounts of effort exerted from each member - Information issues create externalities - Outcomes are not limited to producers/consumers, but rather external factors - Screening and signaling my improve information problems and imbalances - Theory of the second best: - Given failure in the market, the outcome is efficient. When optimal conditions cannot be achieved due to information problems, barriers of entry, externalities, trying to optimize another aspect or reaching another goal could make things worse or not improve the situation Externalities - Externalities: Uncompensated effect of one person’s actions on well-being of others - Unintended/unaccounted for externalities lead to inefficiencies - What can governments do about this?  - Influence behavior and provide incentives that lead to an efficient outcome 1. Implement efficient outcomes 2. Protect the interests of others (negative externalities) 3. Encourage action with positive effects (positive externalities) - Demand curve measures the marginal benefits to consumer - Supply curve represents the marginal cost to producers - Externalities – reading graphs - Private costs: Costs incurred by the individual - Social costs: Private costs plus externalities imposed on others - Eliminate deadweight loss by aligning marginal private cost with marginal social cost. - Inefficiencies occur when market equilibrium does not reflect externalities (only private costs) - Ways to reach socially optimum - Pigouvian tax: Tax on each unit sold - Internalizing the Externality: Accounting for cost/benefits imposed on others will lead to an efficient outcome - How do externalities affect production? - Negative externalities over produce - Positive externalities under produce - How can the government affect the outcome? - Impose taxes - Give subsidies - Command and control policies directly regulating behavior - Market based policies affecting marginal incentive of individuals to use the product How can the government use tax and subsidies? - Ideal corrective tax = external cost of activities with negative externalities - Ideal corrective subsidy = external benefit of activities with positive externalities Types of goods in externalities 1. Private goods: Excludable and rival in consumption 2. Public goods: Not excludable and not rival in consumption 3. Club goods: Excludable and not rival in consumption 4. Common Resource: Not excludable and rival in consumption - Free rider: Individual receiving benefit of good while avoiding the cost - Tragedy of the commons: common pool resource (e.g., water, overfishing, overgrazing land) gets overused because individuals do not recognize the external costs of usage - Coase Theorem: Private parties can resolve market externalities without government intervention Behavioral Economics - Backwards induction: Working backwards from the final stage to determine to most optimal decisions - External validity: Extent which experiments can be generalized beyond the study - Fairness: People care about outcomes relative to others (similar treatment) - Reciprocity: Payback people who do good and bad with however they are treated - Suppose we have a game where we let player 1 make offers to player 2 of how much money to split. If player 2 rejects, no one gets the money out of 10$ per round. - People decide by seeing how much the other benefits - Reciprocates fairness and kindness, as well as the opposite - Variations (People respond differently) - Rationality  - People are overconfident - People give too much weight to small decisions - People are reluctant to change opinions - Time inconsistency - Framing: Choices presented to individuals that can significantly impact decision making - Giving a fine to parents who do not pick up their kids in time (they see it as an extra price) - Overall Biases - People are influenced by baselines - People have limited attention and make mistakes when simplifying complex issues - People aren’t good at sophisticated math - Price/Valuation Biases: - People have trouble doing present value calculations - How choices are framed heavily influences decisions - The presence of other options can bias choices - People reject all choices if there are too many - Expectation and Preference Biases: - People are overconfident in ability to stick to plans such as saving - People are overly optimistic about themselves and their futures - People “live for today” expecting to be more patient tomorrow but then tomorrow is today - People place more value of items in their possession than the same item not in their possession - Law of small numbers: People exaggerate how closely a small sample represents an entire population - Confirmation bias: People like to confirm what they already believe - Hypothesis based filtering: Selecting specific data that aligns with a hypothesis to test validity while excluding irrelevant data - Choice architecture: How to sequence or lay out decisions to encourage efficient decisions that counteract biases - Nudging: Influencing people’s decisions without restricting their freedom to choose