Summary Economics-6 PDF

Table of Contents {#table-of-contents.TOCHeading} ================= [Ch1 -- The Principles and Practice of Economics 5](#ch1-the-principles-and-practice-of-economics) [1.1 The Scope of Economics 5](#the-scope-of-economics) [Economic Agents and Economic Resources 5](#economic-agents-and-economic-resources) [Definition of Economics 6](#definition-of-economics) [Positive Economics and Normative Economics 6](#positive-economics-and-normative-economics) [Microeconomics and Macroeconomics 6](#microeconomics-and-macroeconomics) [1.2 Three Principles of Economics 7](#three-principles-of-economics) [1.3 Optimization 7](#optimization) [Trade-offs and Budget Constraints 7](#trade-offs-and-budget-constraints) [Opportunity Cost 7](#opportunity-cost) [Cost-Benefit Analysis 7](#cost-benefit-analysis) [1.4 Equilibrium 8](#equilibrium) [The Free-Rider Problem 8](#the-free-rider-problem) [1.5 Empiricism 8](#empiricism) [1.6 Is Economics Good for You? 8](#is-economics-good-for-you) [Ch2 -- Economic Methods and Economic Questions 8](#ch2-economic-methods-and-economic-questions) [2.1 The Scientific Method 8](#the-scientific-method) [Models and Data 9](#models-and-data) [An Economic Model 9](#an-economic-model) [Means and Medians 9](#means-and-medians) [Argument by Anecdote 9](#argument-by-anecdote) [2.2 Causation and Correlation 9](#causation-and-correlation) [Causation vs Correlation 9](#causation-vs-correlation) [Experimental Economics and Natural Experiments 10](#experimental-economics-and-natural-experiments) [2.3 Economic Questions and Answers 10](#economic-questions-and-answers) [Ch3: Optimization: Doing the best you can 10](#ch3-optimization-doing-the-best-you-can) [3.1 Optimization: Choosing the Best feasible option 10](#optimization-choosing-the-best-feasible-option) [3.2 Optimization Application: Renting the Optimal Apartment 11](#optimization-application-renting-the-optimal-apartment) [3.3 Optimization Using Marginal Analysis 12](#optimization-using-marginal-analysis) [Marginal Cost 13](#marginal-cost) [Ch4 -- Demand, Supply, and Equilibrium 14](#ch4-demand-supply-and-equilibrium) [4.1 Markets 14](#markets) [Competitive Markets 14](#competitive-markets) [4.2 How do buyers behave? 14](#how-do-buyers-behave) [Demand Curves 14](#demand-curves) [Willingness to Pay 14](#willingness-to-pay) [From individual demand curves to aggregated demand curves 15](#from-individual-demand-curves-to-aggregated-demand-curves) [Building the Market Demand Curve 15](#building-the-market-demand-curve) [Shifting the Demand Curve 15](#shifting-the-demand-curve) [4.3 How do Sellers Behave? 16](#how-do-sellers-behave) [Supply Curves 16](#supply-curves) [Willingness to Accept 16](#willingness-to-accept) [From the individual Supply curve to the market supply curve 16](#from-the-individual-supply-curve-to-the-market-supply-curve) [Shifting the Supply Curve 17](#shifting-the-supply-curve) [4.4 Supply and Demand in Equilibrium 18](#supply-and-demand-in-equilibrium) [4.5 What would happen if the government tried to dictate the price of gasoline? 19](#what-would-happen-if-the-government-tried-to-dictate-the-price-of-gasoline) [Ch5 -- Consumers and Incentives 19](#ch5-consumers-and-incentives) [5.1 The Buyer's Problem 19](#the-buyers-problem) [5.2 Putting it all together. 23](#putting-it-all-together.) [Price changes 23](#price-changes) [Income Changes 24](#section-6) [5.3 From the Buyer's Problem to the Demand Curve 24](#from-the-buyers-problem-to-the-demand-curve) [5.4 Consumer Surplus 25](#consumer-surplus) [An Empty feeling: loss in consumer surplus when price increases 25](#an-empty-feeling-loss-in-consumer-surplus-when-price-increases) [5.5 Demand Elasticities 25](#demand-elasticities) [The Price Elasticity of Demand 26](#the-price-elasticity-of-demand) [The Cross-Price Elasticity of Demand 28](#the-cross-price-elasticity-of-demand) [The Income Elasticity of Demand 29](#the-income-elasticity-of-demand) [Ch6 -- Sellers and Incentives 29](#ch6-sellers-and-incentives) [6.1 Sellers in a Perfectly Competitive Market 29](#sellers-in-a-perfectly-competitive-market) [6.2 The Seller's Problem 29](#the-sellers-problem) [Making the Goods: how inputs are turned into outputs 29](#making-the-goods-how-inputs-are-turned-into-outputs) [The Cost of Doing Business: Introducing Cost Curves 30](#the-cost-of-doing-business-introducing-cost-curves) [The Rewards of Doing Business: Introducing Revenue Curves 31](#the-rewards-of-doing-business-introducing-revenue-curves) [Putting it all together: Using the three components to do the best you can. 32](#putting-it-all-together-using-the-three-components-to-do-the-best-you-can.) [6.3 From the Seller's Problem to the Supply Curve 33](#from-the-sellers-problem-to-the-supply-curve) [Price Elasticity of Supply 33](#price-elasticity-of-supply) [Shutdown 34](#shutdown) [6.4 Producer Surplus 35](#producer-surplus) [6.5 From the Short run to the Long Run 35](#section-33) [Long-Run Supply Curve 36](#long-run-supply-curve) [6.6 From the Firm to the Market: Long-Run Competitive Equilibrium 36](#from-the-firm-to-the-market-long-run-competitive-equilibrium) [Firm Entry 37](#firm-entry) [Firm Exit 38](#firm-exit) [Zero Profits in the Long Run 38](#zero-profits-in-the-long-run) [Economic Profit vs Accounting Profit 39](#economic-profit-vs-accounting-profit) [Ch7 -- Perfect Competition and the Invisible Hand 39](#ch7-perfect-competition-and-the-invisible-hand) [7.1 Perfect Competition and Efficiency 40](#perfect-competition-and-efficiency) [Social Surplus 40](#social-surplus) [Pareto Efficiency 41](#pareto-efficiency) [7.2 Extending the Reach of the Invisible Hand: From the Individual to the Firm 41](#extending-the-reach-of-the-invisible-hand-from-the-individual-to-the-firm) [7.4 Prices Guide the Invisible Hand 42](#prices-guide-the-invisible-hand) (#section-41) [Deadweight Loss 44](#deadweight-loss) [The Command Economy 44](#the-command-economy) [The Central Planner 44](#the-central-planner) [7.5 Equity and Efficiency 45](#equity-and-efficiency) [Ch9 -- Externalities and Public Goods 45](#ch9-externalities-and-public-goods) [9.1 Externalities 45](#externalities) [A "broken" Invisible Hand: Negative Externalities 46](#a-broken-invisible-hand-negative-externalities) [A "Broken" Invisible Hand: Positive Externalities 47](#a-broken-invisible-hand-positive-externalities) [Pecuniary Externalities 48](#pecuniary-externalities) [9.2 Private Solutions to Externalities 48](#private-solutions-to-externalities) [The Coase Theorem 48](#the-coase-theorem) [9.3 Government Solutions to Externalities 49](#government-solutions-to-externalities) [Government Regulation: Command-and-Control Policies 49](#government-regulation-command-and-control-policies) [Government Regulation: Market-Based Approach 49](#government-regulation-market-based-approach) [Corrective Subsidies 50](#corrective-subsidies) [Ch10 -- The Government in the Economy: Taxation and Regulation 50](#ch10-the-government-in-the-economy-taxation-and-regulation) [10.1 Taxation and Government Spending in the US 50](#taxation-and-government-spending-in-the-us) [Where does the money come from? 51](#where-does-the-money-come-from) [Why Does the Government Tax and Spend? 52](#why-does-the-government-tax-and-spend) [Taxation: Tax Incidence and Deadweight Losses 53](#taxation-tax-incidence-and-deadweight-losses) [The Effects of Demand and Supply Elasticities on the Tax Burden 54](#the-effects-of-demand-and-supply-elasticities-on-the-tax-burden) [10.2 Regulation 56](#regulation) [Direct Regulation 56](#direct-regulation) [Price Controls: Price Ceilings and Price Floors 56](#price-controls-price-ceilings-and-price-floors) [10.4 Equity Versus Efficiency 58](#equity-versus-efficiency) [Ch8 -- Trade 58](#ch8-trade) [8.1 The Production Possibilities Curve 58](#the-production-possibilities-curve) [Calculating Opportunity Cost 59](#calculating-opportunity-cost) [8.2 The Basis for Trade: Comparative Advantage 59](#the-basis-for-trade-comparative-advantage) [Specialization 60](#specialization) [Absolute Advantage 60](#absolute-advantage) [The Price of the Trade 60](#the-price-of-the-trade) [8.3 Trade Between States 61](#trade-between-states) [Economy-Wide PPC 61](#economy-wide-ppc) [8.4 Trade Between Countries 62](#trade-between-countries) [Determinants of Trade Between Countries 62](#determinants-of-trade-between-countries) [Exporting Nations: Winners and Losers 62](#exporting-nations-winners-and-losers) [Importing Nations: Winners and Losers 63](#importing-nations-winners-and-losers) [Where do world prices come from? 63](#where-do-world-prices-come-from) [Determinants of a Country's Competitive Advantage 63](#determinants-of-a-countrys-competitive-advantage) [8.5 Arguments against free trade 63](#arguments-against-free-trade) [Ch12 -- Monopoly (12.1-12.5) 64](#ch12-monopoly-12.1-12.5) [12.1 Introducing a New Market Structure 64](#introducing-a-new-market-structure) [12.2 Sources of Market Power 65](#sources-of-market-power) [12.3 The Monopolist's Problem 66](#the-monopolists-problem) [Revenues Curves 67](#revenues-curves) [Price, Marginal Revenue, and Total Revenue 68](#price-marginal-revenue-and-total-revenue) [12.4 Choosing the Optimal Quantity and Price 69](#choosing-the-optimal-quantity-and-price) [Producing the Optimal Quantity 69](#producing-the-optimal-quantity) [Setting the Optimal Price 70](#setting-the-optimal-price) [How a Monopolist Calculates Profits 71](#how-a-monopolist-calculates-profits) [12.5 The "Broken" Invisible Hand: the Cost of Monopoly. 71](#the-broken-invisible-hand-the-cost-of-monopoly.) [Ch13 -- Game Theory and Strategic Play 72](#ch13-game-theory-and-strategic-play) [13.1 Simultaneous-Move Games 72](#simultaneous-move-games) [Best Responses and the Prisoners' Dilemma 73](#best-responses-and-the-prisoners-dilemma) [Dominant Strategies and Dominant Strategy Equilibrium 73](#section-64) [Games without Dominant Strategies 74](#games-without-dominant-strategies) [13.2 Nash Equilibrium 74](#nash-equilibrium) [13.3 Applications of Nash Equilibria 74](#applications-of-nash-equilibria) [Tragedy of the Commons Revisited 74](#tragedy-of-the-commons-revisited) [Zero-Sum Games 75](#section-65) [13.4 How do people actually play such games? 75](#how-do-people-actually-play-such-games) [13.5 Extensive-Form Games 75](#extensive-form-games) [Backward Induction 76](#backward-induction) [First-Mover Advantage, Commitment, and Vengeance. 76](#first-mover-advantage-commitment-and-vengeance.) [Ch14 -- Oligopoly and Monopolistic Competition 76](#ch14-oligopoly-and-monopolistic-competition) [14.1 Two More Market Structures 76](#two-more-market-structures) [14.2 Oligopoly 77](#oligopoly) [The Oligopolist's Problem 77](#the-oligopolists-problem) [Oligopoly Model with Homogeneous Products 77](#oligopoly-model-with-homogeneous-products) [Doing the Best you can: How should you price to maximize profits? 79](#doing-the-best-you-can-how-should-you-price-to-maximize-profits) [Oligopoly Model with Differentiated Products 79](#oligopoly-model-with-differentiated-products) [Collusion: Another Way to Keep Prices High 80](#collusion-another-way-to-keep-prices-high) [14.3 Monopolistic Competition 81](#monopolistic-competition) [The Monopolistic Competitor's Problem 81](#the-monopolistic-competitors-problem) [Doing the Best You Can: How a Monopolistic Competitor Maximizes Profits 81](#doing-the-best-you-can-how-a-monopolistic-competitor-maximizes-profits) [How a Monopolistic Competitor Calculates Profits 82](#how-a-monopolistic-competitor-calculates-profits) [Long-Run Equilibrium in a Monopolistically Competitive Industry 82](#long-run-equilibrium-in-a-monopolistically-competitive-industry) [14.4 The "Broken" Invisible Hand 83](#the-broken-invisible-hand) [Regulating Market Power 84](#regulating-market-power) [14.5 Summing Up: Four Market Structures 85](#summing-up-four-market-structures) (#section-72) [Ch19 -- The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates 85](#ch19-the-wealth-of-nations-defining-and-measuring-macroeconomic-aggregates) [19.1 Macroeconomics Questions 85](#macroeconomics-questions) [19.2 National Income Accounts: Production = Expenditure = Income 86](#national-income-accounts-production-expenditure-income) [Production 86](#production) [Expenditure 86](#expenditure) [Income 86](#income) [Circular Flows 86](#circular-flows) [National Income Accounts: Production 87](#national-income-accounts-production) [National Income Accounts: Expenditure 88](#national-income-accounts-expenditure) [National Income Accounting: Income 89](#national-income-accounting-income) [19.3 What isn't measured by GDP? 90](#what-isnt-measured-by-gdp) [Physical Capital Depreciation 90](#section-95) [Home Production 90](#home-production) [The Underground Economy 91](#the-underground-economy) [Negative Externalities 91](#negative-externalities) [Gross Domestic Product vs Gross National Product 91](#gross-domestic-product-vs-gross-national-product) [The Increase in Income Inequality 91](#the-increase-in-income-inequality) [Leisure 91](#section-96) [Does GDP Buy Happiness? 