Economics 516 Fall 2005 Dan Goldhaber.

Economics 516 Fall 2005 Dan Goldhaber

Chapters 1 and 2: Introduction and Review of Supply and Demand

Why Study Economics? Economic concepts and training help to sharpen thinking about: Relevant alternatives Under what conditions market interventions are likely to be useful Policy options, effects, and implications Many of the simplifications (e.g. human behavior) used in economic theory are useful for clarification of complex issues Some of the types of questions economics can help answer: Would rent control result in more affordable rental units? How much should water cost? What should bus fares be (and should they cover the full cost)? What is the underlying assumption about a society that opts to provide food stamps instead of cash assistance? Why does I-5 get so congested? Economic theory may (seem to) be based on ridiculous assumptions (e.g. measuring utility), but the tools used to represent human behavior and economic systems are key to understanding public policy Calorie example Cornell tuition waiver example Example about ‘How many of you know how to ride a bike? How do you do it? Why is it that it is so difficult to stay upright when the bike isn’t moving but it’s easy when the bike is moving? What’s the angular momentum of the bicycle and what is the force of the gyroscopic precession as you move from 5 to 10 mph? Why don’t we see intricately built buildings anymore?

Thinking Like An Economist
Economics - The study of the allocation of scarce resources Basic assumption is that people are reasonably rational and seek to maximize utility Exchanges take place (assuming no duress) because they make individuals better off Positive and normative analyses - economics is useful in making positive, but not for normative, assessments Opportunity cost of leisure

Costs Opportunity costs consist of the value of our best forgone alternative action. Every action we take has an associated opportunity cost because we could be doing something else. Example: The cost of enrolling in the MPA program includes tuition, fees, etc., but also the lost wages we would have earned if we would have worked instead of attending. Opportunity costs = explicit (monetary) costs + implicit (time) costs Sunk costs are costs that already have been incurred and cannot be recovered regardless of any action we may take. Example: If you spent $1000 repairing your radiator last week and this week you total your car, you wish you wouldn’t have just spent that money last week but there’s nothing you can do to recover it. Marginal costs are costs that depend on the next action taken Example: You are trying to decide whether to go to a movie or to spend those two hours captivated by your economics text.

Is Economic Theory Perfect?
Basic assumption is that market participants are goal oriented (utility maximization), but: No, people don’t always function like “Homo Economicus”: E.g. tipping on the road, contribution to charities, etc. But, the Homo Economicus caricature does help us understand economic systems, and most people do function with a degree of self-interest Seemingly selfless behavior may also be in one’s self interest

Limitations of Rational Consumer Model
Time preferences Independence of utility Imperfect information Kissing example Pizza example Car rebate example

Supply and Demand Law of demand - observation that people demand more of a product when the price of that product is lower, ceteris paribus Demand curves therefore have a negative slope Law of supply - observation that firms will produce and offer more of a product when the price of that product is higher Supply curves therefore have a positive slope

Market Equilibrium The intersection of demand and supply curves determine the equilibrium price and quantity in the market Price does not determine supply and demand in the market, rather it is supply and demand that determine price (in the absence of any intervention) Prices set above equilibrium lead to excess supply, and those set below equilibrium lead to excess demand Prices serve as a signal in the market for rationing and allocating goods In the short run price directs resources/products to those who value them most (are willing to pay) - rationing function In the long run price acts to direct resources away from production of less desirable goods towards those more in demand

Shifts vs. Movements of Supply and Demand Curves
Shifts of demand curve Income Prices of substitutes or complements Tastes/preferences Population Expectations Shifts of supply curve Technology Input/factor prices Number of suppliers Natural conditions (weather) Expectations We use the demand and supply framework to evaluate many public policies -- e.g. rent control, taxation, etc. Learn the differences between changes in demand/supply and changes in quantity demanded/supplied! Shift of supply curve is movement along the demand curve Shift of demand curve is movement along the supply curve

Market Equilibrium Demand Shift Supply Shift P P Q Q d s s0 s1 d1 d0
Market equilibrium price - d d0 Q0 Q1 Q Q Q0 Q1

Elasticity Price elasticity of demand is a measure of how sensitive consumers are to changes in price, p = %Q/%P = (Qd/Q)/ (P/P) Three measures of price elasticity: Elastic, p > 1 Inelastic, p < 1 Unit elastic, p = 1 Elasticities vary among goods Elasticity is key to determining who pays for taxes/shifts in demand/supply curves Price elasticity of supply is a measure of the responsiveness of quantity supplied to changes in price Income elasticity of demand is a measure of how responsive consumers are to changes in income Cross-price elasticity of demand is a measure of how much a change in the price of good X affects the demand for good Y

Consumer Surplus The differential between what one was willing to pay for a purchase and what one actually had to pay for that purchase P Consumer’s surplus P* Q

What Do We Know About Equilibrium Price/Quantity When Things Change?
If only one curve - the supply or the demand - shifts, we can tell what happens to both equilibrium price and quantity (i.e. they go up/down) If both supply and demand shift in the same direction, we can tell what happens to equilibrium quantity but not to equilibrium price If both supply and demand shift in opposite directions, we can tell what happens to equilibrium price but not to equilibrium quantity

The Algebra of Supply and Demand
(1) From (1): From the Demand and Supply equations: P = (3) = 40 P = (3) = 40

Non-Market Clearing Price Policies
Price Ceiling: Prices are not allowed to rise above a certain level Price ceilings create excess demand, or shortages Price Floor: Prices are not allowed to fall below a certain level Price floors create excess supply, or surpluses Supply Supply Price Floor Price Ceiling Demand Demand Qd Qs Qs Qd Surplus Shortage

Algebra of Non-Market Clearing Policies
Government imposes P = 30 Shortage of 2.5 units

Chapter 3: Theory of Consumer Behavior

Indifference Curves and Budget Constraints
Individuals seek to maximize utility by allocating income across a range of purchases subject to the constraints of their budgets Indifference curves represent all the different allocations of purchases where an individual is equally satisfied Shape of the indifference curves describe whether goods are goods or bads We usually assume diminishing marginal utility implies convex indifference curves Perfect substitutes and perfect complements are special cases Intersecting indifference curves represent inconsistent behavior Budget constraints determine the allocations of purchases available to consumer and the budget line describes the maximum that can be purchased if consumer expends all his/her income Curvature of IC describes a consumer’s MRS

Indifference Curves Good Y U3 U2 U1 Good X
Slope of indifference curves indicates MRS Convex shape indicates diminishing MRS U3 U2 Utility increases moving up indifference curves in the northeast direction (U1<U2<U3) U1 Good X

The Marginal Rate of Substitution (MRS)
The MRS at any point on the IC represents the amount of one good (on the vertical axis) that a consumer is willing to trade for another (the good on the horizontal axis) to make her/him indifferent (same utility function) between two allocations The absolute value of the the slope of the IC at a given point The MRS is (usually) different at different points on the IC because of the law of diminishing marginal utility (marginal utility declines as consumption of a good increases)

Budget Constraints Good Y Intercepts where all income is
Spent on one good or the other Budget line shows all consumption baskets that are possible with the given income Good X

