Economics Final Study Guide Midterm 1 ∙ Neoclassical economics o Textbook definition Currently dominant school of economics, characterized by its marginal utility theory of value, its devotion to the general equilibrium model stated mathematically, its individualism, and its reliance on free markets and thIf you want to learn more check out moral pressure constitutes false imprisonment.
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e invisible hand as the best means of allocating resources, with a consequent downplaying of the role of government o Focuses primarily on self regulating market economy o Built on math framework o Assumptions People are rational/self interested/always want more Economy can and should grow forever ∙ Ecological economics o Textbook definition The union of economics and ecology with the economy conceived as a subsystem of the earth ecosystem that is sustained by metabolic flow or throughput from and back to the larger system *also see the definition for throughput* o No single methodology (transdisciplinary) o Built on the assumption that economic system is a subsystem of the global ecosystem Expands when it needs to o Can’t make something out of nothing (thermodynamics) o Main goal Future matters Ecological sustainability o Not elegant or simple Highly complex world ∙ What distinguishes ecological economics from conventional (neoclassical) economics? o Pre analytic vision o Ecological economy is a complex evolving system Feedback loops Highly non-linear change Emergent phenomena Surprise Chaotic behavior Uncertainty and ignorance (in technology and ecology) o The ever growing circular economy Exponential economic growth o The economic system is simple Human behavior is simple (says economists), they always want more (selfish) Market system is simple We can model the system mathematically and show it moves toward optimal equilibrium Perfect knowledge and risk dominate uncertainty and ignorance o Physics of Ecology 1st law of Thermodynamics ∙ you can’t make something from nothing, can’t make nothing from something ∙ Natural resources are essential to economic production ∙ Opportunity cost of economic growth is degradation of ecosystems 2nd law of Thermodynamics ∙ entropy increases in the universe = all work requires energy ∙ One way flow from natural resources human made economic services waste ∙ Increase in disorder and uselessness ∙ Like a digestive system, not a circulatory system ∙ “throughputs” not “inputs” = things don’t disappear ∙ Waste emissions further reduce the flow of goods and services from nature o Laws of ecology Conversion of ecosystem structure into economic products degrades and destroys ecosystems ∙ Example: biodiversity ∙ Waste emissions degrade/destroy ecosystems o Laws of economics Diminishing marginal returns, opportunity costs and uneconomic growth Sustainable growth is an oxymoron Ever continuing growth in material consumption is an impossible goal Economic development is possible but not continuous economic growth o Uneconomic growth o Sustainable scale = as economy grows, scale increases We care about this because we care about future generations Scale = size of economic system relative to the ecosystem that contains and sustains it Comparative and absolute advantage o Absolute Maria is a better lawyer and typist than Jon o Comparative Maria is a better lawyer but only a slightly better typist than Jon o If the opportunity to practice law is the cost, then Jon has a comparative advantage in typing o Opportunity cost and exchange Maria types x2 fast as Jon She gets $200/hr for practicing law Jon charges $10/hr for typing She should practice law and pay Jon to type to save both hours and money ∙ Sources of comparative advantage Nations ∙ Natural resources ∙ Human capital ∙ Built capital Individual ∙ Natural abilities ∙ Education and training ∙ Experience ∙ Capital The difference between complements and substitutes o Complement An increase in the price of one causes a decrease in the demand of the other If a decrease in supply of an unpriced good leads to a decrease in demand for a market good or vice versa o Substitutes Two goods are substitutes in consumption if an increase in the price of one causes an increase in demand for the other If increase in supply of an unpriced good leads to a decrease in demand for a market good and vice versa ∙ Example: water and water bottle Opportunity costso Micro level = the best alternative you sacrifice when doing something else Allocating resources Allocating income ∙ Spend $ on beer and pizza you give it up and it therefore cannot be spent on books Allocating time ∙ If you weren’t doing what you were doing, what would you be doing? o Macro level = what we give up in ecological opportunities when the economy grows Desirable Ends o Definition of economics Allocation of available resources among alternative desirable ends, within and between generations o What are desirable ends? Is the answer to this based on ethical values or objective science? (normative or positive?) o What do economists say is the goal? Endless growth Satisfaction of individual preferences ∙ Preferences weighted by purchasing power Maximization of monetary value Does sustainability matter? Distribution? ∙ Who should own natural goods? Is stability desirable? ∙ Job security? Marginal Analysis Rate of change ∙ Change in one additional unit ∙ “change in margin” Diamond water paradox ∙ Why do