92](#section-97) [19.4 Real vs Nominal 92](#real-vs-nominal) [The GDP Deflator 92](#the-gdp-deflator) [The Consumer Price Index 93](#section-98) [Inflation 94](#inflation) [Ch26 -- Short-run Fluctuations 94](#_Toc153391544) [26.1 Economic Fluctuations and Business Cycles 94](#economic-fluctuations-and-business-cycles) [Patterns of Economic Fluctuations 95](#patterns-of-economic-fluctuations) [The Great Depression 97](#the-great-depression) [26.2 Macroeconomic Equilibrium and Economic Fluctuations 97](#macroeconomic-equilibrium-and-economic-fluctuations) [Labor Demand and Fluctuations 97](#section-100) [Sources of Fluctuations 99](#sources-of-fluctuations) [Multipliers and Economic Fluctuations 101](#multipliers-and-economic-fluctuations) [Equilibrium in the Medium Run: Partial Recovery and Full Recovery 102](#equilibrium-in-the-medium-run-partial-recovery-and-full-recovery) [26.3 Modeling Expansions 104](#modeling-expansions) [Ch27- Countercyclical Macroeconomic Policy 105](#ch27--countercyclical-macroeconomic-policy) [27.1 The Role of Countercyclical Policies in Economic Fluctuations 105](#the-role-of-countercyclical-policies-in-economic-fluctuations) [27.3 Countercyclical Fiscal Policy 106](#countercyclical-fiscal-policy) [Fiscal Policy Over the Business Cycle: Automatic and Discretionary Components 106](#fiscal-policy-over-the-business-cycle-automatic-and-discretionary-components) [Analysis of Expenditure-Based Fiscal Policy 108](#analysis-of-expenditure-based-fiscal-policy) [Analysis of Taxation-Based Fiscal Policy 108](#analysis-of-taxation-based-fiscal-policy) [Fiscal Policies that directly target the labor market 109](#fiscal-policies-that-directly-target-the-labor-market) [Policy Waste and Policy Lags 110](#policy-waste-and-policy-lags) Ch1 -- The Principles and Practice of Economics =============================================== The Scope of Economics ---------------------- Economists study all human behavior. Choice, not money = unifying feature of all the things that economists study. All human behavior = outcome of choices. ### Economic Agents and Economic Resources **Economic agent**: an individual or a group that makes choices. We are all economic agents bc we make a lot of choices every day. !! Not all economic agents are individuals. (group, government, army, firm, uni, political party, sports team...) Economists simplify their analysis by treating these groups as a single decision maker. **Scarce resources:** things that people want, where the quantity that people want (if the resources were being given away for free) exceeds the quantity that is available. !! A resource doesn't need to be luxurious to be scarce, everyday goods are also scarce, like toilet paper. **Scarcity**: the situation of having unlimited wants in a world of limited resources. A good that is valued, and for which there is an opportunity cost of acquiring more. ### Definition of Economics **Economics:** the study of how agents choose to allocate scarce resources and how those choices affect society. Economists study the original choice and its multiple consequences for other people in the world. ### Positive Economics and Normative Economics Economics analysis 1. Describes what people actually do (descriptive): **Positive economics:** analysis that generates objective descriptions or predictions, which can be verified with data. 2. Recommends what people, including society, ought to do (advisory). **Normative economics:** analysis that recommends what an individual or society ought to do. It is dependent on subjective judgmentsdepends in part on personal feelings, tastes, opinions. The people being advised should determine the preferences to be used. The key: what the worker wants. It is legitimate for the worker to choose any level of risk, as long as she understands the implications of that risk for her average rate of return, less risk implies a lower average rate of return. **Prescriptive economics**: type of normative economics used to help individual economic agents choose what is in their personal interest. Normative analysis also generates advice for society in general. Ex: economists evaluate public policies like taxes or regulations. When public policies create winners and losers, citizens tend to have opposing views about the desirability of the government program. Economists must make ethical judgments when evaluating policies that make one group worse off so another group can be made better off. ### Microeconomics and Macroeconomics **Microeconomics:** the study of how individuals, households, firms, and governments make choices, and how those choices affect prices, the allocation of resources, and the well-being of other agents. Microeconomists are called on when we want to understand a small piece of the overall economy. **Macroeconomics**: the study of the economy as a whole. Macroeconomists study economy-wide phenomena, like the growth rate of a country's total economic output, the inflation rate, or the unemployment rate. Macroeconomists design government policies that improve overall, or "aggregate", economic performance. Three Principles of Economics ----------------------------- Economists emphasize 3 key concepts: 1. **Optimization:** picking the best feasible option, given whatever (limited) information, knowledge, experience, and training the economic agent has. Economists believe that economic agents try to optimize but sometimes make mistakes. It explains most choices that people do. 2. **Equilibrium:** the special situation in which everyone is simultaneously optimizing, so nobody would benefit personally by changing is or her own behavior, given the choices of others. The economic system is in equilibrium when each agent cannot do any better by picking another course of action. 3. **Empiricism:** analysis that uses data, evidence-based analysis. Economists use data to dvlp theories, test theories, evaluate the success of diff government policies, determine what is causing things to happen in the world. 3. Optimization ------------ Feasible options are those that are available and affordable to an economic agent. The concept of feasibility goes beyond the financial budget of the agent. Many diff constraints can determine what is feasible. (cannot work + than 24h a day). Any decision can depend only on the info available at the time of the choice. Optimization means that you weigh the info that you have, not that you perfectly foresee the future. When someone chooses the best feasible option given the info that is available, the decision maker is being **rational**. Evaluating the rationality of a decision=examining the quality of your initial decision, not the outcome. ### Trade-offs and Budget Constraints An economic agent faces a **trade-off** when the agent needs to give up one thing to get something else. A **budget constraint** shows the bundles of goods or services that a consumer can choose given her limited budget. = useful economic tools, bc they quantify trade-offs. ### Opportunity Cost We face trade-offs whenever we allocate our time. When we do one thing, something else gets squeezed out. **Opportunity cost:** what you give up from choosing the best alternative use of a resource. Economists often try to put a monetary value on opportunity cost. ### Cost-Benefit Analysis **Cost-benefit analysis**: a calculation that identifies the best alternative, by summing benefits and subtracting costs, with both benefits and costs denominated in a common unit of measurement, like dollars. Used to identify the alternative that has the greatest **net benefit**: the sum of the benefits of choosing an alternative minus the sum of the costs of choosing that alternative. Equilibrium ----------- World: large nb of economic agents who are interacting and influencing one another's efforts at optimization. **Equilibrium:** the situation in which everyone is optimizing, so nobody would benefit personally by changing his behavior. When we say that nobody would benefit personally by changing his behavior, we mean that nobody believes he would benefit from such a change. In equilibrium, nobody perceives that they will benefit from changing their own behavior. ### The Free-Rider Problem Ex: roommates live in a rented house. It would be beneficial to each of the roommates if everyone chipped in and did a little cleaning. Roommates who leave the cleaning to others are an example of something that economists call the **free-rider problem**. When there are a few free riders and lots of contributors, the free riders might be overlooked. Equilibrium analysis helps us predict the behavior of interacting economic agents and understand why free riding occurs. People sometimes pursue their own private interests and don't contribute voluntarily to the public interest. Equilibrium analysis helps us design special institutions, like financial contracts, that reduce or even eliminate free riding. **Free rider:** someone who wants others to pay for a public good but plans to use the good themselves; if many people act as free riders, the public good may never be provided. The free rider problem can be overcome through measures that ensure the users of a public good pay for it. (government actions, social pressures, collecting payments). Empiricism ---------- Economists use data to determine whether our theories about human behavior, like optimization and equilibrium, match up with actual human behavior. We want to know if our theories fail to explain what is happening in the world AND understand what is causing things to happen in the world. Is Economics Good for You? -------------------------- Learning how to make good choices is the biggest benefit you'll realize from learning economics. Ch2 -- Economic Methods and Economic Questions ============================================== The Scientific Method --------------------- **Scientific method**: the ongoing process that economists and other scientists use to: 1. Develop models of the world. 2. Evaluate those models by testing them with data. It enables to separate the good models, those that make predictions that are mostly consistent with the data, from the bad models. Economists can move toward models that better explain the past and even partially predict the future. ### Models and Data **Model:** a simplified description of reality. (=theory) not perfect replicas of reality. Scientists and commuters use the model that is best suited to analyzing the problem at hand. Even if a model is based on assumptions that are known to be false (flatness of the earth), the model may still help us to make good predictions for the future. It is more important for a model to be simple and useful than to be precisely accurate. **Empirical evidence:** facts that are obtained through observation and measurement. Also called data. **Hypotheses:** predictions (typically generated by a model) that can be tested with data. ### An Economic Model All models begin with assumptions. Two important properties of all models: - A model is only an approximation. It is not exactly correct. - A model makes predictions that can be tested with data. ### Means and Medians The **mean** or average is the sum of all the different values divided by the number of values. The **median** value is calculated by ordering the numbers from least to greatest and then finding the value half-way through the list. ### Argument by Anecdote When you look at only a small amount of data, it is easy to jump to the wrong conclusion. Argument by anecdote should not be taken seriously. (Ex: Mark Zuckerberg dropped out of schooldropping out of college is a great path of success). One exception to this rule: Argument by example is appropriate when you are contradicting a blanket statement. ![](media/image2.png) Causation and Correlation ------------------------- ### Causation vs Correlation **Causation** occurs when one thing directly affects another. Scientists refer to a changing factor or characteristic, like the temperature of water in a tea kettle, as a variable. Causation occurs when one variable causes another to change. **Correlation** means that two variables tend to change at the same time. There is some kind of connection. It might be cause and effect, but correlation arise when causation is not present. When two variables are correlated, it suggests that causation may be possible and that further investigation is warranted, it's only the beginning of the story, not the end. Divided into three categories: positive correlation, negative correlation and zero correlation. **Positive correlation** implies that two variables tend to move in the same direction. **Negative correlation** implies that the two variables tend to move in opposite directions. When two variables are not related, we say that they have a **zero correlation.