economics (1 3)

Economics 1-3 Self-Study Tasks 1 & 2 Week 1

IB 1.3 Economics & Social Science, Summary by Boris Nissen Page 1

Problem 1: 1. What are the four basic questions? 2. What are the fundamentals of economics?

Chapter 1 The automobile and economics The automobile a brief history - problem of motorized carriage: translate idea into marketable product technical problems & raise capital - mass production techniques - def. patent: gives the inventor the exclusive right to produce his invention for a limited time high prices

due to no competition (but gains to society more valuable) - problems in 60s: pollution & safety - problem in 70s: scarcity of oil high gas prices & strong Japanese - government interventions to rescue large car-manufacturers from bankruptcy - prospering again in late 90th after new crisis What is Economics? Def. Economics: How individuals, firms, governments and other organizations within our society make choices,

and how those choices determine the way the resources of society are used. Choices are unavoidable because desired goods, services and resources are inevitably scarce.

- choices have to be made by the economy as a whole as well as by each individual - How do all the choices interact to determine the use of scarce resources available to society? The 4 basic questions how economies function: 1. What is produced, and in what quantities?

- also what does account for the changes, the process of innovation and the overall level of production - and what role does the government play and why are some goods more expensive than others

2. How are these goods produced? - there are often different ways to produce, choice is influenced by technology, prices and regulations

3. For whom are these goods produced? - also what determines the differences in income/wages; what about redistribution

4. Who makes economic decisions, and by what process? - Centrally planned economy: government takes responsibility for every aspect of economic activity

answers first 3 questions through a bureaucracy - Mixed economy: mix between public and private decision making; relies primarily on the private

interaction of individuals and firms to answer all 4 questions, but government plays large role too

- economists also ask to what extent decisions are made by government / private individuals; whether decisions are made by individuals for their own interest or the interest of an employer confilicting interest in organizations as those consist of individuals

- economists ask not only how the economy answers the 4 questions, but also how well Is the economy efficient?

Markets and government in the mixed economy - economist believe that reliance on private decision making is necessary for economic efficiency, but that

certain government interventions are desirable balance - market: any situation where exchange takes place - market economy: competition; individuals make choices reflecting own desires; firms are in quest for profits

and the customer benefits - problematic in market economy are equity concerns: balance between equality and efficiency has to be

determined by governments to set the right incentives - the answers to the 4 basic questions given by the market, also appear inadequate in terms of pollution,

education, health, etc. what is the role and why does the government undertake activities - governments set the legal structure and regulates business practices; sometimes also operates like a private

business, or supplies goods and services the private sector does not (e.g. roads, social security) - firms take inputs (various materials of production) and produce output (goods and services they sell) - 3 broad categories of markets in which individuals and firms interact:

- product market = markets in which firms sell to households or other firms - labor market = market where individuals offer their services - capital market

- individuals participate in all markets, as consumers, workers or investors



Terms: - market = used in a broad sense no formal marketplace - capital market = markets in which funds are raised, borrowed and lent - capital goods = machines and buildings - capital goods markets = markets in which capital goods are bought and sold Microeconomics and macroeconomics: The 2 branches of economics (2 different viewpoints) Microeconomics = Detailed study of product, labor and capital markets focusing on the behavior of the units that make up the economy. How individuals make decision and what affects those bottom-up view Macroeconomics = Looks at behavior of the economy as a whole, what is happening in total or on average top-down view The science of economics - economics is a social science studies the social problem of choice in a systematic exploration formulation

of theories and examination of data - theory: set of assumptions and conclusions economists use models to make predictions; those may

describe a general relationship, a quantitative relationship or may make a general prediction - variable: any item that can be measured and that changes economists are interested in relationships - correlation: systematic relationship among variables; measured and tested by statistical tests - causation: not only correlated, but changes in one variable cause the changes in the other; sometimes

direction of causation is not clear - econometrics: branch of statistics developed to analyze particular measurement problems arising in

economics - experimental economics: analyzed certain aspects of economic behavior in controlled laboratory setting

(major new branch) Correlation does not prove a causation; to test different explanations of causation all factors except one have to be held constant; data dos not always speak clearly, sometimes no conclusion is possible Why economists disagree - positive economics: when people are engaged in describing the economy and construct models that predict

change or effects of different policies concerned with what is - disagree over what is the appropriate model of the economy (individuals/firms able to perceive and

calculate self interest; competitive or noncompetitive market) and about quantitative magnitudes - normative economics: when people evaluate alternative policies, weighing up various benefits and costs

concerned with what should be, the desirability - no policy is unambiguously better differences arise because of different models, different estimates

of quantitative relations or differences in values; but more agreement than disagreement Consensus on the importance of scarcity key consensus point of chapter 1

Chapter 2 Thinking like an economist The basic competitive model - economists employ different models of economy, the basic competitive model has 3 components:

- assumptions on how consumers behave rational, self-interested consumers - assumptions about how firms behave rational, profit-maximizing firms - assumptions about the markets in which consumers and firms interact competitive markets with

price-taking behavior - rational choice = people weigh costs and benefits, based on expectation that individuals and firms act in

consistent manner with reasonably well-defined objectives and understanding how to reach them; for firms this assumption is to operate to maximize profits

- economists make no judgement on preferences and dont ask why tastes differ or change; they are concerned with the consequences

- perfect competition = many buyers and sellers, all are in the same position, - price taker = in perfect competition when charging prices over market-price firm loses all sales, at market

price it can sell as much as it wishes consumers and sellers can have to accept market price - basic competitive model = rational, self interested consumers interacting with rational, profit maximizing

firms in competitive markets where firms and consumers are both price takers economy is efficient:



resources are not wasted, not possible to produce more of one without less of another good, not possible to make one better off without making someone else worse off

- economists recognize that actual economies are not perfectly described by basic competitive model Prices, property rights and profits: Incentive and information - in market economies individuals and firms need to be informed and need to have the right incentives,

supplied by prices, profits and property rights - price system: ensures that goods go to those willing and able to pay for them; the price expresses the

scarcity of different goods to maximize profit firms need to produce what customers want using least scarce resources in the most efficient way and find the right price

- return on investment: what you receive back in excess of what you invest - private property property rights: including right of the owner to use and the right to sell it - incentives have costs in form of inequality - incentive-equality trade-off: greater incentives result in greater inequality (and better performance; basic

question: choice of tax rates and welfare systems) - any time society fails to define the owner of its resources and does not allow the highest bidder to use them,

inefficiencies result - legal entitlement = property right, but not full ownership or control (e.g. lifelong living right) Incentives: Providing appropriate incentives is a fundamental economic problem. In modern market economies, profits provide incentives for individuals to work. Property rights also provide people with important incentives, not only to invest and to save, but to put their assets to the best possible use. Rationing - rationing = individuals get less of a good than they would like at the terms being offered - rationing by queues = given to those most willing to wait in line inefficient distribution of resources, as

time spent in line is a wasted resource - lotteries = random allocation fair, but inefficient as they dont go willing and able to pay most - coupon rationing = pay market price and produce a coupon can be tradable or not; if not inefficiency - black market = illegal market in which goods or coupons for goods are traded Opportunity Sets - opportunity set = group of available options; only what is within the opportunity set is relevant for a choice - constraints: limit choices and define the opportunity set; most relevant are time (time constraints) and

money (budget constraints) - when plotting 2 alternatives in a graph, the line usually defines the outer limits of the opportunity set - production possibilities = amounts of goods a firm or society could produce given a fixed amount of land,

labor and other inputs - production possibilities curve = unlike time and budget constraints, which are straight lines, it bows

outward; the individual typically faces fixed trade-offs, but trade-offs faced by society are not fixed - diminishing returns: adding successive units of any input to a fixed amount of other inputs increases the

output, or amount produced, by less and less (e.g. workers on a field) - any inefficiency in the economy results in a point below the production possibilities curve; then it is possible

to have more of every good those points are undesirable, but that does not mean that every point on the production curve is better than any point below (see page 40); (reasons: e.g. depression, etc.)