Utility Maximization With Constraint
Oranges O* None of the points on U1 are the maximum utility because you can consume where U2 is tangent to the budget constraint. U3 provides higher utility than U2, but it is not possible given the budget constraint. U2 is the best you can do. U3 U2 U1 Apples A*

Perfect Substitutes U3 U2 U1 Darigold Butter
Note: Indifference curves have a slope of -1 (i.e. a one-to-one trade off) If the two goods are perfect substitutes to you, you will always spend all of your income on the cheapest of the two goods. This is because you truly can’t tell the difference between them. U3 U2 U1 Land O’ Lakes Butter

Perfect Complements Right Shoes U3 U2 U1 Left Shoes
This is the case where apples and oranges go into your utility function only in a specific proportion. For example, you only eat apples and oranges in your favorite fruit salad that calls for 2 apples and 1 orange. You aren’t any better off if you have 2 apples and 2 oranges than if you only have 2 apples and 1 orange (because the recipe doesn’t work that way). U2 U1 Left Shoes

Effect of a Income Change: Normal Goods
All other goods apples

Effect of a Income Change: Inferior Goods
All other goods Spam

How Much of Each Good Should a Consumer Purchase to Maximize Utility
Apples Oranges Total Utility Marginal Utility Marginal Utility/dollar Marginal Utility /dollar 1 2 3 4 5 6 7 20 35 47 55 61 65 67 20 15 12 8 6 4 2 10 7.5 6 4 3 2 1 15 27 36 39 41 42 15 12 9 3 2 1 10 8 6 2 1.33 0.67 Apples= $2.00/lb Oranges=$1.50/lb

The Effect of Changes in Price on Demand
Apples Oranges Total Utility Marginal Utility Marginal Utility/dollar Marginal Utility /dollar 1 2 3 4 5 6 7 20 35 47 55 61 65 67 20 15 12 8 6 4 2 8 6 4.8 3.2 2.4 1.6 .8 15 27 36 39 41 42 15 12 9 3 2 1 10 8 6 2 1.33 0.67 Now the price of apples increased to $2.50/lb Apples= $2.50/lb Oranges=$1.50/lb

Sample Problem Assume both demand and supply have constant slopes
Questions: What are the demand and supply equations? What are the equilibrium quantity and price levels? What are the new equilibriums if the product is found to be good for your health such that demand at every price increases by 10? P Qd Qs 40 5 15 20

Chapters 4: Individual and Market Demand

Price-Consumption Curve
margarine Price-Consumption curve P=$7 P=$3 P=$2 10 20 32 butter Price 7 3 Demand for butter 2 10 20 32 Quantity of butter

Link Between Indifference Curve Budget Constraint Model and Demand Curve
The utility-maximizing quantities at each price level trace out the individual’s demand curve P $15 $10 $5 P=$15 P=$10 P=$5 Q Q 9 12 15 9 12 15

From Individual to Market Demand
Market demand is made up of the sum of individual demands Total Demand p p p p p D3 D1 D2 D4 15 Q 30 Q 25 Q 10 Q Q 80

Income-Consumption and Engel Curves
Oranges Income Engel Curve Income-Consumption Curve 100 75 The Engel curve looks just like the income-consumption curve except that it has income on the vertical axis. 50 I = 100 I = 50 I = 75 1000 2000 2900 apples 1000 2000 2900 apples

Normal and Inferior Goods
Normal good - one whose quantity demanded rises as income rises Inferior good - one whose quantity demanded falls as income rises Normal good Normal good Normal good Inferior good

Effect of a Price Change on Utility
Compensating Variation: The minimum change in income at the new prices that would make the consumer as well off as they were before the price change Equivalent Variation: The minimum change in income at the old prices that would make the consumer as well off as they are after the price change

Compensating Variation

Equivalent Variation Equivalent Variation

Income and Substitution Effects
The total impact of a price change on the demand for a product can be broken into the income and substitution effects Income effect - the component of the total effect of a price change that results from the associated change in real purchasing power (quasi income) Substitution effect - the component of the total effect of a price change that results from the associated change in the relative attractiveness (relative price) of the good in question Giffen good is one for which the total effect of a price increase/decrease is to increase/decrease the demand for that good (counter intuitive effect) Substitution effect is always in the same direction so a Giffen good is a strongly inferior good, so strongly inferior that the income effect is larger than the substitution effect

Effect of a Price Change: Normal Good
All other goods apples Substitution effect Income effect

Effect of a Price Change: Inferior Good
All other goods Income effect Spam Substitution effect

Effect of a Price Change: Giffen Good
All other goods Income effect Potatoes Substitution effect

Price Elasticity Price elasticity of demand - the percentage change in the quantity demanded that results from a 1 percent change in its price Always less than zero by Law of Demand The value of price elasticity tells whether demand is elastic, inelastic, or unitary elastic Elastic Inelastic Unitary Elastic

Graphical Depiction of Price Elasticity
10 9 Inelastic 2 1 demand 1 2 9 10 Quantity

Elasticity Along a Demand Curve
Price Elastic Unitary Elastic Inelastic demand Quantity

Other Elasticities Income elasticity of demand - the percentage change in the quantity demanded that results from a 1 percent change in income (Y) Cross-price elasticity - the percentage change in the demand for good X that results from a 1 percent change in the price of good Y

What Determines Price Elasticities
Substitution possibilities - greater number of substitutes makes goods more elastic Budget share - greater share of expenditures accounted for by the product, the more elastic Direction of income effect - normal goods will have higher price elasticities than inferior goods b/c the income effect reinforces the substitution effect Time - the longer the time period in question, the greater the price elasticity

Price Elasticity and Total Revenue (Elastic)
Losses in total revenue from lowering the price Price Note that the area of the gains exceeds the area of the losses, implying that the firm has greater total revenue after the price is lowered than before. Gains in total revenue from lowering the price Quantity

Price Elasticity and Total Revenue (Inelastic)
Losses in total revenue from lowering the price Note that the area of the losses exceeds the area of the gains, implying that the firm has less total revenue after the price is lowered than before. Gains in total revenue from lowering the price Quantity

Chapters 5: Using Consumer Choice Theory

Returning to the Concept of Consumer Surplus
Consumer surplus is a dollar measure of the extent to which a consumer (or many) benefits from participating in a transaction Assuming that transactions occur voluntarily (implying that those engaging in them are better off than had the transactions not occurred), consumer surplus represents the difference in what one was willing to pay for a product/service and what one actually had to pay to obtain that product/service The concept of consumer surplus is key to evaluating public policies such as taxation/subsidization, price ceilings/floors, etc.