diamonds cost more than water? o Use value = total value of all units consumed o Exchange value = marginal value (last unit) Basic rules of econ ∙ Optimum occurs when: marginal benefit = marginal cost ∙ I’ll keep buying things as long as the benefit is bigger than the $ it costs ∙ BUT are all benefits measured the same way?Rivalness o An inherent characteristic of certain resources whereby consumption or use by one person reduces the amount available for everyone else Excludability o Legal principle that when enforced allows an owner to prevent others from using his/her asset Stock Flow o Raw materials, ecosystem goods o Material transformation o Used up (depletion) My use leaves less for your use o Rate/flow can be generally controlled Ex: we choose how fast we use fossil fuels Fund service o Ecosystem functions, services, land, machines, labor o Not transformed into what it produces o My use may not leave less for you o Human made fund service resources wear out, not used up o Rate of use can’t be controlled Elastic o More substitutes = more elastic o Small change in price = large change in quantity demand Inelastic o Necessities with few substitutes are inelastic o Small change in quantity supplied leads to large change in price o The case for staple foods because they have few substitutes o The more vertical the line, the more inelastic Supply and Demand o Demand curve Schedule/graph that tells us quantity of a goof that buyers wish to buy at each price, downward sloping Consumption (use now) vs. speculation (exchange to sell later) Substitution effect ∙ Change in quantity demanded of a good that results because buyers switch to or away from substitutes when the price of a good changes (substitutes don’t always exist—epipens) Income effect ∙ Change in quantity demanded of a good that results because a change in the price of a good changes the buyer’s purchasing power When demand shifts, movement along the supply curve Equilibrium is when the supply/demand lines cross in an “X” Determinants of Supply o In the shoes of the producer o Weather o Input prices (costs) o Technology o Subsidies (increases supply because the cost for the company making the good goes down because they’re being paid to produce it) o Expectations o # of sellers Determinants of Demand o In the shoes of the consumer o Income (income goes up, demand generally goes up) o Substitutes o Complements (tennis gets big, people go buy rackets, also buy balls) o Expectations (if you speculate the price of something is going to go up then you buy it now and demand would increase) o Tastes o Advertisements o Increase in population Price Elasticity of Demand o % change in quantity demanded/% change in price o > 1 = elastic o < 1 = inelastic o =1 = unit elastic o Normal good = income elasticity is + o Inferior good = income elasticity is - Midterm 2 Pareto Efficiency o Increasing the welfare of someone without decreasing the welfare of someone else o Neoclassical economists say that you cant measure utility (optimality reached if winners compensate losers) o Equilibrium is pareto efficient o Ecological economists say to solve sustainability/distribution problems first before letting markets allocate Invisible Hand o If one market is making economic profit other firms are going to allocate their resources to where there’s profit o You are likely to enter a different market that is making profit o Organic milk vs. regular milk example organic makes more profit so you switch to that market, then organic market gets too crowded o Resources are allocated to those who value them most (rationing function of price) o Value is determined by preference and weighted by purchasing power o Invisible Hand theoretically minimizes the cost of market products while ensuring a fair return to producers o In a competitive market, all firms tend to earn zero economic profit Rational Spending rule o (AKA equimarginal principle of optimization) Spending should be allocated across goods so that the marginal utility per dollar is the same for each good Applies to all goods o Marginal utility = what we would get from one additional unit Monopoly o Marginal revenue < price o Pure monopoly Most efficient, the only supplier of a unique product with no close subs (patents) o Oligopoly Firm produces product for only a few rivals produce close subs (food, media, banking) Problem with collusion (firms meeting to mess with price and supply) o Monopolistic competition Large # of firms produce slightly different products that are close subs Brand loyalty (cigarettes) o Government regulated monopolies can be a good thing Water system = you wouldn’t want multiple companies involved because it would be too expensive Natural Monopolies o High fixed costs o Low marginal costs o Average total cost decreases as output increases/marginal cost increases o With one company in control, the cheaper it is the more you produce o > 1 company controlling, high fixed costs from all of them would tale double time for price to decrease Competitive firms o Marginal revenue = price Producer surplus o The difference between the amount a producer of a good receives and the minimum amount the producer is willing to accept for the good Economic surplus o Sum of all the individual economic surpluses gained by buyers and sellers in the market o Sum of producer and consumer surplus in market o Maximized @ market equilibrium o A measure that can be used to