Theory Economy Mid-Term PDF

Cap 1: Finding the optimal use of a limited income Market -Every society has resources and needs. Economics thinks about how resources can satisfy the needs of society. -Market is a set of transactions made out of free will from both sides. Voluntary exchange without constrictions from the outsid...

Cap 1: Finding the optimal use of a limited income Market -Every society has resources and needs. Economics thinks about how resources can satisfy the needs of society. -Market is a set of transactions made out of free will from both sides. Voluntary exchange without constrictions from the outside. The parties share a set of rules which makes the exchange possible. →You have market exchanges even if you don't share all the rules of the country you're in (ex. The professional doesn't pay taxes in exchange for a discount, exchange of drugs). →In markets people accept the consequences of the exchange because they accept the rules of the exchange. →On the market, the only information people exchange is the price. -DEF: The market is a coordination mechanism to achieve an allocation of resources. -Economists define if the results of the exchange are desirable or not and if they can be improved, changed or not. Economists study coordination mechanisms and obtain a sort of metric to say which result is better or desirable. They built a scale in which results can be compared, to understand which one is better. Consumer preferences -Economics is the study of individuals and the representation of their preferences -Assumptions about consumer preferences= 1. 2. 3. →There are 3 types of goods compared to another one: equally good, better, worse. You can always make this assessment. Indifference curve =the various combinations of goods that make a consumer indifferent, represents all equally good bundles of goods. -Those equally good bundles have the same utility for the consumer -Features of them= 1. =due to the concept of diminishing marginal utility, meaning that consumers attach a higher value to the first units and less to the last units once you have many of them. 2. =and the more away from the origin you go the better the option is 3. -If they were to cross, it would mean that they have the same value and so bundles belonging to the higher curve would have the same quantity of goods as the bundles in the curve below. →if they did they would violate the rule of consistency 4. =everyone has different preferences of combinations of goods Different shapes of indifference curves 1. -Diminishing marginal rates of substitution (MRS). -Consumers are willing to give up less of one good to get additional units of another as they acquire more of the latter. 2. -a constant MRSbetween the two goods -Ihe consumer views the two goods as perfect substitutes 3. -goods are perfect complements, additional units of one good do not increase utility unless accompanied by more of the other Utility function =a rule that associate a number to different indifference curves - =the need for a number that allows us to say which one ranks higher, not a number that has a content. - =when the highest utility function is reached by one good being at 0, this means that the good is a poor substitute to the competing one. Edgeworth Box Diagram -In reality goods available are not infinite, so x and y are limited and are represented in this box -The basket represented in the box represents simultaneously the good i have and by difference the one the rest of society has -People in society trade to make themselves better off - =when a trade makes at least one participant better off and no participant worse off - =indifference curves are tangent and there is no possibility for one person to be better off without the other getting worse off. - =a line connecting all the pareto optimal of a box, we can find different pareto optimal starting from different allocations of goods -The only way to improve society without someone losing something is to enlarge the box and so to have more resources available in society Budget line =represents all the combinations of goods that a consumer may purchase given current prices within their given income. →I= Px X + Py Y - =budget line and indifference curve are tangent 1. =If the income grows the budget line shifts right (and opposite) and the consumer will search for a bundle of goods that gives him higher utility 2. =If the price of one good decreases the budget line rotates out (and opposite) and the consumer will be able to buy more goods at a lower price - -The way to measure the dollar value of the price reduction is to reflect on the money saved at a lower price. The dollar value of the increased utility from the price reduction is the difference between the 2 budget constraints given by the 2 different utility levels. We obtain this by applying the compensation principle: we search for that level of income that restores the consumer's original level of utility. -Compensation principle= a change in utility created by a change in income or price can be translated to a monetary value by searching for the increase in income that restores the original level of utility. Price change effects 1. =when a change in the price of a good makes it more or less expensive relative to other goods, causing consumers to substitute one good for another. If the price of x decreases x will be consumed more. →Always negative 2. =a change in a good's price effectively changes the consumer\'s real income, or buying power. More of x is purchased as well as more of everything else because you buy the same good at a lower price and have extra income to spend on this or other goods. Using the compensation principle to calculate damages -Anytime that a consumer is pushed away from his optimal allocation of income, harm is imposed. In principle, money damages from this harm are calculable. -2 issues: 1. 