Consumer Surplus P Consumer’s surplus P* Q

Algebra of Consumer Surplus
20 12 10 8 10 Consumer surplus before tax = Consumer surplus after tax = Change in C.S. after tax =

Price Elasticity and Consumer Surplus
Loss in C.S. for inelastic demand Loss in C.S. for elastic demand Elastic Demand Inelastic Demand

Calculating Loss in Consumer Surplus
Supply1 Supply0 Demand Q Loss in Consumer Surplus

Taxation ST P S D Q Deadweight Loss Tax Revenue Loss in C.S.
Loss in P.S. D Q

Taxation on the Supply Side
Lost P.S. = FCDE Lost C.S. = ABCF Tax Revenue = ABDE Deadweight Loss = BCD Tax Paid By Consumer=ABFG Tax Paid By Producer = FGDE A B Pc F G Pno tax C E D Pp D1 Pc = Price paid by consumer Pp = Price received by producer

Taxation on the Demand Side
Lost P.S. = FCDE Lost C.S. = ABCF Tax Revenue = ABDE Deadweight Loss = BCD Tax Paid By Consumer=ABFG Tax Paid By Producer = FGDE Pc A B F G Pno tax C Pp E D D1 D2 Pc = Price paid by consumer Pp = Price received by producer

Algebraic Example of Taxation
Supply and Demand Before Tax The government imposes a $0.404/pack cigarette tax What is the total amount of the tax? What percentage of the tax is paid by the consumers? What percentage of the tax is paid by the producers? What is the total deadweight loss of the tax?

Burden of Taxation: Elastic Demand
P S Loss in C.S. Loss in P.S. D Q

Burden of Taxation: Inelastic Demand
P S Loss in C.S. Loss in P.S. D Q

Algebra of Taxation: Elastic and Inelastic Demand
Two demand curves (elastic & inelastic) have the same initial equilibrium price and quantity Government imposes tax of $60

Bias in Consumer Price Index
Substitution Bias: The CPI does not take into account the fact that consumers will change their consumption basket as relative prices change. (Substitution Effect) Quality Change: The CPI holds a basket of goods as fixed, when in fact the quality of some of the goods may be changing dramatically over time (e.g. the efficacy of pharmaceuticals)

CAFÉ Standards for Automobiles
Justification for government intervention Imperfect information about long-term benefits Imperfect capital markets Externalities (pollution and national security) - estimated to be 12 cents per gallon Government solution - regulations governing average fleet mileage Fines imposed on those who don’t meet government standard (Possible) consequences Increased lobbying expenditure Increased fleet sales “Rebound Effect” Adopted in 1975 with current standards of 27.5 for cars, and 20.7 for trucks (includes SUVs). What is the underlying “objective” of the law? Can higher standards be met? Is this the best way to increase fuel efficiency/limit pollution. 2001 study concludes that it is possible to achieve more than 40% increase in light truck fuel economy over year period at costs that would be recoverable over the life of the vehicle - Is this really possible? Average fuel economy has more than doubled from 12.9 in 1974 (different mix of vehicles however). Why wouldn’t we see the market do this? Imperfect info on consumer side, risk/uncertainty on producer side (e.g. great variance in gas prices). What about a gas tax as an alternative? CBO estimate suggests a CAFÉ standard that would reduce gasoline consumption by 10% would cost producers and consumers $3.6 billion/year. Increasing fuel tax by 46 cents/gallon would save more than 10% and only cost $2.9 billion/year. “Over the initial 14 years, the tax would save 42% more gasoline than would CAFÉ standards with trading, while costing 27% less.”

Graphical Depiction of CAFÉ Standards
Supply with CAFÉ Standards Marginal Social Cost (MSC) Price of Automobiles Supply without CAFÉ Standards Demand for automobiles Quantity of Automobiles

Alternative Way to Meet Objective: Tax and Rebate
$ Amount of rebate Gasoline

Strip Club Moratorium Justification for government intervention: negative externalities Government solution - restrict the number of strip clubs in Seattle to 4 (existing) clubs (Possible) consequences Higher prices Economic profits Possible loss of consumer surplus “Temporary” moratorium has been in effect for over 15 years. Articles suggest that there’s a “monopoly,” but really it’s an “oligopoly.”

Graphical Depiction of Strip Club Moratorium
market supply Price market demand Quantity of strip clubs

Intertemporal Choice Just as consumers make decisions over the purchase of different combinations of goods, they make decisions about whether to purchase goods today or in the future We can examine consumer preferences over intertemporal choice using the tradition IC framework Intertemporal ICs show combinations of current/future consumption for which consumers are indifferent The marginal rate of time preference (MRTP), which is the slope of the Intertemporal IC, shows the rate at which the consumer is willing to trade off consumption today versus consumption tomorrow Consumers may exhibit positive, negative, or neutral time preference (most exhibit positive)

Factors Affecting Time Preferences
Inidividual preferences Uncertainty about future events Value of anticipated future utility/disutility Preferences for a rising consumption standard

Graphical Illustration of Time Preferences
Impatience Neutrality Patience

Intertemporal Budget Constraint
The intertemporal budget constraint is determined by r, the interest rate Assuming consumers can borrow freely, the intertemporal budget constraint is represented by:

Intertemporal Optimality
C2 Y1 (1+r) + Y2 C2* C1 Y1+Y2(1+r)-1 C1*

Changes in the Interest Rate and Optimality
Y1 (1+r0) + Y2 Interest rate begins at r0 Interest rate falls from r0 to r1 Y1 (1+r1) + Y2 Note that the consumer is worse off after interest rates fall because she was initially a saver and now she doesn’t earn as much interest on that money that she saved. Practice: Show that a borrower is better off in this same situation. Y1+Y2(1+r0)-1 Y1+Y2(1+r1)-1

Algebraic Example of Intertemporal Choice
If James earns $50,000 this year and will earn $60,000 next year, what is the maximum interest rate that would allow him to spend $100,000 this year? What is the minimum interest rate that would allow him to spend $115,000 next year?

Homo Economicus? Some people may function as perfect examples of Homo Economicus, but most only approximate this behavior We are satisfiers not maximizers, but this is rational! Limitations of rationality Asymmetric treatment of gains and losses (K-T value function) Failure to appropriately ignore sunk costs Judgmental heuristics and biases Availability Representativeness Anchoring and adjustment So long as people practice “bounded rationality” economic theory is useful It is irrational to try to obtain perfect information

Kahneman-Tversky Value Function
V(gain) loss Losses Gains gain V(loss)

Sunk Costs James and AJ have the same preferences for movies. They’re both eager to see the latest summer blockbuster but work different schedules: James can only attend the matinee ($3.50) and AJ can only attend the evening show ($9.00). Halfway through the movie they both realize they hate it. Which is more likely to walk out? K-T value function helps explain failure to ignore sunk costs!

K-T Value Function and the Market
Sellers, gift givers, etc. can “manipulate” consumers by: Segregating gains (e.g. separate lottery wins) Combining losses (e.g. state and fed tax delinquency notices) Offsetting small loss with a larger gain (e.g. lottery and ink drop) Segregating small gains from large losses (e.g. car rebate) We see examples of all of these practices above in the marketplace

Graphical Depiction of K-T Practices
A manufacturer offers a $1000 rebate on a car purchase 1000 1000 The value of gaining $1000 is much greater than the loss of an additional $ So a company can raise the price by $1000 and then rebate that back to a customer and the customer feels better off.

