Economics

LECTURE 5, PART A
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Review
1. What is meant by the term ‘allocative
efficiency’?
2. What is welfare economics?
3. Explain how buyers’ willingness to pay,
consumer surplus
and the demand curve are related.
4. Explain how sellers’ costs, producer surplus
and the supply
curve are related.
5. Prepare a supply-and-demand diagram,
showing producer
and consumer surplus at the market equilibrium.
On the diagram, show how consumer surplus
and producer surplus changes as a result of the
shift in demand to the right.
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Review
6. What is efficiency and how might we measure
it?
7. Why are issues relating to efficiency classed
as positive? What are the normative issues we
might want to be concerned with?
8. When the tickets for the Glastonbury Festival
go on sale,
the demand exceeds supply by a considerable
margin. Many people who are willing to pay the
price for tickets are excluded from the market.
Explain how charging a higher price for tickets
for the Glastonbury Festival would lead to a
more efficient market allocation. Would this also
be an equitable market allocation? Explain.
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Q 7.2
An early freeze in Normandy ruins half of the
apple harvest. What happens to consumer
surplus in the market for apples? What happens
to consumer surplus in the market for cider?
Illustrate your answers with diagrams.
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Q 7.3
Suppose the demand for French bread rises.
What happens to producer surplus in the market
for French bread? What happens to producer
surplus in the market for flour? Illustrate your
answers with diagrams.
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Q 7.4
It is a hot day, and Günter is thirsty. Here is the
value, in money terms, he places on a bottle of
water:
Value of first bottle €7 Value of second bottle €5 Value of
third bottle €3 Value of fourth bottle €1
a. From this information, derive Günter’s demand schedule.
Graph his demand
curve for bottled water. b. If the price of a bottle of water is
€4, how many bottles does Günter buy? How
much consumer surplus does Günter get from his purchases?
Show Günter’s consumer surplus on your graph. c. If the price
falls to €2, how does quantity demanded change? How does
Günter’s consumer surplus change? Show these changes on your
graph.
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Q 7.5
Maria owns a water pump. Because pumping large amounts of
water is harder than pumping small amounts, the cost of
producing a bottle of water rises as she pumps more. Here is the
cost she incurs to produce each bottle of water:
Cost of first bottle €1 Cost of second bottle €3 Cost of third
bottle €5 Cost of fourth bottle €7 a. From this information,
derive Maria’s supply schedule. Graph her supply curve
for bottled water. b. If the price of a bottle of water is €4,
how many bottles does Maria produce
and sell? How much producer surplus does Maria get from these
sales? Show Maria’s producer surplus on your graph. c. If the
price rises to €6, how does quantity supplied change? How does
Maria’s
producer surplus change? Show these changes in your graph.
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Q 7.6
Consider a market in which Günter from
Problem 4 is the buyer and Maria from Problem
5 is the seller.
a. Use Maria’s supply schedule and Günter’s demand
schedule to find
the quantity supplied and quantity demanded at prices of
€2, €4 and €6. Which of these prices brings supply and
demand into equilibrium?
b. What are consumer surplus, producer surplus and total
surplus in
this equilibrium?
c. If Maria produced and Günter consumed one fewer
bottle of water,
what would happen to total surplus?
d. If Maria produced and Günter consumed one additional
bottle of
water, what would happen to total surplus?
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Q 7.9 Homework (have it
prepared on the paper)
Four consumers are willing to pay the following
amounts for haircuts:
Hans: Juan: Peter: Marcel: €7 €2 €8 €5
There are four haircutting businesses with the
following costs:
Firm A: Firm B: Firm C: Firm D: €3 €6 €4 €2
Each firm has the capacity to produce only one
haircut. For efficiency, how many haircuts
should be given? Which businesses should cut
hair, and which consumers should have their
hair cut? How large is the maximum possible
total surplus?
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Review
1. Give an example of a price ceiling and an example of a
price floor.
2. Which causes a shortage of a good – a price ceiling or a
price floor?
