econ topic 4 quizlet.pdf

Normative vs positive analysis • Normative economic principle: One that says how people should behave. • Positive economic principle: One that predicts how people will behave Market efficiency • Use welfare economics to assess whether the equilibrium price and quantity in a competitive market maximi...

Normative vs positive analysis • Normative economic principle: One that says how people should behave. • Positive economic principle: One that predicts how people will behave Market efficiency • Use welfare economics to assess whether the equilibrium price and quantity in a competitive market maximise the total welfare of buyers and sellers • Welfare economics is the study of how the allocation of resources affects economic wellbeing • About the desirability of the outcome of free markets • Findings: Equilibrium in the market maximises the benefits consumers and producers receive from taking part in the market, that is, total welfare for both the consumers and the producers of the product. Welfare Economics • Buyers and sellers receive benefits from taking part in the market • Want to measure them • Consumer surplus: measures economic welfare from the buyers side • Producer surplus: measures economic welfare from the sellers side Consumer Surplus • Willingness to pay is the maximum amount that a buyer will pay for a good – It measures how much the buyer values the good or service. • Consumer surplus is the buyers willingness to pay for a good minus the amount the buyer actually pays for it – It measures the (net) benefit that buyers receive from a good as the buyers themselves perceive it. Consumer Surplus • Measuring consumer surplus using the demand curve • The area below the demand curve and above the price measures the consumer surplus in the market. Producer Surplus Producer surplus is the amount a seller is paid for a good minus the sellers cost. – It measures the benefit to sellers participating in a market – Just as consumer surplus is closely related to the demand curve, – Producer surplus is closely related to the supply curve. Producer Surplus • Measuring producer surplus using the supply curve • The area below the price and above the supply curve measures the producer surplus in a market. Is the allocation of resources determined by competitive markets desirable? Imagine there is a fictional benevolent social planner (an all-knowing, all-powerful, well-intentioned dictator) who wants to maximise society's well-being. What kind of an allocation would they choose? Is the allocation of resources determined by competitive markets desirable?A feasible allocation is Pareto-efficient if there is no other feasible allocation in which some participant in the economy is strictly better off and no-one else is worse off. • Which allocation would the planner choose? 1. Demand of goods should be allocated to sellers who can produce them at least cost. 2. Supply of goods should be allocated to buyers who value them most highly. 3. The quantity supplied and demanded must maximise total surplus received by all members of society. Efficiency • Total surplus = Producer surplus + Consumer surplus. • Because – Producer surplus = amount received by sellers - cost of sellers; & – Consumer surplus = value to consumers - amount paid by buyers • we have – Total surplus = value to consumers - cost of sellers • Maximising total surplus requires the “last” unit produced and consumed to create a value to buyers that equals its cost to sellers. Market allocation • What allocation is chosen in a competitive market? • Price determines which buyers and sellers participate in the market: – Only buyers who value the good more than the price choose to buy the good; – Only sellers whose costs are less than the price choose to produce and sell the good. • Law of demand and supply: Price adjusts such that quantity demanded equals quantity supplied. – The last unit supplied and demanded creates a value to buyers that equals its costs to sellers. Market allocation • Insight: The equilibrium allocation in a perfectly competitive market is efficient. – Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. – Free markets allocate the demand for goods to the sellers who can produce them at least cost. – Free markets produce the quantity of goods that maximises the sum of consumer and producer surplus. • Policy Implication: Laissez-faire. As the equilibrium outcome is an efficient allocation of resources, the social planner can leave it as they finds it. Disclaimer There are conditions for the equilibrium outcome to be an efficient allocation – There must not be market power. – There must not be externalities. – There must not be asymmetric information about the good traded in the market. Externalities • An externality arises when a person engages in an activity that influences the wellbeing of a bystander and yet the person neither pays nor receives any compensation for that effect. – If the impact on the bystander is adverse, the externality is called a negative externality. – If the impact on the bystander is beneficial, the externality is called a positive externality. Example (Negative externalities) – Car exhaust; – Cigarette smoking; – Barking dogs (loud pets); – Lawn mowers; – Loud music in an apartment building, etc. Example (Positive externalities) – Immunisations; – Restored historic buildings; – Research into new technologies; – Studying for an Economics degree; – Classic example of two-way positive externality: Pollination of trees in orchard by bees of a nearby beehive, which collect nectar in the orchard. Competitive markets without externalities If there are no externalities, the quantity produced and consumed in the market equilibrium is efficient: it maximises