2. -Case in which we don't know the utility function: Zero substitution =two goods have zero substitution when the consumer always chooses them regardless of the price Reputation value -Being trustworthy has an economic value =gain reputation by doing what you said, by sticking to your commitment. Breaking a contract creates a problem of reputation and so less benefits -To break a promise creates a damage and it is possible to measure that damage in different ways Opportunity cost =the value of the next best use of time and money used in the activity we choose or the product we purchase →It is never free even if it is free = what we have to give up if we want 1 extra unit of something =Px/Py Marginal rate of substitution (MRS) =Δy/Δx =Mux/Muy =represents the slope of the indifference curve =it tells me how one good substitute the other in my preferences - →Where the indifference curve and the budget constraint touch they have the same slope MRS= Px/Py Variation of utility -The effect of increasing the quantity of one good (x) keeping the other constant (y) is that the utility increases - =it measures the change in total utility that comes from consuming an additional unit of something. - - - → And because ΔU/Δx = y and ΔU/Δy = x - Cap 2: demand curves and consumer surplus Demand curve =relationship between price and quantity consumed holding constant utility and price →P decreases Q increases →P increases Q decreases Compensated demand curve -This curve isolates the substitution effect by eliminating the influence of the income effect. (take away the income effect) →That is because normally income effects are small - 1. =what is the Q the consumer is willing and able to buy at any given price 2. =what is the maximum P the consumer is willing to pay for one extra unit (Q) - =the demand curve is represented as straight because even if they are not actually linear we can approximate it. -Linear demand curve: Q= a-bP - - parameter: -b= ΔQ/ΔP Consumer surplus =AP-P (Availability to pay - price) =the area underneath the compensated demand curve and above the price at which the good is sold -It measures the benefit of the consumer from paying less than they are willing to pay (b h / 2) -Another way to think about consumer surplus is to apply the compensation principle: When the price of an item increases, the budget line goes towards the origin, and so the level of utility decreases. BUT in calculating the demand curve, we compensated the consumer with enough additional income to return him to his original level of utility. For very small price changes, the amount of compensation given is equal to the change in price x number of units consumed before the price changed. Market demand curve =the horizontal sum of all individual consumers\' demand curves in a market =represents the total quantity demanded by all consumers at each different price →Society surplus Complement and substitute goods - =a good that adds value to another good when they are consumed together -X is complement to Y if the demand of X falls as the price of Increases - =a good that serves the same purpose as another good for consumers -X is substitute to Y if the demand of X increases as the price of Y increases Increase in quantity demanded v. increase in demand 1. 2. =when income increases or more people enter into the market (or opposite) Demand elasticity =how sensitive is the demand curve to the change of price η= ΔQ/ ΔP P/Q →Always negative -If the elasticity is less than unity, the demand curve is inelastic, if it exceeds unity it is elastic. -For a linear demand curve= η= -b P/Q →-b is the same for all the demand curve, what changes is P/Q - -On the bottom of the demand curve η=0 -On the top of the demand curve η= -∞ - η= -b P1 + P2 / Q1 + Q2 Relation of elasticity to total revenue -The maximum revenue depends on price and quantity demanded. It is always maximized exactly where the elasticity of demand is unity, so at the midpoint on the demand curve. If demand is elastic, price reductions increase revenue. If demand is inelastic, price reductions decrease revenue. Imposition of tax - =in the long run we can see a stronger reaction than in the short run - 1. -if the demand curve/the good is really sensitive to price change -People will simply stop buying the good and so also paying taxes -Ex. vacations, eating out, a specific brand of snacks etc... 2. -if the demand curve/the good is not really sensitive to price change -People will need to continue buying the good and so also paying taxes -Ex. gasoline, cigarettes →If the state wants to raise the taxes on goods it will do it looking at elasticity and choosing the one with low elasticity - =a transfer occurs when a dollar loss to one person is exactly the offset by a dollar gain by another person - =inefficiency of the tax system =A loss of one person does not correspond to a gain by another (b h /2)= triangle located above ΔQ -if the demand curve is more sensitive to price change that destroyed part will be bigger - =DWL/ TR TR= Tax Q - DWR/TR = 1/2tax rate η - - =when a tax artificially increases price, it distort the optimal allocation of the income -A tax on a good has no distortion when the demand elasticity is 0 - 1. =designed to affect behavior, the tax is so high it generates 0 R, so η approaches -∞, meaning that consumer surplus is eliminated and TR is 0 because consumptions fall to 0 2. =designed to have a change in R and not in behavior, so η is 0. - →Revenue goes up if η\>1 →Revenue goes down if η\ to cover MC the min ATC must stay the same and so the added tax is oereed by the consumer 2. =The tax will be entirely paid by the producer Short term effect of introduction of subsidies =money given to the seller or to the consumer 1. →the supply curve goes up, right (From P=MC to P=MC+S) →creation of a new market equiliubrium with the new supply curve with the demand curve, P1 to P2 Q1 to Q2 - - →larger quantity of goods, consumer pay a lower price, producer receive higher price →creates higher producer surplus= pink higher consumer surplus = blue →The government pays the difference between the price consumers pay and the price producers receive for every unit sold. As more goods are sold due to the subsidy, this cost grows, exceeding the combined benefit to consumers and producers. The part that exceed is the DWL (orange) \* The Subsidies costs comprehend consumer surplus, producer surplus and DWL 2. →the demand goes up, right (D1 to D2) →creation of a new market equilibrium with the new demand curve with the supply curve, P1 to P2 Q1 to Q2 - - →larger quantity of goods, consumer pay a lower price, producer receive higher price →creates higher producer surplus= pink higher consumer surplus = blue →The government pays the difference between the price consumers pay and the price producers receive for every unit sold. As more goods are sold due to the subsidy, this cost grows, exceeding the combined benefit to consumers and producers. The part that exceed is the DWL (orange) \* The Subsidies costs comprehend consumer surplus, producer surplus and DWL Long term effect of introduction of subsidiaries 1. →From P1 to P2 →Sell less quantity with an higher price 2. →From P1 to P2 →Buy more quantity with a lower price Expected R and TT with possibilities guarda ex. Sunk costs (/Past costs) =a cost that has already been incurred and cannot be recovered or changed and it should not influence decision-making. - =both do not vary but sunk costs have no value in any other use, sunk costs cannot be retrieved in any other way than the use you decided for it. - Decisions must take into consideration all costs, variable and fixed. But after a commitment has been made and a sunk cost arises they should not be relevant for future decisions. Opportunity cost =Value of the next best use of time and money used in the activity we choose or the product we use. Transaction costs =costs created by a market transaction beyond the price of the good or service itself. -They decrease consumer surplus. -They include time and added expenses to get and evaluate informations about the desired transaction to make. Cap 4: Using Demand and supply curves to evaluate policy Price cap -When governments think that the price for something is to high it forces a price cap, a lower maximum price -Q consumers want is bigger than Q firms can supply =Scarse quantity -It creates DWL =limiting number of consumers, of transaction (unities not exchanged anymore) -Producer surplus =smaller -Consumer surplus =bigger and smaller →part of the producer surplus becomes consumer surplus →because DWL -Distributional problem =there is more demand than supply at the capped price, leading to scarcity. - -Consumers getting in line are only the high value consumers= they have more availability to pay so they can cover the extra resource of waiting in line with their surplus. -Full price= price of the good + extra effort -Rent erosion= The consumer surplus replaced by the resources costs. It takes place when property rights are attainable after spending some resources. Property rights to not have Rent erosion -To avoid Rent erosion Property rights must be 1. 2. 