Definition: Microeconomics is the study of how individuals and firms make decisions in a world of scarcity.
Scarcity drives microeconomic analysis:
Economic agents engage in constrained optimization to maximize their well-being.
Key Concept: Opportunity Cost
The cost of an alternative that must be forgone in order to pursue a certain action.
Example: If one decides to buy a shirt over pants, the opportunity cost is the value of the pants not purchased.
Economics is often referred to as the "dismal science" because it emphasizes that nothing is free and every action has an associated cost.
Importance of Adam Smith’s work and the "water-diamond paradox":
Water is essential for life but is typically cheap.
Diamonds are not essential but are expensive due to limited supply.
The market is analyzed through supply and demand curves.
Demand Curve:
Representation of the relationship between the price of a good and the quantity demanded.
Law of Demand: As price increases, quantity demanded decreases (downward-sloping curve).
Supply Curve:
Representation of the relationship between the price of a good and the quantity supplied.
Law of Supply: As price increases, quantity supplied increases (upward-sloping curve).
Market Equilibrium:
The point where the supply and demand curves intersect.
At equilibrium price Pe and quantity Qe, both consumers and producers are satisfied.
Example: If Pe = 3 and Qe = 600 for roses, this represents the price and quantity at equilibrium.
Positive Analysis: The study of how things are (e.g., supply and demand in action).
Normative Analysis: The study of how things should be (e.g., ethical implications of allowing kidney sales).
Example:
The case of kidneys on eBay raised questions about the implicit value of life and access to healthcare.
Discussion on capitalistic economies vs. command economies:
In a capitalistic economy, decisions on production and consumption are made by individuals and firms.
Command economies involve central planning where the government makes these decisions.
The balance between efficiency (of markets) and equity (fairness in outcomes) is a core debate in economics.
The fundamental question of economics revolves around how freely markets should operate and the roles of government in mitigating market failures.
The semester will explore these fundamental issues through a structured approach:
Begin with demand and utility maximization.
Explore supply decisions and market structures.
Analyze outcomes and market failures.
The demand curve represents consumer preferences and choices in the context of the supply and demand model in economics. The objective is to understand how these curves emerge from the utility maximization behavior of consumers.
The model of consumer decision making revolves around two essential components:
Consumer Preferences: What individuals want.
Budget Constraint: What individuals can afford.
The goal is to maximize utility (happiness) given these constraints.
To build our model, we start with three key assumptions regarding preferences:
Completeness: Consumers can express preferences over any set of goods. They cannot claim indifference without expressing a choice.
Transitivity: If a consumer prefers A to B and B to C, then they must prefer A to C.
Nonsatiation: More is always better than less. That is, consumers will always prefer more of a good to less.
Indifference curves graphically represent preferences. Each curve represents a set of consumption combinations among which consumers are indifferent.
An indifference curve illustrates all combinations of goods that provide the same level of utility.
Properties of indifference curves include:
Higher curves represent higher utility.
Indifference curves are downward sloping.
Indifference curves never cross.
Only one curve can pass through a given consumption bundle.
Every individual has an underlying utility function, representing their preferences mathematically. A simple utility function for two goods (e.g., pizza and cookies) could be:
where P is the amount of pizza and C is the amount of cookies.
Marginal utility is the change in utility resulting from a one-unit change in the quantity of a good.
The concept of diminishing marginal utility suggests that as more of a good is consumed, the additional utility gained from consuming an extra unit decreases.
The marginal rate of substitution tells us the rate at which a consumer is willing to substitute one good for another while keeping utility constant. It is defined as:
where MUC is the marginal utility of cookies and MUP is the marginal utility of pizza.
MRS is diminishing: As a consumer consumes more cookies, they are willing to give up fewer slices of pizza for each additional cookie, reflecting the principle of diminishing marginal utility.
Indifference curves are convex to the origin: This is a direct implication of the diminishing MRS.
Understanding these concepts helps explain real-world pricing strategies. For instance:
The prices for larger sizes of beverages (in stores like Starbucks or McDonald’s) often reflect the diminishing marginal utility; thus, larger sizes are disproportionately cheaper than smaller ones for consumers.