Which causes a surplus?
3. Under what circumstances is a price ceiling and a price
floor referred
to as binding?
4. What potential costs and benefits might a government
have to consider in deciding whether to impose a price
floor or a price ceiling?
5. What mechanisms allocate resources when the price of
a good is
not allowed to bring supply and demand into equilibrium?
6. Explain why there has been criticism of rent controls
and whether
this criticism needs revision in the light of new research.
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Economics
LECTURE 5, PART B
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PUBLIC GOODS, COMMON RESOURCES
AND MERIT GOODS
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Governments Intervene In
The Market To Provide
Goods And Services
Most goods in our economy are allocated in
markets.
Free goods provide a special challenge for economic
analysis.
When goods are available free of charge, the market
forces that normally allocate resources in our
economy are absent.
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Governments Intervene In
The Market To Provide
Goods And Services
In such cases, government policy can potentially
remedy the market failure that results, and raise
economic well-being.
◦ public sector: part of the economy where business activity is
owned financed and controlled by the state and goods and
services are provided by the state on behalf of the population as
a whole.
◦ private sector: part of the economy where business activity is
owned financed and controlled by private individuals.
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The Different Kinds Of
Goods
When thinking about the various goods in the
economy, it is useful to group them according to two
characteristics:
◦ Is the good excludable?
◦ Is the good rival?
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Excludability and rivalry
Excludability
◦ Excludability refers to the property of a good whereby a
person can be prevented from using it.
Rivalry
◦ Rivalry refers to the property of a good whereby one person’s
use diminishes other people’s use.
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Types of Goods
1 Private Goods
◦ Are both excludable and rival. 2 Public Goods
◦ Are neither excludable nor rival. 3 Common Resources
◦ Are rival but not excludable. 4 Natural Monopolies
◦ Are excludable but not rival.
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Table 1 Four Types of Goods
Rival?
Yes
Yes
• Chocolates
• Clothing
• Congested toll roads
No
Private Goods Natural Monopolies
No
• The fire service
• Cable TV
• Uncongested toll roads
Excludable?
Common Resources Public Goods
• Fish in the ocean
• Street lighting
• The environment
• Flood control dams
• Congested non-toll roads
• Uncongested non-toll roads
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Public Goods And The Free
Rider Problem
A free-rider is a person who receives the benefit of a
good but avoids paying for it.
Since people cannot be excluded from enjoying the
benefits of a public good, individuals may withhold
paying for the good hoping that others will pay for it.
The free rider problem prevents private markets from
supplying public goods.
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The Free Rider Problem
Solving the Free Rider Problem
◦ The government can decide to provide the public good if
the total benefits exceed the costs.
◦ The government can make everyone better off by
providing the public good and paying for it with tax
revenue.
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Some Important Public
Goods
National Defence
Basic Research
Fighting Poverty
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Common Resources
Common resources, like public goods, are not
excludable.
◦ They are available free of charge to anyone who wishes
to use them.
Common resources are rival goods.....
◦ ..... because one person’s use of the common resource reduces
other people’s use.
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Tragedy of the Commons
The Tragedy of the Commons is a parable that
illustrates why common resources get used more
than is desirable from the standpoint of society as a
whole.
◦ Common resources tend to be used excessively when
individuals are not charged for their usage.
◦ This is similar to a negative externality.
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Some Important Common
Resources
Clean air and water.
Congested roads.
Fish, whales, and other wildlife.
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Merit Goods Can Be Provided By
The Market
Merit goods arise because consumers may have imperfect
information about the benefits of these goods and are not
able to value them appropriately as a result.
◦ Merit goods can be provided by the market but may be under-
consumed as a result.
◦ Intertemporal choice where decisions made today can affect
choices facing individuals in the future
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Education as a Merit Good
Merit goods have two key benefits:
◦ Private benefits of education include career
prospects.
◦ Difficult to calculate private education benefits.
◦ Social benefits include better stock of human
capital.