determine economic efficiency Consumer Surplus o Difference between the total amount that consumers are willing to pay for a good and the amount they actually pay (market price) Deadweight loss o People that are left out due to price o Cut out of the market Fixed factor vs. Variable factor o Fixed An input whose quantity cannot be altered in the short run o Variable Input whose quantity can be altered in the short run ∙ Raw materials, temporary workers Perfectly competitive firm vs. Imperfectly competitive firm o Perfectly comp. Perfectly elastic demand for product o Imperfect Downward sloping demand curve Some control over price Functions of price o Rationing function Distributes scarce goods to consumers who value them most o Allocative Directs resources away from overcrowded markets to markets that are underserved/under-crowded Law of Diminishing Marginal Utility o Tendency for the additional utility gained from consuming an additional unit of a good to diminish as consumption increases beyond a point Accounting profit vs. Economic profit vs. Normal profit o Accounting Revenue – explicit cost o Economic Revenue – (explicit cost + implicit costs (AKA opportunity costs)) o Accounting profit > economic profit always o Normal Covering opportunity costs, breaking even Explicit cost vs. Implicit cost o Explicit Wage, rent, materials, payments from running a business o Implicit Opportunity costs Final concepts Lecture notes from Nov 15-Dec 8 11/15/16 ∙ Non-rival and excludable: tragedy of the non-commons o Why do we have patents? Why would you develop something if someone else could just take it away? o When did patents come about? 1790’s in US 1947 international, rarely used before 1980’s 1995 WTO extends protection 2016 TPP further extends protection for patents ∙ Patents: efficiency and sustainability o Create inadequate incentives for inventions that provide or preserve public goods o Raise costs for research Profit motive prevents sharing of knowledge o Monopolies on non-rival resource Expensive to enforce o Price ration use; MC (not =) MB o Examples New technology for highly efficient solar energy Non-ozone depleting technologies Indonesia’s avian flu ∙ Patents and just distribution o Samuel Slater “Father of American industry” Developed countries own 97% of all patents Raises costs for research that meets the needs of the poor ∙ Golden rice (rice with vitamin A in it) “Standing on the shoulders of giants” ∙ Solution to tragedy of the non-commons o Commons based peer production or social production o Public investment, common ownership o Land grant universities (UVM) o Rate of return on investments in public sector agriculture R+D 60-80% per year ∙ *iclicker* Non-excludable and non-rival = public good ∙ Market goods: the theory of externalities o Externality “an activity by one agent causes a loss (gain) of welfare of another agent” “the loss (gain) of welfare is uncompensated” o Completely internal to economic process You can’t produce something from nothing, unavoidable What are implications for Pareto efficiency? o Externalities and profit maximization ∙ Values of natural capital = mangrove ecosystems o Structure, raw materials, stock flow resources Building materials, charcoal, food o Function, ecosystem services, fund services Storm protection Habitat, nursery Waste absorption Climate stabilization ∙ Values of conversion = shrimp aquaculture o High short term profits, heavily promoted by economists o Shrimp and fish for 3-5 years Carnivorous, net reduction in food production o Less protein than intact ecosystem o Massive waste output o Irreversible(?) destruction of ecosystem o Why convert? ∙ Impact of conversion o On natural capital: loss of ecosystem services, loss of fish production o On social capital: nearby fishing communities that lose jobs, move away from families o On human capital: people need to learn new jobs because they lose their old ones ∙ “Optimal” pollution/degradation graph ∙ Solutions for externalities: Regulations o Best management practices o Best available technologies o Caps on resource extraction, waste emissions Example: no conversion of mangroves to shrimp aquaculture o Non-market mechanism, Producers cannot adjust MC to equal MB But costs and benefits may not be directly comparable 11/17/16 ∙ Market solution: Property rights o Who owns the environment? o Polluter “rights” o Sufferer rights o What about future generations? ∙ Market option 1: property rights o *graph* ∙ Problems with property rights o Transaction costs In absence of transaction costs, no negative externalities What are transaction costs likely to be for externalities affecting public goods? How many people affected by climate change? o Wealth effect o Intergenerational externalities ∙ Market solution 2: Pigouvian taxes o Tax externalities Ideal tax = marginal cost ∙ Example: gas tax $12/gallon, people would buy more gas guzzling cars Can costs be measured in monetary terms? o Basic idea Set price, let this determine Q at which demand = price Price determines scale ∙ “Market” Option 2: Pigouvian tax: getting prices right o *graph* ∙ Market Solution 3: Cap and trade/cap and auction o 3 steps Sustainable scale: set cap ∙ Example: TMDL Just distribution: determine property rights ∙ Example: do resources belong to those who exploit them or to the public? Efficient allocation: tradable quotas (cap and trade) or public auctions (cap and auction) o Basic rule = scale