** There are 2 reasons why correlation is not always = to causation: 1. **Omitted variable:** something that has been left out of a study that, if included, would explain why two variables that are in the study are correlated. 2. **Reverse causality:** when we mix up the direction of cause and effect. ### Experimental Economics and Natural Experiments **Experiment**: a controlled method of investigating causal relationships among variables. **Randomization:** the assignment of subjects by chance, rather than by choice, to a treatment group or a control group. Experiments can be very costly to conduct. + They do not provide immediate answers to !! ?. **Natural experiment:** empirical study in which some process, out of the control of the experimenter, has assigned subjects to control and treatment group in a random or nearly random way. Economic Questions and Answers ------------------------------ Most exciting economic questions share two properties: 1. Good economic questions address topics that are important to individual economic agents and/or to our society. Economists think about economic research as something that contributes to society's welfare. 2. Good economic questions can be answered. Ch3: Optimization: Doing the best you can ========================================= Optimization: Choosing the Best feasible option ----------------------------------------------- Economists use optimization to predict most of the choices that people, households, businesses, and governments make. They don't assume that people always successfully optimize. They are interested in identifying situations in which optimization is a good approximation of behavior and those in which optimization is a bad approximation of behavior. **Behavioral economics** jointly analyzes the economic and psychological factors that explain human behavior. It explains why people optimize in some situations and fail to optimize in others. Optimization Application: Renting the Optimal Apartment ------------------------------------------------------- You are an apartment hunter. You have narrowed your rental choice to 4 possible apartments. Assume that rent decreases the farther you are from work. As rent falls, commuting time increases, generating a trade-off. In normal cost-benefit analysis, the decision maker finds the alternative with the highest value of net benefit, which is benefit minus cost. ![](media/image4.png)First, we need to + the cost of rent and the cost of commuting time to calculate the total cost of each apartment. The total cost includes the **direct cost** of rent and the **indirect cost** of commute time. **The optimum**: the best feasible choice. = the optimal choice. Optimization using total value has three steps: 1. Translate all costs and benefits into common units, like dollars per month. 2. Calculate the total net benefit of each alternative. 3. Pick the alternative with the highest net benefit. [Before and After Comparisons] If apartment hunters make optimal choices, then the choice of an apartment will be affected by a change in the opportunity cost of time. ![](media/image6.png)When the opportunity cost of time increases from \$10/hour to \$15/hour, it becomes more valuable for the commuter to choose an apartment that reduces the amount of time spent commuting. So the optimal choice switches from a relatively inexpensive apartment with a longer commute -far- to a relatively expensive apartment with a shorter commute -close. ![](media/image8.png) Optimization Using Marginal Analysis ------------------------------------ Optimization using marginal analysis is often faster to implement than optimization using total value, because optimization using marginal analysis focuses only on the ways that alternatives differ. It breaks an optimization problem down by thinking about how costs and benefits change as you hypothetically move from one alternative to another. Economists use the word marginal to indicate a difference between alternatives, usually a difference that represents one "step" or "unit" more. **Marginal analysis**: a cost-benefit calculation that studies the difference between one feasible alternative and the next feasible alternative. It compares the consequences -costs and benefits- of doing on step more of something. ### Marginal Cost Instead of thinking about each of the apartments in isolation, let's think about the apartments comparatively. Let's focus on what changes as we hypothetically "move" from one apartment to the next, stepping farther away from the city center. The "Marginal Commuting Cost" reports the value of the extra monthly commuting time that is generated by moving one apartment farther from the city center.\ **Marginal cost:** the extra cost generated by moving from one feasible alternative to the next feasible alternative. ![](media/image10.png)The "Marginal rental Cost" column reports the change in the rental cost generated by moving from one apartment to the next apartment, one step farther from the city center. Optimization using marginal analysis will always pick out a single optimal alternative when the total cost curve has the bowl-like shape. When the total cost is falling, marginal cost will be negative and marginal analysis will recommend moving farther away from the city center, thereby lowering total cost. After total cost bottoms out, marginal cost will afterward be positive, implying that the renter should move no farther out. The **Principle of Optimization at the Margin** states that an optimal feasible alternative has the property that moving to it makes you better off and moving away from it makes you worse off. Optimization at the margins is simple because you can ignore everything about two alternatives that are being compared except the particular attributes that are different. It reminds you to exclude information that is not relevant to your decision. Marginal analysis has three steps: 1. Translate all costs and benefits into common units, like dollars per month. 2. Calculate the marginal consequences of moving between alternatives. 3. Apply the Principle of Optimization at the Margin by choosing the best alternative with the property that moving to it makes you better off and moving away from it makes you worse off. It is most commonly used when there is a clear sequence of feasible alternatives. Ex: how many hours should you sleep tonight? 6? 7? 8? Or 9? More sleep=more rested, but sleep has an opportunity cost, some other activity must be scarified if you are going to get more sleep. Ch4 -- Demand, Supply, and Equilibrium ====================================== 4.1 Markets ----------- **Market**: a group of economic agents who are trading a good or service plus the rules and arrangements for trading. It may have a specific physical location or not. ### Competitive Markets **Market price**: if all sellers and all buyers face the same price. In a **perfectly competitive market**: - sellers all sell an identical good or service. - any individual buyer or any individual seller isn't powerful enough on his or her own to affect the market price of that good or service.\ **Price taker**: a buyer or seller who accepts the market price---buyers can't bargain for a lower price, and sellers can't bargain for a higher price. If sellers have nearly identical goods and most market participants face lots of competition, then the perfectly competitive model is a good approximation of how actual markets work. 4.2 How do buyers behave? ------------------------- We assume that buyers are price-takers: **Quantity demanded:** the amount of a good that buyers are willing to purchase at a given price. **Demanded schedule:** a table that reports the quantity demanded at different prices, holding all else equal. ### Demand Curves The **demand curve** plots the quantity demanded at different prices. A demand curve plots the demand schedule. Two variables are **negatively related** if the variables move in opposite directions. **Law of Demand:** In almost all cases, the quantity demanded rises when the price falls (holding all else equal). ### Willingness to Pay **Willingness to pay**: the highest price that a buyer is willing to pay for an extra unit of a good. ![](media/image12.png)**Diminishing marginal benefit**: as you consume more of a good, your willingness to pay for an additional unit declines. ### From individual demand curves to aggregated demand curves The process of adding up individual behaviors is referred to as **aggregation**. (Ex: the worldwide demand curve for gasoline = the sum of all individual demand curves.) !!!Quantities are being added together, not prices. Economists illustrate demand curves with straight lines, but in real-world they don't tend to be perfectly straight lines. ### Building the Market Demand Curve **Market demand curve:** the sum of the individual demand curves of all potential buyers. It plots the relationship between the total quantity demanded and the market price, holding all else equal. The key property of a demand curve is the negative relationship between price and quantity demanded. ### Shifting the Demand Curve The demand curve shifts when these five major factor change: - ![](media/image14.png)**Tastes and preferences:**. The demand curve shifts only when the quantity demanded changes at a given price. If a good's own price changes and its demand curve hasn't shifted, the own price change produces a **movement along the demanded curve**. - **Income and wealth**: It affects your ability to pay for goods and services. **Normal good**: an increase in income shifts the demand curve to the right (holding the goods' price fixed), causing buyers to purchase more of the good. **Inferior good**: an increase in income shifts the demand curve to the left (holding the good's price fixed), causing buyers to purchase leff o f the good. (boites de conserve) - **Availability and prices of related goods** Two goods are **substitutes** when a rise in the price of one leads to a rightward shift in the demand curve for the other. Two goods are **complements** when a fall in the price of one leads to a rightward shift in the demand curve for the other. - **Nb and scale of buyers** When the nb of buyers increases, the demand curve shifts right. When the nb decreases, the demand shifts left. - **Buyers' beliefs about the future** If a change in these factors reduces the quantity demanded at a given price, then the demand curve shifts left. If a change in these factors increases the quantity demanded at a given price, then the demand curve shifts right. In contrast, if only the good's own price changes, then the demand curve does not shift, and we move along the demand curve. 