Microeconomics Lecture Notes PDF

Lecture 1: 1/25 Ten principles of microeconomics: 1.​ Resources are scarce (whether that be human workers, natural resources, entrepreneurship, time) -scarcity: the limited nature of society’s resources *scarcity has limited resources, and, therefore, cannot produce all...

Lecture 1: 1/25 Ten principles of microeconomics: 1.​ Resources are scarce (whether that be human workers, natural resources, entrepreneurship, time) -scarcity: the limited nature of society’s resources *scarcity has limited resources, and, therefore, cannot produce all the goods and services people want -economics: the study of how society manages its scarce resources economists examine: -how people decide how much they work, what they buy, how much they save, how they invest their savings -how firms decide how much to produce and how many workers to hire -forces and trends that affect the overall economy growth in average income, unemployment, and rate at which prices are rising How people make decisions: Principle 1: people face trade-offs Principle 2: the cost of something is what you give up to get it Principle 3: rational people think at the margin Principle 4: people respond to incentives -How people interact- Principle 5: Trade can make everyone better off Principle 6: Markets are usually a good way to organize economic activity Principle 7: Governments can sometimes (but not always) improve market outcomes Principle 1: People face trade-offs: To get one thing you want, you must give up another thing you want. Making decisions: trading off one goal for another -​ Going to a party night before exam=less time to study -​ Having more money to buy stuff=working longer hours, less time for leisure -​ Protecting the environment=resources could be used to produce consumer goods The more it spends on the military (guns) to protect from foreign aggressors: -​ The less it can spend on consumer goods (butter) to raise its standard of living Population regulations: cleaner environment and improves health: -​ But at the cost of workings well-beings Efficiency: society gets the maximum benefits from its scarce resources Equality: economic prosperity is distributed uniformly among society’s members ***If one wants society to reach equality: taxes would have to be raised, but if one wants taxes at an absolute minimum, then the government would be able to have no interference with goods being produced/dispersed, and equality would be hard to attain for each individual Principle 2: The cost of something is what you give up to get it: Making decisions: -​ Compare costs w benefits of alternative decisions -​ Need to include opportunity costs Opportunity cost of an item: -​ The “price” of what you give up to get it What is the opportunity cost of going to college for a year? -​ Tuition, books, and fees -​ NOT: room and board -​ PLUS: forgone earnings (you could’ve invested that money and earned w interest!!) What is the opportunity cost of going to the movies: -​ The price of the movie ticket -​ PLUS: the value of the time you spend in the theater (money is time bro bro) Principle 3: Rational people think at the margin: Rational people: -​ Systematically and purposefully do the best they can to achieve their goals, given the available opportunities -​ Make decisions by evaluating costs and benefits from marginal changes ​ -small incremental adjustments to a plan of action ​ -marginal benefit vs. marginal cost Principle 4: People respond to incentives Incentive: -​ Something that induces a person to act -​ Can have unintended consequences People respond to incentives: -​ Because rational people make decision by comparing costs and benefits An increase in the price of donuts: -​ Consumers buy fewer donuts -​ Sellers produce more donuts If the government were to raise the gasoline tax by $1… Consumers would: drive more fuel efficient cars, shift to electric cars, carpool, ride bikes, use public transportation, move closer to work -How people interact- Principle 5: Trade can make everyone better off Principle 6: Markets are usually a good way to organize economic activity Principle 7: Governments can sometimes (but not always) improve market outcomes Principle 5: Trade can make everyone better off: People benefit from trade: -​ People can buy a greater variety of goods and services at lower costs Countries benefit from trade: -​ Allows countries to specialize in what they do best Market: -​ A group of buyers and sellers (need not to be in a single location) Organize economic activity: -​ What goods and services to produce -​ How to produce these goods and services -​ How to allocate them to their final user Principle 6: Markets are usually a good way to organize economic activity Market economy: -​ Allocates resources through the decentralized decisions of many firms and households ​ -as they interact in markets for goods and services Prices: -​ Determined by the interaction of buyers and sellers -​ Reflect the good’s value to buyers -​ Reflect the cost of producing the good Adam Smith’s “invisible hand”: -​ Prices adjust to guide market participants to reach outcomes that, often, maximize the well-being of society as a whole Principle 7: Governments can sometimes improve market outcomes: Government: enforce property rights: -​ Enforce rules and maintain institutions that are key to a market economy ​ -people are less inclined to work, produced, invest, or purchase if there is a large risk of their property being stolen Government: promote efficiency: -​ Avoid market failures: market left on its own fails to allocate resources efficiently -​ Externality: source of market failure ​ -how the production or consumption of a good affects bystanders (ex: pollution) Market power:  -​ Source of market failure ​ -a single buyer or seller has substantial influence on market price (ex: monopoly) Government: promote equality: -​ Avoid disparities in economic well-being -​ Use tax or welfare policies to change how the economic “pie” is divided Lecture 2: 1/30 The economist as a science: Economists play two roles: 1.​ Scientists: try to explain the word 2.