Cost - production possibility curve specifies the cost of one option in terms of another when operation on the

constraint or curs, it is only possible to get more of one thing by sacrificing some of another - relative price = trade-off or ratio between the two prices - trade-offs are necessary because resources are scarce; the full answer of the costs of a good/service are what

e.g. the money could otherwise buy - opportunity cost = taking into account the value of all resources (e.g. money and time, foregone income)

that could be used otherwise (formal measurement is the next-best use) (noneconomists often ignore them) - sunk costs = expenditure has already been made and cannot be recovered no matter what choice is made

(have to be ignored but most noneconomists do not ignore them) - marginal costs = extra costs of doing something have to be weighed against the marginal benefits

(additional benefits) most decisions are marginal decisions - economists bring marginal costs into the foreground enable them to think systematically (- investment tax credit = credit on taxes for investments made)



Basic Steps of rational choice: 1. Identify the opportunity sets 2. Define the trade-offs 3. Calculate the costs correctly, taking into account opportunity costs, sunk costs and marginal costs Appendix: Reading graphs - slope = described as rise (change on the vertical axis) over run (change on the horizontal axis) - important is to look at the scaling Problem 2: 1. How could you explain economic environment when using the supply and demand model? 2. What factors affect demand in general? 3. What was the situation of the oil-market in Nov. 1998 and why did prices fall? 4. Difference of change on and change of the supply-demand curve? 5. Why has the demand curve a negative and the supply curve a positive slope?

Chapter 4 Demand, Supply and Price The role of prices - when forces of supply and demand operate freely, price measures scarcity - prices are the way participants in the economy communicate with one another high prices convey the

information of scarcity and the incentive to consume less - noneconomists see more in prices than the impersonal forces of supply and demand - economists see prices as symptoms of underlying causes and focus on the forces of demand and supply

behind price changes Demand - demand = quantity of a good or service that a household or firm chooses to buy at a given price - economists are concerned what people choose to buy with regard to their budget constraint and the given

prices of various goods How does the quantity of a good purchased by an individual change as the price changes (other factors held constant)?

The individual demand curve: Gives the quantity of the good demanded at each price: typically sloping downwards the more expensive a good, the less a person will buy - an individual exits the market, when his/her demand curve hits the vertical axis The market demand curve: Gives the total quantity of the good that will be demanded at each price (can be calculated by adding up all individual demand curves horizontally); also slopes downward - the demand curve for any good assumes that the price of complementary goods is fixed Shifts in demand curves: When only the price changes and everything else is held constant, we have a change on the demand curve, but in reality other changes occur and cause a shift of the (whole) demand curve the amount that will be demanded at each price changes. Sources of shifts in demand curves: - economic factors: change in income, price of a substitute, complement - non-economic factors: change in: composition of the population (demographic effects), tastes, information,

availability of credit, expectations of the future - substitute: 2 goods are substitutes if they satisfy a similar need and an increase in the price of one increases

the demand for the other - complement: 2 goods are complements if e.g. an increase in price for one decreases the demand for the other Shifts in a demand curve versus movements along a demand curve: - a shift along the demand curve is simply the change in quantity demanded as the price changes - a shift of the demand curve is a shift of the whole curve at a given price, more/less is consumed - in practice both effects are often present Supply - supply = quantity of a good or service that a household or firm would like to sell at a particular price - question: How does the quantity supplied change when price changes (everything else kept constant)? - Supply curve: Gives quantity of the good supplied at each price; typically sloping upwards as at higher

prices suppliers can get more profit and thus have an incentive to produce more Market supply curve: Total quantity of a good that firms are willing to produce at each price; sloping upwards (can be calculated by adding horizontally the quantities that each of the firms is willing to produce)



Shifts in supply curves - supply cures can shift, so that the quantity supplied at each prices increases/decreases Sources of shifts in supply curves: change in price of inputs, technology, natural environment, availability of credit, change in expectations Shifts in a supply curve versus movements along a supply curve: the quantity supplied can change because of a change in price (movement along the curve) or because of a shift of the entire curve at a given price Law of supply and demand - Equilibrium = situation where there are no forces (reasons) for change; no one has an incentive to change

the result - Equilibrium price and equilibrium quantity can be found at the intersection of the supply and demand curves - Excess supply: is there when the price is higher than the equilibrium price - Excess demand: is there when the price is lower than the equilibrium price - Law of supply and demand = In competitive market economies actual prices tend to be equilibrium prices, at

which demand equals supply (of course the market may bounce around a little bit process of adjusting); when the market is out of equilibrium, there are predictable forces for change

Using demand and supply curves: - concept of demand and supply curves constitute the economists basic model of demand and supply helps

to explain why prices are high/low and predict consequences of changes Prices: In competitive markets, prices are determined by the law of supply and demand. Shifts in the demand and supply curves lead to changes in the equilibrium price. Similar principles apply to the labor and capital markets. The price for labor is the wage and the price for capital is the interest rate. Structure of economic models: Identity: statement that is true simply because of the definition of terms Behavioral relationships = description of how individuals behave (economists may disagree on strength and

direction) Equilibrium relationships = when no forces for change exist (disequilibrium is thus possible economists

disagree on strength of forces) Price, value and cost - price = what is given in exchange for a good or service (what a good sells for) - cost = the expense of making the object - value in exchange = the price we pay for the object - value in use = importance of the good to us (e.g. water has a high value in use) - diamond-water paradox: the objects with the highest value in exchange often have no/little value in use

can be explained by supply and demand; water is readily available in plentiful quantities, it has a low price not because its total value is low, but because the marginal value (the value of an additional unit of the object) is low

- an equilibrium can also exist when the supply for a good is fixed (e.g. land prices)



Problem 3: 1. What is demand and supply elasticity? 2. What are the actors that can explain the changes in demand and supply elasticity? 3. Why is the tax burden shared between consumers and producers when demand and supply are not perfectly

elastic/inelastic? 4. How can the supply and demand analysis be used to determine the incidence of the tax?

Chapter 5 Using demand and supply Sensitivity to price changes: the price elasticity of demand - demand curve flat change in price has large effect on quantity - demand curve steep change in price has little effect on quantity - reason for steepness: substitution when close substitutes available, curve is flat - elasticity of demand = percentage change in quantity demanded / percentage change in price (actually a

negative number, but always stated positive with understanding it is negative) - large values for price elasticity indicate demand is more sensitive to changes in price Price elasticity and revenues - revenue = price * quantity (R=p*Q) - goods for which it is easy to find substitutes will have high price elasticities

Elasticity Description Effect on quantity demanded of 1% increase in price

Effect on revenues of 1% increase in price

0 Perfectly inelastic Zero Increased by 1% 0 < E < 1 Inelastic Reduced by less than 1% Increased by less than 1% 1 Unitary elasticity Reduced by 1% Unchanged E > 0 Elastic Reduced by more than 1% Reduced Infinite Perfectly elastic Reduced to 0 Reduced to 0

Elasticity and Slope: - slope = change in price / change in quantity - elasticity = 1/slope * p/Q along a linear demand curve, the slope is the same, but the elasticity is very high at low levels of output and

very low at high levels of output - when p and Q are the same, the curve with the smaller slope has the greater elasticity - when price changes are small/moderate we can extrapolate, but as price elasticity is typically different at

different points along the demand curve, extrapolation becomes riskier with large price changes The determinants of the elasticity of demand Most important determinant of the elasticity of demand: availability of substitutes 2 important determinants of the degree of substitutability: - relative price: when price is low + consumption high variety of substitutes available; when prices are

high, it may take a huge price increase before some substitute will be economically feasable (e.g. aluminium in airplane-industry)