1. =easy to establish the right and so little cost of transaction →the more complex is the legal contract (not well defined property rights) the higher are the transaction costs and the lower is the surplus -The cost of the transaction is the legal cost of contracts and essentially is the added price on the beginning price and absorbs surplus 2. =avoid to use the added resources that take away part of the surplus (rent erosion) -Ex. if the coupon to have access to the scarce good (right to get the good) can be exchanged a person with lower surplus will sell the right to get it to someone with higher availability to pay to higher the surplus -if you have the right to be in line and it is freely transferable the rent erosion can be avoided Policy options more efficient than the line one 1. -If the government wants to reduce the use of a good it could put a tax on it instead of putting a price cap =same producer surplus, same consumer surplus and same DWL but the one that was rent erosion is now tax (green) →preferable because the tax goes to the government and can later be re-allocated to the consumers 2. ex. the owner of the gas station makes people pay to enter the gas station What would go to waste with rent erosion goes to in this case the gas station owner 3. \- if the coupon to have access to the scarce good (right to get the good) can be exchanged a person with lower surplus will sell the right to get it to someone with higher availability to pay to higher the surplus -if you have the right to be in line and it is freely transferable the rent erosion can be avoided Policy option even more inefficient than the line one - =require bureaucrats to write + enforce regulations dictating what they think the highest-value uses must be. Through this system, many high-value users will be squeezed-out of the market in favor of low-value users, creating a large loss in total surplus. →Ex. 55 speed limit to reduce use of gasoline= people were just slower and wasted time, they did not buy less. High value users squeezed out of the market in favor of low value users creating a large loss in total surplus. Minimum wage -Similar to the price cap, the government puts a mandatory minimum wage - =obtain the highest amount of surplus, they would have worked for lower than the wage fixed - =obtain less surplus form the job, they work for higher wages. The one not in the market earn a negative surplus at the current wage, so they choose not to work. -The demand curve shows the value the firms attach to additional workers hired. The first workers add lots of value but each marginal worker added creates less value of output. -With a minimum wage firms will need less workers and more workers want to work. That creates DWL because of the number of workers that were employed before with a lower wage. The one who are still employed get a higher rent. - =the way to win the competition to get hired you need is to put more effort →the one that put the more effort are the one that will work for less money because they have more surplus to spend on this resource (effort) =rent erosion (green, middle part) →All the minimum wage jobs are taken by high rent workers for this reason. -Effect of competition and so of more effort= higher quality products and because of that an increase of demand and consequently of supply. - =the additional compensation required to accept less desirable working conditions. As jobs require harder work, potential hires require higher wages to accept these jobs.This concept is the application of the compensation principle. →This attenuates the employment effect. - =not the government, but a union sets a minimum wage The process is the same as a minimum wage implemented by the government but here rent erosion is avoided -How? 1. →Ex. not allowed to start to work earlier, stay more or have shorter lunch breaks. 2. Price supports -Government not satisfied because the equilibrium price is too low -To get a higher price= 1. =Cap the supply to a lower quantity so the price will get higher →consumers transfer surplus to producers and so their rent increases + DWL 2. -Not restricting output and supporting the price by paying for the extra quantity produced at the higher price that consumers do not want →at the beginning both consumer and producer surplus increases but →DWL given by the inefficient expansion of production (quantity produced for nothing because consumer do not want the extra goods) =costly way to do it (big DWL) Cap 5: The economics of monopoly Monopoly =There is only one firm in the industry, which means it has the power to set the price, it doesn\'t have to adhere to the one of the market. →Down sloping demand curve -Assumptions= MC curve is flat and constant and fixed costs are 0. - -Limitations in the choice= demand curve and costs -The firm need to find a price along the demand curve that maximizes the difference between the R and TC, to get an excessive remuneration (TT\>0) -Maximum R is in the middle of the demand curve, where the demand elasticity is 1. After this point R falls and before it still can increase. MR = P(1+1/η) MR= the change in revenue from a one-unit increase in output →In a competitive market the firms cannot choose the price so MR=P -As we said the firm wants to maximize TT not R and so it must also take into consideration TC, that in this case are only the variable ones represented with MC Q. →higher Q increases R but also decreases P and so reduces R -Maximized TT MR=MC - →MC= P(1+1/η) Where 1+1/η \1 →Means that P\>MC (in competitive market it would be MC=P) - -DWL =a loss of surplus because consumers that valued the goods cannot get them →The quantity of MC=P (competitive market) is higher than the one of P\>MC -Rent erosion =firms are ready to spend on resources to get the excessive remuneration →monopoly is not desirable for society →anti monopolistic regulations - -To be a monopoly you need to get the legal title= →you would be ready to pay the government/political party to obtain the legal title to get the extra remuneration (give part