Judgmental Heuristics (Rules of Thumb)
Availability - memory research shows that it is easier to recall an event the more vivid, sensational, or recent it is As a consequence, we often put too much weight on these type of events (e.g. murders and suicides in NYC, “r” as first or third letter) Representativeness - we often overstate the importance of representative events Judgments about muggings Regression to the mean Sophomore/SI jinx Anchoring and adjustment - we often overstate the importance of the anchor (e.g. which is larger 1x2x3…x9 or 9x8x7…1) These heuristics may be efficient in the sense that they help us economize on cognitive effort - give us roughly correct answers

Chapters 6 & 19.1 & 19.2: Exchange Efficiency, and Prices

General and Partial Equilibrium Analysis
Partial equilibrium analysis - the study of how individual markets function in isolation Ceteris paribus What we’ve been doing! Partial equilibrium analysis ignores: Spillover effects - a change in equilibrium in one market may affect other markets too Feedback effects - a change in equilibrium in a market that is caused by events in other markets that, in turn, are the result of an initial change in equilibrium in the market under consideration General equilibrium analysis - study of economic outcomes when one simultaneously considers the the interconnected system of markets Here we are not making ceteris paribus assumptions

A Simply Exchange Economy
An Edgeworth box is a useful tool to help understand general equilibrium in a simply exchange economy with two consumers Provides an understanding of the value of exchange Defines points of optimality for the economy Edgeworth box allows us to judge different allocations between individuals in an economy An allocation “A” is superior to an allocation “B” if at least one individual prefers “A” to “B” and all others are at least as happy with “A” as “B” “A” is said to be Pareto superior to “B” Pareto optimality (efficiency) - set of allocations (between individuals) where it is impossible to make one person better off without making at least some others worse off Contract curve defines the set of Pareto optimal points - all voluntary contracts must lie on the contract curve Inefficient - the condition under which, though a reallocation of resources at lease one person could be made better off w/o making anyone else worse off

Edgeworth Box Beth’s quantity of food Beth’s quantity of clothes
Contract Curve Beth’s quantity of clothes Adam’s quantity of clothes Adam’s indifference curves Beth’s indifference curves Adam’s quantity of food

An Example of a Disequilibrium Relative Price Ratio
Food Beth 220 200 Clothes 60 80 80 At this price, both Adam and Beth want to give up clothes to get more food. They can’t both give up clothes and be able to get more food since it isn’t available in the economy. 60 Clothes Pf = Pc 200 220 Adam Food

The Invisible Hand & Welfare Theorems
The first theorem of welfare economics also known as the Invisible Hand Theorem states that “An equilibrium produced by competitive markets will exhaust all possible gains from exchange” Adam Smith Every competitive equilibrium allocation is efficient The second theorem of welfare economics says that, under relatively unrestricted conditions, any allocation on the contract curve can be sustained as a competitive equilibrium May require reallocation of initial endowments Cautions: These theorems apply, but only under certain conditions We will discuss later whether/when they exist These theorems do not imply that individuals would not prefer different equilibrium points, in general they would, but they are the best that individuals can do given their initial endowments

The Inefficiency of Taxes/Subsidies in General Equilibrium
Taxes or subsidies in an economy change the relative price ratio between goods, which leads to In equilibrium consumers will still have a common value of MRS, and producers will still have a common value of MRTS, but inefficiency arises from the fact that producers and consumers see different price ratios Consumption decisions are based on gross prices (prices inclusive of taxes and subsidies) Production decisions are based on net prices (prices received by producer after tax is paid or subsidy received)

Would the World Be Better Without Taxes?
Not necessarily because: The optimums produced from a competitive economy only apply under certain conditions We will discuss some of the exceptions to these conditions shortly As a society we might care about other things in addition to efficiency, such as equity, human rights, etc. Still, in general, we limit the inefficiency caused by taxation if we impose taxes that keep price distortions to a minimum E.g. same tax rate applied to all products, or a head tax

Chapters 7: Production

Production Any activity that creates present or future activity
We assume an input output relationship defined by the production function defining a relationship by which inputs are combined to produce output Q = F(K, L, E) K = capital, L = labor, E= Entrepreneurship

Fixed and Variable Inputs
Two types of inputs, variable and fixed Variable inputs are those whose quantity can be relatively easily altered Fixed inputs are those whose quantity cannot be altered within a given time period Short-run - the longest period of time during which at least one of the inputs used in production cannot be varied Long-run - shortest period of time required to alter the amounts of every input Note that all inputs are variable in the long run Note that neither the short or long run is defined by specific time periods, and that the short and long runs may be different for different production processes

Law of Diminishing Marginal Returns
Total product - Q = F(K,L), omit E for simplicity Marginal product - change in total product with a change of one of the inputs, holding constant all others MP = MPL Note production function implies diminishing marginal returns Law of Diminishing Marginal Returns - increase in output from an increase in a variable input, ceteris paribus, must eventually decline Average product - average product produced with a given level of input APL = Q/L

Numerical Example of Production (in the Short Run)
Labor Total Product Average Product Marginal Product 1 10.00 10 2 14.14 7.07 4.14 3 17.32 5.77 3.18 4 20.00 5.00 2.68 5 22.36 4.47 2.36 6 24.49 4.08 2.13 7 26.46 3.78 1.96 8 28.28 3.54 1.83 9 30.00 3.33 1.72 31.62 3.16 1.62 11 33.17 3.02 1.54 12 34.64 2.89 1.47

Graphical Representation of Production (in the Short Run)
Q Slope = Marginal Product at L* Slope = Average Product at L* Total Product L L*

Relationship Between Production Curves
Q L Q APL L MPL

Relationship Between Production Curves
Q L Q Q10 - Q9 APL L MPL

Production in the Long run
In the long run all factors of production can be varied Isoquant represents the set of all input combinations that yield a given level of output The production equivalent of an indifference curve Marginal rate of technical substitution (MRTS) is the rate at which one input can be exchanged for another without altering the total level of output MRTS around a point A

Graphical Representation of Marginal Rate of Technical Substitution
K L

Returns to Scale The proportional change in production that occurs with a given change in all inputs defines the returns to scale Constant returns to scale if Q = F(K, L) = F(K, L) Increasing returns to scale if Q = F(K, L) > F(K, L) Decreasing returns to scale if Q = F(K, L) < F(K, L) In theory we should never observe decreasing returns to scale Note that decreasing returns to scale has nothing to do with diminishing marginal returns

Returns to Scale on the Isoquant Map
K 16 14 Q=420 12 Q=400 10 Q=360 Green = increasing returns Yellow = constant returns Purple = decreasing returns 8 Q=300 6 Q=240 Q=180 4 Q=90 2 Q=30 L

Chapters 8: Costs of Production

Cost Definitions Total cost (TC) = all costs of production
If r is the cost of capital (rental cost), and w is the wage, then TC = rK + wL Average total cost (ATC) = total cost/quantity produced Fixed cost (FC) = costs that do not vary with the level of output produced Average fixed cost (AFC) = fixed cost/quantity produced Variable cost (VC) = costs that vary with the level of output produced Average variable cost (AVC) = variable cost/quantity produced Marginal Cost (MC) = change in TC with a 1 unit change in output TC = FC + VC ATC = AFC + AVC MC =

