Introductory Microeconomics ECO 2023
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ECON EXAM 3 REVIEW chapters 9 12 sunk costs Costs that cannot be avoided because they have already been incurred marginalism The process of analyzing the additional or incremental costs or benefits arising from a choice or decision Chapter 9 breaking even The situation in which a firm is earning exactly a normal rate of return TC AVC Q Minimizing loses o If total revenue exceeds total variable cost the excess revenue can be used to offset fixed costs and reduce losses and it will pay the firm to keep operating o If total revenue is smaller than total variable cost the firm that operates will suffer losses in excess of fixed costs In this case the firm can minimize its losses by shutting down 0 shutdown point The lowest point on the average variable cost curve When price falls below the minimum point on AVC total revenue is insufficient to cover variable costs and the firm will shut down and bear losses equal to fixed costs 0 At prices below average variable cost it pays a firm to shut down rather than continue operating 0 Thus the shortrun supply curve of a competitive firm is the part of its marginal cost curve that lies above its average variable cost curve shortrun industry supply curve The sum of the marginal cost curves above AVC of all the firms in an industry Added horizontally Two things that can cause the industry supply curve to shift 1 In the short run the industry supply curve shifts if something say a decrease in price of some input shifts the marginal cost curves of all the individual curves simultaneously 2 In the long run an increase or decrease in the number of firms shifts the industry supply curve If more firms enter the supply shifts to the right if more leave it shifts to the left Internal economies of scale 0 increasing returns to scale or economies of scale An increase in a firm39s scale of production leads to lower costs per unit produced Economies of scale is when input prices are fixed and therefore leads to lower cost per unit of output with more production 0 constant returns to scale An increase in a firm39s scale of production has no effect on costs per unit produced o decreasing returns to scale or diseconomies of scale An increase in a firm39s scale of production leads to higher costs per unit produced Economies of scale 0 Some economies of scale result not from technology but from firmlevel efficiencies and bargaining power that can come with size For instance buying inputs in volume at discounted prices 0 Economics of scale have come from advantages of larger firm size rather than gains from plant sIze longrun average cost curve LRAC The quotenvelopequot of a series of shortrun cost curves minimum ef cient scale MES The smallest size at which the longrun average cost curve is at its minimum Constant return to scales 0 Technically the term constant returns means that the quantitative relationship between input and output stays constant or the same when output is increased 0 Constant returns to scale mean that the firm s longrun average cost curve remains flat Decreasing returns to scale 0 When average cost increases with scale of production a firm faces decreasing returns to scale or diseconomies of scale optimal scale of plant The scale of plant that minimizes average cost In equilibrium each firm has RMC SRAC LRAC Firms make no excess profits so that P SRMC SRAC LRAC and there are enough firms so that supply equals demand The entry and exit of firms in response to profit opportunities usually involve the financial capital market In capital markets people are constantly looking for profits When firms in an industry do well capital is likely to flow into that industry in a variety of forms longrun competitive equilibrium When P SRMC RAC LRACand profits are zero Investment in the form of new firms and expanding old firms will over time tend to favor those industries in which profits are being made and over time industries in which firms are suffering losses will gradually contract from disinvestment When longrun average costs decrease as a result of industry growth we say that there are external economies When average costs increase as a result of industry growth we say that there are external diseconomies longrun industry supply curve LRIS A curve that traces out price and total output over time as an industry expands decreasingcost industry An industry that realizes external economies that is average costs decrease as the industry grows The longrun supply curve for such an industry has a negative slope increasingcost industry An industry that external quot 39 that is average costs increase as the industry grows The longrun supply curve for such an industry has a positive slope constantcost industry An industry that shows no economies or diseconomies of scale as the industry grows Such industries have flat or horizontal longrun supply curves Chapter 10 derived demand The demand for resources inputs that is dependent on the demand for the outputs those resources can be used to produce productivity of an input The amount of output produced per unit of that input Inputs are demanded by a firm if and only if households demand the good or service provided by that firm Inputs can be complementary or substitutable Two inputs used together may enhance or complement each other marginal product of labor MPL The additional output produced by 1 additional unit of labor marginal revenue product MRP The additional revenue 3 firm earns by employing 1 additional unit of input ceteris paribus MRPL MP gtlt PX n firms employing just one variable factor of production a change in the price of that factor affects only the demand for the factor itself When more than one factor can vary however we must consider the impact of a change in one factor price on the demand for other factors as well factor substitution effect The tendency of firms to substitute away from a factor whose price has risen and toward a factor whose price has fallen output effect ofa factor price increase decrease When a firm decreases increases its output in response to a factor price increase decrease this decreases increases its demand for all factors If labor markets are competitive the wages in those markets are determined by the interaction of supply and demand As we have seen firms will hire workers only as long as the value of their product exceeds the relevant market wage This is true in all competitive labor markets demanddetermined price The price ofa good that is in fixed supply it is determined exclusively by what households and firms are willing to pay for the good land is perfectly inelastic pure rent The return to any factor of production that is in fixed supply A firm will pay for and use land as long as the revenue earned from selling the product produced on that land is sufficient to cover the price of the land Stated in equation form the firm will use land up to the point at which MRPA PA whereA is land acres The profitmaximizing condition for the perfectly competitive firm is PL MRPL MP gtlt PX PK MRPK MPK gtlt PX PA MRPA MPA gtlt PX where L is labor K is capital A is land acres X is output and PX is the price of that output If all the conditions hold at the same time it is possible to rewrite them another way MP MPK MPA 1 PL PK PA PX f product demand increases product price will rise and marginal revenue product factor demand will increase the MRP curve will shift to the right If product demand declines product price will fall and marginal revenue product factor demand will decrease the MRP curve will shift to the left The production and use of capital enhances the productivity of labor and normally increases the demand for labor and drives up wages When a firm has a choice among alternative technologies the choice it makes depends to some extent on relative input prices technological change The introduction of new methods of production or new products intended to increase the productivity of existing inputs or to raise marginal products Chapter 11 capital Those goods produced by the economic system that are used as inputs to produce other goods and services in the future physical ortangible capital Material things used as inputs in the production of future goods and services The major categories of physical capital are nonresidential structures durable equipment residential structures and inventories social capital or