econ1101 summary notes

8/17/2019 ECON1101 Summary Notes

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ECON1101: Microeconomics

Chapter 1: Thinking as an Economist

1.1 Economics: The Study of Choice in a World of Scarcity

Economics - study of how people make choices under conditions of scarcity and of the results of those choices

for society

o Microeconomics - the study of individual consumer, firm and market behaviour

o Macroeconomics - the study of the aggregate economy

Scarcity Principle (no-free-lunch principle) - unlimited wants and limited resources forces us to make

economic decisions that involve trade-offs or competing interests

o Economic ecisions - any decision where securing something of value means going without some

other thing of valueo Choice - involves compromise between competing interests; which wants we satisfy first using our

limited resources comes down to the relative importance of competing interestso kinds of limited resources - la!our !human effort and time", land !natural resources, including

physical space", capital !something produced that is long-lasting and used for other productions" and

entrepreneurship !ability and willingness to combine other resources into productive enterprise"

Cost-"enefit Principle - an entity !individual, firm or society" should take an action if, and only if, the e#trabenefits from taking the action are at least as great as the e#tra costs

o "enefit - the largest dollar amount the person would be willing to pay in order to take the action

o Cost - the dollar value of everything the person must give up in order to take the action

o #ationality $ssumption - in studying choice under scarcity, people are assumed to be rational in the

sense that they compare the costs and benefits of alternative actions in pursuing their goals

Ceteris Pari!us (all else e%ual) - the assumption that everything that could affect a variable of interest,

other than the thing being studied, stays the same$

1.& 'earnin to Thin as an Economist

Economic *aturalist - someone who uses basic economic concepts to make sense of observations about all

aspects of everyday life$ Economists need to consider all costs and benefits when making decisions$

Economic Surplus - the gain that results from taking an action when the benefits outweigh the costs

o %ational people will choose actions that generate the largest economic surplus !but at least positive"

+pportunity Cost - the value or benefit of the ne#t-best alternative that must be given up or sacrificed to take

a particular action !which becomes a cost of taking that particular action"

o &um of e,plicit costs !paid to someone else" and implicit costs !cost for yourself"

o Eg$ 'ou have time to either: go shopping with friends and spend (1) or study for a test and improve

your mark by 1)$ The opportunity cost of going shopping is the (1) !e#plicit cost" plus the largest dollar

value you*d be willing to pay for the e#tra 1) marks in the test !implicit cost"$

The %ole of Economic +odels

Model - an abstract representation of reality !in words, diagrams and mathematical statements" to help e#plain

and predict something$ Economics relies heavily on modelling$

o Eg$ Economists use the cost-benefit principle as an abstract model of how an idealised rational individual

would choose among competing alternatives$• They recognise that people usually don*t consciously assess costs and benefits when they make

simple decisions; all the cost-benefit principle really says is that a rational decision is one that is

e#plicitly or implicitly based on a weighing of costs and benefits$• onetheless, people still make sensible decisions most of the time, without being consciously

aware that they are weighing costs and benefits$ This is mainly due to trial and error which

gradually allows people to learn what kinds of choices tend to work best in different conte#ts$


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1. our /mportant ecision Pitfalls

1$ +easure costs and benefits as absolute dollars rather than as proportions

$ .ccount for all opportunity costs

/$ 0gnore sunk costs

Sun Costs - a cost that cannot be recovered at the moment a decision is madeo &ince sunk costs must be borne whether or not an action is taken, they are irrelevant to the decision of

whether to take the action$

o Eg$ %egardless of what you paid to enter an all-you-can-eat restaurant, you should eat same amount

$ now when to use average costs and benefits and when to use marginal costs and benefitsMarinal "enefit 0 Cost - increase in benefit 2 cost associated with a small increase in the level of an activity$erae "enefit 0 Cost - total benefit 2 cost of undertaking n units of an activity divided by n

o 0n many situations, the issue is not whether to pursue the activity at all, but rather the e#tent to which

it should be pursued$ The cost-benefit rule is to keep increasing the level of activity as long as the

marginal benefit of the activity e#ceeds the marginal cost$

*ot-all-costs-and-!enefits-matter-e%ually principle - some costs and benefits !eg$ 3pportunity cost and

marginal costs and benefits" matter in making decisions, whereas others !eg$ &unk costs and average costs and