- time: elasticity of demand is normally larger in the long run than in the short run The price elasticity of supply - elasticity of supply = percentage change in quantity supplied / percentage change in price - elasticity differs at different points of the supply curve (e.g. beginning elastic, then more quantity supplied

the more inelastic, because of the lack of capacity, etc.) - economists distinguish between responsiveness in the long and in the short run: long-run supply elasticity is

greaten than the short-run - short-run supply curve = supply response given the current stock of machines and buildings

Elasticity Description Effect on quantity supplied of 1% increase in price

0 Perfectly inelastic Zero 0 < E < 1 Inelastic Increased by less than 1% 1 Unitary elasticity Increased by 1% E > 1 Elastic Increased by more than 1% Infinite Perfectly elastic

(horizontal line) Infinite increase



Using demand and supply elasticities - shifts in the supply or demand curve adjustment in both price and quantity - supply curve highly elastic/relatively inelastic + shift of demand curve mainly change in quantity/price - demand curve highly elastic/relatively inelastic + shift of supply curve mainly change in quantity/price - extreme case: perfectly elastic/inelastic no effect on price/quantity - shifts in demand/supply curves more likely to reflected in price changes in short run, but quantity changes in

long run Tax policy and the law of supply and demand - when taxes are imposed on a product, the supply curve shifts upwards by the amount of the tax due

decrease in demand depending on the price elasticity of demand: - demand relatively inelastic: tax is mostly passed on or shifted to consumers - demand very elastic: most of tax is absorbed by producer - when demand perfectly elastic/inelastic: producer / consumer has to pay tax entirely alone

Shortages and surpluses - market price = prevailing price determined by intersection of supply and demand, at this price the market

clears (at the price everybody gets as much as he wants/can sell as much as he wants) - shortage = people would like to buy, but cannot find it for sale at the going price price below equilibrium

price; demand exceeds supply - surplus = sellers would like to sell, but cannot sell as much as they would like at the going price price

above equilibrium; supply exceeds demand - occur when going price is not equilibrium price; often occur when adjustments are sluggish - gap between the 2 quantities is the surplus/shortage - sticky prices = when market is not adjusting quickly toward equilibrium - analysis is useful to find direction of change and length of gap is indicator for rate of price change Interfering with the law of supply and demand - law of supply and demand can produce results that some groups/individuals dont like government

action, but assumed benefit based on 2 errors, but: - no one is to blame; anonymous market forces determine the price - when supply and demand are not balanced shortages or surpluses with their own problems

- price ceilings: impose maximum price shortages; producers & those unable to buy suffer; likely to worsen in long-run as incentives to invest are missing (e.g. rent control)

- price floors: impose minimum price surplus (e.g. agricultural problems quota system to reduce excess supply; cost of supporting the price are very high)

price ceilings and floors are unlikely to be effective instruments - government policies taking into account the law of supply and demand will tend to be more effective with

fewer unfortunate side effects (e.g. imposing taxed, stimulating demand) Problem 4: 1. What is a present discounted value? 2. Why do investors expectations have important role in financial markets? 3. What are the several ways to reduce risks?

Chapter 6 Time and risk Interest - principal = original amount lent to the bank (e.g. 1000$) - interest = return on the savings (e.g. 100$ at 10%); typically positive - relative price = amount of one good you have to give up to get one more unit of the other (imp. Price

contains information about the future) - the interest rate is a price, it tells us how much future consumption we can get by not consuming at present tells relative price between present and future

- time value of money = dollar today is worth more than a dollar in the future - present discounted value of amount A a year from now is what you would pay today for A a year from now measure of the time value of money = A / (1 + interest rate)



The market for loanable funds - interest rate is a price and is determined by the law of supply and demand when interests are high less

people are inclined to borrow, but (more) people are saving more, etc. - intertemporal trades = exchanges that occur over time (e.g. borrowing today pay back later) - only positive interest rates can get supply and demand into an equilibrium - intermediaries (banks) make market for loans work fees can by measured by differences in interest rate

charged and payed Inflation and the real rate of interest - money is of value only because of the goods that can be bought with it - inflation = increase in prices over time - nominal rate of interest = stated interest rate - real rate of interest = nominal interest rate rate of inflation (real return/real price) The market for assets - assets = long-lived goods that can be bought at one date and be sold at another not only valued by the

consumer mainly for their present use price for assets depends not only on todays conditions, but also on some expectation on what the assets can be sold for in the future

- present discounted value measures and compares returns anticipated in the future; can change because of: - change in interest rate (interest rate increase often accompanied by drop in share prices) - change in expected price of an asset at the time one expects to sell it expectations can be volatile

Changes in expectations concerning any variable in the future will have an effect today on demand and thus also price

- most expectations are formed by looking at the past - myopic = short-sighted; what is true today is true tomorrow - adaptive = extrapolating events of the recent past into the future - rational = use of all relevant data to form expectations

- but expectations are not always right, only assumption that rational expectations are on average righ The market for risk - most times we try to avoid or minimize risk individuals are risk averse - market for risk = institutions and arrangements by which risks are transferred, transformed and shared - risk-incentive trade-off: the more the individual divests himself of risk, the weaker his incentives to avoid

bad results and to foster good results Responding to risk - avoiding and mitigating risks = simplest way, but if used consequently economic activity will stand still

(e.g. smoke detectors; thorough research) - maintaining options = uncertainties get resolved over time, so it is worth spending to keep options open - diversifying = dont put all your eggs in the same basket - transferring and sharing risks = risk is taken by other person for a fee based on the expected payment

(probability of loss*payment in event of loss) + risk premium (extra payment as incentive to risk taker) - insurance firms = institutions specializing in absorbing risks

- limits on insurance as protection against risk: - adverse selection: problem arises when insurance companies try to raise premiums and best risks stop

buying insurance average riskiness worsens offsets increased premiums; generally term now refers to whole array of actions which can affect the mix of those buying insurance (p. 134)

- moral hazard: general feature of insurance reduces the individuals incentives to avoid the insured-against accident when moral hazard problems are strong, limited or no insurance is offered

Entrepreneurship - entrepreneur = individual responsible for creating new businesses, bringing new products to the market,

developing new processes of production; has to take risks by himself, but also needs resources from others (e.g. capital) who also have to take risk and be rewarded

- skilled entrepreneurs have an advantage, though expectations vary and no one can always say whats going on all business decisions involves risk taking

- innovation displays the vital roles played by time and risk Financial Markets - Financial markets are a central part of modern economies. They are essential for raising capital for new

enterprises, expanding on-going businesses and sharing risks.



Problem 5: 1. Why do governments intervene in the marketplace? 2. How does globalization limit the means to intervene? 3. What are the driving forces behind globalization? 4. Does self-interested behavior always lead to social good?