infrastructure Capital that provides services to the public Most social capital takes the form of public works roads and bridges and public services police and fire protection intangible capital Nonmaterial things that contribute to the output of future goods and services human capital A form of intangible capital that includes the skills and other knowledge that workers have or acquire through education and training and that yields valuable services to a firm over time capital stock For a single firm the current market value of the firm s plant equipment inventories and intangible assets Capital is measured in terms of money or value as a stock value at a point in time When we speak of capital we refer not to money or to financial assets such as bonds and stocks but instead to the firm s actual capital stock investment New capital additions to a firm s capital stock Although capital is measured at a given point in time a stock investment is measured over a period of time a flow The flow of investment increases the capital stock depreciation The decline in an asset s economic value over time capital market The market in which households supply their savings to firms that demand funds to buy capital goods bond A contract between a borrower and a lender in which the borrower agrees to pay the loan at some time in the future along with interest payments along the way financial capital market The part of the capital market in which savers and investors interact through intermediaries capital income Income earned on savings that have been put to use through financial capital markets 2 most important way to receive it are interest and profits interest The payments made for the use of money interest rate Interest payments expressed as a percentage of the loan stock A share of stock is an ownership claim on a firm entitling its owner to a profit share Interest may function as an incentive to postpone gratification Profit serves as a reward for innovation and risk taking Financial markets in action 0 Case A business loan from banks 0 Case B Venture capital from venture capital funds high risk ventures 0 Case C IBM uses retained earnings for investments creating savings for households 0 Case D Company issues stock to households Most real estate in the United States is financed by mortgages A mortgage like a bond is a contract in which the borrower promises to repay the lender in the future Until the last decade most mortgage loans were made by banks and savings and loans Most mortgages are now written by mortgage brokers or mortgage bankers who immediately sell the mortgages to a secondary market Loans in this market are securitizedquot mortgagebacked securities are sold to investors who want to take different degrees of risk Various connections between households and firms facilitate the movement of savings into productive investment Industrialized or agrarian small or large simple or complex all societies exist through time and must allocate resources over time In modern industrial societies investment decisions capital production decisions are made primarily by firms Households decide how much to save and in the long run savings limit or constrain the amount of investment that firms can undertake The capital market exists to direct savings into profitable investment projects Firms have an incentive to expand in industries that earn positive profits that is a rate of return above normal and in industries in which economies of scale lead to lower average costs at higher levels of output Positive profits in an industry stimulate the entry of new firms The expansion of existing firms and the creation of new firms both involve investment in new capital A perfectly competitive firm invests in capital up to the point at which the marginal revenue product of capital is equal to the price of capital Capital produces useful services over some period of time though capital goods do not begin to yield benefits until they are used The investment process requires that the potential investor evaluate the expected flow of future productive services that an investment project will yield The ability to lend at the market rate of interest means that there is an opportunity cost associated with every investment project The evaluation process involves not only estimating future benefits but also comparing them with the possible alternative uses of the funds required to undertake the project expected rate of return The annual rate of return that a firm expects to obtain through a capital investment The expected rate of return on an investment project depends on the price of the investment the expected length of time the project provides additional cost savings or revenue and the expected amount of revenue attributable each year to the project A perfectly competitive profitmaximizing firm will keep investing in new capital up to the point at which the expected rate of return is equal to the interest rate The firm will continue investing up to the point at which the marginal revenue product of capital is equal to the price of capital or MRPK PK Vzi 1rt present discounted value PDV or present value PV The present discounted value of R dollars to be paid if years in the future is the amount you need to pay today at current interest rates to ensure that you end up with R dollars if years from now It is the current market value of receiving R dollars in t yea rs Chapter 12 Input and output markets cannot be considered as if they were separate entities or as if they operated independently Although it is important to understand the decisions of individual firms and households and the functioning of individual markets we now need to add it all up so we can look at the operation of the system as a whole partial equilibrium analysis The process of examining the equilibrium conditions in individual markets and for households and firms separately general equilibrium The condition that exists when all markets in an economy are in simultaneous equilibrium efficiency The condition in which the economy is producing what people want at least possible cost Pareto ef ciency or Pareto optimality A condition in which no change is possible that will make some members of society better off without making some other members of society worse off Several years ago in an effort to reduce state spending the budget of the Massachusetts Registry of Motor Vehicles was cut substantially by reducing the number of clerks in each office Estimates showed that taxpayers in Massachusetts saved about 80000 per year by having fewer clerks at that office Consumer surplus is defined as the difference between the maximum amount that buyers are willing to pay for a good and its current market price Producer surplus is defined as the difference between the current market price of a good and the full cost of producing it In a way it is a measure of profitability A perfectly competitive economy is economically efficient and will lead to a Pareto efficient set of outcomes Under perfect competition 1 Resources are allocated among firms efficiently 2 Final products are distributed among households efficiently 3 The system produces the things that people want The assumptions that factor markets are competitive and open that all firms pay the same prices for inputs and that all firms maximize profits lead to the conclusion that the allocation of resources among firms is efficient You should now have a greater appreciation for the power of the price mechanism in a market economy Each individual firm needs only to make decisions about which inputs to use by looking at its own labor capital and land productivity relative to their prices But because all firms face identical input prices the market economy achieves efficient input use among firms Prices are the instrument of Adam Smith s l invisible handquot allowing for efficiency without explicit coordination or planning We all know that people have different tastes and preferences and that they will buy very different things in very different combinations As long as everyone shops freely in the same markets no redistribution of final outputs among people will make them better off If you and buy in the same markets and pay the same prices and buy what I want and you buy what you want we cannot possibly end up with the wrong combination of things Free and open markets are essential to this result The condition that ensures that the right things are