of the extra remuneration to get the possibility to get the total) →existence of a legislations to limit subsidiaries that can be given by the firms to the gov/political parties to limit this form of corruption -The competition between firms to secure the possibility to get the property right to be a monopoly creates rent erosion because it transforms surplus in resource costs. -Number of possible participants =a competitive market for monoèpoly is in equilibrium when there are a number of participants so that the chance of winning the prize, times the prize amount, equals the cost of playing. Expected winnings= 1/N Prize 1/N Prize = CP - -The area that in a competitive market would be consumer surplus in monopoly is formed by =producers' excessive remuneration (Rent erosion) + DWL + only some consumer surplus - =How much P is larger than MC M= (-1 / 1+η) 100 where -η\>1 -the greater the demand elasticity the lower the monopoly percentage markup over competitive price () That is because M= P-MC/MC And P= MC (η/ η+1) →M= MC (η/ η+1)-MC /MC This simplified is the formula above Price discrimination =when a firm sells the same product (with same MC) to consumers at a different price depending on the consumers' availability to pay -Need for the condition of consumers not being able to sell the goods →otherwise a lower AP consumer will sell it to a higher AP consumer and will gain surplus →the consumer would become the competitor, not a monopoly anymore because there are competitors -If a monopoly does not make price discrimination it woulds need to lower the price to not lose the possibility to sell the good to consumers with a lower AP -If it does price discrimination it can receive bigger TT form all the different demand conditions Perfect price discrimination =maximum profit that a monopoly could ever achieve =charging the maximum price the consumer is willing to pay to all consumers with different AP →all consumer surplus is now excessive remuneration (all efficient trades occurs) → no consumer surplus but also no DWL -Still we have to take into consideration the social cost of monopoly that in this case is not formed by both DWL and Ret erosion, but only by rent erosion that is all the excessive remuneration. Other ways to extract consumer surplus 1. =a requirement to purchase a product B as a condition to purchase product A. →product A is sold to a low price but with the condition to have to purchase product B at a higher price, the price of B exceeds prices of similar products in the market. 2. =each consumer fears that his bid will be insufficient to obtain a good, so his tendency is to bid an amount that largely reduces consumer surplus. In these markets there are either one or just few sellers. →Ex. to buy gasoline you need to have a card and those cards are sold at an auction. The bid has to include the Q of gasoline. The cards are given to the ones that bid a higher quantity →consumers will bid an amount that cuts well in their consumer surplus because they are afraid that if the bid not enough quantity to win a card →the owner does not get all surplus available but has a good deal. When there is no possibility to make price discrimination and we have two demands of two markets for the same good =The firm does not want to give benefit to the captive or outside market, it just wants to maximize its TT so the regulation applied changes the surplus generated (given to one or to the other) Introduction of taxes in monopoly P=MC+tax (higher MC line) -Because the variation of P is multiple of the variation in MC →P will become bigger to still have excessive remuneration Rival and Non-Rival goods in consumption 1. =satisfies only one consumer →if you want to satisfy more consumers you have to produce more - -Market demand= horizontal sum of the individual demand curves (Q=a-bP) 2. =satisfies more consumers →if you want to satisfy more consumers you do not have to produce more - -Demand of Non-Rival goods in consumption =vertical sum of all the AP of society for every quantity =Market demand= vertical sum of the individual demand curves (P= a-bQ) In the other cases= horizontal sum (q=A-bP) → AP1+AP2+AP3= AP of society for every quantity -Sustainable P and Q for society on the demand curve of society →MC=P - -MC of serving consumers =0 =no more costs to increase production, goods that can satisfy more consumers - →Price discrimination in competitive markets -Condition= fixed costs present and are important relative to variable costs -Always expands output and increases consumer surplus -Examples= 1. →Ex. movie theaters or restaurants -Gourmet restaurants often serve lunch at a lower price than the one for dinner. Because they do that the price for lunch is also contributing to lowering the dinner price. This means that restaurant owners who do not serve lunch will find it difficult to compete with restaurant owners that do it. This is possible because they can offer lower dinner prices and still earn a competitive rate of return on their investments. -Same with theaters that offer shows in the afternoon at lower prices. →Two different demands (the one of dinner and of lunch) are vertically summed to have the demand of society that gives a sustainable price and quantity To achieve that quantity you need P1 for the first demand and P2 for the second demand so you can create two prices to achieve the sustainable price. 