◦ Individuals don’t take account of social benefits when making
decisions about their education, so left to the private market
education would be under consumed.
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Healthcare, Insurance and
Pensions as Merit Goods
Individuals are bad at assessing risks especially those in
the future.
Governments subsidise health and make laws about
insurance cover.
Governments encourage savings for private pensions.
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De-merit Goods
De-merit goods are over-consumed if left to the market
mechanism.
◦ They which generate both private and social costs which are
not taken into account by the decision-maker.
Alcohol has a private and social cost.
•Social cost includes health care and
antisocial behaviour.
•Governments can tax alcohol or make laws
to help control consumption.
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Summary
1 Goods differ in whether they are excludable and
whether they
are rival.
◦ A good is excludable if it is possible to prevent someone
from using it.
◦ A good is rival if one person’s enjoyment of the good prevents
other people from enjoying the same unit of the good.
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Summary
2 Public goods are neither rival nor excludable.
3 Because people are not charged for their use of
public goods,
they have an incentive to free ride when the good is
provided privately.
4 Governments provide public goods, making
quantity decisions
based upon cost-benefit analysis.
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Summary
5 Common resources are rival but not excludable.
6 Because people are not charged for their use of
common
resources, they tend to use them excessively.
7 Governments tend to try to limit the use of
common resources.
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EXTERNALITIES AND MARKET FAILURE
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Externalities
An externality is an uncompensated impact of one
person’s actions on the well-being of a bystander.
Externalities cause markets to be inefficient, and so
fail to maximize total surplus.
An externality arises...
. . . when a person engages in an activity that affects the
well-being of a bystander and yet neither pays nor
receives any compensation for that effect.
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Externalities
When the impact on the bystander is adverse, the
externality is called a negative externality.
When the impact on the bystander is beneficial, the
externality is called a positive externality.
◦ In either situation, decision makers fail to take account of
the external effects of their behaviour.
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The Social Costs and Social
Benefits of Decision Making
Market decisions are be based on weighing up
private costs and private benefits.
Social costs and social benefits are lost or gained by
those not party to the initial decision.
Market decisions may not take account of the social
costs and benefits of their actions.
The market equilibrium is not efficient when there
are externalities.
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Types of externalities
Negative Externalities
◦ Car exhaust fumes
◦ Cigarette smoking
◦ Barking dogs (loud pets)
◦ Loud stereos in an apartment building
Positive Externalities
◦ Immunizations
◦ Restored historic buildings
◦ Research into new technologies
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Externalities And Market
Inefficiency
Negative externalities lead markets to produce a
larger quantity than is socially desirable.
Look at the market for aluminium (figure 1)
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Figure 1 The Market for
Aluminium
Price of Aluminum
Supply (private cost)
Equilibrium
Demand (private value)
0
Q
MARKET

Quantity of Aluminum
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Negative Externalities
The Market for aluminum
◦ The quantity produced and consumed in the market
equilibrium is efficient in the sense that it maximizes the
sum of producer and consumer surplus.
◦ If the aluminum factories emit pollution (a negative
externality), then the cost to society of producing
aluminum is larger than the cost to aluminum producers.
◦ For each unit of aluminum produced, the social cost
includes the private costs of the producers plus the cost to
those bystanders adversely affected by the pollution.
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Figure 2 Pollution and the
Social Optimum
Price of Aluminum
Social cost
Cost of pollution
Equilibrium
Demand (private value)
Q
OPTIMUM

Q
MARKET
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Supply (private cost)

Optimum
0
Negative Externalities
The intersection of the demand curve and the
social-cost curve determines the optimal output
level.
• The socially optimal output level is less
than the market equilibrium quantity.
Internalizing an externality involves altering
incentives so that people take account of the
external effects of their actions.
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Negative Externalities
Achieving the Socially Optimal Output
◦ The government can internalize an externality by
imposing a tax on the producer to reduce the equilibrium
quantity to the socially desirable quantity.
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Positive Externalities
A positive externality exists when an
externality benefits the bystanders.