produced is P MC Society will produce the efficient mix of output if all firms equate price and marginal cost We have built a model of a perfectly competitive market system that produces an efficient allocation of resources an efficient mix of output and an efficient distribution of output The perfectly competitive model is built on a set of assumptions all of which must hold for our conclusions to be fully valid We have assumed that all firms and households are pricetakers in input and output markets that firms and households have perfect information and that all firms maximize profits These assumptions do not always hold in real world markets market failure Occurs when resources are misallocated or allocated inefficiently The result is waste or lost value There are four important sources of market failure 1 Imperfect market structure or noncompetitive behavior In imperfectly competitive markets with fewer firms competing and limited entry by new firms prices will not necessarily equal marginal costs As a consequence in a market with firms that have some market power where firms do not behave as pricetakers we are not guaranteed an efficient mix of output 2 The existence of public goods Goods and services that bestow collective benefits on members of society Generally no one can be excluded from enjoying their benefits The classic example is national defense 3 The presence of external costs and benefits A cost or benefit imposed or bestowed on an individual or a group that is outside or external to the transaction 4 Imperfect information The absence of full knowledge concerning product characteristics available prices and so on Quantitative Literacy Assignment Cost NAME Banner ID Part 1 Compute the values for the blank cells Henry Korn amp Sons Inc A Perfectly Competitive Firm Q Price TR MR Per Ton FC VC P A A MC Per Ton Fields PerTon Tr AVT CoFCC fC i PP tPee err or r TT T00 lonn on 0 4000 0 1 4000 24000 5 9 0 0 0 2 4000 40000 3 4000 60000 4 4000 85000 5 4000 1 5 6 0 0 0 6 4000 169000 7 4000 221000 8 4000 286000 Experience indicates that their yield is 1000 tons per eld Therefore for all per ton computations use thousands for Q in the formulas eg 1000 2000 etc tons instead of 12 etc elds Part II On the grid at the right 7 PLOT the per ton P MR AVC ATC and MC Use an EXCEL or similar program to graph and plot on a separate graph paper and STAPLE it to this assignment Use titles on graph axes and variables Part III Individual Writing Questions Answer the following questions in a few wellwritten sentences 1 How many elds should Henry amp Sons plant this spring to maximize pro ts and what determines this 2 Should they try to get a price higher than 40 per ton to improve pro ts Why or why not 3 Assume the price is 40 per ton should they consider closing down Why or why not 4 Explain which of the variables computed in the table and plotted on the graph represent the supply and demand curves for the Henry Korn amp Sons Company 5 Explain what the supply and demand curves indicate to the Henry Korn rm ECON Exam 4 Chapter 13 imperfectly competitive industry An industry in which individual firms have some control over the price of their output market power An imperfectly competitive firm s ability to raise price without losing all of the quantity demanded for its product Forms of Imperfect Competition and Market Boundaries A monopoly is an industry with a single firm in which the entry of new firms is blocked An oligopoly is an industry in which there is a small number of firms each large enough so that its presence affects prices Firms that differentiate their products in industries with many producers and free entry are called monopolistic competitors pure monopoly An industry with a single firm that produces a product for which there are no close substitutes and in which significant barriers to entry prevent other firms from entering the industry to compete for profits A monopoly firm has no supply curve that is independent of the demand curve for its product A monopolist sets both price and quantity and the amount of output that it supplies depends on its marginal cost curve and the demand curve that it faces Monopoly in the Long Run Barriers to Entry barriers to entry Factors that prevent new firms from entering and competing in imperfectly competitive industries natural monopoly An industry that realizes such large economies of scale in producing its product that singlefirm production of that good or service is most efficient patent A barrier to entry that grants exclusive use of the patented product or process to the inventor Government Rules In some cases governments impose entry restrictions on firms as a way of controlling activity Ownership of a Scarce Factor of Production lf production requires a particular input and one firm owns the entire supply of that input that firm will control the industry network externalities The value of a product to a consumer increases with the number of that product being sold or used in the market rentseeking behavior Actions taken by households or firms to preserve positive profits government failure Occurs when the government becomes the tool of the rent seeker and the allocation of resources is made even less efficient by the intervention of government public choice theory An economic theory that the public officials who set economic policies and regulate the players act in their own selfinterest just as firms do price discrimination Charging different prices to different buyers perfect price discrimination Occurs when a firm charges the maximum amount that buyers are willing to pay for each unit Example Airlines movie theaters hotels and many other industries routinely charge a lower price for children and the elderly In each case the objective of the firm is to segment the market into different identifiable groups with each group having a different elasticity of demand The optimal strategy for a firm that can sell in more than one market is to charge higher prices in markets with low demand elasticities Major Antitrust Legislation The Sherman Act of 1890 The substance of the Sherman Act is contained in two short sections Section 1 Every contract combination in the form of trust or otherwise or conspiracy in restraint of trade or commerce among the several States or with foreign nations is hereby declared to be illegal Section 2 Every person who shall monopolize or attempt to monopolize or combine or conspire with any other person or persons to monopolize any part of the trade or commerce among the several States or with foreign nations shall be deemed guilty of a misdemeanor and on conviction thereof shall be punished by fine not exceeding five thousand dollars or by imprisonment not exceeding one year or by both said punishments in the discretion of the court rule of reason The criterion introduced by the Supreme Court in 1911 to determine whether a particular action was illegal quotunreasonablequot or legal quotreasonablequot within the terms of the Sherman Act The Clayton Act and the Federal Trade Commission 1914 Clayton Act Passed by Congress in 1914 to strengthen the Sherman Act and clarify the rule of reason the act outlawed specific monopolistic behaviors such as tying contracts price discrimination and unlimited mergers Federal Trade Commission FTC A federal regulatory group created by Congress in 1914 to investigate the structure and behavior of firms engaging in interstate to J what unlawful unfair behavior and to issue ceaseanddesist orders to those found in violation of antitrust law A firm has marketpower when it exercises some control over the price of its output or the prices of the inputs that it uses The extreme case of a firm with market power is the pure monopolist In a pure monopoly a single firm produces a product for which there are no close substitutes in an industry in which all new competitors are barred from entry Our focus in this chapter on pure monopoly which occurs rarely has served a number of purposes First the monopoly model describes a number of industries quite well Second the monopoly case illustrates the observation that imperfect competition leads to an inefficient allocation of resources Finally the analysis of pure monopoly offers insights into the more commonly encountered market models of monopolistic competition and oligopoly which we discussed briefly in this chapter and will discuss in detail in the next two chapters Chapter 