benefits" don*t$

Chapter : Comparative .dvantage: the 4asis for Trade

&.1 +pportunity Cost and Specialisation

$!solute $dantae - when one person is able to produce a 56& with less resources than another personComparatie $dantae - when one person*s opportunity cost of producing a 56& is lower than another

person*s opportunity cost

Speciali2ation - to concentrate on the activities for which opportunity cost is lowest !ie$ +ost efficient"o Economic systems based on speciali7ation and the e#change of 56& are generally far more productive

than those with less speciali7ation

&.& The Principle of Comparatie $dantae

Principle of Comparatie $dantae - states that when people speciali7e in the activities for which their

opportunity is lowest !ie$ +ost efficient, comparative advantage" and then trade to get the 56& they do not

produce themselves, the total value of 56& produced can be ma#imi7ed and everyone can be better off

+athematically: consider e#ample of , 1 person economies !8 hours per day", value of 1 bread 9 1 pi77a:

Time to !ae pi22a Time to !ae !read

on ) mins 1) mins

ames /) mins /) mins

+.C to !ae pi22a +.C to !ae !read

on bread pi77a

ames 1 bread 1 pi77a

o on has .. and C. in bread, ames has C. in pi77a

o on should, according to

With Specialisation


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o E#perience o Cultural institutions

Comparatie $dantae is ynamic - it can change over timeo The process of speciali7ation helps build comparative advantage: as you focus more and more on one

production, you become better at that production and relatively not as good on other productions,

increasing the differences between opportunity costso Countries can attempt to @build* comparative advantage in particular industries by adopting strategic

trade policies such as subsidi7ing domestic firms and government investments in research

&. /llustratin Comparatie $dantae 3raphically

Production Possi!ilities Cure (PPC) - a graph that describes the ma#imum amount of one good that can

be produced for every possible level of production of the other good$o


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9.1 Comparatie $dantae as a "asis for Trade

Countries hae different resources - population si7e and density, labour skills, fertility of soil, climate,

natural resources, technology, culture, etc$o &uch differences in national resources provide countries with comparative advantages in the production

of different 56& !ie$ They can produce certain 56& at a lower opportunity cost than other countries"o


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Sellers #eseration Price - the smallest dollar amount for which a seller would be willing to sell an additional

unit, generally eBual to marginal costo &ellers are willing to sell additional units if the price !revenue per unit, or the marginal benefit" is at

least as great as the opportunity cost !marginal cost" of supplying that e#tra unito .s price increases, producers are able to cover the higher opportunity cost of further production

!principle of increasing opportunity cost"

. Maret E%uili!rium

Maret E%uili!rium - situation in market where no participant in the market has any

reason to alter their behaviour !ie$ o tendency to change, in terms of both price and

Buantity demanded and supplied"

o 0s price and Buantity at which demand and supply curve intersect

There are two situations in which forces known as maret forces will move a market

towards its eBuilibrium:

1$ E,cess Supply - price of good e#ceeds eBuilibrium price, causing Buantity supplied

G Buantity demandedo ?nsold stock -G suppliers* ↓ price$ .s price ↓, Buantity demanded ↑ and

Buantity supplied ↓$ This proceeds until market returns to eBuilibrium

$ E,cess emand - price of good below eBuilibrium price, causing Buantitydemanded G Buantity suppliedo &hortage of stock -G bidding -G ↑ price$ .s price ↑, Buantity demanded ↓ and

Buantity supplied ↑$ This proceeds until market returns to eBuilibrium

%egulated +arket

Price Ceilin - a ma#imum allowable price, specified by law !to help low-income

producers" -G e#cess demand

Price loor - a minimum allowable price, specified by law !to help producers" -G

e#cess supply

"lac maret - an illegal market in which the price e#ceeds the legally imposed ceiling

.5 Predictin and E,plainin Chanes in Price and ;uantities

Chanes in the ;uantity emanded 0 Supplied (E,pansion or Contract in emand 0 Supply) - a

movement along the demand 2 supply curve that occurs in response to a change in price

Chanes in emand 0 Supply - a shift of the entire demand 2 supply curve !ie$ change in the Buantity of

56& demanded or supplied at each price level"