Chapter 7 The public sector Answers of the private market on the 4 basic questions (summary): 1. What is produced and in what quantities? interaction of supply and demand 2. How it is produced? determined by competition 3. For whom is it produced? determined by income of individuals 4. Who makes decisions? everyone - the government has to set and enforce basic laws of society and provide a framework within which firms can

compete fairly against one another The changing roles of government - deregulation = eliminating regulations limiting certain businesses; seen as excessively burdensome,

interfering with rather than helping economy - privatization = relying on private sector to provide services formerly provided by government - nationalization = public ownership of resources - question of appropriate balance of public and private sectors is answered differently in different countries

and over time governments always been responsible for fundamentally public functions (e.g. justice) - changes over time often in response to perceived failures of the market economy after Great Depression

the New Deal and various employment programs, but in 1970th period of deregulation and privatization - in 1980th calls for more government activity to spur economy increased support for R&D - from 1900 to 1995 the total government spending increased from 8% to 34% - since 1950 there has been steady increase in share of federal funds allocated to health social security and

welfare coupled with a decrease in share allocated to defense - states and localities account for 40% of public sector spending (e.g. police, schools, roads, etc.) - 2 features distinguish private from public institutions:

- people responsible are elected or appointed by elected person legitimacy derived from electoral process - government has right of compulsion government can do things private institutions cannot, like

confiscating property, collect taxes, etc. - eminent domain = right to seize private property for public use (with fair compensation)

- disadvantage of public sector: absence of profit motive general disadvantage Adam Smiths Invisible Hand and the central role of markets - The wealth of nations, 1776 public interest is best promoted by individuals pursuing own self-interest - invisible hand = self-interest leads to social good; by pursuing own interest someone frequently promotes

that of society more effective then when he really intends to - history shows that greater liberty results in huge increases in production almost everyone gained - concerns with market outcomes can be divided into 3 categories dealing with:

- ignorance of laws of economics - redistribution of income - genuine failures of private markets

Government and ignorance of laws of economics - tackling the problem of scarcity (high/low prices) by passing laws about prices simply shifts the problem

shortages/surpluses (the price is no meaningless variables but measures scarcity) Government and redistribution - market forces may result in very unequal distribution of income concern for greater economic equality

and thus redistribution is a generally accepted role of government, but disagreement about benefits/costs & best method

- redistribution affects incentives overall economic performance may suffer Government and market failures - market failures = cases in which market fails in its role to produce economic efficiency government may

be able to correct this - government also has other roles, as efficiency is not everything (e.g government discourages robbery)



- principle of consumer sovereignty = individuals are the best judges of what is their own interest and should be left to do what they want as long as their action does not directly influence others

- merit goods = good the government encourages because it believes there is some public interest in their consumption that is not an externality (e.g. education)

Market Failures: - extreme fluctuation in economic activity come with high costs (forgone output and human misery) thus

instead of waiting for equilibrium to be restored by market forces governments try to avoid them (both downturns and booms)

- when scarce resources are idle economy operating below production possibilities curve - even when economy is at full employment, resources will not be efficiently allocated if 1. competition is limited

- competition forces firms to be more efficient; but without competition profits for the individual firms are higher government enforces laws to enhance competition

2. there are no externalities - externality = consequences of an action that are external to the individual or firm, that consequently

does not bear all consequences of his/its action - externalities are pervasive and can be negative (air pollution) or positive (new inventions) - with negative externalities present the market price is too low, as it only reflects the private costs and

not all (e.g. pollution) equilibrium price is too low; government can offset this e.g. by taxes - with positive externalities the market price is too high; government can offset this e.g. by subsidies

3. public goods are involved - public goods (extreme case of positive externalities) consumption is nonrivalrous (consumption of

one individual does not subtract from that of others) and they have property of nonexcludability (costs to exclude any individual are high)

- pure public good = marginal costs of providing it to additional person are strictly 0 and it is impossible to exclude people from receiving it most goods government provides are not pure public goods; both marginal costs and ease of exclusion can be very high (high on both: education)

- free-riding = because it is difficult to exclude individuals from benefits, they have an incentive to avoid paying for them

- in absence of government some level of purchase of public goods, but society is better off if level of production is increased and citizens are forced to pay for the increased level of public services

4. markets are missing (e.g. Social Security insurance not provided privately) 5. information is limited

- markets are very efficient in conveying information, but some markets do not provide enough of it & may be important for efficient functioning of economy & pure public good (weather forecasts)

- research can also be seen as a process of acquiring information (positive externalities!)

Governments options - 4 approaches how government can accomplish societys ends most efficiently 1. Taking direct action government takes charge itself (produce by itself or buy from private sector) 2. Providing incentives to the private sector to alter workings or the private market directly (e.g.

subsidies) or indirectly (through taxes); both manipulate the price system to achieve desired ends 3. Mandating action in the private sector make it a requirement backed up by threat of legal punishment

(e.g. standards) does not directly show up as cost or gains in government budget 4. Combining options Causes of Government Failures - market failures = potential role for government, but likelihood of success has to be evaluated - imperfect information: problem in both private and public sector - incentives and the efficiency of government: incentives in public sector are problematic; public officials

cannot be rewarded for efficient performance, their salary is comparably low and it is difficult to fire or demote incompetent/lazy ones (some legislation is also made only for benefits of home district)

- waste in government: government is often less efficient than private firms, but not necessarily - unforseen responses to a program: success or failure often depends also on how private sector responds An appraisal of the role of government Government plays an important role in modern economies: it redresses market failures, redistributes income, and provides social insurance against risks such as unemployment, health care costs, disability, and retirement. Although the design and scope of government activity are often debated, there is broad agreement about the importance of the role of government in the economy.



Driving forces of globalization: 1. Political factors

1.1. Liberalization of the good markets 1.2. Liberalization of the capital markets 1.3. Freedom of settlement for foreign investors 1.4. Liberalization of the service markets

2. Economic & technological factors 2.1. Better transport, communication and information systems 2.2. Increased spending on R&D & shorter product life-cycles 2.3. Arise of sector-spreading technologies 2.4. Arise of new competitors 2.5. New alternative locations

Problem 6: 1. What is the budget constraint and how does it explain the trade-off between 2 goods? 2. What happens when income increases? Whats the income effect? 3. What is the indifference curve and how does it apply to substitution? 4. What is the substitution effect?

Chapter 8 The consumption decision - 4 basic economic choices facing the household: spending, working, saving and investing The basic problem of consumer choice - consumer has to allocate (divide) his available income among alternative goods chooses the most

preferred point out of the opportunity set The budget constraint - opportunity set is defined by the budget constraint (ignore at first possibilities of borrowing/saving money

or changes in constraint) - 2 important features of the budget constraint: 1) only points on the budget constraint are really relevant; 2)

the budget constraint reveals the trade-offs - trade-offs are expressed by: the slope and the relative price - economists represent choices by putting the purchases of the good they are focusing on the horizontal axis

and all others on the vertical axis distance on vertical axis measures expenditure on other goods... Choosing a point on the budget constraint: individual preferences - process of identifying budget constraints and trade-offs is the same for different people, but the point an

individual chooses depends on his preferences; they bring marginal benefits (how much better of with an extra unit) against marginal costs (how much does it hurt to give the other thing up) into an equilibrium

- price is a quantitative measure of the marginal benefit (few people go for the extremes) What happens to consumption when income changes? - income elasticity of demand = percentage change in consumption / percentage change in income

measures how much the consumption of a particular good increases with income - income elasticity of necessities is less than 1; of luxuries greater than 1 - inferior goods = consumption decreases as income increases (income elasticity is negative) - normal goods = consumption increases with income (income elasticity is positive) - long-run elasticities are larger than short-run income elasticities - diagrams on how households spend their income are helpful in determining how a tax will affect differnet

groups A closer look at the demand curve - why some goods have a greater price elasticity can be explained by the budget constraint model - when the price for a good is increase it is as if the consuming person has less income to spend - income effect = when there is less income to spend the expenditure on each good is reduce, the reduction in

consumption of the product with the price increase is called the income effect - magnitude of the income effect depends on 2 factors:

- how important the commodity is to the individual - how large the income elasticity is