14 oligopoly A form of industry market structure characterized by a few dominant firms Products may be homogenous or differentiated Oligopolists compete with one another not only in price but also in developing new products marketing and advertising those products and developing complements to use with the products The behavior of oligopolistic firms depends on the other firms composing the oligopoly Five Forces model A model developed by Michael Porter that helps us understand the five competitive forces that determine the level of competition and profitability in an industry concentration ratio The share of industry output in sales or employment accounted for by the top firms contestable market Markets in which entry and exit are easy The Collusion Model cartel A group of firms that gets together and makes joint price and output decisions to maximize joint profits tacit collusion Collusion occurs when price and quantityfixing agreements among producers are explicit Tacit collusion occurs when such agreements are implicit The PriceLeadership Model price leadership A form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy predatory pricing when a large firm tries to eliminate smaller firms by cutting prices too low The Cournot Model 2 firms and each assumes the other will not change its price or outputs duopoly A twofirm oligopoly best repsonse equillibrium the intersecting of two firms in a oligopoly game theory Analyzes the choices made by rival firms people and even governments when they are trying to maximize their own well being while anticipating and reacting to the actions of others in their environment dominant strategy In game theory a strategy that is best no matter what the opposition does kinkeddemand theory demand is more elastic for price increases than price decreases prisoners dilemma A game in which the players are prevented from cooperating and in which each has a dominant strategy that leaves them both worse off than if they could cooperate Nash equilibrium In game theory the result of all players playing their best strategy given what their competitors are doing maximin strategy In game theory a strategy chosen to maximize the minimum gain that can be earned titfortat strategy A repeated game strategy in which a player responds in kind to an opponent s play A Game with Many Players Collective Action Can Be Blocked by a Prisoner39s Dilemma Coordinated collective action in everybody s interest can be blocked under some circumstances A multipleplayer game can result in a classic prisoners dilemma where collusion if it could be enforced would result in an optimal outcome but where dominant strategies result in a suboptimal outcome The only necessary condition of oligopoly is that firms are large enough to have some control over price With the exception of the contestabIemarkets model all the models of oligopoly we have examined lead us to conclude that concentration in a market leads to pricing above marginal cost and output below the efficient level n u I Yet vigorous product may produce variety and lead to innovation among Industrial Concentration and Technological Change One of the major sources of economic growth and progress throughout history has been technological advance Several economists notably Joseph Schumpeter and John Kenneth Galbraith argued in works now considered classics that industrial concentration where a relatively small number of firms control the marketplace actually increases the rate of technological advance The role of the government 0 Regulation of mergers CellerKefauver Act Extended the government s authority to control mergers Her ndahlHirschman Index HHI An index of market concentration found by summing the square of percentage shares of firms in the market In 1997 the Department of Justice and the FTC issued joint Horizontal Merger Guidelines updating and expanding the 1984 guidelines The guidelines define llcoordinated interaction as actions by a group of firms that are profitable for each of them only as the result of the accommodating reactions of others This behavior includes tacit or express collusion and may or may not be lawful in and of itself One view concerning the role of government in regulating markets is that high levels of concentration lead to inefficiency and that government should act to improve the allocation of resources to help the market work more efficiently An opposing view holds that the clearest examples of effective barriers to entry are those created by government Further complicating the debate firms that dominate a domestic market may be erce O competitors in the international arena which has implications for the proper role of government Cha pter 15 Products Price a Number dilfercnriated decision Easy Distinguisth of rms or homogeneous variable entry b Examples Perfect 39 7 39 a 39 j V r compelilion 39 l 1 i Monop 01y One Oneversion or many Yes No Still constrained Public utillty versmns of a product by market demand Patented drug Monopolistic if u 7 competition 39 r 39 r r Oligopoly monopolistic competition A common form of industry market structure in the United States characterized by a large number of firms no barriers to entw and product differentiationex restaurants product differentiation A strategy that firms use to achieve market power Accomplished by producing products that have distinct positive identities in consumers minds How many varities o In well working markets the level of product variety reflects the underlying heterogeneity of consumers tastes in that market the gains if any from coordination and cost economies from standardization o In industries that are I quot 39 quot I quotquot quot in consumer tastes lack of need for coordination and modest or no scale economies from standardization give rise to a large number of firms each of which has a different product 0 Even within this industry structure however these same forces play a role in driving levels of variety How do firms differentiate products horizontal differentiation Products differ in ways that make them better for some people and worse for others ex salt and vinegar chips behavioral economics A branch of economics that uses the insights of psychology and economics to investigate decision making ex jam purchases and tastes commitment device Actions that individuals take in one period to try to control their behavior in a future period ex buying gym membership vertical differentiation A product difference that from everyone s perspective makes a product better than rival products ex BMW with GPS Advertising 0 For advertising 0 Differentiated products and advertising give the market system its vitality and are the basis of its power 0 Product differentiation helps to ensure high quality and variety and advertising provides consumers with valuable information on product availability quality and price that they need to make efficient choices in the marketplace 0 Open Questions 0 There are strong arguments on both sides of the advertising debate and even the empirical evidence yields to conflicting conclusions Some studies show that advertising leads to concentration and positive profits others that advertising improves the functioning of the market 0 The Case Against Product Differentiation and Advertising 0 The bottom line critics of product differentiation and advertising argue is waste and inefficiency Enormous sums are spent to create minute meaningless and possibly nonexistent differences among products Advertising raises the cost of products and frequently contains very little information Often it is merely an annoyance Advertising can lead to unproductive warfare and may serve as a barrier to entry thus reducing real competition Perfectly competitive firms face perfectly elastic demand if they try to raise the price there are substitutes so they will sell nothing If a firm distinguishes its product it can raise the price Monopolistic competitive firms have a more elastic demand than monopolies and a less elastic demand than perfectly competitive firms In the short run a monopolistically competitive firm will produce up to the point MR MC At qu 2000 in panel a the firm is earning shortrun profits equal to POABC 2000 In panel b another monopolistically competitive firm with a similar cost structure is shown facing a weaker demand and suffering shortrun losses at q1 1000 equal to CABP1 1000 As new firms enter a monopolistically competitive industry