&hifts in the emand Curve• Price of related oods

o &ubstitute 5oods !used in place of each other" - direct relationship between the price of one good and

demand for anothero Complimentary 5oods !used together" - inverse relationship between the price of one good and

demand for another• /ncome

o ormal !superior" 5ood - demand varies directly with income

o 0nferior 5ood - demand varies inversely with income

• Tastes or preferences - increased preference by buyers for 56& -G ↑

• *um!er of !uyers - increase in the population of potential buyers -G ↑

• uture e,pectations - consumers e#pect higher prices in the future -G ↑

&hifts in the &upply Curve• Costs of inputs - decrease in cost of inputs -G ↑&

• Technoloy - improvement in technology that reduces cost of production -G ↑&

• *um!er of firms in industry - increase in number of suppliers -G ↑&

• uture e,pectations - e#pectation of lower prices in future -G ↑&

• *ature - eg$ 0mprovement in weather -G ↑& of agricultural products


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.7 Marets and Social Welfare

Consumer Surplus - the difference between the consumer*s

reservation price !marginal benefit" and the price they actually pay

!eBuilibrium price"

Producer Surplus - the difference between the price received by

the supplier and their reservation price

Economic Surplus - the sum of the consumer and producer

surpluso +a#imi7ed at market eBuilibrium

o Cash on the ta!le - a metaphor used by economists to

describe une#ploited gains from e#change !ie$ the market

can still increase its economic surplus by moving to

eBuilibrium position"

Socially +ptimal ;uantity - Buantity of a 56& that results in the

ma#imum possible difference between the total benefits and total

costs from producing and consuming the 56&o 0s the level where +4 9 +C of the 56&

o +arket eBuilibrium is where +4 9 +C for all private

participants in the market

Efficiency - occurs when all 56& are produced and consumed at

their respective socially optimum levels

+arket eBuilibrium Buantity is socially optimal if all costs of

producing the good are borne by private sellers and if all benefits

from consuming the good accrue directly to private buyers !ie$ o

e#ternalities"$ 0n such situations, the private market eBuilibrium is efficient$

4ut factors such as pollution are social costs that don*t fall to the producers, and is thus unaccounted for by the

market !ie$ .t market eBuilibrium, social +C G private +C 9 private +4 and is thus not socially optimal"*eatie E,ternalities - market eBuilibrium Buantity is larger than socially optimal Buantity

Positie E,ternalities - market eBuilibrium Buantity is smaller than socially optimal Buantity

E%uili!rium Principle - a market in eBuilibrium leaves no une#ploited opportunities for individuals, but may

not e#ploit all gains achievable through collective action$

ead6eiht 'oss - the decrease in consumer and producer surplus that results from an inefficient allocation

of resources

Chapter : Elasticity

5.& Price Elasticity of emand

Price Elasticity of emand - percentage change in Buantity demanded that results from a 1H change in price

o ε 9


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/nelastic emand - ε K 1 !a given H change in < smaller H change in Buantity demanded"

4nit Elastic emand - ε 9 1 !a given H change in < same H change in Buantity demanded"

eterminants of


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The 'a6 of emand - the Buantity demanded of a 56& in a given time period declines as its price rises and

increases as its price falls, ceteris paribus$

o *eeds - bare material levels of consumption !food, shelter, clothing" reBuired to maintain our health

o Wants - any consumption that e#ceeds needs

7.& Translatin Wants into emand

4tility - the satisfaction people derive from their consumption activitieso 4tility ma,imi2ation assumption - people try to allocate their incomes so as to ma#imise their

satisfaction or total utility

Marinal 4tility - additional utility gained from consuming an additional unit of good in a given period of timeo 'a6 of iminishin Marinal 4tility - the tendency for the marginal utility to diminish as

consumption increases beyond some pointo &uggests that spending all of our income on one good is not a good strategy to ma#imise utility

+ptimal Com!ination of 3oods - the affordable combination of 56& that yields the highest total utilityo #ational Spendin #ules - spending should be allocated across 56& so that marginal utility per dollar

is the same for each good

•

• 0f the ratio of marginal utility to price is higher for good A than good ', the consumer can

increase their total utility by purchasing more of good A and less of good '

7. $pplyin the #ational Spendin #ule

#eal Price - the dollar price of a good relative to the average dollar price of all other goods