- substitution effect = at a higher price, the relative price changes and substitute products become more attractive (magnitude depends on ease of substitution)

this explains how we derive the demand curve and why it has the shape it does (at each price we draw the budget constraint and identify the point along the budget constraint chosen the higher the price the more substitutes chosen)

Importance of distinguishing between income and substitution effects - understanding responses to price changes: substitution effect helps to understand differences in price

elasticity between products and on different points along the demand curve; the income effect is always present reducing consumption of all commodities but leads to an increased consumption of substitute commodities

- understanding inefficiencies associated with taxes: purpose of taxes is to raise revenue; thus any tax leads to some reduction in consumption through the income effect; but also change relative prices and distort economic activity raised by the substitution effect

Utility and the description of preferences - utility = benefits of consumption individuals get from the combination of goods they consume - the preferred bundle of goods give the individual a higher utility he will choose the bundle within the

budget constraint that maximizes utility - there is no unique way to measure utility, but what an individual is willing to play reflects his preferences - marginal utility = extra utility of an additional unit (often measured by extra amount willing to pay) - law of diminishing marginal utility = each successive increment increases utility less - the individual is best of, if the marginal utility of the last increment of two goods are the same - in choosing between 2 goods the consumer will adjust his choices to the point where the marginal utilities

are proportional to the prices: MU1/P1 = MU2/P2 - consumer surplus = difference what consumer actually pays and he would have been willing to pay (area

between price-line and demand curve) - consumer buys until the price is equal to the marginal utility of the last unit he chose to buy - there is always some consumer surplus as long as a consumer has to pay a fixed price for all items purchased Looking beyond the basic model: How well do the underlying assumptions match reality? - though in some cases it needs to be extended or modified, it is of importance 4 points of criticism: - it does not reflect the human thought process but it works! - Individuals often dont know what they like; a well defined preference has to be consistent - People often also dont know prices what is assumed by the model - Peoples attitudes can also depend on the price Appendix: Indifference curves and the consumption decision - indifference curves = give combinations of goods among which an individual is indifferent / which yield

same utility can be used to derive demand curve and separate changes in consumption into income and substitution effects

- at any point in the space of an indifference diagram a curve can be drawn, but indifferent curves cannot cross

- an individual always prefers an indifference curve that is higher than another (more is better) - marginal rate of substitution = slope of the indifference curve how much of one good an individual is

willing to give up in return for one more unit of the other - diminishing marginal rate of substitution = as we move along an indifference curve, we increase the amount

of one good hat an individual has and he requires less and less of the other good to compensate him for each one-unit decrease in the quantity of the first good slope becomes flatter from left to right

- an individual chooses the point where the marginal rate of substitution equals the relative price the point where an indifference curve is tangent to the budget constraint

- budget constraints and indifference curves also explain why some goods have a negative income elasticity with inferior goods the point of tangency moves to the left as the budget constraint line moves up

- the demand curve can be derived from the different tangent points of the indifference curves with the changing budget constraint lines when the price for one good increases

Substitution and income effects - the substitution and income effects can also be isolated using the indifference curve - the substitution effect is a movement along an indifference curve - the income effect is the shift between indifference curves



Problem 7: 1. What other trade-off decision do we make? 2. How can we graphically show the substitution effect/income effect by the budget constraint? 3. How can the budget constraint be used to analyze the decision between consuming in 2 periods?

Chapter 9 Labor supply and savings The labor supply decision Choice between Leisure and consumption (assumption person spends all income) - in last decades average work week declined & fraction of women in labor force increased married

households typically devote more hours work outside home than in the decades ago - leisure = all time an individual could potentially work for pay he actually spends not working - people are able to influence how much labor they supply (e.g. moonlighting taking second job; working

overtime; social conventions respond over time to attitudes of workers, e.g. 40 h 35 h week) - decision about how much labor to supply is a choice between consumption or income and leisure;

underlying the budget constraint (wage) is the time-constraint any individual has to find the appropriate trade-off between consumption and leisure balance out marginal profits

- income effect = increase in wages makes individuals better off work less - substitution effect = increase in wages changes trade-off, individual gets more for giving1 h leisure up

work more With labor supply, income and substitution effects work in opposite directions so the net affect of an

increase in wages is ambiguous (opposed to reinforcement with goods). - evidence opts for men for a backward-bending labor supply curve; at high wages the income effect of

further increases in wages outweights the substitution effect labor supply decreases - labor supply elasticity is positive but small Labor force participation - labor force participation decision = whether to work (crossing with y-axis in indiv. labor supply curve) - reservation wage = below the individual does not participate in labor force (for men traditionally low) - labor force = all those who have and are looking for jobs - in past decades labor supply curve for women very elastic (flat) because they were indifferent - movement along the labor supply curve = wages go up participation goes up - shift of the labor supply curve = due to change in attitudes, etc. Tax policy and labor supply - increase in tax rates is equivalent to a decrease in wages impact on labor supply - different views on the magnitudes of income and substitution effects lead to different views, but generally:

men have relatively low labor supply elasticity changing taxes have little effect; women have high labor supply elasticity (labor supply response is large) changes have considerable implications

- financial incentive for secondary earner is often low (child care, taxes, etc.) The retirement decision - retirement decisions are also lead by substitution amount of consumption they have to give up/get and

the income more leisure or not effect - for many people the income effects dominates the substitution effect early retirement Human capital and education - output depends on number of hours worked as well as productivity of those hours - human capital = knowledge developed by formal schooling, on-the-job learning, etc. - physical capital = plant, equipment, etc. - human capital is more significant than physical capital (2/3 3/4 of all is human capital) - education is costly as obvious and opportunity costs have to be regarded - the production possibilities curve can show the trade-offs an individual makes when choosing for more

education; spending more on education in youth raises future income, but each additional investment in education provides smaller and smaller return (diminishing return)

The widening gap - unskilled labor and skilled labor can be seen 2 separate labor markets; the equilibrium wage for skilled

workers is higher than for unskilled workers



- change in technology shifts demand for skilled labor to the right and for unskilled labor to the left, though damped in the long run responses of the supply, the wages for skilled labor go up and those for unskilled go down increasing wage and income equality

Budget constraints and savings - savings are also assumed to be made in a rational manner - saving decision = decision when to spend or consume - 2 period budget constraint can be used to analyze the choice saving (postponing consumption) results in

interest, the cost of saving is that the individual has to wait - the relative price is 1 + interest rate (important is the real interest rate taking inflation into account) - compound interest = interest is paid on interest already earned - the slope is the compound interest of the base amount (usually 1 dollar) - smoothed consumption = consumption in each of the 2 different periods is about the same (marginal value is

about the same) - life-cycle savings = savings motivated to smooth consumption over ones lifetime and to provide for

retirement Savings and the interest rate - changes in interest rate has both income and substitution effects; income: higher interest rates make people

better off - reduce savings; substitution: return on savings is increased thus they consume less and save more - substitution and income effects work in opposite direction net effect is ambiguous - estimates indicates that substitution effect outweighs income effect savings function (gives level of

savings for each level of real interest rate) is steep, but not vertical - magnitude of response of savings to interest rate is important for government Other factors affecting savings - generous social security system reduces need to save for retirement, but earlier retirement and longer

lifetime outweigh this - aggregate savings = sum of savings of all individuals in society - dissaving = spending of savings (retirees typically dissave) - aggregate savings rate = aggregate savings / aggregate income - bequest motive = leave something to descendants - precautionary motive = save as protection against emergencies - target saving = save for needs for which it may be hard to borrow sufficient funds Appendix: Indifference curves and the labor supply and savings decisions - indifference curves can be used explain the point chosen on the budget constraint of leisure vs. Consumption at point of tangency marginal rate of substitution equals wage

- the decision whether to work or not can also be clearified by the use of indifference curves - the decision how much to save is also explained by indifference curves; the slope in the point of tangency is

then 1+interest rate - when the interest rate changes, we can notice the substitution effect as a change on the indifference curve

and the income effect as a change in indifference curves See page 224! Problem 8: 1. What are the decisions firms have to make to maximize their satisfaction? 2. Explain the 2 graphs!