​ Policy advisors: try to improve it As scientists, economists employ the scientific method -​ dispassionate development and testing of theories about how the world works -​ devise theories, collect data, and analyze these data to verify or refute their theories Economists make assumptions -​ Simplify the complex world and make it easier to understand Economists use models -​ Omit many details to allow us to see what is truly important and are built with assumptions -​ Simplify reality to improve our understanding of it -​ All models are subject to revision The circular flow diagram: Circular flow diagram: -​ Visual model of the economy -​ Shows how dollars flow through markets among households and firms Two decision makers: -​ Firms and households Interacting in two markets: -​ Market for goods and services -​ Market for factors of production (inputs) Households: -​ Own and sell the factors of production -​ Buy and consume goods and services Firms: -​ Hire and use factors of production -​ _________ Markets for goods and services: -​ Are bought and sold -​ Sellers: firms -​ Buyers: households Markets for factors of production: -___ -___ -___ The production possibilities frontier (PFF): Production possibilities frontier: -​ A graph that shows various combinations of outputs -​ That the economy can possibly produce -​ Given the available factors of production and the available ___ -​ Assume the following: -​ A country produces only two goods: airplanes and soybeans -​ It has the fixed amount of resources (labor) -​ And it has a fixed amount and quality of technology The available technology and resources can be used to produce: -​ Only soybeans (5000 tons) -​ Only airplanes (100 airplanes) -​ A combo of soybeans and airplanes Efficient levels of production: economy will attempt to get the most they can (points on the PPF) Inefficient levels of production: points inside the PPF Not feasible: points outside the PPF Point F: 80 airplanes, 4000 tons of soybeans = not possible Point G: 30 airplanes, 2500 tons of soybeans = possible, but not efficient! (can produce more!!) -​ All points on the PPF are efficient bc resources are fully utilized -​ Points under the PPF are inefficient bc some resources are underutilized (workers unemployed, factories idle) -​ Points above the PPF are not possible Moving along a PPF: -​ Involves shifting resources from the production of one good to another Society faces a tradeoff: -​ Getting more of one good requires sacrificing some of the other Slope of the PPF: -​ _______ The shape of the PPF: Straight line: constant opportunity costs -​ Previous example: opportunity cost of 1 airplane is 50 tons of soybeans Bowed outwards PPF: increasing opportunity cost -​ As more units of a good are produced, we need to give up increasing amounts of the other good being produced It is bowed outwards because: -​ Workers have different skills -​ There are different opportunity costs of producing one good in terms of the other -​ There is some other resource, or mix of resources, with varying opportunity costs Micro- and macroeconomics: Microeconomics: -​ The study of how households and firms make decisions and how they interact in markets Macroeconomics: -​ The study of economy-wide phenomena including inflation, unemployment, and economic growth Economists are scientists: -​ Explain the causes of economic events -​ Use positive statements Economists are policy advisors: -​ Recommend policies to improve economic outcomes -​ Understanding of what's happening -​ Value judgments about what ought to be done (use normative statements) Positive versus negative statements: Positive: -​ Attempt to describe the world as it is -​ Confirm or dispute by examining evidence -​ “Minimum wage laws cause unemployment” Negative: -​ Attempt to prescribe how the world should be -​ “The government should raise the minimum wage” “The government should print less money” → normative statement→ value statement, cannot be confirmed or refuted “An increase in the price of pizza will cause an increase in consumer demand for movie streaming” → positive → describes a relationship Lecture 3: 2/1 0 -​ Inferior goods: income elasticity < 0 Cross-price elasticity of demand: -​ How much the quantity demanded of one good responds to a change in the price of another good -​ Percentage change in quantity demanded of the first good divided by the percentage change in one price of the second good -​ Substitutes: cross-price elasticity > 0 -​ Complements: cross-price elasticity < 0 The price elasticity of supply: -​ How much the quantity supplied of a good responds to a change in its price -​ Percentage change in quantity supplied divided by the percentage change in price -​ Loosely speaking, it measures sellers’ price-sensitivity -​ Elastic supply: the quantity supplied responds substantially to price changes -​ Inelastic supply: if the quantity supplied responds only slightly The variety of supply curves: -​ Supply is unit inelastic -​ Price elasticity of supply = 1 -​ Supply is elastic -​ Price elasticity of supply > 1 -​ Supply is inelastic -​ Price elasticity of supply < 1 Supply is perfectly inelastic -​ Price elasticity of supply = 0 -​ Supply curve is vertical Supply is perfectly elastic -​ Price elasticity of supply = infinity -​ Supply curve is horizontal The flatter the supply curve -​ The greater the price elasticity of supply The determinants of supply elasticity: -​ Greater price elasticity of supply: -​ The more easily sellers can change the quantity they produce -​ Price elasticity of supply is greater in the long run than in the short run -​ In the long run: firms can build new factories, or new firms may be able to enter the market More applications: 1.​ Can good news for farming be bad news for farmers: -​ New hybrid of wheat: 20% increase production per acre -​ Supply curve to the right -​ Higher quantity and lower price -​ Demand is inelastic: total revenue falls -​ Paradox of public policy: induce farmers not to plant crops Lecture 8: 2/20 (chapter 6 → END OF MIDTERM 1) Economists as policy analysts and advisors: -​ Try to use theories to change the world Policies: -​ Often have effect that their architects did not intend or anticipate -​ Taxes -​ Price controls -​ Alter the private market outcome The surprising effects of price controls: Price ceiling: -​ Legal maximum on that price at which a good can be sold (can’t go above it) -​ Example: rent-control laws Price floor: -​ Legal minimum on the price at which a good can be sold (can’t go below it) -​ Example: minimum wage laws **A price ceiling above the equilibrium is NOT BINDING- has no effect on the market outcome **If the price ceiling IS BINDING- causes a shortage How price ceilings affect market outcomes: Effects of a binding price ceiling on a competitive market: -​ Shortage arises -​ Sellers must ration scarce goods among potential buyers -​ Long lines (inefficient, wasting buyers time) -​ Bias of sellers (inefficient and unfair) Price floors: -​ Are an attempt by the government to maintain prices at other than equilibrium levels -​ Places a legal minimum on prices -​ Not binding: price floor set BELOW equilibrium (you’re selling ice cream for $3 and now the government says you can’t charge over $4…. It’s not binding because you’re not affected and below the equilibrium) -​ Binding: price floor set ABOVE equilibrium The price floor is binding: causes a surplus (example: unemployment) If the price ceiling is binding- causes a shortage (example: now the government says you MUST sell ice creams for over $4.. It’s binding because your customers aren't gonna want anymore, and there will then be a shortage in how much you’re selling) How price floors affect market outcomes: Effects of a