*ominal Price - the absolute price of a good in dollar terms

o Even when price of a good increases in nominal terms, consumption of that good may increase because

the price of the good has actually decreased in real terms

7.5 /ndiidual and Maret emand Cures

The market demand curve for a 56& is the hori7ontal summation of all individual demand curves for that 56&

!ie$ at each price level, add all the individual Buantity demanded"$

7.7 emand and Consumer Surplus

Consumer Surplus - the difference between the consumer*s reservation price !marginal benefit" and the price

they actually pay !eBuilibrium price" for a producto $reate consumer surplus in the maret !ie$ &ummation of marginal benefit minus price for

every good consumed" 9 area between the demand curve and the eBuilibrium price lineo The benefit or total welfare consumers receive from participating in the market as they perceive it

Chapter 8:


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To cover opportunity cost under conditions of diminishing marginal returns !or output", price must rise to give

incentive for suppliers to supply more$

0ndividual and +arket &upply CurvesThe Buantity that corresponds to a given price on the market supply curve is the sum of the Buantities supplied

at that price by all individual sellers !ie$ &ame as demand"$

=.& Supply in Perfectly Competitie Marets

Profit - the total revenue a firm receives from the sale of its product minus all costs !e#plicit and implicit"

incurred in producing ito


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Marinal Cost (MC) - additional cost of producing one more unit of outputo +C 9 ITC 2 IJ

o +C declines at first due to increasing returns, then increases due to diminishing returns

o +C curve will intersect the minimum points of .PC and .TC


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M$ *um!er of suppliers - since market supply is the hori7ontal aggregation of individual supply curves,

market supply will shift to the right as the number of individual suppliers increase and vice versa$

=.7 Supply and Producer Surplus

Producer Surplus - the difference between the amount actually received by the seller !eBuilibrium price" and

the seller*s reservation price !marginal cost"o 9 area between the eBuilibrium price line and the supply curve

Chapter Q: Efficiency and E#change

A.1 Maret E%uili!rium and Efficiency

Efficient (Pareto Efficient) - a situation is efficient if there is no opportunity for e#change or trade that will

make at least one person better off without harming others !ie$ economic surplus is ma#imised"

Pareto-improin transaction - a transaction that leaves at least one person better off without harming

others !ie$ a transaction that creates additional economic surplus"

+nly the e%uili!rium 6ill ma,imise economic surplus (ie. Efficient) - the market price is the only price

at which buyers and sellers cannot design a surplus-enhancing or first sered policies -


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o 5ives little weight to the interests of consumers with a greater marginal benefit for !or greater

opportunity cost for not" taking an actiono . better alternative is a compensation policy, which allows a more efficient allocation of 56& since the

56& are provided to those who value them the most !minimi7es the loss in economic surplus"

A. Marinal Cost Pricin of Pu!lic Serices

To achieve the largest possible total economic surplus:

• /n priate marets - goods are e#changed at eBuilibrium prices !where value of the last unit to the buyeris e#actly eBual to the seller*s marginal cost of producing it"$

• 3oernment as sole proider of 3DS - charge each customer e#actly the marginal cost of providing the

56&o 0f there are multiple marginal costs for providing a 56& !eg$ .cBuiring water from different sources", a

government should share every household the highest marginal cost

A.5 Ta,es and Efficiency

/ncidence of Ta, - division of the ta# burden between the increase in price paid by the consumer and

decrease in revenue received by the producer$o #elatie incidence is shaped by the relative price elasticity of demand and supply; the burden of the

ta# will be borne by the side of the market that is more inelastic

Now a Ta# Collected from a &eller .ffects Economic &urplus. ta# levied on the seller of a product has the same effect on eBuilibrium as a rise in +C eBual to the amount of

the ta# !ie$ ecrease in supply by the si7e of the ta#"$o Causes total economic surplus to shrink !to area of triangle bounded by '-a#is, demand curve and new

supply curve$ Nowever, consumers receive a reduction other ta#es paid by an amount eBual to the

additional ta# revenue and this adds to consumer surplus$o onetheless, the ta, still leads to an oerall loss in economic surplus eBual to half the value of

the ta# per unit multiplied by the decrease in Buantity between the eBuilibrium points before and after

the ta#$ This is known as a dead6eiht loss$• To minimise deadweight loss, ta# goods that have more inelastic demand and2or supply

ead6eiht 'oss - the reduction in total economic surplus that arises when a market operates at some priceand output combination other than the one at which marginal benefit eBuals marginal cost !ie$ EBuilibrium"$