4.3 How do Sellers Behave? -------------------------- **Quantity supplied:** the amount of a good or service that sellers are willing to sell at a given price. ### Supply Curves **Supply schedule**: a table that reports the quantity supplied at different prices, holding all else equal. The **supply curve** plots the quantity supplied at different prices. A supply curve plots the supply schedule. Two variables are **positively related** if the variables move in the same direction. **Law of Supply**: In almost all cases, the quantity supplied rises when the price rises (holding all else equal). ### Willingness to Accept **Willingness to accept**: the lowest price that a seller is willing to get paid to sell an extra unit of a good. At a particular quantity supplied, willingness to accept is the height of the supply curve. Willingness to accept is the same as the marginal cost of production. ### ### From the individual Supply curve to the market supply curve **Market supply curve**: the sum of the individual supply curves of all the potential sellers. It plots the relationship between the total quantity supplied and the market price, holding all else equal. ![](media/image16.png) ### ### ### ### Shifting the Supply Curve The supply curve shifts when these variables change: - **Prices of inputs used to produce the good** **Input**: a good or service used to produce another good or service. The **supply curve shifts** only when the quantity supplied changes at a given price. If a good's own price changes and its supply curve hasn't shifted, the own price change produces a **movement along the supply curve**. - **Technology used to produce the good** - **Nb and scale of sellers** - **Seller's beliefs about the future** 4.4 Supply and Demand in Equilibrium ------------------------------------ ![](media/image18.png)Competitive markets converge to the price at which quantity supplied and quantity demanded are the same. **Competitive equilibrium**: the crossing point of the supply curve and the demand curve. When the market price is above the competitive equilibrium price, quantity supplied exceeds quantity demanded, creating **excess supply**. When the market price is below the competitive equilibrium price, quantity demanded exceeds quantity supplied, creating **excess demand.** ![](media/image20.png)Effects of Shifts of demand and supply: !!! Demand and supply curves are formally represented by functions q of price p: Q(P). BUT, in our usual diagrams, we draw the inverse: P(Q). 4.5 What would happen if the government tried to dictate the price of gasoline? ------------------------------------------------------------------------------- Markets will end up at the competitive equilibrium only if prices are allowed to respond to market pressures. Some markets have prices that are set by laws, regulations, or social norms. Ch5 -- Consumers and Incentives =============================== 5.1 The Buyer's Problem ----------------------- "How do consumers decide what to buy?". 3 ingredients of the buyer's problem: foundations for the demand curves. 1. **What you like** The benefits that you receive from consuming goods and services = direct result of your tastes and preferences. The consumer wants to maximize the benefits from consumption. As part of the buying decision, consumer must figure out how to make the most of every dollar and must consider the trade-offs that they face. Buying decisions reveal a lot about tastes and preferences. From all the things you are able to buy, you most prefer the things that you choose to buy. 2. **Prices of goods and services** Prices allow us to formally define the relative cost of goods. We assume 2 characteristics of prices: 1. Prices are fixed. A non-negotiable sticker price. 2. Consumers can buy as much of any good as they want at the fixed price if they have sufficient money to pay for it. In this way, our consumer is a price-taker. Because each buyer is a small part of the market, an individual purchase will not have an effect on the market as a whole. When considering prices, you must take into account not only the price of the good you wish to buy but also the prices of all other available goods. The relative prices of goods determine what you give up when you purchase something. 3. **How much money you have to spend.** **The budget set**: the set of all possible bundles of goods and services that can be purchased with a consumer's income. The **budget constraint** represents the goods or activities that a consumer can choose that exactly exhaust her entire budget. 2 assumptions: 1. We assume that consumers do not save/borrow. 2. ![](media/image22.png)We plot the budget constraint as a smooth line, even though our examples will be using whole units. - We can see important trade-offs between jeans and sweaters. - ![](media/image24.png)Because the budget constraint is a straight line, its slope is constant. The slope represents the opportunity cost of one pair of jeans. This means that the opportunity cost is constant. **Consumption bundle**: a complete list of quantities for available goods. X= ([*X*~*B*~; *X*~*C*~]{.math.inline}). **Indifference curve**: graphical representation of preferences. - Indifference curves slope downward due to trade-offs: If you are indifferent between two combinations, the combination that has more of one good must have less of the other good. - Higher indifference curves correspond to higher utility levels. - Indifference curves do not cross. **Utility function**: mathematical representation of preferences. A utility function U(X) assigns to each consumption bundle an index number of happiness. For any two consumption bundles X and Y, the utility function can be used to extract the individual's preferences as follows: - If U(X) \> U(Y) then the individual strictly prefers bundle X to Y. - If U(X) = U(Y) then the individual neither prefers X to Y nor Y to X; it is indifferent between consumption bundles X and Y. Utility is an ordinal concept: - Only the ranking of utility levels has a meaning, the difference between utility levels is meaningless. - U(A)=20 and U(B)=40 does NOT mean than the individual prefers bundle B twice as much as 1. ![](media/image26.png) The **Marginal utility** of any goods i is the additional utility generated by one additional unit of good i holding the quantities of all other goods constant. This can be written as the partial derivative of U with respect to the good. MU is not interesting itself, but because it is helpful to calculate the MRS. [MRS~1, 2~]{.math.inline} = the individual's valuation of good 1 evaluated in units of good 2. The **MRS** is the slope of the indifference curve, and it falls as we move to the right along the curve. The MRS is the trade-off that a person is willing to make between two goods. **Law of diminishing MRS:** As a good bundle becomes more abundant (relative to other goods), it is easier and easier to substitute one of its units such that its "value" in terms of other goods are perceived by an individual falls: MRS Decreases! ![](media/image28.png) **Marginal rate of transformation (MRT):** the quantity of some good that must be scarified to acquire one additional unit of another good. At any point, it is the slope of the feasible frontier**. =** [\$\\frac{\\mathbf{P}\_{\\mathbf{1}}}{\\mathbf{P}\_{\\mathbf{2}}}\$]{.math.inline} = slope of BC. ![](media/image30.png) **Constrained optimization problem:** problem in which a decision-maker chooses the values of one or more variables to achieve an objective (such as maximizing profit) subject to a constraint that determines the feasible set (such as the demand curve). 5.2 Putting it all together. ---------------------------- An optimizing buyer makes decisions at the margin. - You should make your purchase decisions based on marginal benefits per dollar spent. - ![](media/image32.png)In doing so, an important conclusion results: when optimizing, the marginal benefit that you gain from the last dollar spent on each good is equal. Consumer Equilibrium Condition: Where [MB~*s*~]{.math.inline} is the marginal benefit from sweaters, [MB~*j*~]{.math.inline} is the marginal benefit from jeans, and [*P*~*s*~]{.math.inline}and [*P*~*j*~]{.math.inline} are the prices of sweaters and jeans. If marginal benefits are not equal, then you can do better by shifting consumption toward the good that has higher marginal benefits per dollar spent. In equilibrium, the ratio of marginal benefits to prices must be identical across goods. If it is not the case, then you can purchase a diff basket of goods and be better off. (cost-benefit principle). In cases where goods are not easily divisible and our decision rule cannot be met exactly, the general intuition still holds: you should always spend additional dollar on the good for which your marginal benefits per dollar spent are the largest. 1. Utility function (Cobb Douglas). 2. MU of both products (partial derivatives). 3. MRS = [\$\\frac{\\text{MU}\_{1}}{\\text{MU}\_{2}}\$]{.math.inline} 4. MRT = Slope of BC = [\$\\frac{p1}{p2}\$]{.math.inline} 5. MRT = MRS 6. Substitute into BC. ### Price changes When the price of one good relative to the price of the other good changes, the slope of the budget constraint must also change. When a price changes, the opportunity cost changes. The buyer will change the optimal quantities consumed. ![](media/image34.png) ### ### ### ### ### ### ### ### Income Changes When income is doubled, the y-intercept and x-intercept of the budget constraint also must double, because you have twice as much income. You can now buy more. Even with the expansion of income, the relative prices stay the same. 5.3 From the Buyer's Problem to the Demand Curve ------------------------------------------------ An individual's willingness to pay measured over different quantities of the same good makes up the individual's demand curve. The demand curve isolates the contribution that a good's own price makes toward determining the quantity demanded in a given time period, keeping everything else the same. **Quantity demanded:** the amount of a good that buyers are willing to purchase at a particular price. A **demand curve** maps how quantity demanded responds to price changes, holding all else equal. With the three pieces of the buyer's problem in place, we can derive your demand curve. Every point on the demand curve represents a unique price and quantity level. ![](media/image36.png) 5.4 Consumer Surplus -------------------- In markets, the process of optimal decision making by consumers often yields total benefits well above the price that we pay for goods. **Consumer surplus:** the difference between the willingness to pay and the price paid for the good. (diff between what the buyer is willing to pay and what he actually pays). !!!! Consumer surplus is different from the total benefits. **Total benefits** provide how much overall satisfaction you gain from consuming the good. ### ![](media/image38.png)An Empty feeling: loss in consumer surplus when price increases 5.5 Demand Elasticities ----------------------- **Elasticity:** the measure of sensitivity of one variable to a change in another. !!!NOT the same as the slope of a line. Elasticity measures changes in % terms. It takes into account not only the direction of change but also the size of the change. Three measures of elasticity: 1. Price elasticity of demand. 2. Cross-price elasticity of demand. 3. Income elasticity of demand. ### The Price Elasticity of Demand **Law of Demand:** when the price of a good increases, the quantity demanded falls.