◦ The social value of the good exceeds the
private value. ✧Example: Education yields
positive externalities.
◦ A better-educated population leads to
improved productivity and economic growth.
The economic growth is the positive
externality as it benefits everyone.
◦ The marginal social benefit (MSB) is the
private value plus the external benefit to
society at each price.
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Figure 3 Education and the
Social Optimum
Price of Education
Supply (private cost)
MSB or
Demand
Social value
(private value)
0
Q
MARKET

Q
OPTIMUM

Quantity of Education
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Positive Externalities
The intersection of the supply curve and the social
value curve determines the optimal output level.
◦ The optimal output level is more than the equilibrium
quantity.
◦ The market produces a smaller quantity than is socially
desirable.
◦ The social value of the good exceeds the private value of
the good.
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Positive Externalities
Internalizing Externalities:
◦ Subsidies can be used to attempt to internalize positive
externalities.
◦ Government intervention to promote
technology-enhancing industries.
◦ Patent laws give the individual (or firm) with patent protection a property
right over its invention.
◦ Without property rights there would be less research.
◦ Property rights provide the exclusive right of an individual, group or organization
to determine how a resource is used.
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Positive Externalities
A technology spillover is a type of positive externality
that exists when a firm’s innovation or design not only
benefits the firm, but enters society’s pool of technological
knowledge and benefits society as a whole.
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Positional Externalities
A positional externality is a situation which exists
when the payoff to one individual is dependent on
their relative performance to others.
A positional arms race is a situation where
individuals invest in a series of measures designed
to gain them an advantage but which simply offset
each other.
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Private Solutions To
Externalities
Government action is not always needed to solve the
problem of externalities.
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Types of Private Solutions
Social norms and Moral Behaviour
◦ Do unto others as you would have them do unto you.
Charities that deal with externalities.
◦ E.g. Greenpeace.
Self-interest
◦ Where two firms gain from each other’s presence
Social Contracts
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The Coase Theorem
The Coase Theorem is a proposition that if private
parties can bargain without cost over the allocation
of resources, they can solve the problem of
externalities on their own.
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Why Private Solutions Do
Not Always Work
Transactions Costs
◦ Transaction costs are incurred in the process
of agreeing to and following through on a
bargain.
◦ Sometimes the private solution approach fails
because transaction costs can be so high that
private agreement is not possible. Bargaining
Problems
◦ Each party tries to hold out for a
better deal. Difficult to Coordinate the
interested parties. Asymmetric
Information and Irrational Behaviour.
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Public Policies Toward
Externalities
When externalities are significant and private
solutions are not found, government may attempt to
solve the problem through . . .
◦ Command-and-control policies.
◦ Market-based policies.
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Command and Control:
Regulation
Command-and-Control Policies
◦ Usually take the form of regulations:
◦ Forbid certain behaviours.
◦ Require certain behaviours.
◦ Examples:
◦ Requirements that all students be immunized.
◦ Stipulations on pollution emission levels set by the government.
◦ Needs good information
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Market based policies
✧Pigovian taxes are taxes
enacted to
correct the effects of a negative
externality.
• Government uses taxes and subsidies to
align private incentives with social
efficiency.
• Firms that can reduce pollution with the least
cost are likely to do so (to avoid the tax) while
firms that encounter high costs when reducing
pollution will pay the tax.
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Regulation Versus
PigovianTax
✧If the government decides it
wants to
reduce the amount of pollution
coming from a specific plant, the
government could...
◦ Tell the firm to reduce its pollution by a specific amount
(i.e. regulation).
◦ Levy a tax of a given amount for each unit of pollution the
firm emits (i.e. Pigovian tax).
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Tradable Pollution Permits
Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm to
another.
◦ A market for these permits will eventually develop.
◦ A firm that can reduce pollution at a low cost may prefer
to sell its permit to a firm that can reduce pollution only at
a high cost.