Chapter >: 0nternational Trade and Trade


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9.5 The /nefficiency of Protectionism

• ree trade is efficient because it ensures that oods 6ill !e produced 6here opportunity cost is

lo6est (ie$ 4y countries who have a comparative advantage", ma#imi7ing consumption possibilities• Trade !arriers are inefficient and reduce the si2e of the total economic surplus - loss in consumer

surplus G increases producer surplus and government revenue 2 revenue for import licensees• 5ains from trade could be used to assist groups that have been hurt by trade

• +uch of the income loss arisin from !arriers to trade is a!sor!ed !y poor> deelopin economies

Chapter =: The Juest for


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o espite economic loss, if < G .PC !the shutdown

condition", firms will temporarily continue to supply

at their profit-minimising output !


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EBuilibrium 2 @no cash on the table* principle doesn*t mean there are never any valuable opportunities to e#ploit,

but that there are none when the market is in eBuilibrium$ EBuilibrium will not be socially optimal when the

costs or benefits to individual participants in the market differ from those e#perienced by society as a whole$

Chapter 1): +onopoly and 3ther Dorms of 0mperfect Competition

1J.1 /mperfect Competition and Price-Settin

/mperfectly Competitie Maret - a market in which firms have at least some ability to set their own price$

Three different forms include:

o Pure Monopoly - a market in which a single firm is the only supplier of a product for which there are

no close substitutes

o +liopoly - a market in which only a few rival firms produce goods that are close substitutes

o Monopolistic Competition - a market in which a large number of firms produce slightly differentiated

products that are reasonably close substitutes for one another$

+arket


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$ 5overnment-created monopolies - oernments can confer maret po6er on firms by the use of

patents, copyright protection and the grant of licenses and franchises

/$ Economies of &cale !more important barrier"

Constant returns to scale - a production process is said to have constant returns to scale if, when all inputs

are changed by a given proportion, output changes by the same proportion

/ncreasin returns to scale (economies of scale) - a production process is said to have increasing returns

to scale if, when all inputs are changed by a given proportion, output changes by more than that proportion

*atural Monopoly - a monopoly that results from economies of scale, because a sinle firm can sere the

6hole maret at a lo6er cost than can t6o or more firms (due to cost adantae of larer output)

$ etwork Economies !more important barrier"

The effect of network economies is that as the number of people using a certain product increases, the

consumers* perception of its Buality and value increases !eg$ etworking between +icrosoft software"$ Dirmly

entrenched network economies can be as persistent as a source of monopoly as economies of scale$

1J. Economies of Scale and the /mportance of i,ed Costs

Total Cost (TC) 9 Di#ed cost !D" 6 +arginal Cost # Juantity !+C#J"

$erae Total Cost ($TC) 9 TC 2 J 9 D 2 J 6 +C

&ince fi#ed costs or start-up costs don*t increase as output

increases, the .TC of production for goods will decrease as

output increases$ Though .TC is always higher than +C, the

difference between the two diminishes as output grows$

.t e#tremely high levels of output, .TC becomes very close to

marginal cost, because the firm is spreading out its fi#ed

costs over an e#tremely large volume of output !such that

fi#ed cost per unit or D2J becomes almost insignificant"$

This economies of scale effect on reducing .TC is most significant for goods whose production entrails large

fi#ed !start-up" costs and low variable !reproduction" costs$ This e#plains why many industries such as software

and drugs are dominated by either a single firm or a small number of firms$

1J.5 Profit Ma,imisation for irms that are Price Setters

Marinal #eenue - change in a firm*s total revenue that results from a one-unit change in output !ITC 2 IJ"

+arginal %evenue for the &ingle-


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• Economic profit if < G .TC at the profit-ma#imising

level of output$• Economic loss if < K .TC at the profit-ma#imising

level of outputo +onopolist will do best by shuttin do6n

and produce nothin in the short run if P

@ $?C at profit-ma#imising level of output$o +onopolist will leave the market in the long

run in face of economic losses

4ut unlike perfect competition, monopolist don*t earn normal profit in the long run - if they are earning an

economic profit, more firms will not !or cannot" enter the market and split the economic profit$