binding price floor on a competitive market -​ Causes a surplus -​ Undesirable rotating mechanisms -​ The sellers who appeal to buyers’ biases will sell more than those who do not Markets are usually a good way to organize economic activity -​ Economists often oppose price ceilings and price floors -​ Prices are not the outcome of some haphazard process -​ Prices have the crucial job of balancing supply and demand -​ coordination of economic activity Governments can sometimes improve market outcomes -​ Want to use price controls -​ Because of unfair market outcome -​ Aimed at helping the poor -​ Often hurt those they are trying to help -​ Other ways of helping those who are in need -​ Rent subsidies -​ Wage subsidies (earned income tax credit) Government uses taxes: To raise revenue for public projects -​ Roads, schools, and national defense Legally the government can: -​ make the seller or the buyer to pay the tax Tax incidence -​ The manner in which the burden of tax is shared among the members of the market When a good is taxed: -which curve shifts depends on elasticity more= hit more by shift Lecture 9: 2/22 Welfare economics Allocation of resources refers to: -​ How much of each good is produced -​ Which producers produce it  -​ Which consumers consume it Welfare economics: -​ Studies how he allocation of resources affects economic well-being Conclusion: -​ The equilibrium of supply and demand maximizes the total benefits received by all the sellers and buyers combined Willing to pay (WTP): -​ The max amount that a buyer will pay for a good -​ How much the buyer values the good Consumer surplus, CS=WTP-P -​ The amount that a buyer is willing to pay minus the amount that the buyer actually pays -​ Benefits buyers receive from participating in the market At the Q, the height of the D curve is the WTP by the marginal buyer– the buyer who would leave the market if the P were any higher Total consumer surplus: -​ The area below the demand curve and above the price -​ The height of the demand curve=the value buyers place on the good (WTP) -​ Each buyers CS= WTP - P -​ The sum of the consumer surplus of all buyers in the market -​ The benefit that buyers derive from a market as the buyers themselves perceive it ***CS is the area between the P and D curve, from 0 to Q Cost -​ The value of everything a seller must give up to produce a good -​ Including opportunity costs -​ Willingness to sell, WTS= Cost -​ The lowest price accepted by the seller for one unit of a good or service -​ The cost is a measure of the WTS: produce and sell the good/service only if the price > cost Producer surplus: PS= P - cost -​ Amount a seller is paid for a good minus the cost of producing it -​ Price received minus willingness to sell -​ Measures the benefit sellers receive from participating in a market At each Q. the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower Benevolent Social Planner: -​ Hypothetical committee all-knowing, all-powerful, well-intentioned -​ Want to maximize the economic well-being of everyone in society -​ Total surplus= consumer surplus + producer surplus -​ Evaluate market outcomes -​ Cars about efficiency and equality Allocation of resources- desirable? -​ competitive markets: -​ determined by interactions of many self interested buyers and sellers -​ total surplus: the measure of society’s well-being -​ to consider whether the market’s allocation is efficient TOTAL SURPLUS= CS+PS -​ Consumer surplus= value to buyers - amount paid by buyers -​ Buyers gains from participating in the market -​ Producer surplus= amount received by seller - cost to sellers -​ Sellers’ gains from participating in the market ** total surplus= value to buyers - cost to sellers Markets efficiency: Efficiency -​ The allocation of resources maximizes total surplus -​ Is the pie as big as possible? Equality -​ Distribute economic propensity uniformly among members of society -​ Everyone gets an equal slice of pie ……….. ​ Market efficiency and market failure: Forces of supply and demand -allocate resources efficiently Assumptions about how markets ….. Lecture 10: 2/27 A tax -​ Drives a wedge between the price buyers pay fand the price sellers receive -​ Raises the price buyers pay -​ Lowers the price seller receive -​ Reduces the quantity bought and sold  -​ THESE EFFECTS ARE THE SAME WHETHER THE TAX IS IMPOSED ON BUYERS OR SELLERS Total surplus= consumer surplus + producer surplus -​ Maximized at equilibrium With a per-unit tax of $T: -​ CS decreases -​ PS decreases -​ Government gains tax revenue ($T x QT) The determinants of deadweight loss: Price elasticities of supply and demand How big should the government be? Other economists: labor supply is more elastic: -​ Labor taxes are highly distortionary -​ Many groups of workers have elastic supply and respond to more incentives -​ Many workers can adjust their hours -​ Many families have 2nd earners, some discretion over whether and how much to work -​ Many people can choose when to retire; incentive to work part-time -​ Some work in the “underground economy” to evade taxes As tax increases: -deadweightnloss increases -even more rapidly than size of tax When the tax is small, increasing it causes tax revenue to rise Lecture 11: 3/5 Determinants of trade: Equilibrium of trade: -​ Only domestic buyers and sellers -​ Equilibrium price and quantity -​ Determined on the domestic market -​ Total benefits from trade = total surplus -​ Consumer and producer surplus Benefits of world trade: Pw=the world price of a good, the price prevails in world market Pd= domestic price without trade A small economy is a price taker in world markets: -​ Its actions have no effect on Pw (world price) When a small economy engages in free trade, Pw is the only relevant price: -​ No seller would accept less than Pw (can sell the good for Pw in world markets) Without trade: CS=A+B PS= C Total surplus: A+B+C With trade: CS=A PS=B+C+D Total surplus: A+B+C+D Lecture 12: 3/7 Externalities: Arises when someone engages in an action that influences a bystander’s well-being and when no compensation is paid for that effects Negative: -​ Impact on bystander is adverse Positive: -​ Impact on bystander is beneficial Market inefficiency: Buyers and sellers -​ Do not consider the external effect of their actions: market equilibrium is not efficient “Government actions can sometimes improve market outcomes” -​ Why markets sometimes fail to allocate resources efficiently -​ How government policies can potentially improve the market’s allocation -​ What kinds of policies are likely to work best Negative externalities: -​ Air or water pollution from a factory -​ Second hand smoke -​ Texting while driving or walking The social cost: With negative externalities, the social cost includes: -​ Private cost (supply curve; direct cost to sellers) -​ External cost (costs to bystanders harmed) The social cost curve -​ Is above the supply curve -​ Takes into account the external costs imposed on society -​ Social cost: private+external costs Internalizing the externality: -​ Altering the incentives so that people take into account the external effects of their actions -​ In our example, a $60/ton tax on sellers will make sellers’ costs=social costs If market participants pay social costs(tax on producers): -​ MARKET EQUILIBRIUM=SOCIAL OPTIMUM Positive externalities: -​ Being vaccinated against contagious diseases -​ Research into new technologies -​ People going to college If negative externality: -​ Market quantity> than socially desirable If positive externality: -​ Market quantity < than socially desirable To remedy the issue– “internalize the externality” -​ Tax goods with negative externalities -​ Subsidize goods with positive externalities Public policies toward externalities: 1.