Numerical Example of Costs (1)
Labor Total Product Marginal Product of Labor Total Fixed Cost Total Variable Cost Total Cost Average Total Cost Marginal Cost --- 100 1 10.00 50 150 15.00 5.00 2 14.14 4.14 200 12.07 3 17.32 3.18 250 14.43 15.73 4 20.00 2.68 300 18.66 5 22.36 2.36 350 15.65 21.18 6 24.49 2.13 400 16.33 23.43 7 26.46 1.96 450 17.01 25.48 8 28.28 1.83 500 17.68 27.37 9 30.00 1.72 550 18.33 29.14 10 31.62 1.62 600 18.97 30.81 11 33.17 1.54 650 19.60 32.39 12 34.64 1.47 700 20.21 33.90

Numerical Example of Costs (2)
Labor Total Product Marginal Product of Labor Total Fixed Cost Total Variable Cost Total Cost Average Total Cost Marginal Cost --- 2000 1 40 52.50 2 100 22.00 3 190 12.11 4 270 8.89 5 340 7.35 6 400 6.50 7 450 6.00 8 490 5.71 9 520 5.58 10 540 5.56 11 550 5.64 12 555 5.77

Graphical Representation of Relationship Between Diminishing Marginal Returns and Increasing Marginal Cost APL L The area where MPL begins to decline exactly corresponds to the area where MC begins to rise. The maximum value of MP corresponds to the minimum value of MC. MPL MC AVC L

Graphical Representation of All Costs
TC $/L VC r2 FC FC Q $/Q MC ATC AVC AFC Q

Costs in the Long Run and the Optimal Input Combination
Isocost line - a set of input bundles each of which costs the same amount The production equivalent of a budget line The slope of the isocost line is the negative of the input price ratio (-w/r if labor is on the x-axis and capital is on the y-axis) Maximum output for a given input cost is a point where isoquant is just tangent to the isocost line Also the point of minimum cost for a given level of output

Production Optimality
If isoquant is tangent to isocost line at optimum, we know that: Slope of isoquant = slope of the isocost line and Slope of isoquant = MRTS = (-K/ L) = (-MPL/MPK) Slope of isocost line = (-w/r) therefore (-MPL/MPK) = (-w/r) and (MPL/w) = (MPK/r) Economic interpretation is that firms should hire inputs to the point where the marginal output per dollar is the same for all inputs Were this not the case, firm could increase output and reduce cost - would not be at an optimum

Graphical Representation of Production Optimality
K Isoquant K* Q = Q1 Isocost Line Slope = -w/r L L*

Optimality: Cost Minimization
K TC=$2000 TC=$1750 TC=$1500 K* Q=100 L L*

Optimality: Profit (Output) Maximization
K K* TC = $1500 Q=100 Q = 90 Q = 80 L L*

Effects of a Change in Input Prices: Cost Minimization
K The slope of the isocost line is -w/r. In this case, assume the price of capital (r) remains constant at r=1. The wage rate increases from 1 to 2. Q=100 L

Output Expansion Path Q3 Q2 Q1 TC1/r Expansion Path TC2/r TC1/r TC2/w

Long Run ATC Curve SMC1 SMC1 ATC1 ATC3 SMC1 LATC ATC2 LMC

Chapters 9: Perfect Competition

Perfect Competition Assumptions: Free Entry
All buyers and sellers have perfect information Many firms producing a homogenous product Factors of production are perfectly mobile in the long run Implications: Firms are “price takers,” that is, they cannot sell anything above the prevailing market price The firm’s supply curve will be the portion of their marginal cost curve above their average total cost curve In the long run, economic profits are zero

Perfect Competition: Numeric Example
Quantity ATC MC ∏(P=22) ∏(P=4) 4 6 10 64 -8 8 14 84 -24 18 96 -48 12 22 100 -80 26 -120

Total Revenue and Total Cost
TC TR Fixed Cost (-) Fixed Cost

Perfect Competition: Zero Profit
Price/Marginal Revenue Marginal cost Supply curve Average total cost Demand = Price = Marginal revenue wheat

Perfect Competition: Negative Profit (losses)
Price/Marginal Revenue Marginal cost Average total cost Demand = Price = Marginal revenue losses wheat

Perfect Competition: Positive Profit
Price/Marginal Revenue Marginal cost Average total cost Demand = Price = Marginal revenue Profits wheat

Perfect Competition: Labeling Curves/Optimums/Profit/Loss
A B C D E T G H I U V J K L M W N O P Q R

Supply/Shutdown Decision
Competitive firms will, in the short run, supply products so long as price must equal marginal cost on a rising portion of the MC curve, and it must exceed the minimum value of the AVC curve MC P Supply AVC Shut Down Q

Short-Run Competitive Industry Supply Curve
MC1 MC1 S = MC1 + MC2 4 5 10 5 10 4 5 10 20

Elasticity of Supply Price elasticity of supply - the percentage change in quantity supplied that occurs in response to a 1 percent change in product price Short-run competitive industry supply curve will always be upward sloping because of the law of diminishing marginal returns implying elasticity of supply is always positive

Algebra of Market and Individual Firm Output
A market consists of 100 firms. For each firm, Total market supply is given by If market demand is given by Then the profit for each firm is given by Profit in the market is equal to What happens in the long-run

Chapters 10: Using the Competitive Model

Efficiency of Competitive Equilibrium
Competitive markets result in allocative efficiency - a condition in which all possible gains from exchange are realized Competitive equilibrium leaves no room for mutually beneficial exchange Consumers would certainly pay less than equilibrium price, but no producer would sell for less Producers would certainly accept more than equilibrium price, but no consumer would pay more The cost to produce the last unit of output (the MP of the last unit) equals the price paid

Producer Surplus for the Firm
Alternative Measures of Producer Surplus MC MC P* Producer Surplus I Producer Surplus II AVC Q* Q*

Aggregate Producer Surplus

Total Surplus Price Quantity Consumer Surplus Producer Surplus S P* D

Loss of Surplus Due to Market Interventions
Consumer Surplus Consumer Surplus Consumer Surplus Loss Loss Loss Producer Surplus Producer Surplus P Producer Surplus D Price Ceiling Tax Fixed Supply

Adjustments in the Long Run
P P P1 Profit P2 Profit P3 Zero profit D Qi Q

Burden of Taxation ADAM - P. 271

Deadweight Loss of an Excise Tax
ADAM, p. 274

Chapters 16.1-16.5, 17.1-17.4, 18.1, 18.2: Input & Labor Markets, Wages & Rent

Input Demand Curve of a Competitive Firm
Input demand shows the total quantity of the input that will be demanded at various prices Input demand will depend on the marginal value product (MVP), which is the extra revenue a competitive firm receives by selling the additional output generated when employment of an input is increased by 1 unit For a competitive firm, MVP = MPL * P (this is b/c output price is constant for a competitive firm) It makes sense for a firm to hire to the point where MVP = w, w = MPL*P and therefore w/MPL = P

Competitive Firms Demand for Labor: All Inputs Variable
When all inputs are variable, an input’s MVP curve shifts with changes in the employment of other inputs A lower wage rate causes the firm to substitute toward labor and away from capital Input demand is a “derived demand” reflecting the fact that industry demand for an input ultimately derives from consumers’ demand for the final product produced by that input ADAM, please add Figure 16.3 & definition + show the substitution & output effects of an input price change (p. 447)