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Figure and Pollution 4a. The
Permits
Equivalence of Pigovian Taxes
(a) Pigovian Tax
Price of Pollution
P Pigovian
tax 1. A
Pigovian tax sets the price of
Demand for
pollution . . .
pollution rights 0
Q
Quantity of
2. . . . which, together
Pollution
with the demand curve, determines the quantity of pollution.
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Figure and Pollution 4b The
Permits
Equivalence of Pigovian Taxes
(b) Pollution Permits
Price of Pollution
Quantity of Pollution
2. . . . which, together with the demand curve, determines the
price of pollution.
Supply of pollution permits
P
Demand for pollution rights 0
Q
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Public/Private Policy Toward
Externalities: Property
Rights
Property rights
◦ If I have ownership rights over the air 1 km above my
house then no one can legally pollute it.
◦ I can negotiate with a firm that wishes to pollute that air
and agree a price for the right to do so.
◦ However, it is a complex task to establish a system of
such property rights and they may be expensive to
enforce.
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Control of Positional Arms
Races
✧An incentive must exist to
prevent the investment in attempts
to gain some benefit which is
ultimately mutually offsetting.
◦ Laws against performance enhancing drugs in sport.
◦ External body overseeing any dispute over the social
norms.
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Summary
1 When one party’s activity affects another
party,
the effect is called an externality. 2
Negative externalities cause the socially
optimal
quantity in a market to be less than the
equilibrium quantity. 3 Positive
externalities cause the socially optimal
quantity in a market to be greater than
the equilibrium quantity. 4 Those
affected by externalities can sometimes
solve the problem privately.
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Summary
5 Coase theorem states that if people can
bargain
without a cost they can always reach an
agreement in which resources are allocated
efficiently.
6 When private parties cannot adequately
deal with
externalities, then the government steps in.
7 The government can either regulate
behaviour or
internalize the externality by:
◦ Using Pigovian taxes or by issuing pollution
permits,
◦ It might create property rights so that the
private parties may be able to bargain and
reach a satisfactory outcome.
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INFORMATION AND BEHAVIOURAL
ECONOMICS
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Principal And Agent
The two parties to an economic
decision can be referred to as principal
and agent.
◦ The principal is a person for whom another
person, called the agent, is performing some
act.
◦ The agent is a person who is
performing an act for another person,
called the principal. The principal
cannot always be sure that the
interests of the agent are sufficiently
aligned with the interests of the
principal.
◦ At the heart of the principal-agent problem is
asymmetric information.
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Asymmetric Information
A difference in access to relevant knowledge is
called information asymmetry.
Asymmetric information is where two parties have
access to different information.
◦ A worker knows more than his employer about his work
effort. This is an example of a hidden action.
◦ A seller of a used car knows more than the buyer about
the car's condition. This is an example of a hidden
characteristic.
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Hidden Actions and Moral
Hazard
Moral hazard refers to the tendency of a
person who is imperfectly monitored to
engage in dishonest or otherwise
undesirable behavior.
◦ Workers (agents) may be tempted to shirk
their work-related responsibilities...
◦ ... because their employers (the principals) do not monitor their
behaviour closely.
◦ Employers can respond by:
◦ Better monitoring - High wages - Delayed payment.
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Hidden Actions and Moral
Hazard
✧Adverse selection is where one side knows
more about their situation ✧Insurance company
needs to distinguish between its high- risk and
low-risk customers. ✧Some investment banks
hide the full extent of the risk of certain
investments sold to their clients. ✧Regulations
are put in place to address the problems e.g. fit
smoke alarms or face higher premiums - no
claims bonus –restrict building on flood plains.
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Hidden Characteristics:
Adverse Selection and the
Lemons Problem
The market for cars
◦ In the used car market, cars can be
classified as oranges (good cars) or lemons
(duff cars).
◦ Only the seller knows if it is an orange or
lemon.
◦ The buyer will not wish to pay a high price
if there is a risk of buying a lemon.
◦ Maybe most cars are lemons, otherwise
why sell good car.