in search of profits the demand curves of existing profitmaking firms begin to shift to the left pushing marginal revenue with them as consumers switch to the new close substitutes This process continues until profits are eliminated which occurs for a firm when its demand curve is just tangent to its average total cost curve Economic efficiency and resource allocation 0 Because entry is easy and economic profits are eliminated in the long run we might conclude that the result of monopolistic competition is efficient There are two problems however 0 First once a firm achieves any degree of market power by differentiating its product as is the case in monopolistic competition its profitmaximizing strategy is to hold down production and charge a price above marginal cost 0 Second the final equilibrium in a monopolistically competitive firm is necessarily to the left of the low point on its average total cost curve which means a typical firm in this industry will not realize all the economies of scale available Chapter 16 market failure Occurs when resources are misallocated or allocated inefficiently externality A cost or benefit imposed or bestowed on an individual or a group that is outside or external to the transaction The study of externalities sometimes called spillovers or neighborhood effects is a major concern of environmental economics The marginal benefits to Harry exceed the marginal costs he must bear to play his game system for a period of up to 8 hours When the noise of the game occurs a cost is being imposed on Jake When we add the costs borne by Harry to the damage costs imposed on Jake we get the full cost of the game play to the twoperson society made up of Harry and Jake Playing more than 5 hours is inefficient because the benefits to Harry are less than the social cost for every hour above 5 f Harry considers only his private costs he will play for too long a time from society s point of view marginal social cost MSC The total cost to society of producing an additional unit of a good or service MSC is equal to the sum of the marginal costs of producing the product and the correctly measured damage costs involved in the process of production Acid rain is an excellent example of an externality and of the issues and conflicts involved in dealing with externalities In complex cases of externalities like acid rain often governments get involved The United States began its work in reducing acid rain with the Clean Air Act in 1990 Clearly the most significant and hotly debated issue of externalities is global warming Individual actions can also create externalities The key issue is weighing the costs and benefits to all parties In some cases when other people or firms engage in an activity there are side benefits from that activity The problem with positive externalities is that the individuals in charge have too little incentive to engage in the activity marginal private cost MPC The amount that a consumer pays to consume an additional unit of a particular good marginal damage cost MDC The additional harm done by increasing the level of an externality producing activity by 1 unit If producing product X pollutes the water in a river MDC is the additional cost imposed by the added pollution that results from increasing output by 1 unit of Xper period Five approaches have been taken to solving the problem of externalities 1 Private bargaining and negotiation small parties clear rule no cost to bargain 2 Legal rules and procedures 3 Governmentimposed taxes and subsidies TAX MDC If a perunit tax exactly equal to marginal damage costs is imposed on a firm the firm will weigh the tax and thus the damage costs in its decisions 4 Sale or auctioning of rights to impose externalities 5 Direct government regulation While each is best suited for a different set of circumstances all five provide decision makers with an incentive to weigh the external effects of their decisions a process called internalization Coase theorem Under certain conditions when externalities are present private parties can arrive at the efficient solution without government involvement injunction A court order forbidding the continuation of behavior that leads to damages liability rules Laws that require A to compensate B for damages imposed Internalizing externalities Taxes and subsidides 0 Measuring damages 0 The biggest problem with using taxes and subsidies is that damages must be estimated in financial terms 0 Even if we assume that a tax correctly measures all the damage done the decision maker may find it advantageous to continue causing the damage Reducing Damages to an Efficient Level 0 Taxes also provide firms with an incentive to use the most efficient technology for dealing with damage Taxes also provide firms with an incentive to use the most efficient technology for dealing with damage The Incentive to Take Care and to Avoid Harm o All externalities involve at least two parties and it is not always clear which party is quotcausingquot the damage 0 The best solution to an externality problem may not involve stopping the externality generating activity yet it might be most efficient for the damaged party to avoid the damage however they may not have the incentive if they are being paid 0 Subsidizing External Benefits 0 Activities that provide external social benefits may be subsidized at the margin to give decision makers an incentive to consider them subsidized housing 0 Pollution permit trading is an example of selling or auctioning pollution rights Direct Regulation of Externalities Taxes subsidies legal rules and public auctions are all methods of indirect regulation designed to induce firms and households to weigh the social costs of their actions against their benefits For obvious reasons many externalities are too important to be regulated indirectly Direct regulation of externalities takes place at federal state and local levels example EPA public goods social or collective goods Goods that are nonrival in consumption andor their benefits are nonexcludable nonrival in consumption A characteristic of public goods One person39s enjoyment of the benefits of a public good does not interfere with another s consumption of it everybody benefits nonexcludable A characteristic of most public goods Once a good is produced no one can be excluded from enjoying its benefits freerider problem A problem intrinsic to public goods Because people can enjoy the benefits of public goods whether or not they pay for them they are usually unwilling to pay for them dropinthebucket problem A problem intrinsic to public goods The good or service is usually so costly that its provision generally does not depend on whether any single person pays All societies past and present have had to face the problem of providing public goods When members of society get together to form a government they do so to provide themselves with goods and services that will not be provided if they act separately In the early 19505 economist Paul Samuelson building on the work of Richard Musgrave demonstrated that there exists an optimal or a most ef cient level of output for every public good The Samuelson Musgrave Theory An efficient economy produces what people want Private producers whether perfect competitors or monopolists are constrained by the market demand for their products If they cannot sell their products for more than it costs to produce them they will be out of business Because private goods permit exclusion firms can withhold their products until households pay Buying a product at a posted price reveals that it is quotworthquot at least that amount to you and to everyone who buys it At a price of 3 A buys 2 units and B buys 9 for a total of 11 At a price of 1 A buys 9 units and B buys 13 for a total of 22 We all buy the quantity of each private good that we want Market demand is the horizontal sum of all individual demand curves A is willing to pay 6 per unit for X1 units of the public good B is willing to pay only 3 for X1 units Society in this case A and B is willing to pay a total of 9 for X1 units of the good Because only one level of output can be chosen for a public good we must add A s contribution to B s to determine market demand This means adding demand curves vertically optimal level of provision for public goods The level at which society39s total willingness to pay per unit is equal to the marginal cost of producing the good by samuelson One