the sum of producer and consumer surplus. Effect of a negative externality in production Assume the production causes pollution, leading to an external cost( c ), per unit produced. Then the cost to society of producing a good is larger than the cost to producers (social cost = private cost + c). Effect of a negative externality in production • Both with and without external costs, supply is determined by the private marginal cost. • Hence, the equilibrium (determined by the intersection of the supply curve with the demand curve) does not change from the situation without external cost. • However, in equilibrium, the willingness to pay of (value to) the marginal buyer is smaller than the cost to the marginal seller plus the cost of the externality (= the social cost of the last unit). • The social optimum takes both types of cost into account, it is determined by the intersection of the social cost and demand. • With a negative externality, the socially optimal level is less than the equilibrium quantity: The market participants trade too high a quantity. Effect of a positive externality in consumption Assume the consumption of a good (e.g., education) leads to an external benefit(b), per unit consumed. Then the benefit to society of consuming the good is larger than the benefit to the consumer (social value = private value + b). Effect of a positive externality in consumption • Both with and without external benefit, demand is determined by the private marginal benefit (private value). • Hence, the equilibrium (determined by the intersection of the supply curve with the demand curve) does not change from the situation without external benefit. • However, in equilibrium, the sum of the willingness to pay of (value to) the marginal buyer and the external benefit (value) to the bystander (= social value of the last unit) is greater than the cost to the marginal seller. • The social optimum takes both types of benefit into account, it is determined by the intersection of the supply and social value curves. • With a positive externality, the socially optimal level is larger than the equilibrium quantity: The market participants trade too low a quantity. Main insights 1. With a negative externality, the equilibrium quantity is too high compared to the social optimum. 2. With a positive externality, the equilibrium quantity is too low compared to the social optimum. This holds for externalities in production and consumption. Policies that deal with externalities • Example (Externalities and climate change) – There is now overwhelming scientific evidence that climate change is a serious global threat. – Scientific reports urge immediate action to reduce emissions of greenhouse gases such as carbon dioxide. – Greenhouse gas pollution is a classic case of a negative externality in production: Because producers do not face the external cost of burning fossil fuels, too much of this fuel is burnt from society’s perspective. • To solve the problems of climate change, we need to understand the best ways to deal with negative externalities. Policies that deal with externalities • Example (Externalities and education) – There is ample evidence that education generates positive spillovers. – For example, a more educated population elects better governments, which benefits society as a whole, even the less educated voters. Getting an education enables a person to come up with inventions, which creates consumer surplus for many other members of society. – Education is a classical example for a positive externality in consumption: Because consumers do not reap the external benefits of getting educated, they get too little education from society's perspective. • To solve the problems of education, we need to understand the best ways to deal with positive externalities. One way is to internalise the externalities. • Internalising an externality involves altering incentives so that people take account of the external effects of their actions. This achieves the socially optimal output. – The government can internalise a negative production externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity. – The government can internalise a positive consumption externality by subsidising the buyers of education to increase the equilibrium quantity to the socially desirable quantity. The command-and-control approach consists of a `command', which sets a standard - the maximum level of permissible pollution, and a `control', which monitors and enforces the standard. • In environmental policy, there are two types of standards – ambient standards and emissions standards. – Ambient standards set the minimum desired level of air or water quality, or the maximum level of a pollutant, that must be maintained. – An emissions standard species the maximum level of permitted emissions. • Command-and-control in education: mandatory schooling (equivalent to an emissions standard in environmental policy). • Main advantages of standards – They are easy to understand (think of environmental policy: Standards implement an assured maximum level of pollution). – They are a pragmatic approach when there is uncertainty about the effects of the externality (e.g., of pollution on the environment). • Main disadvantages of standards over market-based instruments, such as taxes or subsidies: – Firms have no incentives to reduce pollution beyond the standard. – Standards tend to be less costeffective than market-based instruments. Tradable pollution permits combine the advantages of commandand-control with those of marketbased instruments. – We implement an assured maximum level of pollution. – Firms with low abatement costs reduce their pollution by a lot and sell their pollution permits to firms with high abatement costs