​ command-and-control policies: regulation -​ Regulate behavior directly by requiring or forbidding certain behaviors -​ Impossible to prohibit all polluting activity Examples: -​ Dictate a maximum level of pollution -​ Require that firms adopt a particular technology to reduce emissions 2.​ Market-based policies: -​ To align private incentives with social efficiency -​ Private decision makers will choose to solve the problem on their own 1.​ Corrective taxes and subsidies 2.​ Tradable pollution permits Corrective taxes (Pigovian taxes): -​ Align private incentives with society’s interests -​ Induce private decision makers to take into account the social costs of a negative externality -​ Should equal the external cost -​ Place a price on the right to pollute -​ Reduce pollution at a lower cost to society (than regulation) -​ Raise revenue or the government -​ Enhance economic efficiency A pollution tax is efficient: -​ Firms with low abatement costs will reduce pollution to reduce their tax burden -​ Firms with high abatement costs have greater willingness to tax Regulation requiring all firms to reduce pollution by a specific amount is not efficient -​ Firms have no incentive to reduce emission further once they have reached the required target The gas tax can be viewed as a corrective tax targeting three negative externalities: -​ Congestion: the more you drive, the more you contribute to congestion -​ Accidents: larger vehicles cause more damage in an accident  -​ Pollution: cars cause smog; burning of fossil fuels cause climate change Tradable pollution permits system: -​ reduces pollution at a lower cost than regulation -​ Firms with low cost of reducing pollution do so and sell their unused permits -​ Firms with high costs of reducing pollution buy permits result= pollution reduction is concentrated among those firms with lowest costs Lecture 13: 3/12 Ramadan markuban! Reducing pollution using pollution permits or corrective taxes: firms pay for their pollution -​ Corrective taxes: pay a tax to the government -​ Firms can pollute as much as they want, and just pay the tax -​ Pollution permits: pay to buy permits -​ Internalize the externality of pollution People face trade-offs: -​ Eliminating all pollution is impossible -​ The value of environmental measures must be compared with their opportunity costs Clean environment is a normal good!!!!!! -​ Positive income elasticity -​ Rich countries can afford a cleaner environment, have a more rigorous environmental protection -​ Clean air and clean water: law of demand -​ The lower the price of environmental protection, the more the public will want it -​ Using pollution permits and corrective taxes reduces the cost of environmental protection Types of private solutions: -​ Moral codes and social sanctions -​ No littering -​ Charities -​ Sierra Club → donations to colleges and universities -​ Self interest and relevant parties -​ Apple orchard and beekeepers The course theorem -​ If private parties can bargain without cost over the allocation of their resources -​ They can solve the problem of externalities on their own Whatever the initial distribution of rights -​ Interested parties can reach a bargain -​ Everyone is better off -​ Outcome is efficient Why private solutions do not always work High transaction costs: -​ Costs that parties inure in the process of agreeing to and following through on a bargain Stubbornness: -​ Bargaining simply breaks down Coordination problems: -​ Large number of interested parties -​ Coordinating everyone is costly Lecture 14: 3/14 last one! End of exam 2! Goods you can consume without paying: -​ Parks, mountains, lakes -​ Goods without prices: market forces that normally allocate resources are absent (can’t allocate demand and supply) -​ Private markets: cannot ensure that goods are made available and used correctly for the maximum amount of people to enjoy -​ “Governments can sometimes improve market outcomes Excludability: -​ People can be prevented from using a good -​ Excludable: fishing in the pond; tacos -​ Not excludable: fishing in the ocean, going to park Rivalry in consumption: -​ One person’s use of a unit of a good reduces another person’s ability to use it -​ Rival: fish tacos, oversold concert -​ Not rival: uncongested road Different kinds of goods: Private goods:  -​ Excludable & rival in consumption (pizza) Public goods: -​ Not excludable & nonrival in consumption (national defense) Common resources: -​ Not excludable & rival in consumption (deer in the forest) Club goods: -​ Excludable and nonrival in consumption (cable tv) Examples: 1.​ Fish in private pond- rival, excludable (private good) 2.​ Fish in the ocean- rival, non excludable (common resource) 3.​ Specific research on cholesterol-lowering drug for which a patent can be obtained- nonrival, excludable (club good) 4.​ Basic research on lifestyle and cholesterol levels: nonrival, non excludable (common good) Rival in congestion?=only if congested excludable?= only if toll road Possibilities: -​ Uncongested non-toll road: public good -​ Uncongested toll-road: club good -​ Congested non-toll road: common resource -​ Congested toll-road: private good Free rider: -​ Person who receives the benefit of a good but avoids paying for it The free-rider problem: -​ Public goods are not excludable, so people have an incentive to be free riders -​ Prevents the private market from supplying the goods ***Forced riders: for example, if you pay taxes that goes to support public schools, but you enroll your kids in private school → you’re the forced rider How the government can remedy the free-rider issue: -​ If total benefits of a public good exceeds its costs -​ Provide the public good -​ Pay for it with tax revenue -​ Make everyone better off -​ Problem: measuring the benefit is usually difficult Some important public goods:  -​ National defense -​ Basic research: general knowledge Fighting poverty: Temporary assistance for needy families program, TANF -​ Temporary income support for poor families w children Supplemental nutrition assistance program, SNAP -​ Subsidized food purchases for low-income households Earned income tax credit, EITC -​ Tax rebates for low-wage workers The government: -​ provides public goods bc private market on its own will not produce an efficient quantity -​ Must determine what kinds of public goods to provide -​ Must determine what quantity of public good to provide Cost benefit analysis: -​ Study compares the costs and benefits to society of providing a public good -​ Estimate the total costs and benefits of the project to society as a whole -​ Are rough approximations at best! -​ There are no price signals to observe Common resources are NOT EXCLUDABLE -​ Cannot prevent free riders from using it -​ Little incentives for firms to provide Common resources are rival in consumption -​ Each person’s use reduce others’ ability to use -​ Role of government: ensure that they are not overused Tragedy of the commons: Parable that shows why common resources are used more than desirable from the standpoint of society as a whole Social and private incentives differ: The private incentives outweigh the social incentives Fish, whales, and other wildlife -​ Oceans: least regulated common resource -​ Needs international cooperation -​ Difficult to enforce an agreement  -​ Fishing and hunting licenses -​ Limits on hunting and fishing seasons Start of final studying!! Lecture 15: 3/26 Government can sometimes improve market outcomes -​ Providing public goods -​ Regulating the use of common resources -​ Remedying the effects of externalities The government -​ Raises revenue through taxation -​ To perform its many functions Lessons about taxes: -​ A tax on a good reduces the market quantity of that good -​ Burden of tax is shared between buyers and sellers– depending on price elasticities of demand and supply -​ A tax causes a deadweight loss -​ Taxes can increase efficiency when used to internalize externalities and thereby correct market failures Government revenue has increased: -​ As percentage of total income -​ As economy's income has grown -​ Governments revenue from taxation has grown even more -​ 1902: 7% of income -​ Recent: 30% of income Personal income taxes: -​ On wages, interest, dividends, profits (small businesses it operates) Payroll taxes: -​ On the wages that a firm pays its workers -​ Mostly earmarked to pay for social security and medicare Corporate income taxes (tax on profits) Other taxes (excise, estate taxes, custom duties) Taxes and efficiency: -​ Policymakers’ objectives: -​ Equity and efficiency Costs of taxes to taxpayers -​ Tax payment itself -​ Deadweight losses -​ Taxes distort the decisions that people make -​ Administrative burdens -​ Taxpayers bear as they comply with the tax laws **People respond to incentives Taxes distort incentives -​ Causes people to allocate resources according to tax incentives rather than true costs and benefits Deadweight loss -​ The fall in taxpayers wellbeing exceeds the revenue that the government collects CASE STUDY: Should income or consumption be taxed? -​ Income tax discourages people from saving *lost income compounds over time -​ Some economists advocate taxing consumption instead of income *would restore incentive to save *better for individuals retirement income security and long-run economic growth -​ Consumption tax-like provisions in the U.S. tax code include individual retirement accounts, not 401k plans *people can put limited amount of saving into such accounts *funds are not taxed until withdrawn at retirement -​ Europe’s value-added tax (VAT) is like a consumption tax btw Administrative burden: -​ Includes the time and money people spend to comply with the tax laws -​ Encourages the expenditure of resources on legal tax avoidance -​ Is a type of deadweight loss -​ could be reduced by simplifying tax laws Average tax rate: -​ Total taxes paid, divided by total income -​ Measures the sacrifice a taxpayer makes Marginal tax rate: -​ The extra taxes paid on an additional dollar of income -​ Measures the incentive taxes on work effort, saving, etc The benefits principle: -​ People should pay taxes based on benefits they receive from government services -​ Tries to make private goods similar to public goods -​ Ex: gasoline taxes -​ Wealthy citizens should pay higher taxes: they benefit more from public services -​ Police, fire protection, national defense, anti-poverty programs The ability to pay principle: -​ Taxes should be levied on a person according to how well that person can shoulder the burden -​ All taxpayers should make an “equal sacrifices” -​ Vertical equity -​ Horizontal equity Lecture 16: 3/28 We assume that the firm’s goal is to maximize profit -​ Profit = total revenue – total cost -​ The amount a firm receives from the sale of its output: TR = P x Q “The cost of something is what you give up to get it” Explicit costs: -​ Input costs that require an outlay of money by the firm (paying wages to workers) Implicit costs: -​ Input costs that do not require an outlay of money by the firm (opportunity cost of the owner's time) Total cost: sum of both the implicit and explicit costs Accounting profit: -​ Total revenue, minus total explicit costs Economic profit: -​ Total revenue minus total costs (explicit and implicit costs) Accounting profit is greater than economic profit: because accounting profit ignores implicit costs Accountants focus on explicit costs, while economists examine both explicit and implicit → economists consider opportunity costs Production and costs: Assumption: -​ Production in the short run -​ Factory size is fixed -​ To increase production: hire more workers Production function -​ Relationship between -​ Quantity of inputs used to make a good -​ And the quantity of output of that good -​ GETS FLATTER as output increases Marginal product: -​ Increase in output that arises from an additional unit of input -​ Other input constant -​ Slope of the production function Marginal product of labor: MPL = change in Q/change in L Diminishing MPL: -​ Marginal product of an input declines as the quantity of the input increases -​ Production function gets flatter as more inputs are being used -​ The slope of the production function decreases **Rational people think at the margin Hiring one extra worker: -​ Increases output by MPL -​ Increases costs by the wage paid Diminishing marginal product: -​ Law of diminishing returns In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc) AFC (average fixed cost): AFC= FC / Q AVC (average variable cost): AVC= VC / Q ATC (average total cost): ATC= TC / Q = AFC + AVC -​ The cost of the typical unit produced -​ Total cost divided by the quantity of output -​ ATC is falling when marginal cost is below it and rising when marginal cost is above it Marginal cost: MC= change in TC / change in Q -​ The increase in total cost that arises from an extra unit of production x Short run (SR): -​ Some inputs are fixed, ex: factories, land -​ The costs of