◦ Therefore many people avoid buying vehicles in
the used car market
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Hidden Characteristics:
Adverse Selection and the
Lemons Problem
The insurance market
◦ In insurance markets, buyers with low risk
may decline to purchase insurance because the
price is too high.
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Signalling to Convey Private
Information
Signalling
◦ Signalling refers to an action taken by an
informed party to reveal private information
to an uninformed party.
◦ Advertising is an example – it’s worth advertising a good
product because it will generate repeat business.
Advertising a poor product may generate one-off
purchases but won’t be as cost effective.
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Screening to Induce
Information Revelation
Screening
◦ Screening is an action taken by an
uniformed party induces an informed party
to reveal information.
◦ An example is the use of deductibles by insurers to
induce motorists to reveal their own judgments about their
riskiness.
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Asymmetric Information and
Public Policy
When some people know more than
others do, the market may fail to put
resources to their best uses. Although
asymmetric information may call for
government action, three facts
complicate the issue:
◦ Private markets can sometimes deal with
information asymmetries on their own
◦ The government rarely has more information
than the private parties.
◦ The government itself is an imperfect
institution.
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Deviations From The
Standard Economic Model
Recently, a field called behavioural economics has
emerged in which economists make use of basic
psychological insights to examine economic
problems.
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People Aren’t Always Rational
Economists assume that human beings
are always rational.
◦ Firm managers maximize profit.
◦ Consumers maximize utility.
◦ Given constraints that they face, these
individuals make decisions by rationally
weighing all costs and benefits. Real people are
more complex.
◦ People can be forgetful, impulsive, confused,
emotional, and short-sighted.
◦ They are satisficers.
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People Care About Fairness
The ultimatum game.
◦ Two volunteers are to play a game and could win a total
of €100.
◦ Player A’s job must propose a division of the prize between
himself and the other player.
◦ Player B decides whether to accept or reject it.
◦ If Player B accepts the proposal, both players are paid
according to the proposal. If Player B rejects the proposal,
both players receive nothing.
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People Care About Fairness
Conventional economic theory and the ultimatum
game.
◦ Player A should know that if he offers €1
to Player B and keeps €99 for himself,
Player B should accept it.
◦ €1 is greater than €0 so Player B is still
better off than not accepting the proposal.
Reality and fairness.
◦ Such a paltry offer would often be rejected
by Player B.
◦ Knowing this, Player A should offer a more
substantial portion of the money to Player
B.
◦ People maybe driven by a sense of
fairness.
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People Are Inconsistent
Over Time
Would you prefer (A) to spend 50
minutes doing a boring task
immediately or (B) to spend 60
minutes doing the task tomorrow?
◦ Many people choose B to put it
off for another day. Would you prefer
(A) to spend 50 minutes doing the
task in 90 days or (B) to spend 60
minutes doing the task in 91 days?
◦ Many people will now choose A to
minimize the time spent on the task.
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People Are Inconsistent
Over Time
People often make plans for themselves but then fail
to follow through.
The desire for instant gratification can induce the
decision maker to abandon his past plan.
An important implication is that people should try to
find ways to commit their future selves to following
through on their plans.
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 Summary 1 In many economic
transactions, information is
asymmetric. 2 When there are
hidden actions, principals may
be concerned that agents suffer from the
problem of moral hazard. 3 When there
are hidden characteristics, buyers
may be concerned about the problems
of adverse selection among sellers. 4
Private markets sometimes deal with
asymmetric information with signalling
and screening.
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 Summary 5The study of psychology and
economics reveals
that human decision making is more
complex than assumed in conventional
economic theory. 6Systematic mistakes
that people make include
mental accounting and herd mentality. 7
Prospect theory suggests people attach
different
values to gains and losses and do so in
relation to some reference point. The
endowment effect is when the value
placed on something owned is greater
than on an identical item not owned.
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Summary
8 People are not always rational, they
care
about the fairness of economic
outcomes, and they can be
inconsistent over time.
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