\ By how much? Is a good elastic or inelastic? **Price elasticity of demand** measures the percentage change in quantity demanded of a good due to a percentage change in its price. ![](media/image40.png) - Because of the Law of Demand, the price elasticity of demand will generally be negative. - The distinction between whether a good has a price elasticity of demand greater or than or less than 1 is of great import. The revenues critically depend on the price elasticity of demand. - Elasticity is very diff from the slope of the line. Even though the slope is the same over the entire demand curve (bc demand is linear), the elasticity varies. This is bc the ratio of price to quantity changes as we move along the demand curve. As this ratio grows, demand becomes more elastic. - Elasticities tend to vary over ranges of the demand curve. The elasticity is different depending on what you use as the starting and ending points. **Arc elasticity**: method of calculating elasticities that measures at the midpoint of the demand range. It achieves a stable elasticity regardless of the starting point by using the average price and quantity in the calculation: ![](media/image42.png) When doing economic analysis, computing the arc elasticity provides a more accurate description of consumer responsiveness. Elasticity Measures: - ED\>1: elastic **demand**. The % change in quantity demanded is greater than the % change in price. - Theoretically, demand may be **perfectly elastic** = demand is highly responsive to price changes, the smallest increase in price causes consumers to stop consuming the good altogether. (ED=∞) (if you raise the price by one cent, the demand is gone). - ED=1: **unit elastic demand**. A 1% price change affects quantity demanded by exactly 1%. A price increase does not affect total expenditures on the good. - ED\AVC), then each plant should expand production until marginal cost equals price. We assume that P\>AVC. The manager of the older plant will expand production until MC = P = MR. ![](media/image76.png) The total cost of production can be computed by multiplying the average total cost times the quantity (ATC X Q) Under the assumptions of a perfectly competitive market, allowing the market to operate freely not only permits each plant manager to maximize his own plant's profit by producing where MR = MC but in so doing the plants also achieve something that neither plant manager set out to do: minimize total costs of production. This is true because [MC~OLD~**=** MC~NEW~]{.math.inline}**,** which is a necessary condition to minimize total costs across the producers. In a competitive market, the second distinct function of the equilibrium price is that it efficiently allocates the production of goods in an industry. Why? Because an optimizer expands production until MC = P; thus, marginal costs are equalized across firms, because all firms face the same market price. 7.4 Prices Guide the Invisible Hand ----------------------------------- **Adam Smith:** when markets are functioning well, those who are promoting their self-interest are also promoting the interests of society more broadly, as if led by an "invisible hand" to do so. When markets algin self-interest with social interest, we obtain very desirable results. Why? Market prices act as the most important piece of information, leading the high-value buyers to buy and the low-cost sellers to sell. ![](media/image78.png)Ex: prices adjust until the quantity demanded of oceanfront property equals the quantity supplied of oceanfront property. Prices force entrepreneurs to allocate the production of goods efficiently, whether across firms in the same industry or across industries in the global economy. The flow of labor and physical capital to sectors with the highest rewards causes the production to be at just the right level in a competitive equilibrium. **Price control**: a government restriction on the price of a good or service. If price controls are binding (price is held below the equilibrium price), a shortage results: quantity demanded exceeds quantity supplied. Restricting the price to its old level does not give entrepreneurs an incentive to supply their product. When price controls are imposed, the market is no longer free to operate efficiently. ### ![](media/image80.png) ### Deadweight Loss **Deadweight loss**: the decrease in social surplus from a market distortion. Binging price controls have three effects: - They lower social surplus, bc the number of trades decrease compared to the number in a free market. - They redistribute surplus from one side of the market to the other. In this case, the surplus is transferred from producers to consumers. - For the people who benefit, there is a reallocation of surplus, which occurs through non-price mechanisms. In this case, those consumers who are willing to wait the longest, are the most connected, or those who are the strongest, receive the goods. ### The Command Economy **Gross domestic product (GDP):** the market value of final goods and services produced in a country in a given period of time. ### The Central Planner Two problems: When the interests of economic agents coincide, a **coordination problem** of bringing the agents together to trade arises. When the optimizing actions of two economic agents are not aligned, these agents face an **incentive problem**. Two solutions: - **Command economy**: central agency directs resources, provides incentives. - **Market economy**: prices direct flow of resources, provide incentives for participants. BUT in planned economies, rewards are based on meeting quantity targets, not quality. Reason for the fall of most planned systems: the central planner does not fully understand consumer wants and needs and the production capabilities of every sector of the economy, and it is difficult to incentivize workers if prices are not utilized. Because any individual knows only a small fraction of all that is known collectively, it is impossible to replicate the work of the invisible hand. In a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation are made to use the material or its products more sparingly; that is, they move in the right direction. 7.5 Equity and Efficiency ------------------------- A market economy has features that are remarkable at providing price signals that guide resources in a way that maximizes social surplus and makes the economy efficient. Market forces act to eliminate waste, guiding resources to their correct destinations, and provide incentives for all market participants to promote their own interests, whin in turn promote the broader interests of society. Maximizing efficiency directs us toward marketing the societal pie as large as possible. Another consideration is how the pied is allocated. **Equity** is concerned with the distribution of resources across society. = An even distribution of goods across society. Several questions arise concerning equity and efficiency. These are questions in the domain of normative economics, and they are often debated by policymakers and economists. In a perfectly competitive equilibrium, we know that Pareto efficiency holds. It is not possible to make a starving African child better off without making someone else worse off. In order to increase the well-being of the child, it will be necessary to take a few hundred dollars from other people. This kind of intervention presents an important trade-off between efficiency and equity. This is one major purpose of taxation. Perfectly competitive markets do not necessarily result in outcomes that we, as a society, would consider to be fair. Ch9 -- Externalities and Public Goods ===================================== 9.1 Externalities ----------------- Assuming the electricity industry is a perfectly competitive market: At the equilibrium point, the two lines that intersect and the invisible hand most efficiently allocates resources: social surplus is maximized. BUT, when producing electricity, plants emit nasty pollutants which can cause lung irritations and pneumonia. The power plant imposes an externality on the public as a by-product of producing electricity. An **externality** occurs when an economic activity has either a spillover cost to or a spillover benefit for a bystander. (in this case, a negative externality). Because the owners of the plant do not have to pay for the costs that the plant imposes on society, they do not take into account the health or discomfort of the citizenry in their production decisions. Free markets allocate resources in a way that ignores these negative externalities. ### ### A "broken" Invisible Hand: Negative Externalities The market is efficient because social surplus is maximized, and plants expand production until MC = MR = P. BUT, when there are negative externalities present, this market outcome is no longer efficient. Negative externalities impose an additional cost on society that is not explicitly recognized by the buyers and sellers in the market. In computing the efficient outcome, we must adjust the supply curve to take account of the negative externalities or external costs. The supply curve is the marginal cost curve for the firm and includes a plant's expenditures for inputs, such as labor. The external costs that society bears are ignored.\ To arrive at the efficient production level, we need to recognize both the firm's marginal cost and the marginal external costs of production. Together, they sum to **the marginal social cost of production**. **MSC** = Marginal cost + Marginal external cost. [*Q*~optimal~ ]{.math.inline} is less than [*Q*~market~]{.math.inline}, bc when a negative externality must be accounted for, a smaller quantity of electricity should be generated since it is now more costly to produce each unit. Yellow-shaded region: the area between the marginal social cost curve and the market demand curve between units [*Q*~optimal~ ]{.math.inline}and [*Q*~market~]{.math.inline}. The triangle represents the sum of the losses for each unit, the difference between the total marginal cost and total marginal benefits to society as a whole. Yellow-shaded triangle = deadweight loss of the negative externality. A deadweight loss is usually in the form of a triangle with the arrow pointing in the direction that society would prefer. ### ### A "Broken" Invisible Hand: Positive Externalities **Positive externalities** occur when an economic activity has a spillover benefit that is not considered when people make their own decisions. Ex: educational attainment not only helps a student through better employment opportunities and higher wages but also confers significant benefits on others (⇑ civic engagement, ⇓ crimes). Assuming that education is a perfectly competitive market, [*Q*~market~]{.math.inline} is an efficient outcome: with no externalities, the invisible hand is driving the market to an efficient equilibrium. BUT, in the case of positive externalities, the invisible hand does not yield socially efficient results. Positive externalities create external social benefits that are reaped by others. ![](media/image82.png)The efficient amount of education from the point of society is given by [*Q*~optimal~ ]{.math.inline}. This is where society's marginal benefit from another unit of education equals the marginal cost of producing that unit of education. But this won't be the same as the equilibrium quantity in a free market. The education industry will only produce until its MC = the private demand for education, not the social demand. ![](media/image84.png) ### Pecuniary Externalities The two types of externalities we have just seen create market inefficiencies. A **pecuniary externality** occurs when a market transaction affects other people only through market prices. (millions of new consumers enter the market and buy iPhonemarket demand will shift rightward, increasing price). Pecuniary externalities do NOT create market inefficiencies.\ Negative and Positive externalities lead to "wrong" equilibrium quantities because they create an external cost or external benefit that is not reflected in the market price. Pecuniary externalities don't create these effects because their impact is completely embodied in prices, the market price correctly reflects the society-wide impact of market transactions. Pecuniary externalities are necessary for efficient markets bc as goods become more or less scarce, their price should change. 9.2 Private Solutions to Externalities -------------------------------------- ExternalitiesMarket outcome inefficient. 1. Negative externalitiesFree markets produce and consume too much. 2. Positive externalitiesFree markets produce and consume too little. How to achieve a more efficient outcome? When agents account for the full costs and benefits of their actions, they **are internalizing the externality.