Competitive Industry Demand for Labor
ADAM, add figure 16.4

Elasticity of an Industry’s Demand Curve for an Input
Elasticity of input demand is the sensitivity of input demand to changes in input cost = (%input demand)/(%input cost) Four major determinants of the elasticity of an industry’s demand for an input Elasticity of the final product The substitutability of one input for another in production The supply of other inputs Time period

Supply of Inputs ADAM, FIGURE 16.5

Equilibrium in Input Markets
ADAM, SPLIT SLIDE - FIGUREs 16.6 & 16.7

Income Leisure Choice of the Worker
ADAM, FIGURE 17.1

Supply of Hours of Work ADAM, FIGURE 17.2

A Backward Bending Labor Supply Curve?
ADAM, FIGURE 17.3

Why Do Wages Differ? If wage rates differ across occupations and there is free entry and exit from/into occupations, shouldn’t we see individuals leave the low wage occupation (shifting supply to the left) and enter the high wage occupation (shifting supply to the right), equalizing wages across occupations. So why do wages differ across individuals and occupations? Compensating wage differentials Differences in human capital Differences in ability

Minimum Wages ADAM, FIGURE 18.1 split, one with the floor above equilibrium and one with the floor below equilibrium

Burden of Social Security Tax
Social security is financed by a payroll tax composed of two equal-rate levies, one collected from employers and one collected from employees (about 7.6% on each for the first $80K of income), so who really pays for this tax ADAM, BURDEN OF Soc Sec Tax - add split slide graphs with differently sloped supply curves (p. 505)

Chapter 11: Monopoly

Monopoly Assumptions: Restricted entry
One firm produces a distinct product Implications: A monopolist firm is a ‘price setter,’ that is, they can affect the market price and set it to maximize their profits (demand curve slopes downward) Profit maximizing output occurs where MC=MR (like perfect competition), but price is above MC Economic profits are positive in the long run A monopolist sets price and quantity simultaneously and therefore does not have a true supply curve The monopolist’s profit-maximizing output will not be socially optimal That a firm has the only product in the market does not necessarily mean it has a monopoly - one way to determine whether firm has monopoly power is to look at the cross-price elasticity of demand

Sources of Monopoly Various sources of barriers to entry, such as:
Exclusive control over natural resources Economies of scale Natural monopoly has a constantly downward sloping LRATC curve Patents/trademarks Network economies Government licenses or franchises Product differentiation

Monopoly: Numeric Example
Q P TR MR TC MC ATC Profit 100 200 -200 10 90 900 420 22 42 480 18 80 1440 67.5 660 30 36.67 780 24 70 1680 40 37.5 28 60 1108 52 39.57 572 50 1500 -90 1240 66 41.33 260

Monopoly Price/Marginal Revenue P* profits widgets Q*
Inefficiency or deadweight loss Marginal cost P* Average total cost profits demand widgets Q* Marginal revenue

Algebra of Marginal Revenue and Elasticity
Recall: Price Elasticity of Demand Therefore, Monopolist will never operate on inelastic portion of the demand curve

Monopolist Profit-Maximizing Markup

Algebra of Monopoly Optimums
A monopolist faces the following demand and marginal cost curves What is the profit-maximizing price it will charge? What is the total profit? What is the size of the inefficiency? Profit maximizing price: $120. Profit: $32,000. DWL: $12,000

Two-Plant Monopoly Market 1 Market 2 Total MC MR1 + MR2 P2 P1 MC*
Q1 + Q2 Q1 Q2

Total Revenue: Monopoly v. Perfect Competitor
TR = P*Q Slope = P* Q Q Perfect Competitor Single-Price Monopoly

Monopoly v. Perfect Competitor
Price setter MR is declining and below demand curve Equilibrium price is set above MC Economically inefficient Perfect Competitor Price taker MR is constant Marginal cost pricer Economically efficient

Chapters 12: Product Pricing with Monopoly Power

Price Discrimination Price discrimination is the practice of charging different prices in different markets for the same basic product Price discrimination is practiced as a method to maximizing total profit by charging prices that are closest to the highest that each customer (market) are willing to pay Perfect price discrimination (first degree price discrimination) occurs if monopolist is able to charge exactly what each consumer is willing to pay P1 P2 Economic Profit P3 SMC ATC Second degree price discrimination - a schedule along which prices decline as quantity purchased increases (e.g. electric utilities). D Q1 Q2 Q3

Three Necessary Conditions for Price Discrimination
Some degree of market power Seller must have some means of approximating what different buyers are willing (the maximum) to pay for each unit of output Seller must be able to prevent resale (or arbitrage) of the product

Algebra of Monopoly Optimums with Perfect Price Discrimination
A monopolist faces the following demand and marginal cost curves If the firm can perfectly price discriminate, what is the price it will charge the person with the lowest willingness to pay? What is the total profit? Profit Condition: Demand = MR = MC 200-Q/5 = 40, Q = 800, P = $40 Profit = 1/2 *(160*800) = $64,000

Algebra of Monopoly Optimums with Segmented Markets
Adam, please put in an example like p. 336

Intertemporal Price Discrimination & Peak-Load Pricing
Adam, please add in graph and numeric example - p

Chapters 13 & 14: Imperfect Competition & Game Theory

Reality: Imperfect Competition
Perfect competition and monopoly represent idealized market structures that rarely exist These are useful in showing tendency and direction, but in the real world the payoff to an action often depends not only on the action itself, but also on how it relates to actions taken by others Read the 3 economist, 3 lawyer parable on page 455, it’s funny (particularly if you are an economist) Game theory is a useful tool to use to analyze likely outcomes when individual payoffs depend on the actions of others Three elements of game theory: 1) the players, 2) the list of possible strategies, and 3) the payoffs associated with each combination of strategies

Algebraic Example of Game Theory in the Marketplace
MEXICO OIL VENEZUELA PETROLEUM Cooperate (P=5) Cheat (P=4)

Oligopoly Assumptions: Restricted entry Few firms producing
Implications: The actions of one oligopoly firm will affect the prices and profits of the other firm(s) in the market There are several possible hypotheses about how oligopoly firms behave May collude and act as a monopoly May compete against each other and drive prices to the perfectly competitive level May compete, but arrive at equilibrium somewhere between the monopoly and perfectly competitive prices The exact structure of the oligopoly likely depends on the products they are producing and the degree of product differentiation

Cournot Duopoly Model Two firms in the market that sell identical products Each firm assumes that the other will keep production levels fixed regardless of their own production Each firm has a “reaction function” that determines of the optimal level of output given the other firm’s output Q1 Firm 2’s reaction function Q1*=(a-bQ2)/2b Q2*=(a-bQ1)/2b a/3b Firm 1’s reaction function Q2 a/3b

Bertrand Model Two firms in the market that sell identical products
Each firm assumes that the other will keep prices fixed at the current level regardless of the price they set Each firm’s best strategy is to sell just below the price of the other firm so that they can capture the entire market demand The firms will continue to reduce the price until it reaches the competitive market price