Today’s focus was on consumer preferences, utility functions, and the derivation of the demand curve from these concepts. The next topic will involve budget constraints and the implications for demand.
In this lecture, we focus on consumer choice under budget constraints. Specifically, we will elaborate on the construction of budget constraints, how consumers make constrained choices, and an illustrative example using food stamps.
A budget constraint represents the limit on a consumer’s choices, given their income and the prices of goods.
The fundamental axiom of consumer choice is that "more is better." However, consumers are limited by their budget, which defines what goods they can purchase.
For the purpose of this discussion, we assume:
Budget equals income: Y = I
No savings or borrowing
The consumer allocates their income between two goods: pizza and cookies
Let:
Y: Total income (money available to spend)
P: Number of pizzas
C: Number of cookies
pP: Price per pizza slice
pC: Price per cookie
The budget constraint can be represented mathematically as:
pP ⋅ P + pC ⋅ C ≤ Y
The intercepts of the budget constraint are calculated as follows:
Y-intercept (max pizzas):
X-intercept (max cookies):
For example, with Y = 72, pP = 12, and pC = 6:
Max pizzas =
Max cookies =
The slope of the budget constraint (the Marginal Rate of Transformation, MRT) is given by:
This indicates the rate at which one good can be substituted for another while keeping the budget constant.
The opportunity cost is the value of the next best alternative foregone. For example, the opportunity cost of one slice of pizza equals two cookies when the prices are as defined above.
Consumers aim to maximize their utility subject to their budget constraint.
Consumers will choose a combination of goods that maximizes their utility, subject to the budget constraint. The utility can be represented with a function:
Graphically, the highest attainable indifference curve under the budget constraint represents the optimal choice for the consumer. The point of tangency between the indifference curve and the budget constraint represents the optimal consumption bundle.
Supplemental Nutrition Assistance Program (SNAP, formerly food stamps) affects consumer choices:
SNAP provides funds specifically for purchasing food.
Compare cash transfers versus food stamps.
When consumers receive cash, the budget constraint shifts outward, allowing more flexibility in choice. For food stamps, the budget constraint may kink, reflecting restrictions on spending.
Cash Transfer Budget : Y + cash → new budget constraint
Initial Budget Line: Runs from Y (food) to Y (shelter).
Shift with Cash: Budget line shifts from Y to Y + 500.
Two different consumer types:
Person Y: Moves upward on the budget line.
Person X: May only gain a slight increment in food but substantially increase their spending on shelter.
Understanding consumer behavior under budget constraints helps to illustrate broader economic theories concerning welfare programs like food stamps. While empirical evidence suggests mixing cash transfers may improve well-being, the paternalistic reasoning for SNAP designs calls into question the nature of consumer choice.
In this lecture, we will derive demand curves using consumer choice theory, discuss the elasticity of demand, the effect of income changes on demand, and analyze the impact of price changes using the substitution and income effects.
We start with the foundational model in consumer choice. The demand for goods can be derived from a utility function.
Assume the utility function is of the form:
u = P ⋅ C
where C represents cookies, and the price of cookies Pc is given. Let:
Income (I) = $72
Price of pizza (Pp) = $12
Price of cookies (Pc) = $6
Define the budget constraint:
BC : Pc ⋅ C + Pp ⋅ P = I
For the initial prices:
Maximum cookies when pizza is zero: C = 12 (at Pp = 0)
Maximum pizza when cookies are zero: P = 6 (at Pc = 0)
If prices change, new budget constraints can be derived as shown in the following figures (placeholders for figures will be identified below):
When Pc rises to $9:
New intercepts: 8 cookies (x-intercept) and 6 pizzas (y-intercept).
New budget constraint: BC2
The slope of the new budget constraint:
The effect of price changes shows a move from point A (6 cookies, 3 pizzas) to point B (4 cookies, 3 pizzas).
When Pc falls to $4:
New intercepts indicate an ability to purchase 18 cookies.
New budget constraint: BC3
Now, the new budget constraint slope:
This moves from point A to point C (3 pizzas, 9 cookies).