2. →Ex. goods that are going to expire soon or an airline with empty sets soon before departure -Foods that are going to expire soon are sold by grocery stores at a lower price because even if they earn less they still earn something, that is because otherwise the goods would be thrown away. Not all consumers are interested in buying goods that are going to expire. -Same with empty seats not long before departure, there will be a discount on those seats because if the airline does not sell it they would be worthless. Still not consumers are interested in sacrificing certainty to get on the flight o a lower price. 3. →Ex. allocation of fixed expenses in grocery markets -The store does not assign too much common expenses on products with a high demand elasticity (because they would lose a lot of sales) but they assign it to products with inelastic demand. This is a formula similar to the monopolist one where they charge a higher price to those who react less to price increases. In different grocery stores the allocation of the common expenses may be different. If a good costs a little more in a store and a little less in another, this does not mean that excessive profit exists in either store if we look at the situation from the perspective of the total costs. In between =they are not taken into consideration in the book but also variations in between monopolies and perfect competition exist. Nash equilibrium (limited number of firms) -If in a market there are two firms that are supplying the same good they must decide the Q to produce to maximize their TT taking into consideration each other\'s decisions. 1. = If Firm A produces 0 Q (MC=P) Firm B will produce QM (quality of the market) 2. =If Firm B produces 0 Q (MC=P) Firm A will produce QM (quality of the market) -They must reach the Nash equilibrium =an optimal mutual response, where the two reaction curves are tangent -The point QM in both reaction curve contains the same Q →The segment that connects QM of Firm A and of Firm B represents the production of the two firms - →The segment connecting the point MC=P of firm A and of firm B represents the perfect competition →The Nash equilibrium point must be higher than the segment connecting the QM and lower of the segment connecting the MC=P - -A higher P of firm A will make consumers go to firm B →Firm B demand curve shifting right Add +P to the two demand curve because they depend on each other →The Nash equilibrium is found when we reach the same P for both (price of the competitive level) - →Both firms can achieve a higher TT because of a bigger R Cheating =the tendency of participants in a collusive scheme to violate their assigned quota, the agreement they made to apply the same price and so to produce a fixed quantity. The firms wanting to have more excess profit put a higher price and so produce more quantity, their collective action increases output and drives back the price towards competitive levels. →Having an agreement on the price would make TT higher for the Firms but their action gives the result of always ending up at the competitive level price. (not the optimal point) - -OPEC= international cartel of many large oil-producing countries -OPEC raises the price from 4 (market price) to 12 to earn maximum profit for the group. To have P=12 Q needs to be restricted to 8 billion. -A country cheats and produces more Q -If all countries do the same thing the P=12 is not sustainable anymore and it would be pushed back to 11 with a Q of 9 -If all countries go on cheating again, which happens because the price fell, more Q will be produced and the price will continue to get pushed back to the original one (market price). -OPEC at this point can decide to have another meeting to get back to P=12 but the process will start over again. →To be able to stay at the agreed price without cheating there is the need for a legal binding agreement with punishment for infringement - - =laws with the aim of promoting competition in the marketplace and preventing monopolies. -Those laws make it difficult to make collusion agreement because firms that make them are in direct violation of the law (both with written or oral agreements because of written evidence or witnesses) -In this situation firms are still able to agree with each other to maintain an agreed price but tacitly. →Antitrust laws make cheating easy and emphasize the natural tendency of firms to cheat on other firms. Prisoner\'s dilemma =when unable to explicitly collude, because of antitrust laws, criminals have the natural tendency to cheat on each other. This process gives the participants the worst outcome as a group. So they do not reach the Nash equilibrium. - \* If both prisoners confess= 5 years in prison \* If boh do not confess= 2 years in prison \* If one confesses and the other does not= 1 year for you and 10 for the other -Reasoning of both prisoners= \* If the other confesses? Better to confess or get 10 years instead of 5 \* If the other does not confess? Better to confess because 1 year instead of 2 →Because both prisoners made this reasoning they get 5 years each and they do not obtain the best result as a group.