these inputs are FC Long run (LR): -​ All inputs are variable, ex:firms can build more factories or sell existing ones In the long run: -​ ATC at any Q is the cost per unit using the most efficient mix of inputs for that Q (ex: the factory size w the lowest ATC) Economies of scale:  -​ Long-run average total cost falls as the quantity of output increases -​ Increasing specialization among workers -​ More common when Q is low Constant returns to scale: -​ Long-run average total cost stays the same as the quantity of output changes Diseconomies of scale: -​ Long-run average total cost rises as the quantity of output increases -​ Increasing coordination problems in large orgs -​ Ex: management becomes stretched and can’t control costs (more common when Q is high) Horizontal equity: the idea that taxpayers w similar abilities to pay taxes should pay the same amount Vertical equity: the idea that taxpayers w a greater ability to pay taxes should pay larger amounts Ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden Benefits principle: the idea that people should pay taxes based the benefits that they receive from government services Tax incidence: the burden of the tax is not always borne by who pays the bill (ex: tax on fur coats– tax on those who sell and produce the fur coats, bc the quantity of fur coats demanded will fall dye to increase of price – sooooo burden falls on the seller bc now people won’t buy coat and they’re still be taxed to produce the coats w no payback) Market power: a single buyer or seller (small group) control market prices Market failure: the inability of some unregulated market to allocate resources efficiently Externalities: decisions of buyers and sellers affect people who are not participants in the market at all Inefficient equilibrium: from the standpoint of society as a whole Lecture 17: 4/9 Characteristics of perfectly competitive markets: 1.​ Markets with many buyers and sellers 2.​ Trading identical products -​ Because of the first two: each buyer and seller takes the market price as given (price takers) 3.​ Firms can freely enter or exit the market The revenue of a competitive firm: Total revenue: TR = P x Q Average revenue: AR = TR / Q -​ How much revenue the individual firm receives for one unit produced Marginal revenue: MR = change in TR / change in Q -​ Change in TR from an additional unit sold -​ How much additional revenue does the firm receive if it increases production by one unit For competitive firms: AR = P = MR Goal of a firm: maximize profit = TR - TC -​ TR = P x Q and TC = FC + VC What Q maximizes a firm’s profit? -​ Think at the margin: if Q increases by one unit, revenue rises by MR and cost rises by MC Comparing MC with MR: -​ If MR > MC: increase Q to raise profit -​ If MR < MC: decrease Q to raise profit Furthermore, since marginal revenue is always equal to price (P) for a firm in a competitive market, the optimal quantity for such a firm is the one at which P=MC Shutdown: -​ a short-run decision not to produce anything because of market conditions  -​ Q = 0 in the short-run Exit: -​ A long-run decision to leave the market A key difference: -​ If shut down in SR, must still pay FC -​ If exit in LR, zero costs Should a firm shut-down in the short run? -​ Cost of shutting down = revenue loss = TR -​ Benefit of shutting down = costs savings = VC (bc firm must still pay FC) -​ Shut down if TR < VC, or P < AVC -​ Produce Q = 0 in short-run Sunk cost: -​ A cost that has already been committed and cannot be recovered -​ Should be ignored when making decisions -​ You must pay them regardless of your choice -​ In the short run, FC are sunk costs -​ So, FC should not matter in the decision to shut down ​ Lecture 18: 4/11 Monopoly: A firm that is the sole seller of a product without close substitutes -​ Has market power: price maker -​ The ability to influence the market price of the product it sells -​ Arise due to barriers to entry -​ Other firms cannot enter the firm to compete with it 1.​ Monopoly resources A single firm owns a key resources required for production -​ Single water provider in town -​ DeBeers Diamond Company- owns most of the world’s diamond mines -​ Relatively rare in practice 2.​ Government regulation Government created monopolies -​ The government gives a single firm the exclusive right to produce the good -​ Patents for new pharmaceutical drugs -​ Lead to higher prices and higher profits (than under competition)  -​ Also encourage some undesirable behavior (provides incentives for creative activities) 3.​ The production process: a natural monopoly A single firm can produce the entire market Q at a lower cost than could several firms -​ Arises when there’s economies of scale over the relevant range of output -​ Distribution of electricity, water, etc. -​ Club goods (excludable, non rival in competition) Monopoly versus competition: Competitive firm: -​ Price taker -​ Small, one of many -​ Faces individual demand at P: perfectly elastic at demand Monopoly firm: -​ Price maker, market power -​ Faces the entire market demand: downward sloping demand Increasing Q effect on revenue: -​ Output revenue: higher output raises revenue -​ Input revenue: lower price reduced revenue Marginal revenue, MR output effect Monopoly profit maximization: -​ Produce Q where MR = MC -​ Sets the price at the highest the consumers are willing to pay for that quantity -​ Find this price on D curve -​ P > MR = MC -​ If P > ATC, the monopoly earns profit A competitive firm takes P as a given -​ Has a supply curve that shows how its Q depends on P A monopoly firm is a “price-maker” -​ Q does not depend on P -​ Q and P are jointly determined by MC, MR, and the demand curve  -​ Hence, no supply curve for monopoly Welfare costs of monopolies: Competitive market equilibrium: -​ At P = MC and maximizes total surplus Monopoly equilibrium: at P > MR = MC -​ The value to buyers of an additional unit (P) exceeds the costs of the resources needed to produce that unit (MC) -​ The monopoly Q is too low → could increase total surplus with a larger Q -​ Monopoly results in a deadweight loss Monopoly profit is not in itself necessarily a problem for society -​ Greater producer surplus for monopoly -​ Smaller consumer surplus -​ Transfer of surplus from consumers to monopoly The inefficiency: -​ Monopoly produces Q < efficient quantity -​ Deadweight loss Price discrimination (price customization) -​ Sell the same good at dif prices to dif customers -​ Firm can increase profit by charging a higher price to buyers w larger willingness to pay -​ Requires the ability to separate customers according to their willingness to pay Lecture 19: 4/16 Two extreme forms of market structures: -​ Perfect competition: many firms, identical products, price takers, P = MC -​ Monopoly: one firm, price maker, P > MC Intermediate forms of competition: in between the extremes -​ Oligopoly: only a few sellers offer similar or