Chapter 11 The firms costs - price takers = firms in competitive markets have to accept prices set by forces of supply and demand - 2/3 of economy produces primarily services Profits, costs and factors of production - profits = revenues costs - revenue = quantity * price - costs = total expense of producing the good - factors of production (inputs) = labor, materials and capital goods (machinery, buildings) - intermediate goods = supplies a company purchases from other firms - profit-maximizing is cost minimizing (at given prices and levels of output)



Production with one variable input - production function = relationship between quantity of inputs used in production and the level of output - marginal product = increase in output corresponding to a unit increase in any factor of production - diminishing returns = as more and more of one input is added, while other inputs remain unchanged, the

marginal product of the added input diminishes (slope flattens out) - increasing returns = increasing input raises output more than proportionately (slope become steeper) - constant returns = each additional unit of input increases output by the same amount (straight line) - fixed inputs = inputs not dependent on level of output - variable inputs = inputs that fall and rise with the level of production - average productivity = ratio of output to input at any point of production function (slope of line from the

origin to the point) - maximum productivity line = steepest line from the origin to the production function (tangent) increases

first, then decreases Cost curves - fixed costs = costs associated with inputs that do not vary with the level of production (horizontal line) - variable costs = any cost that the firm can change during the time period under study; rise or fall with level

of production - total costs = sum of variable and fixed costs - marginal costs = extra cost corresponding to each additional unit produced (usually upward sloping) - the marginal cost curse is the slope of the total cost curve - average cost = total costs / output (slope of line from origin to point on total cost curve) or sum of average

variable and average fixed costs - average variable costs = total variable costs / output - the typical average cost curve is U-shaped at first the fixed costs are spread over few units and thus are

high, then as production increases they are allocated over more units and the average cost declines, with the cost curve getting steeper and steeper (due to deminishing returns on production factors) the average variable costs increase and the total average costs increase again

- declining average costs = declining costs over level of output that is likely to prevail in the market - the marginal cost curve intersects the marginal cost curve in its minimum - an increase in the price of a variable factor shifts all 3 cost curves (total, average, marginal); while an

increase in price of a fixed factor only shifts the total and average cost curves upward Production with many factors - fundamental difference is that with many factors it becomes possible to produce same output in different

ways cost minimization involves weighing the costs of different mixes of inputs - alternative possibilities for production form a continuum firm can smoothly subtitute one input for

another - principle of substitution = an increase in price of an input (relative to the others) will lead the firm to

substitute other inputs in its place prices cannot be raised without bearing consequences (wages!) - when comparing 2 production processes and the price for one factor that one process uses less increases, the

cost curves shift upwards unequally and the point at which the one process is superior to the other also shifts - an increase in any price shifts the cost function up, the magnitude depends on how much of it is used and

how easy it is to substitute it Short-run and long-run cost curves - short-run cost curve = cost of production with given stock of machines; labor as the principal input can be

varied they are constant over a wide rage: - unused/excess-capacity region = marginal costs do not increase much - full-capacity region = marginal cost curve becomes steeply upward sloping

- overhead costs = costs a firm must bear simply to operate, whether or not they can be varied in short-run - fixed costs = costs that are fixed in the short run, whether or not they represent overhead costs - long-run cost curve = cost of production when all factors are adjusted; may not have the same shape as those

for the short run (U-shaped), as e.g. new plants can be built - when firms minimize total costs of producing at a particular output, they minimize average costs

- long-run average cost curve is a bumpy curve often drawn as straight line - can be sloping slightly downward because research has to be done just once, can be sloping upward at

some point as more and more supervision is required, or can also be sloping downward (also marginal cost curve sloping downward) as more efficient machines can be used

- constant returns to scale = output increases just in proportion to all inputs together (prevalent in producing) - diminishing returns to scale = output increases more than proportionally - increasing returns to scale = economies of scale = output increases more than proportionally



Looking beyond the basic model: Cost curves and the competitiveness of markets - degree of competition in an industry depends to a considerable degree on the cost structure - in markets with very little overhead costs there are more companies as when the overhead costs are high - costs of research and development are overhead costs - when a company is in the upward sloping part of its average cost-curve, there is a chance for new entrants Economies of scope - joint products = products that are produced naturally together - economies of scope = reached when it is less expensive to produce a set of goods together than separately Appendix: Cost minimization with many inputs - isoquants = alternative ways of producing a particular quantity of output can be drawn as curves; higher

isoquants represent higher levels of production - marginal rate of technical substitution = the amount of extra input required to substitute the reduction in

another factor to keep the output constant slope of the isoquant (cahnges along the curve) equal to the ratio of the marginal products

- diminishing marginal rate of technical substitution = it becomes increasingly difficult to substitute a factor if very little of it is used

- the minimum of costs is reached when the mrginal rate of technical substitution is equal to the relative price of the 2 factors

- isocost curve = combinations of inputs that cost the same amount (analogous to budget constraint) parallel lines/cuves (depending on fixed or variable prices of inputs)

- isocost curves are the same for all firms with same prices for inputs, but isoquants differ - to maximize production at given costs, you have to find the highest isoquant, the one that is tangent to the

isocost curve - to minimize costs at a given level of production, you have to find the lowest isocost curve, tangent to the

isoquant - the total cost curve can be derived from the tangent points of the isocost lines and the isoquants page 280



Problem 9: 1. Whats the competitive equilibrium model? 2. How do the marginal cost curve, the total revenue curve and the total cost curve influence the production

decision?

Chapter 12 Production Revenue - revenue curve = relationship between revenue and output - marginal revenue = extra revenue a firm receives from selling an extra unit In competitive markets it is

the same as the market price of the unit (firm gets the same market price regardless of the number) Basic conditions of competitive supply - when choosing how much to produce the profit-maximizing firm produces to the point where the marginal

costs equals marginal revenue, which in a competitive market is equal to price - when plotting the total revenue curve and the total cost curve into a diagram the profit/loss is the distance

between the 2 graphs marginal costs and marginal revenue are the slopes of those curves and when they are equal the distance, means the profits are greatest (page 286)

Entry, exit, and market supply - if price exceeds minimum average costs, it pays for a firm to enter a market; if the price is above the

minimum average cost cmin then the firm will produce at a level at which price equals marginal costs at this point marginal costs always exceed average costs; profits can also be shown (page 287)

- different firms have different minimum costs - a firm decides to exit a market, when the price is below the minimum average variable costs (costs that vary

with the level of output), if it is between average costs and average variable costs it makes a loss, but there would be an even bigger loss if it ceased production (production of additional units is still productive) all under the assumption that fixed costs are sunk costs = nonrecoverable costs when it goes out of business

- the firms supply curve entering the market is thus zero up to the critical price (price = minimum average

costs) and then coincides with the marginal cost curve; for a firm that has already entered the market and has sunk costs, the supply curve coincides with the marginal cost curve so long as price exceeds minimum average variable costs (page 291)

- the overall market supply curve can be derived by summing up the amounts each firm is willing to supply at

any given price 2 market responses: higher price: raise output, new entrants; lower price: lower output, market exits products are produced at the lowest possible price by the most efficient firms