From these points, a demand curve can be plotted. The demand curve represents the relationship between price and quantity demanded:
Demand Curve: Qd = f(P)
For instance:
At Pc = 6, Qd = 6
At Pc = 9, Qd = 4
At Pc = 4, Qd = 9
The elasticity of demand (ϵ) is defined as:
It measures the percentage change in quantity demanded in response to a percentage change in price.
Perfectly Inelastic: ϵ = 0 (e.g., essential goods like insulin).
Perfectly Elastic: ϵ = − ∞ (e.g., identical substitutes).
When the price of a good changes:
Substitution Effect: Change in quantity demanded as price changes, holding utility constant.
Income Effect: Change in quantity demanded due to the change in real income resulting from the price change.
Substitution Effect: Price increases, optimal quantity decreases.
Income Effect: Being poorer, demand for the inferior good may increase.
A Giffen good is a rare case where higher prices lead to higher quantity demanded due to the dominance of inferior income effects.
Understanding the derivation and behavior of demand curves through changes in price and income helps clarify consumer behaviour in markets. The key takeaways include:
Demand curves are derived from utility functions and budget constraints.
The elasticity of demand is critical for understanding consumer responsiveness to price changes.
The interplay between substitution and income effects explains consumer choices under varying economic conditions.
Producer theory expands on consumer theory, moving from the demand curve to the supply curve. While consumer theory primarily dealt with optimizing utility given income and prices, producer theory involves firms that decide their income based on production choices.
Producers utilize a production function to transform inputs (labor and capital) into output. The general form is:
q = f(L, K)
where:
q = quantity of goods produced (firm-specific)
L = labor input
K = capital input
We differentiate between firm output (q) and market output (Q).
The inputs in production are categorized into:
Labor (L): Refers to the workers employed.
Capital (K): Refers to machines, buildings, and equipment used in production.
Inputs can be classified as:
Variable Inputs: Easily changed (e.g., hours worked).
Fixed Inputs: Hard to change quickly (e.g., size of a factory).
The distinction between short run and long run is critical:
Short Run: Some inputs are fixed, typically K is fixed and L is variable.
Long Run: All inputs can change; both L and K are variable.
In the short run, firms aim to maximize profits by hiring labor while keeping capital fixed. The short-run production function can be expressed as:
q = f(L, K̄)
The focus is primarily on Marginal Product of Labor (MPL), which is defined as:
Diminishing marginal product states that as more units of labor are added, the contribution of each additional unit of labor to output eventually decreases.
In the long run, firms have the flexibility to change both labor and capital. The production function remains similar:
q = f(L, K)
Firms must decide the optimal mix of labor and capital. The concept of Isoquants is used here, representing combinations of labor and capital that yield the same level of output.
The MRTS of labor for capital is defined as the slope of the isoquant:
where:
MPK is the marginal product of capital.
Returns to scale assesses how output responds when all inputs are increased proportionally:
Constant Returns to Scale: Doubling inputs leads to double the output.
Increasing Returns to Scale: Doubling inputs leads to more than double the output.
Decreasing Returns to Scale: Doubling inputs leads to less than double the output.
Productivity is defined as the efficiency of converting inputs into outputs, which can be influenced by innovations in production processes:
q = A ⋅ f(L, K)
where A signifies the total factor productivity at time t.
Notable economists like Thomas Malthus predicted limits on productivity due to fixed agricultural land, but innovations in technology have allowed more efficient production techniques which have led to increased productivity over time.
The trends in productivity growth in the U.S. over the decades illustrate these concepts:
Post-WWII: 2̃.5% growth rate.
1973-1990s: Decline to 1̃% growth rate.
Mid-1990s to mid-2000s: Growth rose 2.3%.
Post-2005: Reduction back to 1.5%.
The distribution of productivity gains raises important questions regarding equity:
Post-1973, gains were predominantly captured by the top income brackets.
The growth in productivity does not always equate to proportional income increases across society.
Understanding producer theory helps frame the economic realities of production, profitability, and productivity. It highlights not just the technical aspects of how firms operate but also the broader implications for societal wealth and equity.
In the lecture, we delve into producer theory, focusing on how producers maximize profits by minimizing costs. By understanding how costs vary with output, we can derive cost functions that help shape supply curves.
In the short run, we consider:
Fixed Costs (FC): Costs that do not change with output levels, such as capital costs.