major problem exists To produce the optimal amount of each public good the government must know something that it cannot possibly know everyone s preferences Tiebout hypothesis An efficient mix of public goods is produced when local landhousing prices and taxes come to reflect consumer preferences just as they do in the market for private goods example crime rate in housing towns social choice The problem of deciding what society wants The process of adding up individual preferences to make a choice for society as a whole Impossibility theorem A proposition demonstrated by Kenneth Arrow showing that no system of aggregating individual preferences into social decisions will always yield consistent nonarbitrary results voting paradox A simple demonstration of how majorityrule voting can lead to seemingly contradictory and 39 39 results A 39 cited quot39 39 of the kind of inconsistency described in the impossibility theorem logrolling Occurs when congressional representatives trade votes agreeing to help each other get certain pieces of legislation passed Government Inefficiency Theory of Public Choice Looking at the public sector from the standpoint of the behavior of public of cials and the potential for inefficient choices and bureaucratic waste rather than in terms of its potential for improving the allocation of resources has become quite popular This is the viewpoint of what is called the public choice field in economics that builds heavily on the work of Nobel laureate James Buchanan RentSeeking Revisited A monopolist would be willing to pay to prevent competition from eroding its economic profits Many if not all industries lobby for favorable treatment softer regulation or antitrust exemption This as you recall is rent seeking Theory may suggest that unregulated markets fail to produce an efficient allocation of resources not that government involvement necessarily leads to efficiency Government attempts to produce the right goods and services in the right quantities efficiently may also fail There is no question that government must be involved in both the provision of public goods and the control of externalities The question is not whether we need government involvement but how much and what kind of government involvement we should have Just as critics of government involvement must concede that the market by itself fails to achieve full efficiency defenders of government involvement must acknowledge government s failures Many on both sides agree that we get closer to an efficient allocation of resources by trying to control externalities and by doing better to produce the public goods that people want with the imperfect tools we have than we would by leaving everything to the market Chapter 18 equity Fairness human capital The stock of knowledge skills and talents that people possess it can be inborn or acquired through education and training compensating differentials Differences in wages that result from differences in working conditions Risky jobs usually pay higher wages highly desirable jobs usually pay lower wages Another source of wage inequality among households lies in the fact that many households have more than one earner in the labor force Second and even third incomes are becoming more the rule than the exception for US families minimum wage The lowest wage that firms are permitted to pay workers If the equilibrium wage in the market for unskilled labor is below the legislated minimum wage the result is likely to be unemployment The higher wage will attract new entrants to the labor force quantity supplied will increase from L to L5 but firms will hire fewer workers quantity demanded will drop from L to LB Unemployment hurts primarily those who are laid off and thus its costs are narrowly distributed For some workers the costs of unemployment are lowered by unemployment compensation benefits paid out of a fund accumulated with receipts from a tax on payrolls property income Income from the ownership of real property and financial holdings It takes the form of profits interest dividends and rents transfer payment Payments by government to people who do not supply goods or services in exchange economic income The amount of money a household can spend during a given period without increasing or decreasing its net assets Wages salaries dividends interest income transfer payments rents and so on are sources of economic income money income The measure of income used by the Census Bureau Because money income excludes non cash transfer payments and capital gains income it is less inclusive than economic income Lorenz curve A widely used graph of the distribution of income with cumulative percentage of households plotted along the horizontal axis and cumulative percentage of income plotted along the vertical axis The Lorenz curve is the most common way of presenting income distribution graphically The larger the shaded area the more unequal the distribution If the distribution were equal the Lorenz curve would be the 45degree line 0A Gini coef cient A commonly used measure of the degree of inequality of income derived from a Lorenz curve It can range from 0 to a maximum of 1 Ratio of total shaded are to total area under the 45degree line What has caused the rise in inequality Is it the forces of free trade immigration and globalization all working together to worsen the position of the middleincome workers who find themselves competing with workers in lowerincome countries Is it the declining power of unions and deregulation that have opened up more labor markets to the forces of competition Is it technological change that has favored the welleducated worker at the expense of unskilled labor These are difficult questions debated across the world Empirical evidence of the extent to which immigration has in fact reduced wages of lowerincome workers is mixed To determine whether the net benefits of immigration outweigh its net costs we must ask one important question To what extent does immigration reduce domestic wages and increase unemployment Going forward education may be key to reducing inequality in the United States and across the world Poverty is a very complicated word to define n simplest terms it means the condition of people who have very low incomes One school of thought argues that poverty should be measured by determining how much it costs to buy the llbasic necessities of lifequot Some say that poverty is culturally defined and is therefore a relative concept not an absolute one Although it is difficult to define precisely the word poverty is one that we all understand intuitively to some degree It is also a word that we have been forced to define formally for purposes of keeping statistics and administering public programs poverty line The officially established income level that distinguishes the poor from the nonpoor It is set at three times the cost of the Department of Agriculture s minimum food budget Data on the distribution of wealth are not as readily available as data on the distribution of income The distribution of wealth is more unequal than the distribution of income Some argue that an unequal distribution of wealth is the natural and inevitable consequence of risk taking in a market economy It provides the incentive necessary to motivate entrepreneurs and investors Others believe that too much inequality can undermine democracy and lead to social conflict Many of the arguments for and against income redistribution apply equally well to wealth redistribution utility possibilities frontier A graphic representation of a two person world that shows all points at which l s utility can be increased only if J s utility is decreased f society were made up of two people and J and all the assumptions of perfect competition held the market system would lead to some point along PP Every point along PP I is efficient it is impossible to make I better off without making J worse off and vice versa Which point is best Is B better than C Those who argue against government redistribution believe that the market when left to operate on its own is fair that llone is entitled to the fruits of one s effortsquot The argument most often used in favor of redistribution is that a society as wealthy as the United States has a moral obligation to provide all its members with the necessities of life In declaring war on poverty in 1964 President Lyndon Johnson put it this way There will always be