Long-run versus short-run supply - in very short run firms may be unable to adjust production at all only price changes (vertical s. curve) - in short run firms may adjust variable inputs like labor (upward sloping supply curve) - in long run firms may be able to buy more machines and other firms may decide to enter or exit long run

curve is flatter, in the extreme approximately horizontal - the time required for adjustments may vary from industry to industry Looking beyond the basic model: sunk costs, entry and competition - overhead costs = costs present regardless of level of production, are fixed but not sunk as e.g. buildings can

be sold (not e.g. logos sunk costs) - contestable markets = even in a market with only one firm, this firm will make zero profits just as in a

market with many firms if sunk costs are low due to the threat of other firms entering - if there are high sunk costs the threat of competition diminishes high profits without much fear of entry

possible Accounting profits and economic profits - firms try to maximize profits with competition profits are driven to 0 why would firms even produce? - accountants and economists think about profits differently in 2 respects:

- opportunity costs - the amount of money that could be earned from an alternative use of the resources has (opportunity

costs) has to be subtracted out of profits



- costs always have to be evaluated according to the current opportunity costs, though these may be difficult to calculate

- economic rent = difference between the price that is actually paid and the price that would have to be paid in order for the good/service to be produced - rents are unrelated to effort and are determined entirely by demand firms earn economic rent to

the extent they are more efficient than others - when economists say competition drives profits to zero, they are focusing on the fats that in

competitive equilibrium, price equals marginal cost for every firm producing competition drives profits to zero at the margin

- accounting profits = revenues expenditures - economic profits = revenues rent economic costs (including opportunity costs of labor and capital) Factor demand - factor demand = demand for the various inputs is also called derived demand as it flows from the decisions

of how and how much to produce - the demand for a factor can be derived from the quantity a firm is willing to produce at a given price, but

also by calculating the point where an the value of the marginal product of that factor is equal to its price - value of the marginal product of labor = price of good * marginal product of labor (MPL= extra output) - e.g. a firm hires up to the point where the value of its marginal product equals the wage form that

equilibrium condition the demand curve for the factor (labor) can be derived - demand curve for labor = curve giving the value of the marginal product of labor at each level of

employment - price increases shift the demand curve for labor to the right - demand for labor depends on both wage and the price the firm receives for the good/service - real product wage = wage/price measures what firms pay workers in terms of the goods they produce;

firms hire till the real product wage equals marginal product of labor (MPL = w/p) - market demand for labor = at a given set of prices we add up the demand for labor by each firm at any

particular wage rate downward sloping - when the price of any input falls, the demand for that input increases due to substitution (cheaper input

instead of the others) and the lower price lowers the marginal cost of production at each level of output and thus leads to an increase in the level of production

- when drawing a demand curve for a factor we assume all others and the price of the output fixed competitive firms take the price they receive for their product as well as that they have to pay for the

production factors as given Appendix: Alternative ways of calculating the demand for labor - all three ways are just different ways of writing one formula demand for labor depends only on the real

product wage, if wage and price double the demand is unaffected

Chapter 13 Competitive equilibrium General equilibrium analysis - partial equilibrium analysis = analyzing what is going on in one market ignoring the effects of other

markets can be used if reverberations from initial imposition of e.g. a tax are so dispersed that they can be ignored without distorting analysis (e.g. tax on cigarettes)

- general equilibrium analysis = also taking into account the interactions and interdependencies within the various part of the economy focuses on the fact that, in equilibrium, the returns to all investments throughout the economy must provide the same rate of return per dollar invested (adjusting for risk) better than partial equilibrium analysis e.g. for corporate income taxes

The basic competitive equilibrium model - simplified we can think of 3 different markets, the labor, capital and product market (we assume workers

have the same skills, disregard risk so interest is the same, and there is only one product) - supply and demand in all 3 markets depend on the supply and demand in the others - the economy as a whole is in equilibrium only when all markets clear simultaneously (demand equals

supply) general equilibrium occurs at a common wage rate w, price, p and interest rate, r at which all three markets are in equilibrium



- in general equilibrium of the economy requires finding the prices for each good and for each input such that the demand for each good equals the supply and the demand for each input equals the supply

The circular flow of funds - another way to think about the interrelations of the various parts of economy is considering the flow of

funds through economy circular flow - it focuses on

- how funds flow through economy - balance conditions that always have to be satisfied

- every component of the circular flow has to balance flows of funds out (e.g. if government wants to pay a subsidy to a firm it has to raise taxes, borrow money or reduce spending)

- the interconnections and balance conditions are the same as those in the competitive general equilibrium model, but even when the economy were not competitive the circular flow diagram would be still true

Competitive general equilibrium and economic efficiency - economists are not only interested in describing the market equilibrium, but in evaluating it establish in

what sense and under what conditions the market is efficient Pareto efficiency - pareto efficiency = allocation of resources when no one can be made better off without making someone else

worse off (concept of efficiency related to concern with wellbeing of people) usually the efficiency economists refer to

- if something has consequences beyond redistribution, it is pareto inefficient Conditions for the pareto efficiency of the market economy - an economy must meet 3 conditions to be pareto efficient show us why the basic competitive model

attains pareto efficiency (rational, perfectly informed households...): - exchange efficiency: goods must be distributed among individuals in a way that means there are no gains

from further trade; any prohibition or restriction results in exchange inefficiency can only be achieved when all individuals the same marginal rate of substitution - price system ensures that exchange efficiency is attained (price is rough measure of marginal benefit) - exchange inefficiency: nontradable coupons, different prices for different individuals

- production efficiency: economy has to operate on the production possibilities curve in free market where all firms face the same prices they take appropriate actions to economize on each of the inputs production efficiency can only be achieved when all firms have the same marginal rate of technical substitution between any 2 inputs

- product-mix efficiency: the economy must produce a mix of goods reflecting the preferences of consumers - price system ensures this to be satisfied; the result is a point on the production possibilities curve the

trace-off are given by the marginal rate of transformation that has to equal the marginal rate of substitution to satisfy the product-mix efficiency

Competitive markets are pareto efficient because: a rearrangement of resources can only benefit people who voluntarily agree to it. But in competitive equilibrium, people have already agreed to all the exchanges they are willing to make; no one wishes to produce more or less or to demand more or less, given the prices he faces. Competitive markets and income distribution: - efficiency is better than inefficiency, but may lead to a very unequal distribution of resources - to attain an efficient allocation of resources with the desired distribution of income, if the assumptions of the

competitive model are satisfied by the economy, the sole role of the government is to redistribute initial wealth (e.g. free basic education)

Looking beyond the basic model: Market failures and the role of government Free-market view: The competitive model provides a good description of the economy, and government intervention is not required. Imperfect-market view: In many markets, the competitive model does not provide a good description for instance, because competition is limited and information is imperfect. There are important market failures, evidenced by unemployment and environmental pollution, requiring at least selective government intervention. The efficiency of competitive markets: At the center of the modern economy are competitive markets. Through the profit motive and the price system, competitive markets lead to economic efficiency. However, there are important exceptions, where markets fail to



produce efficient outcomes. For instance, markets may not be competitive, and markets produce too much goods with negative externalities (like pollution), and too little goods with positive externalities (like basic research). Problem 10: 1. Explain the different market structures. 2. What is predatory pricing? 3. What are the economic arguments for a market to be naturally dominated by just one firm? (show by use of

curves)

Chapter 14 Monopolies and imperfect competition - in the competitive model buyers and sellers take the price as given and then decide how much to buy or sell - not all markets are very competitive some companies do not take but make the price price makers Market structures - market structure = how a market is organized - perfect competition = many firms, each believes that nothing it does will have any effect on the market price price-takers