Stackelberg Model Two firms in the market that sell identical products
The market consists of a “leader” and a “follower” The follower is a naïve Cournot duopolist The leader will choose its quantity level by taking into account how that will affect the follower’s response Q1 Firm 2’s reaction function Firm 1’s [leader’s] demand curve: P = a - b[Q1 + (a-bQ1)/2] = (a-bQ1)/2 Firm 2’s [follower’s] reaction function : (a-bQ1)/2b a/2b Firm 1’s reaction function Q2 a/4b

Comparison of Oligopoly Models
Monopoly a/2 Cournot Assume MC=0 Stackelberg Bertrand/ Perfect Competition a/2b a/b

Monopolistic Competition
Differentiated products Many sellers Free entry Each seller faces a downward-sloping demand curve UnderCuts Cheap Snips Dean Suarez Salon

Classic Prisoner’s Dilemma
CLYDE Squeal Remain Silent BONNIE 12 years for B 12 years for C 0 years for B 20 years for C 20 years for B 0 years for C 1 year for B 1 year for C They both will end up squealing which is the socially WORST (for those two) possible outcome because the total years in prison is the greatest with this strategy. Payoff to an action often depends not only on the action itself, but also on how it relates to actions taken by others

Game Theory Nash equilibrium - the combination of strategies in are such that neither player has any incentive to change given the strategy of others Players in games may have dominant or non-dominant strategies Dominant strategy - when a player has a strategy in a game that produces better results regardless of the strategy chosen by other players (opponents) Each player may have a dominant strategy, but the result of each player exercising their dominant strategy may be less beneficial for the players (e.g. price wars) and/or society as a whole Non-dominant strategy - when at least one player does not have a dominant strategy, rather the best strategy for that player is dependent on what others choose Nash equilibrium may occur even if a player does not have a dominant strategy b/c one (or more players) bases decision on what others will do

Nash Equilibrium: Dominant Strategy
PEPSI Advertise Don’t Advertise COKE C: $100 m P: $100 m C: $250 m P: $25 m C: $25 m P: $250 m C: $200 m P: $200 m

Nash Equilibrium: Non-Dominant Strategy
ADIDAS Advertise Don’t Advertise NIKE N: $100 R: $100 N: $135 R: $200 N: $50 R: $125 N: $140 R: $115

Chapters 15 & 19.7: Using Noncompetitive Market Models & Regulation

Graphical Depiction of Efficiency Loss Due to Single-Price Monopoly
Consumer Surplus Economic Profit Efficiency Loss LAC=LMC Q* QC

Regulation of (Natural) Monopoly
State ownership and management (e.g. elected boards) Downside is weakened incentives for profit leading to X-inefficiency (when firms fail to attain maximum output for a given combination of inputs) Rate of return regulation - prices are set to allow monopolist to earn a set (competitive) rate of return on invested capital Downside is that regulators can’t be sure of the competitive rate (if rate is set too high then price is too high, if set too low then monopolist will eventually go out of business) Exclusive contracting (with natural monopoly) - have competition for who gets to be the exclusive contractor Enforcement of antitrust laws - effort to prevent monopolies from forming (note that this is not effective for natural monopoly)

Causes of Economic Inefficiency
Market power - firms with market power do not marginal cost price (P>MC) As a consequence, the relative price in the industry where there is market power, call it Pp/Pc > MCp/MCc, where Pc and MCc are the price and marginal cost in a perfectly competitive industry Implies that more of the market power good should be produced and less of the perfectly competitive good since consumers would like to trade for more of it Imperfect information - consumers may not know how much utility they will get from consumption of a good Externalities/public goods - consumption/production of a good might impact other than the consumer/producer, but this impact is not taken account of in the production/consumption so the market does not lead to efficient allocation

Chapters 20: Public Goods, Externalities, & Government

Tragedy of the Commons Commuters in West Seattle have to get downtown to work. Suppose they can either get there by driving alone in their car via the West Seattle bridge or by taking the monorail. Travel on the monorail always takes 30 minutes regardless of how many people ride. The bridge, on the other hand, begins to get congested if more than three thousand cars travel at a time. Assume that each commuter values their time at $ per hour. Number of cars on the bridge (in thousands) Average commute time along the bridge Total commute time via the bridge (in thousands of minutes) Marginal time cost of one more car taking the bridge Monetary cost to individuals of taking the bridge Net Monetary benefit of individuals taking the bridge instead of the monorail 1 15 min 15 $ 3.00 2 30 3 45 4 17.5 min 70 25 $ 3.50 $ 2.50 5 20 min 100 $ 4.00 $ 2.00 6 22.5 min 135 35 $ 4.50 $ 1.50 7 25 min 175 40 $ 5.00 $ 1.00 8 27.5 min 220 $ 5.50 $ 0.50 9 30 min 270 50 $ 6.00 $ 0.00 10 32.5 min 325 55 $ 6.50 $ -0.50 11 35 min 385 60 $ 7.00 $ -1.00

Analysis of Common Property Problem
How much would West Seattle be willing to pay to build a monorail that would get them downtown in 30 minutes? Given that the monorail does exist: Left to their own devices, how many commuters travel the bridge and how many commuters take the monorail? What is the socially efficient number of commuters on the bridge and the monorail? How much would Seattle need to subsidize monorail riders to achieve the socially efficient ridership?

Externalities An externality is when the production or consumption of a good has an impact (may be positive or negative) on others in the market There are, in theory, eight possible types of externalities: Positive, consumer-consumer Positive, producer-producer Positive, producer-consumer Positive, consumer-producer Negative, consumer-consumer Negative, producer-producer Negative, producer-consumer Negative, consumer-producer Positional externalities - externalities that arise when rewards or sanctions are determined not by absolute position (e.g. performance), but by one’s position in society

Coase Theorem Externalities exist because property rights are not assigned for all goods Coase Theorem states that when the parties affected by externalities can negotiate costlessly with one another, an efficient outcome results no matter how the law assigns responsibility for damages Law often doesn’t assign responsibility Affected parties can never negotiate completely costlessly; sometimes the costs of negotiation are quite high

Interventions to Deal with Externalities
Taxation of negative externalities Subsidization of positive externalities Assignment of property rights

Intervention to Deal with Negative Externalities: Fixing the Tragedy of the Commons
Cost of Taking Bridge MC AC $ 6 Tax/Toll This is from the previous example of the cars on the bridge. You might want to note that the curves don’t exactly fit the data but you get the idea. In the case of the data, MC and AC are never falling, they’re always increasing. $ 4 # of cars C*

Intervention to Deal with Negative Externalities: Fixing the Tragedy of the Commons from Benefit Side Net Benefit of Using Bridge $2.00 This is the mirror image of the previous slide. Average Benefit C* Marginal Benefit

Alternative Intervention to Deal with Negative Externality
Two neighbors live across the street from each other. The neighbor on the east side of the street wants to build a second story onto his house. The one on the west side doesn’t want the morning sunrise to be blocked. The city has given the East Side neighbor the permit for the addition. How much would the West Side neighbor be willing to pay her neighbor not to build the addition? How much would the West Side neighbor be willing to pay if she had to pay a lawyer $250 to negotiate the agreement? East Side Neighbor Builds Gains to East Side Neighbor $1,000 Damage to West Side Neighbor $1,400