identical products -​ Monopolistic competition: many firms sell similar but not identical products Oligopoly: Concentration ratio -​ Measure a market’s domination by a small number of firms -​ The percentage of total output in the market supplied by the four largest firms -​ Less than 50% for most industries -​ Greater than 90% in aircraft manufacturing, tobacco, passenger car rentals, and express delivery services Characteristics: -​ numerous firms competing over customers -​ Product differentiation -​ Not price takers; D curve slopes downward -​ Free entry and exit -​ Zero economic profit in the long run -​ Examples: books, video games, restaurants, piano lessons, cookies, clothing Profit maximization in the short-run for the monopolistically competitive firm: -​ produce the quantity where MR = MC -​ Price: on the demand curve -​ If P > ATC = profit -​ If P < ATC = loss -​ Similar to monopoly If monopolistically competitive firms are making profit in short run: -​ New firms: incentive to enter the market -​ Increase number of products -​ Reduces demand faced by each firm -​ Demand curve shifts to the left; prices fall -​ Each firm’s profit declines to zero If losses in the short run: -​ Some firms exit the market, remaining firms enjoy the higher demand and prices Monopolistic competition in long-run: -​ Excess capacity: quantity is not at minimum ATC (it is on the downward sloping portion of ATC) -​ Markup over marginal costs: P > MC Perfect competition: -​ Quantity: at minimum ATC (efficient scale) -​ P = MC Monopolistically competitive markets; -​ Do not have all the desirable welfare properties of perfectly competitive markets Sources of inefficiency: -​ Markup of price over marginal costs -​ Too much or too little entry (number of firms in the market) -​ Product variety externality -​ Business-stealing externality The welfare of society: Markup, P > MC -​ Market quantity < socially efficient quantity  -​ Deadweight loss of monopoly pricing The product-variety of externality: -​ Consumers get extra surplus from the introduction of the new products The business-stealing externality: -​ Losses incurred by existing firms when new firms enter the market Advertising: Incentives to advertise: -​ When firms sell differentiated products and charge prices above marginal cost -​ Advertise to attract more buyers Advertising spending: -​ Highly differentiated goods: 10-20% of revenue -​ Industrial products: little advertising -​ Homogenous products: no advertising In monopolistically competitive industries: -​ Product differentiation and markup pricing naturally lead to the use of advertising -​ The more differentiated the good →the more advertising firms buy Economists disagree about the social value of advertising: -​ Wasting resources? Valuable purpose? Firms advertise to manipulate people’s tastes -​ Is psychological rather than informational -​ Creates a desire that otherwise would not exist Advertising impedes competition -​ Increase perception of product differentiation -​ Foster brand loyalty, higher markups -​ Makes buyers less concerned with price differences among similar goods Defense of advertising: -​ It provides useful info to the buyers -​ Informs customers on their choices -​ Ads promote competition and reduces market power Advertising is a sign of quality: -​ Even if it contains little apparent information -​ The real info offered is a signal -​ Willingness to spend a large amount of money is a signal of quality of product -​ Content of ad = irrelevant lowk Brand names: spend more money on advertising and charge higher prices than generic substitutes Critics of brand names: -​ Products are not differentiated -​ Irrationality: consumers are willing to pay more for brand names Defenders of brand names: -​ Consumers get info about quality -​ firms have incentive to protect the reputation of their brand name Lecture 20: 4/18 I.​ Oligopoly A.​ Few firms that make up the entirety of the industry B.​ Causes deadweight loss but lower than monopoly C.​ Cartels 1.​ Firms agree to limit production to keep prices higher 2.​ For example OPEC 3.​ This is when they make the most profits 4.​ Strong incentives hinder a group of firms from maintaining the cooperative outcome 5.​ The market becomes a monopoly D.​ Duopoly 1.​ Market with only two sellers 2.​ The simplest type of oligopoly E.​ Strategic behavior in oligopoly 1.​ A firm’s decisions about P or Q can affect other firms and cause them to react 2.​ The firm will consider these reactions when making decisions F.​ Game theory 1.​ Collusion a)​ Agreement among firms in a market about quantities to produce or priceso to charge b)​ One possibile duopoly outcome 2.​ Both firms would be better off if both stick to the collusion agreement a)​ But each has an incentive to cheat II.​ III.​ Concentration ratio A.​ Measure a market’s domination by a small number of firms B.​ Percentage of total output in the market supplied by the four largest firms  C.​ Less than 50% for most industries D.​ Greater than 90%in: aircraft manufacturing, tobacco, passenger car rentals, and express delivery services E.​ Herfindahl Hirschman index 1.​ Obtained by summing squares of each firm’s market share 2.​ Most useful when firms are not of equal size 3.​ Used by FTC and the DOJ to block mergers between companies 4.​ Industry a)​ Unconcentrated (Below 1000) b)​ Moderately concentrated (1000-1800) c)​ Highly Concentrated (HHI above 1800) IV.​ Measuring Market concentration A.​ Government oppositions 1.​ Any merger that raises the HHI by more than 100 to a value above 1800 2.​ Any merger that results in the new firm having more than 30% market share and the merger raises the HHI by 100 points Lecture 21: 4/23 Nash Equilibrium -​ Economic factors interacting with one another, each choose their best strategy -​ Given the strategies that all other actors have chosen When firms in an oligopoly individually choose production to maximize profit -​ Produce Q: greater than monopoly Q, less than competitive Q -​ The price: is less than the monopoly P, greater than the competitive P = MC The output and price effects: Increasing output has two effects on a firm’s profits: -​ Output effect: because P > MC, increasing output raises profits -​ Price effects: raising production increases quantity sold, which reduces price and reduces profit on all units sold As the number of sellers in an oligopoly increases: -​ The price effect becomes smaller -​ The oligopoly looks more and more like a competitive market -​ The price approaches marginal cost -​ The market quantity approaches the socially efficient quantity Another benefit of international trade The prisoner's dilemma: -​ Particular “game” between two captured prisoners -​ Illustrates why cooperation is difficult to maintain even when it is mutually beneficial Dominant strategy -​ Strategy that is best for a player in a game -​ Regardless of the strategies chosen by the other