1J.7 Why the /nisi!le Gand "reas o6n 4nder Monopoly

Social efficiency is achieved at the output level where market demand curve

!marginal benefit to society" intersects with the monopolist*s marginal cost

curve !marginal cost to society"$

o &ocial efficient output level is when the firm is producing at 9+C

o 4ut since the monopolist produces at +% 9 +C and G+%, the

monopolist*s profit-ma#imising output can never be socially efficient$• There is economic surplus that is not realised or une#ploited

opportunities, represented by the dead6eiht loss

4ut the inisi!le hand is completely idle in monopoly marets:

o 0ndividual self-interest still leads people to respond to the incentive of une#ploited opportunities !eg$

evelop substitute goods or production methods that do not rely on owning a uniBue resource"o Even the monopolist itself has an incentive to e#pand output - if only there was some way to maintain

the price of e#isting units and cut the price of only the e#tra units$• +onopolists constantly struggle to find ways of serving buyers with low reservation prices

without spoiling the price at which they sell to high reservation price buyers

1J.= 4sin iscounts to E,pand the Maret

0nefficiency occurs in monopoly markets where the firm is a sinle-price price-setter because the firm is

reluctant to cut price to eBuilibrium price and increase Buantity to eBuilibrium Buantity - in the firm*s point of

view, the price reduction the firm must grant e#isting buyers to e#pand output is a loss$


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Economic profit 9 1>) !8#/)" - 8#= 9 (8

0f perfectly price discriminate !9+%":

.-D, 8 papers edited !+%G+C"

Economic profit 9 1) !)6/>6S/)" - 8#= 9 (/8

/mperfect Price iscrimination - price discrimination in which at least some buyers are charged less than

their reservation prices$ problems that make perfect price discrimination impractical 2 impossible for sellers:

1$ &ellers need to find out every consumer*s reservation price$ &ellers need some means of e#cluding those with high reservation price from buying at a low price

3roup Pricin - a form of price discrimination where different discounts are offered in different sub-markets,

while members of a particular sub-market all receive the same discount

o &ub-markets use observable characteristics of buyers !eg$ .ge or employment status" to make a

generalisation of reservation prices of buyers possessing those characteristics

Gurdle Method of Price iscrimination (?ersionin) - the practice by which a seller offers a discount to all

buyers who overcome some obstacle

o Eg$ iscounted printer if bought in bundle with a keyboard and mouse, temporary sales period !those

with low reservation prices are more likely to reorganise shopping schedule to buy during sale periods"o Nurdle method solves both the seller*s problem:

1$


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Efficient regulation: marinal cost pricin rule !socially optimum price"

o < 9 where 9+C

o Causes monopoly to have economic loss - they can never recover

the cost of their start-up fi#ed costs, and forces them to o

!anrupt in the lon run

.verage cost pricing: aerae cost pricin rule !fair return price"

o < 9 where 9.TCo Eliminates any positive economic profits since


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ash eBuilibrium is bottom right cell

11.& The Prisoners ilemma 3ame

Prisoners ilemma - a game in which each player has a dominant strategy, and when each plays their

dominant strategy, the resulting payoffs are smaller than if each had played a dominated strategy


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E,ternalities - an e#ternal cost or benefit of an activity

1$ *eatie E,ternality (e,ternal cost) - a cost of an activity that falls on people other than those who

pursue the activity !additional marginal cost unaccounted for by market supply"

$ Positie E,ternality (e,ternal !enefit) - a benefit of an activity received by people other than those

who pursue the activity !additional marginal benefit unaccounted for by market demand"

0n either case, the e#ternalities

cause the competitive eBuilibrium

to result in a loss of economicsurplus eBual to the area of the

shaded triangle$

Rhen all relevant costs

and benefits of an activity accrue directly to the people who produce and consume it !ie$ no e,ternalities",

the leel of the actiity that is !est for the indiidual 6ill also !e the !est for society

• Rhen an activity generates e#ternalities !negative or positive", individual self-interest will not result in the

best allocation of resources for society !in other words, goods will not be produced at their socially optimal

levels which, by definition, is inefficiency"$o 0ndividuals and firms who consider their own costs and benefits will tend to engage too much in

activities with negative e#ternalities and too little in activities with positive e#ternalities

Coase Theorem

Coase Theorem - if at no cost people negotiate the purchase and sale of the right to perform activities that

cause e#ternalities, they can always arrive at efficient solutions to the problems caused by e#ternalities$

o 0nformal rules and social norms often take care of reciprocal social costs without the need for either