some Americans who are better off than others But it need not follow that the llpoor are always with usquott is high time to redouble and to concentrate our efforts to eliminate povertyWe know what must be done and this nation of abundance can surely afford to do it utilitarianjustice The idea that quota dollar in the hand of a rich person is worth less than a dollar in the hand of a poor person If the marginal utility of income declines with income transferring income from the rich to the poor will increase total utility Rawlsian justice A theory of distributional justice that concludes that the social contract emerging from the lloriginal position would call for an income distribution that would maximize the well being of the worstoff member of society Karl Marx labor theory of value Stated most simply the theory that the value of a commodity depends only on the amount of labor required to produce it Private charity may fail for the same reason that the private sector is likely to fail to produce national defense and other public goods People will find it in their interest not to contribute We turn to government to provide goods and services we want that will not be provided adequately if we act separately Redistribution always involves those who end up with less and those who end up with more Because redistributional programs are financed by tax dollars it is important to know who the donors and recipients are who pays the taxes and who receives the benefits of those taxes Social Security system The federal system of social insurance programs It includes three separate programs that are financed through separate trust funds the Old Age and Survivors Insurance OASI program retired workers the Disability Insurance DI program and the Health Insurance HI or Medicare program public assistance orwelfare Government transfer programs that provide cash benefits to 1 families with dependent children whose incomes and assets fall below a very low level and 2 the very poor regardless of whether they have children The Supplemental Security Income program 55 is a federal program financed out of general revenues that was set up under the Social Security Administration in 1974 SSI is designed to take care of the elderly who end up very poor and have no or very low Social Security entitlement As with welfare qualified recipients must have very low incomes and virtually no assets unemployment compensation A state government transfer program that pays cash benefits for a certain period of time to laidoff workers who have worked for a specified period of time for a covered employer Medicaid and Medicare Inkind government transfer programs that provide health and hospitalization benefits Medicare to the aged and their survivors and to certain of the disabled regardless of income and Medicaid to people with low incomes food stamps Vouchers that have a face value greater than their cost and that can be used to purchase food at grocery stores Over the years the federal government and state governments have administered many different housing programs designed to improve the quality of housing for lowincome people A complex program the EIC essentially allows lowerincome families with children a credit equal to a percentage of all wage and salary income against their income taxes Some firms acquire market power and tend to underproduce and overprice Unregulated markets give private decision makers no incentives to weigh the social costs of externalities Goods that provide collective benefits may not be produced in sufficient quantities without government involvement The final distribution of wellbeing determined by the unfettered market may not be considered equitable by society Remember still that government is not a cure for all economic woes There is no guarantee that publicsector involvement will improve matters Many argue that government involvement may bring about even more inequity and inefficiency because bureaucrats are often driven by selfinterest not public interest Chapter 19 No matter what functions we end up assigning to government to do anything at all government must first raise revenues The primary vehicle that the government uses to finance itself is taxation Taxes may be imposed on transactions institutions property meals and other things but in the final analysis they are paid by individuals or households tax base The measure or value upon which a tax is levied tax rate structure The percentage of a tax base that must be paid in taxes 25 percent of income for example proportional tax A tax whose burden is the same proportion of income for all households progressive tax A tax whose burden expressed as a percentage of income increases as income increases regressive tax A tax whose burden expressed as a percentage of income falls as income increases average tax rate Total amount of tax paid divided by total income marginal tax rate The tax rate paid on any additional income earned Taxpayers may deduct income taxes paid to a state charitable contributions to qualifying organizations real estate taxes and interest paid on a mortgage to finance the purchase of a home as well as other items benefitreceived principle A theory of fairness holding that taxpayers should contribute to government in the form of taxes in proportion to the benefits they receive from public expenditures abilitytopay principle A theory of taxation holding that citizens should bear tax burdens in line with their ability to pay taxes If we accept the idea that ability to pay should be the basis for the distribution of tax burdens two principles follow First the principle of horizontal equity holds that those with equal ability to pay should bear equal tax burdens Second the principle of vertical equity holds that those with greater ability to pay should pay more The three leading candidates for best tax base are income consumption and wealth Income to be precise economic income is anything that enhances your ability to command resources Economic Income Consumption Change in Net Worth Consumption is the total value of goods and services that a household consumes in a given period Wealth or net worth is the value of all the goods and services you own after your liabilities are subtracted Net worth Assets Liabilities Thomas Hobbes argued that people should pay taxes in accordance with llwhat they actually take out of the common pot not what they leave inll since consumption is the best measure of wellbeing Taxing consumption is more efficient than taxing income A tax that distorts economic choices creates excess burdens According to proponents of income as a tax base you should be taxed not on what you actually draw out of the common pot but rather on the basis of your ability to draw from that pot which is measured best by income Still others argue that the real power to command resources comes not from any single year s income but from accumulated wealth Aggregate net worth in the United States is many times larger than aggregate income It is important to note that if income is already taxed a wealth tax in essence taxes the same dollars again What is the single best measure of ability to pay There is ongoing debate in the United States about whether it would be better to shift toward a more comprehensive consumption tax One of the oldest and most common forms of taxation in the world is the taxation of property held by an individual at the time of his or her death estate The property that a person owns at the time of his or her death estate tax A tax on the total value of a person s estate The United States levies a Gift and Estate Tax on gifts made over a person s lifetime and the value of the person s estate for estates over a certain level tax incidence The ultimate distribution of a tax burden sources sideuses side The impact of a tax may be felt on one or the other or on both sides of the income equation A tax may cause net income to fall damage on the sources side or it may cause prices of goods and services to rise so that income buys less damage on the uses side tax shifting Occurs when households can alter their behavior and do something to avoid paying a tax example tax on bananas shifts to famrers when consumers dont purchase them With no taxes on wages the wage that firms pay is the same as the wage that workers take home At a wage of W0 the quantity of labor supplied and the quantity of labor demanded are equal Recall that the demand for