players When oligopolies form a cartel -​ Hoping to reach a monopoly outcome, they become players in a prisoners’ dilemma -​ The monopoly outcome is jointly irrational, but each firm has an incentive to cheat: self-interest makes it hard to maintain the cooperative outcome with low production, high prices, and monopoly profits Other examples of the prisoners’ dilemma: -​ Ad wars: two firms spend millions of dollars on ads to compete against each other → each firm’s ads cancel out the effects of the other, and both firm’s profits all by the cost of the ads -​ Arms race between military superpowers: each country would be better off if both disarm, but each has a dominant strategy of arming. -​ Common resources: all would be better off if everyone conserved common resources, but each person’s dominant strategy is overusing the resources Governments can sometimes improve market outcomes: Policy makers: -​ Try to induce firms in an oligopoly to compete rather than cooperate -​ Move the allocation of resources closer to the social optimum Chapter 21: I.​ Monopsony A.​ One buyer in market II.​ Measuring inequality A.​ Four questions 1.​ How much inequality exists in the US 2.​ How many people ive in poverty 3.​ What problems arise in measuring inequality and poverty  4.​ How often do people move between income classes III.​ Quintile Ratio A.​ Income share of the highest quintile divided by income share of the lowest quintile B.​ Allegedly the personal computer has raised income inequality C.​ Skill bias can cause income inequality IV.​ Poverty rate A.​ Percentage of the population whose family income falls below an absolute level (poverty line) B.​ Poverty line 1.​ Set by the federal government (three times cost of providing an adequate diet) V.​ Poverty Facts A.​ Correlates with race 1.​ BLack and hispanics are more than twice as likely to live in poverty as whites B.​ Poverty is correlated with age 1.​ Children are more likely than average to be members of poor families 2.​ Older adults are less likely than average to be poor C.​ Poverty is correlated with family composition 1.​ Families headed by a single mother VI.​ Problem in measuring inequality A.​ Data on income distribution and poverty rate 1.​ Give us some idea about the degree of inequality in our society Shriya my queen speaks the words of the wise: Utilitarian: political philosophy according to which the government should choose policies that maximize the total utility of everyone in society -​ Balance the gains from greater equality against the losses caused by the distorted incentives from the redistribution of income Liberal contractarian (John Rawls): according to which the government should choose policies deemed to be just, as evaluated by impartial observers behind a “veil of ignorance” -​ Aim to maximize the well-being of the worst-off person in society -​ Income redistribution is a form of social injustice Libertarian: the government should punish crimes and enforce voluntary agreements but not redistribute income -​ Equality of opportunities is more important than equality of incomes Topics on the frontier of microeconomics: Asymmetric information -​ One person holds more knowledge about what is going on than another, and one might have the incentive to conceal the information that they know Political economy Behavioral economy -​ Studies of human decision-making have found several systematic mistakes that people make -​ People are overconfident -​ People give too much weight to a small number of vivid observations -​ Confirmation bias, people are less likely to change their minds -​ Honestly, humans sometimes just care about fairness -​ People are inconsistent over time → instant gratification now! Lecture 22: 4/30 Information asymmetry: -​ A difference in knowledge that is relevant to an interaction -​ “I know something that you don’t” Hidden actions: -​ One person knows more than another about an action he or she is taking Hidden characteristics: -​ One person knows more than another about the attributes of a good he or she is selling Moral hazards: -​ Tendency of a person is unmonitored to engage in activity that is dishonest or otherwise undesirable Principal-agent problem: the principal cannot perfectly monitor the agent’s behavior, so the agent tends to undertake less effort than the principal considers desirable How principals may respond:  -​ Better monitoring: hidden cameras to increase the chance of detecting undesirable behavior -​ Higher wages: efficiency wages to increase penalty for being caught shirking -​ Delayed payment: firms will delay payment (ex: end-of-year bonuses) increase the penalty for being caught shirking -​ Government regulation Adverse selection: -​ The tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party -​ If the seller knows more than the buyer about the good being sold, the buyer runs the risk of being sold a good at a low quality Signaling: -​ Action taken by an informed party to reveal private info to an uninformed party Effective signals: -​ Are costly: not everyone can use it -​ Must be less costly, or more beneficial, to the person with the higher-quality product Screening: -​ Action taken by an uninformed party to induce informed party to reveal private information -​ Some screening is common sense -​ Others are more subtle: offer two options of a good/service to induce customers to reveal their preferences Asymmetric info: inefficient allocation -​ Government can sometimes improve market outcomes Complications of using public policy: -​ Markets can sometimes deal with the problem using signaling or screening -​ The government rarely has more information than private parties -​ The government itself is an imperfect institution Choosing between two outcomes: -​ Majority rules Choosing among several outcomes: -​ “Democracy might run into some problems” -condorcet The condorcet voting paradox: -​ The failure of majority rule to produce transitive preferences for society Ranked-choice voting: -​ The voters rank all of the candidates -​ Each vote is assigned to that voter’s first choice -​ The candidate with the fewest votes is then eliminated, and those votes are reallocated to the voters’ second choice.. and so on … -​ Candidates are successfully eliminated until one of them has the majority Arrows properties of a voting system: 1.​ Unanimity: if everyone prefers A to B, then A should beat B 2.​ Transitivity: if A beats B, then A should beat C 3.​ Independence of irrelevant alternatives: the ranking between any two outcomes should not depend on whether a third option is available 4.​ No dictators: there is no person who always gets his way, regardless of everyone else’s preferences Median voter theorem: -​ A mathematical result showing that is voters are choosing a point along a line -​ And they all want the point closest to their own optimum -​ Then majority rule will pick the most preferred point of the median voter