is price determining ∙ Market Option 3: Tradable quotas: setting ecologically sustainable scale o *graph* 11/29/16 ∙ What’s better, tax or quota? o Prices adjust to ecological constraints faster then ecosystems adjust to economic impacts o Distributional impacts Taxes Quota = use quotas with ecological constraints ∙ Ignorance and Uncertainty o Perfect markets require perfect information o Asymmetric information Nobel prize in 2000 Theory of lemon o Irreducible ignorance New technologies Fossil fuels, etc. o Time logs o Ecosystem function o Solution = better information flows, precautionary principle ∙ A symmetric preference formation o What forms our preferences? o In what direction are our preferences pushed, towards market or non-market goods? o Solution = balanced information flows (would change the way we handle things) ∙ Missing markets o For a market to work, everyone must be able to participate o Future generations can’t participate in today’s markets o People without money can’t participate Example: many indigenous people o How much would the Mona Lisa sell for if it were auctioned off in St. Albans Not very much o Solution = inalienable property rights for future generations Cheap form of energy maybe Stable climate ∙ Taxes and Efficiency o What’s the impact of taxes? On market equilibrium? On efficiency? On distribution? (who pays them?) ∙ *iclicker* What is deadweight loss? o A: The reduction in total economic surplus that results from the adoption of a policy ∙ Graphs o The effect of a tax on the equilibrium quantity and price of potatoes o Deadweight loss caused by a tax o Dead loss caused by externalities o Taxes can eliminate deadweight loss o Elasticity of demand and deadweight loss from a tax ∙ BUT… o The less elastic the demand, the greater share of the tax paid by the consumer o What are the distributional implications of taxes on necessities? o What are the distributional implication of a carbon tax? Who reduces consumption the most? o How effective are taxes as a policy to prevent addictive behavior? Tobacco example ∙ Taxes and efficient o Who pays a tax? The more inelastic the demand, the more the consumer pays The more elastic the supply, the more the consumer pays When supply is perfectly inelastic, the tax falls entirely on the producer ∙ What do you think? o If the demand for food is inelastic, why is it not taxed? o Tax on pollution? o Tax on deforestation? o Would a tax on land be efficient? ∙ How do property taxes currently work? o Tax on combined value of buildings and land o What is the impact on economic efficiency and distribution? ∙ Demand for land o What makes land valuable? What other people do Examples: swimming pool or school system o Price is determined by demand o What determines demand? Population, basic needs Natural features Factor of production Speculation Public and private investments o Rent is major expenditure for the poor ∙ Graphs o Supply and demand for buildings o Tax on buildings (production cost) o Tax on land (no production cost) ∙ Impact of shift in land and tax o Land prices fall Price*interest ≤ Net Revenue: P*i ≤ R ∙ Assume R is equal to your current rent. ∙ If you buy your apartment, R is the money you save, or the money you could make renting it to someone else. If the interest payments on your loan (P*i) is ≤ R, it makes sense to buy Must account for taxes = P*t ∙ You pay taxes on real estate, which have to be subtracted from R. The rule therefore is to buy if P*i ≤ R-P*t Rearrange to get P*i+P*t ≤ R, which is the same as P ≤ R/(i+t) ∙ When t increases, P decreases High t à more money goes to government, less to banks (i.e. interest on loans). ∙ Total costs for buyer are the same. Supply is fixed so demand sets the price o Ends problem of underwater mortgages With high taxes, if revenue decreases, price decreases and P*t decreases With low taxes, if revenue decreases, P decreases, but interest payments on mortgage don’t o Ends speculation If revenue increases, P increases, P*t increases Land owner doesn’t benefit from price increase Speculative gains taxed away o Speculative demand and market instability 12/1/16 ∙ Impact of shift in land tax continued… o Helps reduce urban decay o With current real estate tax, improving run down buildings increases taxes o Shifting taxes off building and onto land means taxes will be the same for an abandoned building and a high rise apartment o Abandoned buildings no longer affordable on high value land (urban land) o Landowners must improve or sell o Limited impact on rural properties where land values are low and there are fewer buildings ∙ Housing prices and speculation (chart and graph) ∙ Impact continued… o Increases supply of buildings on most valuable land Where is the most valuable land? Rents fall o Reduces urban sprawl With constant population, more people living in urban areas = less in rural areas Much lower infrastructure costs (roads, schools, water, electricity, etc.) o No deadweight loss ∙ Economic rent vs. economic profit o Definition: That part of a payment for a factor of production that exceeds the owner’s reservation price Think about land, fossil fuels, etc. o Market forces will not push economic rent to zero because inputs can’t be replicated easily But taxes can push it to zero o Farmer example An absentee landowner rents farmland to a corn farmer for $30,000/year Farmer generates an income (TR-explicit costs) of $30,000/year (normal