** When the external effects of their actions are internalized, the market equilibrium moves toward higher social well-being. ### ### The Coase Theorem A **property right** gives someone ownership of a property or resources. **The Coase Theorem** states that private bargaining will result in an efficient allocation of resources if transaction costs are zero. The person who values ownership the most will end up owning the property right, the outcome will match his preferences. NEVER bc transaction costs are never zero. Government intervention is not necessary to solve externality problems, private bargaining can do the job. Although we reach the efficient outcome regardless of initial property rights, who holds the initial property rights is not irrelevant. The initial property right allocation is an important determinant of the final distribution of surplus. We should be cautious about relying too much on private solutions to externalities: 1. The assumptions that the parties involved, those creating the externality and those suffering from it, can negotiate economically is critically important. As long as the transaction costs associated with negotiations aren't too high, the efficient economic outcome can be achieved. 2. Whether the property right is clearly defined is important; in many cases, the law is not clear on who holds it. 3. It's easy enough to imagine that bargaining can lead to an efficient solution with a small nb of affected people. But it is more difficult to see how much bargaining could work between, say, a power plant and 100000 affected fishermen. Even when property rights are perfectly established, the cost of bargaining itself, the **transaction costs** associated with making an economic exchange might be too high to permit this sort of arrangement from happening. (legal fees, time, awkward situation). 9.3 Government Solutions to Externalities ----------------------------------------- Governments respond to externalities in two main ways: 1. **Command-and-control policies**, in which the government directly regulates the allocation of resources. 2. **Market-based policies**, in which the government provides incentives for private organizations to internalize the externality. ### Government Regulation: Command-and-Control Policies If negative externality: [*Q*~market~]{.math.inline} \> [*Q*~optimal~ ]{.math.inline}. **Command-and-control regulation** either directly restricts the level of production or mandates the use of certain technologies. Rather than focusing producer efforts on developing cheaper ways to use the mandated technology, the regulator should incentivize producers to find or dvlp the most cost-effective technologies. ### Government Regulation: Market-Based Approach A **market-based regulatory approach** internalizes externalities by harnessing the power of market forces. The most prominent market-based approaches to dealing with externalities are corrective taxes and subsidies. 1. Corrective Taxes **Pigouvian tax / Corrective tax**: tax designed to induce agents who produce negative externalities to reduce quantity toward the socially optimal level. 1^st^ step: estimate the MEC (marginal external cost). 2^nd^ step: levy a corrective tax in this amount to reduce the equilibrium quantity to the social optimum. you levy a per-unit tax equal to the marginal external cost of the externality. Because the level of the tax is equal to the difference between S and MSC, plants now choose a profit-maximizing output that is equal to [*Q*~optimal~. ]{.math.inline} The Pigouvian tax creates a virtual market supply curve that is identical to the MSC curve by having each plant consider the externality when making production choices. They consider the externality bc they account for the tax when making their production decisions. ### Corrective Subsidies **Corrective Subsidies / Pigouvian Subsidies** are designed to induce agents who produce positive externalities to increase quantity toward the socially optimal level. 1^st^ step: estimate the MSB (marginal social benefit). 2^nd^ step: levy a corrective subsidy in this amount to increase the equilibrium quantity to the social optimum. you levy a per-unit subsidy equal to the marginal social benefit of the externality. Because the level of the subsidy is equal to the difference between D and MSB, individuals now have an incentive to choose the socially efficient level, or [*Q*~optimal~ ]{.math.inline}. The Pigouvian subsidy creates a virtual demand curve that is identical to the MSB curve by having individuals consider the externality. You consider the externality bc when making your decision, you take account the corrective subsidy. The subsidy aligns your and society's incentives. Externalities potentially drive a wedge between social benefits and costs and private benefits and costs. This wedge creates a distortion (deadweight loss) if the quantity levels of the free-market equilibrium diverge from those of the social optimum. Corrective taxes and subsidies can cause agents to internalize their externalities. In using such taxes, the government raises tax revenues and algins private and social incentives. To do so, it relies on estimates of externalities. Ch10 -- The Government in the Economy: Taxation and Regulation ============================================================== 10.1 Taxation and Government Spending in the US ----------------------------------------------- The federal government collects only about two-thirds of total taxes in the US economy. There are also state and local governments that impose and collect taxes and spend the revenue they generate. ![](media/image86.png)State government hold jurisdiction over particular states.\ Local governments exist at the country and city levels. A **budget deficit** occurs when tax revenues do not cover government spending. A **budget surplus** occurs when tax revenues exceed government spending. ### Where does the money come from? **Tax revenues, or receipts**, are the money a government collects through a tax. These are collected via various types of taxes. Federal receipts: 1. **Individual** **income taxes** represent the largest portion. 2. Payroll taxes represent about a third of the federal government's receipts. **Payroll tax / Social insurance tax**: a tax on wages that employers are required to withhold from employee's pay. (Often listed as Federal Insurance Contribution Act tax, or FICA taxes). 3. Corporate income tax provides 10% of the overall pie. **Corporate income tax**: taxes paid by firms to the government from their profits. 4. All other taxes make up the remaining 9%. This includes **excise taxes**, which are paid when purchasing specific goods such as alcohol, tobacco, and gasoline. Source of revenue for state and local governments: 1. 30%: All Other category, which encompasses miscellaneous taxes and fees that state and local governments collect. These include tolls on roads and sales from public transportation tickets, vehicle licenses, and hunting and fishing licenses. 2. 22%: **Revenue from the Federal Government**: taxes collected at the federal level and then redistributed to the states (used to redistribute resources toward power states). 3. 18%: **Sales taxes**: paid by a buyer, as a percentage of the sale price of an item. The value-added tax (VAT) is similar to the Sales tax, except that it is imposed at each stage of the production process leading up to the final sale rather than being entirely collected at the time of sale of the final good. 4. 17% **Property taxes**: taxes on land and structures on which local governments rely to fund schools, libraries, and public services such as policies and fire protection. 5. 13% **Individual income taxes**. ![](media/image88.png) ### Why Does the Government Tax and Spend? Factors influencing government taxation and spending decisions: - **Raising revenues** Most taxation is intended to raise revenues for the funding of public goods such as national defense, public education, police protection and infrastructure projects. Markets often fail to provide optimal amounts of public goods Governments levy taxes and use the returns for the provision of public goods. ![](media/image90.png)(Education, policing and infrastructure are all included in the "Other" category, but not for state and local governments). - **Redistributing funds via transfer payments** Market outcomes can be inequitable. Governments use transfer payments and the tax system to limit the extend of such inequality and the economic hardships that the poorer households in the society suffer. **Transfer payments:** payments from the government (which are not made as a payment for the provision of a good or service) to certain groups, such as the elderly or unemployed. **BUT the tax system itself is progressive, meaning highly redistributive in many economies.** **A progressive tax system is one in which tax rates increase with taxable base income.** **The average tax rate for a household is given by total taxes paid divided by total income.** **The marginal tax rate refers to how much of the last dollar earned is paid out in tax.** In a **proportional tax system**, households pay the same % of their income in taxes regardless of their income level. The marginal and average tax rates do not vary with income. In a **regressive tax system**, the marginal tax and average tax rates decline with income so that low-income households pay a greater % of income in taxes than do high-income households. - **Financing operations** Governments tax to pay for their own operations: salaries of presidents, members of Congress and other politicians, and the sizable bureaucracy in charge of the day-to-day running of government operations and services. - **Correcting market failures and externalities.** ### Taxation: Tax Incidence and Deadweight Losses The tax burden can be shared between a buyer and a seller even if it seems to fall on just one of them. **Tax Incidence** refers to how the burden of taxation is distributed. The deadweight loss of taxation is the loss in total surplus due to the gap that the tax has created between the price received by sellers and the price paid by consumers. (c): we see that government has taken the portion of pre-tax consumer surplus labeled "Incidence on consumers". We calculate this by finding the portion of tax revenue that lies above the pre-tax equilibrium. This portion of tax revenue used to be part of consumer surplus but is no longer part of it. It represents the incidence of taxes on consumers. Similarly, the portion of tax revenue that lies below the pre-tax equilibrium is the incidence of the tax on producers, the portion of tax revenue that is lost producer surplus. ![](media/image92.png)Both buyers and sellers bear its burden. In competitive markets, tax incidence and equilibrium prices and quantities are independent of whether the tax is imposed on consumers or producers. ### The Effects of Demand and Supply Elasticities on the Tax Burden The fact that the incidence of the tax is identical for buyers and sellers in the examples above is drew to how we drew the market and demand supply curve. Buyers and sellers were equally sensitive to price changes at the original equilibrium. BUT in general, the elasticity of market demand will NOT be the same as the elasticity of market supply. ![](media/image94.png) When the supply curve becomes more elastic, a smaller portion of tax revenues lies below the pre-tax market price. Buyers bear more of the tax burden bc the market supply curve is more elastic than the market demand curve. If the demand curve is more elastic than the supply curve, the producers bear more of the burden of the tax. General rule: the tax burden falls less heavily on the side of the market that is more elastic, that is, more responsive to price changes. The more inelastic bears the burden. When supply is more elastic than demand, the tax burden falls more heavily on buyers. When demand is more elastic than supply, the tax burden falls more heavily on sellers. Intuition: When buyers are more price-elastic, they have more alternatives to turn to. If buyers are price inelastic, they have few good alternatives. This means that the more elastic buyer will bear less of the price increase than the less elastic buyer. Same for producer. As supply and demand becomes more price-elastic, the deadweight loss of taxation increase. This means that the greater the price elasticity of either supply or demand, the greater the deadweight loss will be, all other things being equal. 