Coasian deals or formal rules

0f negotiation is costless, the task of adFustment generally falls on the party who can accomplish it at the lowest

cost, hence being efficient even if it may not be in accordance with societal norms$

Eg$ %uth operates a factory that dumps to#ins into lake, negative e#ternality to Nugh who operates a fishery

Total daily surplus without filter !)" G with filter !))" more efficient to operate without filter

Nugh should adFust - Nugh*s cost of putting up with

to#in !/)" K %uth*s cost of installing filter !M)"

%uth could pay Nugh (/1 and both are still better off

operating without a filter than with a filter

Oegal %emedies To E#ternalities

Rhen negotiation is costly or impractical, legal remedies can address the problems of e#ternalities$

o +any laws are made to address the problems caused by e#ternalities - they help people achieve the

solutions they might have reached had they been able to negotiate with one another$


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eg$ Each firm emits tonnes of pollution2day$

5overnment wants to half total emissions$ options:

1$ %eBuire each firm to curtail its emissions by half -

total cost 9 M)) 6 >) 9 (M>)$ &et a ta# of (T per tonne of pollution2day !if +C of

cutting a tonne K (T, either firm will cut 1 tonne

than pay ta# of (T" - (T 9 (1)1 to get &ludge 3il to cut 1 tonne !.49(1)) +C" and orthwest Timber to

cut / tonnes !C

9(1)) +C", total cost 9 1)) 6 1>) 9 (>)

Juantity-4ased +40*s

Mareta!le permit system - also known as @cap and trade*, involves the creation of a market to facilitate the

trade of environmental goods !eg$ Rater, pollutant"

o 0n the case of a negative e#ternality, establishing such a system involves / steps:

1$ &et a Buantity cap$ efine entitlements !property rights" and distribute these among users/$ Create a market to enable the trading of entitlements

Oike ta#es, it reduces pollution by concentrating on firms that can do it at lowest cost$ 4ut unlike ta#es, it:

• oes not induce firms to make costly investments that they will have to abandon if the clean-up falls short

of the target level•


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• Dor self-interest - will send cow onto commons if income per cow G (1/

• E#pect villagers to send a cow onto the commons !th villager indifferent between buying cow or bond"

• Total villager income 9 1/ !bond" 6 #1/ !cow" 9 (8M - not most efficient allocation of villagers* resources

because they could have earnt that same amount by all buying bonds

0f villagers make their investment decisions collectively !behaving as one entity or private owner":

• Dor group-interest - will send cow onto commons if its marginal contribution to village income G (1/

• E#pect a single cow to be sent onto the commons !socially optimal number"

• Total villager income 9 8 !cow" 6 #1/ !bond" 9 (Q>

The Effect of


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Eg$ Oabelling of students who study too much as a social misfit or @nerd* prevents a positional arms race - when

students are graded on the basis of ranking, a positional arms race ensues because if all students were to

double the amount of time they studied, the distribution of grades would remain essentially the same$

Nowever, social norms tend to change in order to accommodate the progressively more e#cessive behaviour

and spending patterns that are characteristic of such races$

Chapter 1/:


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o &ignificant communication costs !insignificant between people, but significant between thousands"

o Dree-rider problems

o ifficulty in reaching an agreement on fair sharing of costs

5 types of ta, to fund pu!lic oods

1$ Gead ta, - ta# that collects the same amount from every ta#payer$ #eressie ta, - ta# under which the proportion of income paid in ta#es declines as income rises/$ Proportional income ta, - ta# under which all ta#payers pay the same proportion of their income in ta#es$ Proressie ta, - ta# in which the proportion of income paid in ta#es rises as income rises

Eg$ eighbours . and 4, cost of septic tank filtration system for Foint consumption 9 (1)))

.*s RT)) and 4*s RT


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1.5 Priate Proision of Pu!lic 3oods

• 5overnment provision of public good has disadvantages - many people have to pay for public goods they

don*t want• +any social institutions have evolved to provide public goods outside the government sector -

o The challenge is to devise a scheme for raising the reBuired revenues to provide the public good

1$ undin !y donation - private charities, volunteering, etc !Eg$ Rikipedia"