profit) A new government subsidy for ethanol increases revenue from the farmland by $30,000 year What happens to the rent, the farmer’s income, and the price of the land? With high land tax, increase in value goes to government ∙ The invisible hand in action o Assume An unskilled worker has two job choices ∙ Textile worker ∙ Renting land to grow rice A state funded irrigation program doubles ag output without changing the market price. What happens to income of landless? What happens to price of land? Who benefits? ∙ *iclicker* What happens to income of landless? o Answer: If income of landless farmer increases, other landless people will offer to pay higher rent, until landowner captures all rent ∙ Impact of a tax on oil o Tax on in ground value of oil = royalties o Tax on negative externalities from oil = green tax o Who pays tax when demand is less elastic than supply? Higher share of taxes paid by the consumer ∙ General principles o Tax the wealth created by nature of society “Tax what we take, not what we make” o Tax the bads, not the goods Tax unhealthy foods or tobacco, etc. Economics of Climate Change ∙ Goals o Ecological sustainability o Just distribution o Efficient allocation ∙ Thresholds o Stock threshold What’s a safe level? 350 ppm? 450 ppm? CO2 vs. CO2e o Flow threshold Emissions exceed absorption 12/6/16 ∙ Surprises, emergent phenomena and tipping points o Time lags and uncertainty How long before we know the effects of 400 ppm? ∙ Recovery time o Paleocene Eocene thermal maximum 170,000 years ∙ Impacts on essential, non-substitutable resources (food, water, ecosystem, extreme water events, risk of irreversible changes) ∙ Distribution: Mitigation o Equal reductions per country? o Equal emissions per capita? o Accounting for accumulated stocks ∙ Distribution: Adaptation o Adaptation fund o Who will pay for green technologies? Private sector? Public sector? ∙ Efficiency issues ∙ Mainstream issues ∙ Market failures o Fossil fuels: market goods with negative externalities o Climate stability: pure public good Impossible for individuals to choose how much to consume o Waste absorption capacity: open access regime Creating property rights Once we choose acceptable level of emissions, markets could allocate o Green technology: knowledge required to solve problem is non rival, excludable o Ignorance and uncertainty o Missing generations ∙ The Challenge *graph* ∙ Solutions o Do the benefits of halting climate change justify the costs? o How do we measure costs and benefits that occur in the future? o Discounting Opportunity cost of money (ex: 7%) Pure time preference Richer future (stern review example) Uncertainty ∙ Basic tools o Prescription CAFÉ standards, banning coal, etc. o Penalties Taxes and fines o Payments Subsidies and public investments o Property rights Tradable permits Common asset trust Inalienable rights for future generations o Persuasion Do the right thing o Power International power imbalances One dollar, one vote or one person, one vote? 12/8/16 ∙ The Nature of reality o The earth is finite o The economy is a physical system o Etc. ∙ The order of analysis o What are desirable ends? o What are the scarce resources? o What is the nature of the scarce resources? o How do we allocate? o We can only decide how to allocate after we know what we wants, and the resources we have to attain it ∙ Desirable ends: what makes people happy? o Money? = once basic needs are met, no o Desiring less = people who are fine with what they have o Family and friends o Community o Helping others o Getting old o Gratitude = keeping a list of things that we’re grateful for ∙ Satisfaction and income *graph* ∙ Economics should be a science, not an ideology o Science: empirical testing of hypotheses and theories o Ideology: refuse to test hypotheses or refuse to discard them when new evidence comes along o Starting from the assumption that the markets (private property rights) are always the best is an ideology o Staring with the assumption that socialism (public property rights) is always best is ideology ∙ The economic system is inherently complex o We depend on natural resources, and must understand both physics and ecology o Some resources meet the criteria for efficient allocation but most don’t Plus market efficiency may not be desirable o Human desires are complex o Human motivations are complex o Markets are never perfect But market instruments offer powerful tools ∙ Market model is super simplified o Natural resources are infinite o Most goods and services fit the market model o Only money matters, more is always better Calories model of nutrition o Only concern is efficient allocation o Prices are the only required feedback loop ∙ Economists should consider: o Ecological sustainability o Social justice o Efficient allocation o Whatever tools and feedback loops are required to achieve these goals ∙ Trade offs o Conventional course vs. this course ∙ Would addressing ecological problems be a sacrifice? ∙ How do we get there? o Information flows Transparent government Independent media Education o Changing the rules o Changing the goals o Changing the paradigm What is possible? ∙ Transcending the paradigm o Not everything I taught you is true o Systems evolve, knowledge improves o What is true now may not be true in the future o Never blindly accept what you learn in college ∙ Sustainability doesn’t require sacrifice, economic growth does Assignment #12