10.2 Regulation --------------- The main tool that governments use to deal with externalities and other sources of market failures is regulation. **Regulation**: actions by the federal or local government directed at influencing market outcomes, such as the quantity traded of a good or service, its price, or its quality and safety. Governments regulate the activities that create negative externalities. They also use regulation to limit the market power of certain firms, which, by creating a departure from competitive markets, constitutes another major source of market failures. ### Direct Regulation **Direct regulation (command-and-control regulation)**: direct actions by the government to control the amount of a certain activity. It affects just about every walk of life, from the safety of foods and drugs to the miles per gallon our cars achieve to when we can drop out of school. Though regulation plays an indispensable role in society, it has costs and limitations. Ex: shortage of physicist. The government proceeds to use quantity regulation to choose 5000 people to become physicist. It would not yield an efficient result. Unlike market forces that guide resources to their best use, this type of command would fail bc you can't force people into a career. A Pigouvian subsidy is a viable alternative, bc it uses market forces to encourage people at the margin to internalize the externality. ### Price Controls: Price Ceilings and Price Floors ![](media/image96.png)**Price ceiling:** a maximum price on a market good. ![](media/image98.png)The only time price ceilings have an effect on the market is when they are below the market clearing price. **Price Floor**: a lower limit (below which the price cannot fall) on the price of a market good. A price floor has similar implications to those of a price ceiling, except that instead of a shortage, a price floor causes a surplus, quantity supplied at a price floor would typically be greater than quantity demanded. Because price floors tend to keep the price artificially high, surplus is shifted from consumers to producers.\ A price floor not only has deadweight loss but also reallocates surplus to sellers. 10.4 Equity Versus Efficiency ----------------------------- Two faces of governments: 1. Provides valuable services ranging from public goods to efficiency-enhancing regulations and redistributions. 2. Introduces deadweight losses via taxation or unnecessary regulations and corruption. Balance? The **equity-efficiency trade-off** refers to the balance between ensuring an equitable allocation of resources (equity) and increasing social surplus or total output (efficiency). These two goals are often, but not always, in conflict. Economic analysis does not tell us what those value judgments should be, but such analysis is crucial because it determines the shape of the curve, thus providing us the menu from which we have to make our choices between equity and efficiency, and because it also highlights some of the choices that are "dominated" (always worse than other options). The **welfare state**: the set of insurance, regulation, and transfer programs operated by the government, including unemployment benefits, pensions, and government-run and -financed healthcare. Ch8 -- Trade ============ 8.1 The Production Possibilities Curve -------------------------------------- We can all be better off by trading with one another, because trade allows total production to be maximized. ![](media/image100.png)A **Production Possibilities curve (PPC)** shows the relationship between the maximum production of one good for a given level of production of another good. It highlights the trade-offs that you make deciding what to produce. - Points on the PPC are attainable and efficient. - Points inside the PPC are attainable but inefficient. - Points beyond the PPC, are unattainable. ### ### ### ### Calculating Opportunity Cost What you give up to produce one additional web site: ![](media/image103.png)What you give up to produce one additional computer program: 8.2 The Basis for Trade: Comparative Advantage ---------------------------------------------- ![](media/image105.png)**Comparative advantage:** the ability of an individual, firm, or country to produce a certain good at a lower opportunity cost than other producers. The key to determining who has a comparative advantage: compare individual opportunity costs. ### Specialization Complete specialization occurs when each individual, firm, or country produces only what it has a comparative advantage in and relies on trade for the other goods and services it needs. ### Absolute Advantage **Absolute advantage**: the ability of an individual, firm, or country to produce more of a certain good than other competing producers, given the same amount of resources. Gains to trade still remain because even though you can produce more websites and more computer programs in a given day than Olivia can produce, you do not have a comparative advantage in producing both goods. ![](media/image107.png)With linear PPCs, unless two people have exactly the same opportunity cost, one will always have a comparative advantage in producing one good and the other person in producing the other good. Always interest to trade unless same opportunity cost. ### The Price of the Trade The **terms of trade:** the negotiated exchange of goods for goods (1 for 1, 2 for 1...). The principle of comparative advantage does not provide an exact terms of trade, but it does provide a range in which trade will occur. In this way, it prescribes how the gains to trade are split between the two parties. In this example, if the exchange rate is 1 computer program for 1 website, you are worse off from trade because you are working 30 days, whereas with no trade you need to work 25 days. At a one-for-one trading rate, you would not participate in the trade. At which range of terms of trade would it be beneficial to both of you? Consider each person's computer program opportunity cost.\ You give up 3/2 websites for every computer program you produce. For you to give Olivia one computer program, she must give you at least 3/2 websites. For Olivia: Given her opportunity cost, the most she is willing to give up for 1 computer program is 2 websites. For both people to engage in the trade, the trading price must lie between their opportunity costs. Prices closer to 3/2 websites per program favor Olivia, while prices closer to 2 websites per program favor you. The gains to trade shrink as the trading partners become more alike. 8.3 Trade Between States ------------------------ If trade were not allowed to occur between states, by law or because transportation costs were too high, some people might lack even the most basic modern necessities. **Export:** any good that is produced domestically but sold abroad. **Import:** any good that is produced abroad but sold domestically. ### Economy-Wide PPC Imagine adding together the PPCs of hundreds of thousands of people, you quickly get a smoothly curved line pointing away from the origin. The curvature represents the general principle of increasing opportunity cost. We see increasing opportunity costs in the economy wide PPC because moving to production extremes is difficult, as some inputs are quite well suited for producing apples, whereas other inputs are better suited for producing oranges. ![](media/image109.png)As you move resources increasingly into production of one good, the opportunity cost of doing so increases at an increasing rate. [Short Run:] PPC is fixed. [Long Run]: resources are not fixedincreases in natural resources or changes in productivity due to population growth, changes in technology, and increases in worker education shift the PPC outward. 8.4 Trade Between Countries --------------------------- Large increase in trade: the world is becoming more interdependent. **Net importer**: a country for which imports are worth more than exports over a given time period. Until recently, most manufactured goods on the world market were produced in advanced economies. Recently, China has surpassed the US in manufactured exports. The value of manufactured exports from China now far exceeds that from the US and other dvlpd nations. ![](media/image111.png)China's growth is indicative of the pattern of trade observed for developing countries as a whole. ### Determinants of Trade Between Countries **Free trade:** ability to trade without hindrance or encouragement from the government. **World price**: prevailing price of a good on the world market. - If the domestic price is below the world price: exporter. - If the domestic price is above the world price: importer. ### Exporting Nations: Winners and Losers When a country open itself to trade and becomes an exporter of goods and services: 1. Sellers win. 2. Buyers lose. ### ![](media/image113.png)Importing Nations: Winners and Losers When a country opens itself to trade and becomes an importer of goods and services: 1. Sellers lose. 2. Buyers win. Once again, the overall gains to trade for Denmark are positive. Denmark is much better off, allowing the winners to potentially compensate the losers. Taxing consumers and sending the revenues to producers is one way in which such compensation can take place. ### Where do world prices come from? As countries open up their borders and act on their comparative advantages, the sum of all these actions lets us consider a world supply and a world demand for a product. Intersection of these two = world price. ### ### Determinants of a Country's Competitive Advantage Factors that contribute most comparative advantage at the country level: 1. Natural resources (to a large degree, beyond the countries' control, unless squandered). 2. Stocks of human-made resource (more controllable, depend on the PPC) 3. Technology 4. Education, work habits, and experience of labor force 5. Climate Comparative advantage can change over time. 8.5 Arguments against free trade -------------------------------- 1. **National security concerns** Trade not optimal in a defense-oriented world. A country won't produce just oranges if it fears military attack from other nations. Rather, it will invest in defense technology and will maintain a variety of agricultural industries to preserve its integrity in times of war. Likewise, a country might be hesitant to completely specialize, bc it might find itself too reliant on other countries. 2. **Fear of the effects of globalization on a nation's culture** **Globalization**: the shift toward more open, integrated economies that participate in foreign trade and investment. As the world becomes increasingly interdependent, it also becomes more homogeneous. 3. **Environmental and resource concerns** Tangible goods are not the only things traded by countries; such abstract goods as environmental quality may be traded as well. Countries with lax environmental policies allow for more pollution from firms than do countries with strong environmental policies. These countries, in an effort to promote economic growth and jobs, use lax pollution regulations to attract industry. 4. **Infant industry arguments** These arguments rely on the idea than in industries with economies of scale or substantial learning by doing, it is important for policymakers to protect local firms early in their dvlpt. \+ Starting a cp in isolation may deprive it of "technological spillovers" that is competitors, all located near one another, may enjoy, the isolated cp will be the last to learn of trade secrets. Basis of any infant industry argument: a cp is currently too weak to withstand competition from other firms. To survive, the cp requires government protection.\ **Protectionism**: the idea that free trade can be harmful, and government intervention is necessary to control trade. One form of protectionism: tariffs. [The effects of Tariffs] **Tariffs**: taxes levied on goods and services transported across political boundaries. !!! It is not free. Tariffs interfere with equilibrium prices and quantities, artificially reducing social surplus in a country. We can see one reason economists in general do not favor such protectionism: it raises prices for consumers and lowers social surplus. 