Intervention to Deal with Negative Externalities
Social MC Individual MC PE TAX P0 Demand (MV) QE Q0

Intervention to Deal with Positive Externalities
Price MC SUBSIDY Individual Marginal Benefit Social Marginal Benefit Quantity

When Is The Market Less Likely to Be Efficient
When markets are less competitive In the case of externalities May be positive or negative May occur on production or consumption side In the case of public goods In the case of asymmetric/poor information

Public Goods Public goods are those goods that, to a greater or lesser degree, possess two key traits, nondiminishability and nonexcludability (a special case of externalities) A nondiminishable good is one for which one persons consumption of a good has no effect on the amount of it available to others (MC = 0) A nonexcludability good is one for which it is not possible to prevent consumers (paying or nonpaying) from consuming that good Two types of public goods Pure public good is one that has a high degree of nondimishability and nonexcludability (e.g. national defense) Collective good is has a high degree of nondiminishability, but may have excludible properties (e.g. roads) Public goods may be provided by either the government or the private sector

Optimal Quantity of Public Goods
Aggregate willingness to pay curve (like the aggregate demand curve) is the vertical sum of individual’s willingness to pay curves Optimal quantity of a public good is the quantity, Q*, corresponding to the intersection of aggregate willingness to pay and marginal cost curves with the proviso that the total cost of producing Q* does not exceed the total amount that the public would be willing to pay The fact that the optimal quantity of public goods may differ from person to person suggests “Tiebout” sorting associated with local provision of public goods

Public Goods: Graphical Example
MC Aggregate Willingness to Pay Curve A* = 13 A* = 8 A* = 5 Q*=10

Provision of Public Goods
Funding by donation Suffers from free rider problem Sale of by-products - e.g. commercial TV Creating excludability techniques - cable TV Legal/private contracts - e.g. condo/home association

Public Goods: Numeric Example
A town has 100 people with identical preferences for a fireworks display. Each person has a willingness to pay P=40-.2Q How much would the town be willing to pay for 100 shells at their fireworks display? The aggregate willingness to pay is P = Q The town is willing to pay $2000 or $20 each.

Government Interventions to Try to Create Efficient Resource Allocation
Control over pricing e.g. The setting of rates for natural monopolies Information, licensure, certifications, etc. e.g. FDA, FAA Regulations governing production techniques e.g. mandating smokestack scrubbers Taxation/subsidies e.g. cigarette tax Creation of “new” markets e.g. pollution credit markets

Another Key Role for Government: Income Redistribution
As a society we may care not only about efficiency (pretty much everything we’ve been talking about), but also equity The two may be linked if utility functions are interdependent (my utility depends on your utility) Rawlsian pre-birth lottery - thought experiment on what constitutes a just distribution of income What should the distribution of income (& rewards for work/talent) look like for those behind the veil of ignorance? Risk aversion suggests that social safety net acts as pre-birth insurance policy Methods of Redistribution Welfare programs Negative income tax Jobs programs

Public Choice Major way we make policy is through majority voting, where the median voter (the voter whose ideal outcome lies above the ideal outcomes of half the voters) determines the outcome But there are some unpalatable properties of majority voting, including Intransitivity- With more than 2 choices, the least preferable choice may be selected if the voters are split between the most preferred choices Majority voting may sometimes imply so the order of the votes may be very important Allows for agenda manipulation (we see this all the time in politics) Lack of consideration of strength of preference

And the Winner Is…The Loser
A city has the choice between four mayoral candidates: Tara, Sarah, Wendy and Amy. Amy was recently added to the ballot when her corporate fraud conviction was overturned on a technicality When asked, 74% of the citizens list Amy as their last choice out of the four candidates. However, in deciding between the candidates A,B, and C they are evenly split. When they vote, the final tally will be: Tara 24.67% Sarah % Wendy % Amy 26% Amy Wins!

And the Winner Is…Who Knows?
Three people are voting on three alternatives. The orders of their preferred choices are listed below. This group prefers Johnson over Duritz and Zavala over Johnson, but prefers Duritz over Zavala. If these elections are run sequentially, then the order in which they are done will determine the outcome. Meghan Cory Jon Johnson 1 2 3 Duritz Zavala

We’re All Winners! Johnson Johnson Zavala Duritz Zavala Zavala Zavala
Congratulations Mayor Zavala! Duritz Zavala Zavala Zavala Duritz Johnson Er…Congratulations Mayor Duritz! Duritz Duritz Duritz Johnson Wait…Congratulations Mayor Johnson! Zavala Johnson

Extra Topics

Economics of Information
Thus far we have assumed all economic entities have perfect information when making decisions - this is obviously a gross simplification We generally worry more about information flows between adversaries (those with conflicting goals) than those with common goals b/c there is goals in common - there’s an incentives problem Signaling: the conveying of credible information - signals work better when: They are costly to fake (costly to fake principle) Disclosure of favorable qualities creates an incentive for individuals to disclose unfavorable ones (full disclosure principle)

Information Problem: Adverse Selection & Moral Hazard
If individuals have different attributes(i.e. they are heterogeneous), they will have different incentives to engage in economic trades (e.g. the purchase of insurance) Adverse selection is the process whereby the less desirable potential trading partners are the ones who volunteer for trades We often see the problem of adverse selection arise with insurance when insurers cannot accurately distinguish between the good and bad insurance risks A consequence of adverse selection is differential prices charged to individuals with different characteristics(statistical discrimination) based on attributes other than the attribute (e.g. careful driving) we care about most - related to arguments over national health care Insurance against losses may lead to an altering (inefficient type) of behavior referred to as moral hazard

Inefficiency Associated with Imperfect Information
Assume that teenage boys make up 10% of drivers and that they cause an average of $1000/year in auto accidents where all other drivers cause an average of $100/year. Imagine that a law is passed that prohibits insurance companies from charging different rates based on personal characteristics. If all drivers are required by law to have insurance, what is the minimum premium insurance companies would charge for all drivers? If drivers are not required to have insurance, who would opt to buy insurance (assume they are risk neutral)? In the above case, what is the premium the insurance would end up charging?

Choice Under Uncertainty
In the real world we make choices (economic transactions) based on uncertain payoffs Thus, we calculate the expected value of alternative transactions in order to make decisions Expected value is the weighted average of all possible outcomes associated with a choice Von Neumann-Morgenstern expected utility model is the formal model whereby individuals are assumed to choose the alternative that brings the highest expected utility Expected utility of a gamble (virtually everything is a gamble at one level or another) is the expected value of utility over all possible outcomes

Concavity of Utility Function and Risk Aversion
Suppose a person gets utility only from the level of their wealth (W). These specifications have very different implications for the expected change in utility for a risky endeavor. Risk Neutral: Utility= aW Risk Aversion: Utility= W1/2 Risk Loving: Utility = W2

Expected Utility Problem
Suppose U=W1/2 You currently have wealth of $900 but have a 50% chance of losing $800 of it What is the maximum you would be willing to pay for an insurance policy that protects you from this risk?

Graphical Depiction of Expected Utility Problem
30 20 10 Income 100 400 500 900

Economics 516 Fall 2005 Dan Goldhaber.

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