$ eelopment of ne6 means to e,clude non-payers - scrambling TP signals to non-payers, electronictoll charges for urban roads

/$ Priate contractin - gated private communities$ Sale of !y-products - radio and TP programming costs are paid by the sale of advertising, not-for-profit

groups selling calendars, books and bumper stickers, etc

4y how much is economic surplus reduced by a pay-to-view chargeV

1.7 Sources of /nefficiency in the

Political Process

5overnment does much to help the economy function more efficiently, but it can also be a source of waste:

Por "arrellin - enacting legislation which do not satisfy the cost-benefit criterion !total costs G total benefit"

but which benefit constituents by more than their share of the e#tra ta#es reBuired to pay for the proFects$

o Eg$ . public proFect delivers benefits of (1)) million for an electoral district which contains 1H of thecountry*s ta#payers, but costs the federal government (1M) million$ &ince the district*s share of the ta#

bill will be only (1$M million, the residents are (=>$M million better off$

#ent Seein - the socially unproductive efforts of people 2 firms to win a pri7e !eg$ when individuals or firms

use real resources in an effort to win favours from the government"

1.= What should 6e Ta,8

•


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Chapter 1: Economics of 0nformation

The invisible hand theory assumes that buyers and sellers are fully informed$

• 5iven that consumers are not fully informed, they must employ strategies for gathering information$

15.1 Go6 the Middleman $dds ?alue


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Eg$ Two kinds of apartments - one which rents for (/8) !)H" and remaining which rents for ()) !>)H"$ The

only way you can discover the rent for a vacant apartment is to visit it in person, which costs (8$ The first

apartment you visit is one that rents for ())$

o Pisiting another apartment is a gamble with a )H chance to win ()-(89(/ and an >)H chance of

losing (8 !ie$ -(8"$o E#pected value of gamble 9 !)$"!/" 6 !)$>"!-8" 9 (

o Pisiting another apartment is a better-than-fair gamble

The Commitment


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Principal-$ent Pro!lem - a situation where an agent, whose actions are costly to monitor and whose

o!ecties are not alined 6ith those of the principal, takes actions that do not result in the best outcome

for the principal

+ercomin the principle-aent pro!lem

• .gent*s concern for reputation and pride mitigate the problem to a certain e#tent

• .ligning interests of agent with those of the principal !eg$ .llowing customer tipping to induce waiters to

provide good service"

• Rritten Buotes, seeking price estimates from many potential agents, getting nd

opinions• esigning incentive-compatible reward schemes

The Credibility


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15.5 isappearin Political iscourse

• The theory that people who support a position may remain silent> !ecause speain out 6ould

create a ris of !ein misclassified on the !asis of their mem!ership of a statistical roupo Eg$ Rhy might proponents of @safe inFecting rooms* often remain silentV 4ecause they could be

misinterpreted of supporting the use of drugs$

Information and health care delivery

First dollar insurance coverage: Insurance that pays all expenses associated with claims

generated by the insured actiity!

Example: I" hospital care is completed coered by insurance# the marginal cost to a patient

would be $ero# otherwise they might only stay "or one day! %his change in behaiour is an

example o" moral ha$ard# because the patient has more incenties to stay at hospital than

when he was directly responsible "or the cost o" the hospital stay himsel"! %his also causes

waste and ine&ciency# as there is lost economic surplus "or staying the extra days!

Solution: Cash payment to the patient to let them decide the amount o" days they want to

stay# noting that the cash payment only coers "or a bit less than two days worth o" hospital

stay hence only able to "ully coer one day o" hospital stay! In this way# economic loss is

reduced# and both the patient 'N( the insurance company hae a more balanced

distribution o" economic surplus )instead o" the patient using all the economic bene*ts

proided by the insurance company+!

Private health care insurance: 'ttempts to encourage priate health insurance are o"ten

"rustrated by aderse selection! Mounting insurance premiums hae caused many people in

good health to do without health coerage# resulting in higher premiums "or those whoremain insured!

Oligopoly – Two models: Kinked demand curve and the collusive oligopoly

%he kinked demand curve model o" oligopoly is based on the assumption that each *rm

beliees that i" it raises its price# others will not "ollow# but i" it cuts its price# other *rms will

cut theirs!


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I" they act as one *rm )collusie oligopoly+# it will closely resemble a monopoly!

econ1101 summary notes

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