5. **Potential negative effects on local wages and jobs** Ch12 -- Monopoly (12.1-12.5) ============================ 12.1 Introducing a New Market Structure --------------------------------------- A more common market situation than perfect competition is one in which a firm is not simply a price taker, but a price-maker. **Price makers**: sellers that set the price of goods. Such a firm has the ability to set the price of the good because it has market power. **Market power**: the ability of sellers to affect prices. **Monopoly:** an industry structure in which only one seller provides a good or service that has no close substitutes. In this way, a monopolist is not concerned with the behavior of other sellers. The price chosen by the monopolist is one that makes the cp the highest profit. ![](media/image115.png) 12.2 Sources of Market Power ---------------------------- The ability of a cp to control a market (=gain market power) relies on barriers to entry. **Barriers to entry:** obstacles that prevent potential competitors from entering the market. They provide the seller protection against competition. It ranges from complete exclusion of market entrants to prevention of a new firm from entering. Two types of market power arise from barriers to entry: 1. **Legal Market Power.** A firm has legal market power when it obtains market power through barriers to entry created not by the firm itself but by the government. (patents and copyrights). **Patent:** the privilege granted to an individual or cp by the government, which gives him or her the sole right to produce and sell a good. **Copyright**: exclusive right granted by the government to the creator of a literacy or artistic work. Copyright protection is diff across countries and in many cases extends long after the author's death. Such exclusivity laws = benefit for the innovator-turned-monopolist. They can charge higher prices than would occur under perfect competition. As consumers, we are all worse off, bc we must pay higher prices for these goods BUT: - Patents and copyrights are only temporary, and eventually ally the protected goods enter the public domain. At that time, other producers are able to distribute them. - Blockbuster drugs and best-selling books are difficult and costly to produce, and without the increased incentive for creative activity, the expensive investment to create new prescription drugs or best-selling books might never be made. 2. **Natural Market Power** Natural Market Power occurs when a firm obtains market power through barriers to entry created by the firm itself. Two main sources of monopoly power: - [The monopolist owns or controls a key resource necessary for production]. **Key resources:** materials that are essential for the production of a good or service. The most basic way for a firm to dvlp market power naturally is to control the entire supply of such resources (assuming that no substitutes). Ex of key resources: apartment complex, diamond mines, creative talents, individual expertise. **Network externalities** occur when a product's value increases as more consumers begin to use it. - [There are economies of scale in production over the relevant range of output. ] Monopolies also form bc it is practical for both producers and consumers. Ex: transmission of electricity. Better to have one provider serve the entire town bc of the economies of scale that the single provider enjoys. **Economies of scale** occur when the ATC per unit of output decreases as total output increases. In this case we have assumed a constant marginal cost. This means that over the entire production range of interest, the marginal cost is the same. For goods and services that have economies of scale over the relevant range of output; it is efficient for a single firm to serve the entire market, bc it can do so at lower cost than any larger nb of firms could. **Natural monopoly**: a market in which one firm can provide a good or service at a lower cost than can two or more firms. Often such firms are the first suppliers in a given market, and the cost advantages they achieve through producing a large nb of goods preclude would-be competitors from entering. \>\< to monopolies that arise through legal means, natural monopolies emerge when unique cost conditions characterize their industry. Because of these cost conditions, natural monopolists worry less about potential market entrants than do monopolies that arise through legal means. Large economic profits attract entrants +++ in legal monopolies. This is bc potential entrants realize that they cannot achieve the low costs of the natural monopolist, bc on entry they likely will "split the market". Much higher costs and lower profits for each seller. 12.3 The Monopolist's Problem ----------------------------- 2 important similarities with the perfectly competitive seller's problem: 1. The monopolist must understand how inputs combine to make outputs. 2. The monopolist must know the costs of production. All of the production and cost concepts applied for PCM apply to this.\ \ BUT one important diff; At the market price, the perfectly competitive cp can sell as many units as it wishes. But if it charges a bit more, it will lose all of its business bc consumers can buy identical good from another seller who is ready to sell at a lower price. If it charges a bit less, it sells the same nb of units but does not raise as much revenue. A firm facing a perfectly elastic demand curve is a price-taker. Because the monopolist is the sole market supplier, it faces the market demand curve, which is downward sloping. The monopolist can increase price and not lose all of its business. ![](media/image117.png)The market demand curve tells us exactly the trade-off the monopolist faces when it changes its price. Of course, the monopolist prefers to sell a lot of units for a high price, but the downward sloping market demand curve makes this outcome impossible. A monopoly is powerful, but it cannot sell at a point above the market demand curve. ### Revenues Curves Important trade-off between price and quantity sold that the monopolist faces: a higher price yields more revenue per unit sold, but fewer units sold. High fixed costs are typical for industries that spend large amounts of money on researching and dvlp products. In such instances, it is common for marginal cost to be constant over large ranges of output, bc mass production of the product leads each additional unit of production to have a constant additional cost per unit. ![](media/image119.png) If you lower the price from \$5 to \$4, you bring 600 M more in total revenues.\ This arises from two effects: - **Quantity effect**: the lower price allows you to sell 200 million more units = increase in revenues. - **Price effect:** those people who were buying at the old price now only have to pay \$4 = loss in revenues. In this case, the price effect is smaller than the quantity effect. This means that demand is elastic over this range of the demand curve. More general pattern: With price decreases, moving down the D curve, when the quantity effect dominates the price effect, then total revenue increases. If the price effect dominates the quantity effect, then total revenue falls. Alternatively, if price increases, the nature of these relationships' reverses. ![](media/image121.png) ### Price, Marginal Revenue, and Total Revenue Demand curve and marginal revenue curve: The curves begin at the same point on the price axis, bc the price of Claritin is the marginal revenue from selling the first unit of Claritin. Thereafter, marginal revenue lies below the demand curve, and as quantity expands the difference between the demand curve and the marginal revenue curve grows larger. This is bc for the monopoly to increase its sales, it must lower the price on all goods sold. For every linear demand curve: the marginal revenue curve is twice as steep as the demand curve, because the slope of the marginal revenue curve is twice as large (in absolute value) as the slope of the demand curve. The total revenue for Claritin is hill-shaped. When total revenue is rising, marginal revenue is positive. When total revenue is falling, marginal revenue is negative. Total revenue is at his maximum when the marginal revenue curve crosses the quantity axis, that is the point where an additional unit of output causes marginal revenue to equal zero. To maximize revenue, the cp should set price where the elasticity of demand equals 1. This price is exactly in the middle of the demand curve. This means that for prices above \$3 (the elastic portion of the demand curve), a price increase will lower total revenue. Alternatively, for prices below \$3 (the inelastic portion of the de- mand curve), a price increase will raise total revenue. 12.4 Choosing the Optimal Quantity and Price -------------------------------------------- ### Producing the Optimal Quantity The profit maximizing level of output produced is given by the intersection of the marginal revenue and marginal cost curves.\ MC = MR = P. One difference: whereas firms in a perfectly competitive market are price-takers, monopolists are price-makers, they set the price for they goods or services, because there are no competitors. ### Setting the Optimal Price The pricing decision is linked to the nature of the market demand curve. ![](media/image123.png) ![](media/image125.png)Steps in the production and pricing decisions facing the monopolist: Similar to perfectly competitive market BUT price is set at a level higher than marginal cost for a monopolist, whereas price is equal to marginal cost for a perfectly competitive firm. Monopolist: Set P\>MR=MC. Perfectly competitive firm: P=MC=MR. The marginal decision making concerning the level of production is identical across these two market structures: expand production until MC=MR. The difference arises from the fact that the firm in a competitive industry does not set its price (the market does), whereas the monopolist sets a price based on the market demand curve. The monopolist sets a price that is on the elastic portion of the demand curve (Ch5: the top half of a linear demand curve is elastic) ### How a Monopolist Calculates Profits Monopolists, unlike sellers in competitive markets, do not have a supply curve. To create a supply cure under perfect competition, it is necessary for firms to be price-takers, whose production is based on the given market price. Under this assumption, we simply determine the quantity at which the marginal cost of producing the last unit of a good is equal to the market price. Monopolists, as price-makers, do not vary their production based on market price bc they set the price; it makes no sense to ask how much of a good a monopolist will produce at a given price. Monopolists will produce at MR=MC, but MR depends on the negatively sloped demand curve that the monopolist faces. A monopolist's production decision is based on demandit cannot be depicted as an independent supply curve. 12.5 The "Broken" Invisible Hand: the Cost of Monopoly. ------------------------------------------------------- The Invisible hand creates harmony between individual and social interests. Social surplus is maximized. Important factor that can break the powerful result of the invisible hand: market power. A firm that exercises market power causes a reallocation of resources toward itself, thereby sacrificing social surplus. Ex: Market for Claritin before and after the patent expired. Patent Monopoly. Monopoly rights expiredgeneric drugs could enter the market and sell close substitutes. (a): long-run equilibrium of the market after the patent's expiration. Firms have a constant MC curve, so ATC=MC (no fixed costs in the long-run). The equilibrium price is lower (\$1)boom in quantity demanded. (b): Before Claritin's patent expired. Consumer surplus was dramatically smaller. ![](media/image127.png)This cost to society is DL = surplus that would exit in the competitive equilibrium but is lost when the cp is a monopoly. Ch13 -- Game Theory and Strategic Play ===========================

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