labor in perfectly competitive markets depends on its productivity The shape of the demand curve for labor shows how responsivefirms are to changes in wages Household behavior and thus the shape of the labor supply curve depend on the relative strengths of income and substitution effects The labor supply curve represents the reaction of workers to changes in the wage rate A payroll tax drives a quotwedgequot between the price of labor that firms face and takehome wages With a tax on firms of ST per unit of labor hired the market will adjust shifting the tax partially to workers When the tax is levied firms must first pay W0 T This reduces the labor demand to Ld The result is excess supply which pushes wages down to W1 and passes some of the burden of the tax onto workers The ultimate burden of a payroll tax depends on the elasticities of labor supply and labor demand For example if supply is relatively elastic as in part a the burden falls largely on employers if the supply is relatively inelastic as in part b the burden falls largely on workers The corporate profits tax or corporation income tax is a tax on the profits of firms that are organized as corporations Corporations are firms granted limited liability status by the government Limited liability means that shareholdersowners can lose only what they have invested The owners of partnerships and proprietorships do not enjoy limited liability and do not pay this tax rather they report their firms income directly on their individual income tax returns Like the payroll tax the corporate tax may affect households on the sources or the uses side of the income equation It may affect profits earned by owners of capital wages earned by workers or prices of corporate and noncorporate products Many researchers have done complete analyses under varying assumptions about tax incidence and in most cases their results are similar State and local taxes with sales taxes playing a big role seem as a group to be mildly regressive Federal taxes dominated by the individual income tax but increasingly affected by the regressive payroll tax are mildly progressive The overall system is mildly progressive When taxes distort economic conditions they impose burdens on society that in aggregate exceed the revenue collected by the government excess burden The amount by which the burden of a tax exceeds the total revenue collected Also called deadweight loss principle of neutrality All else equal taxes that are neutral with respect to economic decisions that is taxes that do not distort economic decisions are generally preferable to taxes that distort economic decisions Taxes that are not neutral impose excess burdens In practice all taxes change behavior and distort economic choices If the industry is perfectly competitive longrun equilibrium price will be 20 per unit of X If 1000 units ofXare sold consumers will pay a total of 20000 for X If the industry is perfectly competitive price will be 26 per unit owahen a tax of 1 per unit of capital is imposed If technology B is used and if we assume that total sales remain at 1000 units total tax collections will be 1000 x 4 x 1 4000 But consumers will pay a total of 26000 for the good 6000 more than before the tax Thus there is an excess burden of 2000 A tax that alters economic decisions imposes a burden that exceeds the amount of taxes collected An excise tax that raises the price of a good above marginal cost drives some consumers to buy less desirable substitutes reducing consumer surplus The size of the excess burden from a distorting tax depends on the degree to which decisions or behaviors change in response to it Less elastic more inelastic smaller excess burden more elastic larger excess burden principle of second best The fact that a tax distorts an economic decision does not always imply that such a tax imposes an excess burden If there are previously existing distortions such a tax may actually improve efficiency The idea that taxes work together to affect behavior has led tax theorists to search for optimal taxation systems however impossible to implement bringing us full circle First Lecture Notes 1 About the class 7 question and answer Some one must answer 2 Not In class not on the test 3 Test I 7 easiest of all test ii very hard test iii the hardest test iv like test ii Eight Principles of business 1 What is every business in business for Provide a product or service 2 The most difficult thing a business has to do Convince a customer to buy 3 How do you price a product or service Whatever the customer is willing to pay 4 What is the costliest item a business has Employee 5 What is the most valuable asset Employee 6 What is the most fundamental nancial principle for any business Cash in gtcash out 7 How does any business stay in business for the long term Differentiate 8 What is quality Smiley faces based on Number Nine 7 Goal of any business Make Money very vague concept Maximize Pro t 0r Minimize Loss Economics The study of how individuals choose to use the scarce resources provided to them Opportunity Cost The best alternative that we forgo or give up when we make a choice or a decision Microeconomics The branch of economics that examines the functioning of individual decisionmaking units that is firms and households Macroeconomics The branch of economics that examines the economic behavior of aggregatesincome employment output and so on on a national scale Behavioral economics Uses psychological theories relating to emotions and social context to help understand economic decision making and policy Much of the work in behavioral economics focuses on the biases that individuals have that affect the decisions they make Comparative economics Examines the ways alternative economic systems function What are the advantages and disadvantages of different systems Econometrics Applies statistical techniques and data to economic problems in an effort to test hypotheses and theories Most schools require economics majors to take at least one course in statistics or econometrics Economic development Focuses on the problems of lowincome countries What can be done to promote development in these nations Important concerns of development for economists include population growth and control provision for basic needs and strategies for international trade Economic histogy Traces the development of the modern economy What economic and political events and scienti c advances caused the Industrial Revolution What explains tremendous growth and progress of post World War II Japan What caused the Great Depression ofthe 1930 s Environmental economics Studies the potential failure of the market system to account fully for the impacts of production and consumption on the environment and on natural resource depletion Have alternative public policies and new economic institutions been effective in correcting these potential failures Finance Examines the ways in which households and firms actually pay for or finance their purchases It involves the study of capital markets including the stock and bond markets futures and options capital budgeting and asset valuation Health economics Analyzes the health care system and its players government insurers health care providers and patients industrial organization international economics labor economics law and economics public economics urban and regional economics Positive economics An approach to economics that seeks to understand the operation of systems without making judgments It describes what exists and how it works what would happen 0 Descriptive economics The compilation of data that describe phenomena and facts 0 Economic theory A statement or set of related statements about cause and effect action and reaction Normative economics An approach to economics that analyzes outcomes of economic behavior evaluates them as good or bad and may prescribe courses of action Aka policy economics should we Ockham39s razor The principle that irrelevant detail should be cut away Ceteris Paibus All else equal A device used to analyze the relationship between two variables while the values of other variables are held unchanged 0 02 04 06 08 1 12 14 16 18 2 22 02 04 06 08 12 14 16 18 22 demand demand supply 40 30 20 supply new supply new demand Price for Toyotas thausa nds 45 4O 35 3O Market for Toyotas in US2008 A A New Eq Pt W 39 quot 02 04 06 08 1 12 14 16 18 2 Toyotas in US Millions Price for GM Thausa nds 02