- monopoly = a single firm supplies the market price-maker - imperfect competition: several firms, each aware that its sales depend on the price it charges and possibly

other actions it takes, such as advertising - oligopoly: sufficiently few firms that each worries about how rivals will respond to any action it

undertakes - monopolistic competition: sufficiently many firms that each believes that its rivals will not change the

price they charge should it lower its own price Monopoly output - the basic principle of output determination point where marginal revenue equals marginal cost is the

same for monopolies and competitive markets, but a monopolist can only sell more if he lowers price in a competitive market demand curve for individual firm is horizontal marginal revenue is not equal to the present market price, it is less than it

- demand curve facing a monopolist is downward sloping, because he control the entire market - marginal revenue = revenue from selling one more unit loss in revenues from the price reduction on all

other units = price - p * Q (p is negative; for competitive firm equal to 0) (marginal revenue curve if half of demand curve!)

at the point chosen the marginal benefit of an extra unit exceeds the marginal cost monopolies reduce economic efficiency

- the larger the elasticity of demand (the flatter the demand curve), the smaller the discrepancy between marginal revenue and price can be illustrated by: marginal revenue = p (1 1/elasticity of demand) see page 341

- in a monopoly the price is higher by the factor 1 /(1 elasticity of demand) see page 343 Monopoly profits - the total profits can be seen in 2 ways:

- as difference between total revenues and total costs - as number of units produced multiplied by the profit per unit (difference between average cost and

demand curve; in competitive market average and marginal cost curve) - pure profit = monopoly rents = extra return because monopolist is able to reduce output and increase price Price discrimination - price discrimination = charging different prices to different customers or in different markets other way

to increase profits (in competitive markets not possible as price equals marginal costs at the output level a firm chooses to maintain and it can sell as much as it wants)

Imperfect competition - in imperfect competition a firm believes that when it lowers prices it can capture some but not all sales from

other firms - market power = ability of a firm to throw its weight around - competitiveness of a particular market can be assessed by the elasticity of demand a single firm faces in

perfect competition a vertical line demand curve a horizontal line, in imperfect competition downward sloping



- 2 factors affect the elasticity of the demand curve facing a firm and thus its market power: - number of firms in the industry and concentration of production within firms (e.g. measured by the

four-firm concentration ratio = fraction of output produced by the top 4 firms in an industry) - product differentiation

- imperfect substitutes = goods sufficiently similar to be used for many of the same purposes, but different enough that one may be somewhat better than the other (in some purposes/perceived) typically faced by firms in an industry with imperfect competition

- product differentiation = fact that similar products nonetheless differ bases of product differentiation are: 1) differences in characteristics of products; 2) differences in location of different firms; 3) perceived differences, often induced by advertising

- imperfect substitutability implies a departure from perfect competition as the demand curve is downward sloping

Barriers to entry: Why is competition limited? - barriers to entry = factors that prevent competition from springing up in situation of monopoly or imperfect

competition; without them monopoly can only be temporary - Government policies:

- grants local monopolies on telecommunications, electricity, etc. - patents = most important monopolies granted by government today incentives for new inventions - policies that restrict entry: e.g. licensing of lawyers to protect the consumers

- Single ownership of an essential input (very seldom) - Information (does not pass through economy in the full and complete way)

- firms engage in research to get an advantage over competitors, even when not granted a patent it will take time before what they learn disseminates to rivals

- consumers have imperfect information concerning products sold by different firms (low price may be perceived as low quality)

- Economies of scale and natural monopolies - Natural monopoly = whenever the average costs of production for a single firm are declining up to

levels of output beyond those likely to emerge in the market (e.g. power supply) natural monopolist protected by knowledge that it can undercut its rivals should they enter as they are smaller and average costs decline with size, their average costs are higher (economies of scale can be reached)

- whether a particular industry is a natural monopoly thus depends on the output at which average costs are minimized (most important determinant is size of fixed costs) relative to the size of the market (most important determinant is transportation cost)

- fixed costs also explain why only a limited number of firms produce each variety of a good and why variety of goods is limited

- Market strategies - Some companies maintain monopoly status though it cannot be explained by factors above they

make possible entrants believe that the high profits currently earned by it will disappear should the new firm enter the market 3 different entry-deterring practices - Predatory pricing: company in the market lowers its price below the new entrants cost of

production in order to drive it out and discourage future entry; company may itself loose money, but hopes to recover losses when entrant leaves by raise prices back to monopoly level (illegal)

- Excess capacity: newcomers will look at excess capacity in the market and realize that the incumbent firm can increase production with minimal effort signal of willingness to engage in fierce price competition

- Limit pricing: firm charges less than ordinary monopoly price and produces at a level beyond that at which marginal revenue equals marginal cost to make their marginal cost look lower discourage entrant / attract less attention

Equilibrium with monopolistic competition - barriers are sufficiently weak that firms enter to the point where profits are driven to 0, but competition is

imperfect as products are differentiated every firm faces downward sloping demand curve - like in the monopoly the firms sets marginal revenue equal to marginal cost and the resulting quantity is less

than the quantity at which average costs are minimum every firm has a minimonopoly on its brand or store location, but the profits are incentives for other firms to enter the market

- major difference to monopoly is the lack of barriers - the point where profits are 0 is where the demand curve is tangent to the average cost curve monopolistic

competition equilibrium - in monopolistic competition equilibrium, price and average cost exceed the minimum average cost less at

a higher price is produced compared to perfect competition, but there is variety in products available



- trade-off between variety and cost fact that goods are sold at a price above the minimum average cost dos not necessarily mean that the economy is inefficient!

Schumpeterian competition - Schumpeterian monopolistic competition = different markets are dominated at different times by one or two

firms with technological superiority, but are constantly threatened by new innovations - Superior firms act like monopolists but have to reinvest profits in new products and research to maintain

position positive view! Appendix A: Monopsony - monopsonist = single buyer in a market (e.g. government for sophisticated defense systems) - consequences of monopsony are same as of monopoly less is produced at a higher price (e.g. as firms

hire labor until the value of the marginal product of labor is equal to the wage, but a monopsonist has to calculate that for each person he hires more he has to pay more, also for all others)

Appendix B: Demand for inputs under monopoly and imperfect competition - as in perfect competition the monopolist hires employees until the marginal revenue produce equals wage,

for the competitive firm this is simply the price*extra quantity produced, but for the monopolist as we know the price changes with quantity and thus the marginal revenue product (MRP) is equal to the marginal revenue*marginal physical product

Chapter 15 Oligopolies Collusion - sometimes oligopolists try to collude to maximize their profits act jointly as if they were a monopoly and

split up resulting profits; but hard to maintain the cooperative behavior required - cartel = group of companies that formally operate in collusion - variety of cooperative arrangements: e.g. sharing inventories, research findings or other information 3 problems facing cartels: - Problem of self-enforcement:

- cartels seek to restrict output and thus raise prices above marginal costs, it pays any single member of the cartel to produce more than agreed on and take advantage of higher price = free riding on the cartel

- in cartels the output and thus price is set like in a monopoly; the marginal revenue of the cartel as a whole has to be equal to the marginal cost; the larger the gap between price and marginal costs, the incentives to cheat are strong

- self-enforcement = major problem of cartels is to enforce collusive arrangement on members; especially because of antitrust laws but as profits are so high, some take the risk of violating the law

- Problem of coordination: - Tacit collusion = where explicit collusion is illegal members of an oligopoly who wish to take

advantage of their market power must rely on an implicit understanding that the oligopolys interests are best served if its members do not compete too vigorously and avoid price cutting coordination difficult as the different members dont know how others will react in certain situations

- Ways to circumvent the coordination problem: - Price leader = one firm of the cartel, often the 2nd or 3rd largest member of the industry sets prices

and the others follow hard to prove illegal practice - Facilit

economics (1 3)

Documents