Variable Costs (VC): Costs that change directly with the amount of output, such as labor costs.
Total Costs (TC): Defined as the sum of fixed and variable costs:
TC = FC + VC
The production function we work with is:
where:
q = quantity produced
L = labor input (variable in both short and long run)
K = capital input (fixed in the short run)
The cost of production can be represented as:
C = r ⋅ K + w ⋅ L
where:
r = rental rate of capital
w = wage rate
Assuming specific values:
Let r = 10 and w = 5.
To derive the cost function, replace L using the production function:
1. From
2. Substitute L into the cost function:
For a fixed level of capital K = 1:
C = 10 + 5q2
Thus, the short-run cost function is:
Cost Function: C = 10 + 5q2
Marginal Cost (MC): The additional cost incurred from producing one more unit of output.
Average Cost (AC): The total cost divided by the quantity produced.
As production begins, average costs decline as fixed costs are spread over more units. Eventually, as marginal costs rise due to diminishing returns, average costs will increase.
The intersection point between MC and AC marks the minimum average cost.
In the long run:
Capital is no longer fixed, allowing firms to adjust both labor and capital optimally for cost minimization across varying output.
The goal is to find the economically efficient combination of L and K by mapping out isocost curves:
C = wL + rK
Isocost lines represent combinations of L and K that yield the same cost. The slope of the isocost curve is given by:
The optimal input mix occurs at the tangency between an isoquant (representing production levels) and an isocost line:
where MPL and MPK are the marginal products of labor and capital, respectively.
The long-run expansion path indicates how the optimal combination of inputs changes with the quantity produced.
The long-run average cost curve represents the lowest possible costs for producing each quantity level. It is derived from the various short-run cost curves corresponding to different production levels:
Long-run cost curves are everywhere lower than short-run cost curves since firms can adjust their capital structure optimally.
Given production and input prices, we could derive the long-run cost function from:
TC = C(L, K) where L and K have been optimized
Understanding the relationship between input costs and production can guide firms in making strategic choices about production capabilities. The derived functions emphasize that being able to adjust production factors in the long run yields lower costs compared to the restricted decisions available in the short run.
Fixed Costs: Costs that do not change with the level of output in the short run, such as rent or salaries.
Sunk Costs: Costs that cannot be recovered once incurred. These costs are irrelevant for future business decisions.
Example: A doctor’s education costs (med school) represent a sunk cost because they cannot be undone.
The tendency to consider sunk costs when making decisions can lead to poor economic outcomes.
Example: Buying concert tickets for
A perfectly competitive market is characterized by many firms selling identical products where each firm is a price taker (i.e., cannot influence the market price).
The demand curve for an individual firm is perfectly elastic.
Identical Products: All firms sell products that are perceived as identical by consumers.
Full Information: Consumers have complete knowledge about prices.
Low Transaction Costs: Minimal costs associated with searching for and engaging in market transactions.
Market demand (Q) is a downward-sloping function of price.
Firm demand (q) can be expressed as:
q = Q(p) − S0(p)
where S0(p) is the supply from all other firms in the market.
The elasticity of demand for a firm can be derived from:
where dQ/dp is negative (downward-sloping) and dS0/dp is positive (upward-sloping supply).
For N identical firms:
ei = N ⋅ ed − (N − 1)es
where ei is the elasticity of demand for the individual firm, ed is the elasticity of market demand, and es is the elasticity of market supply.
Profit (π) is defined as:
π = R − C
where R is revenue and C is total cost.
Economic profit considers opportunity costs, which accountants typically ignore.
Profit maximization occurs when marginal revenue (MR) equals marginal cost (MC):
MR = MC
In a perfectly competitive market, MR is equal to the market price (P):
P = MC
Example of a cost function:
C(q) = 10 + 5q2
Revenue function for price P = 30:
R(q) = P ⋅ q = 30q
If a tax of $10 is applied per unit, the new cost function becomes:
C(q) = 10 + 5q2 + 10q
The new marginal cost becomes:
MC = 10q + 10
A firm should continue to produce as long as it can cover its variable costs, even if it incurs losses.
The decision to shut down occurs if staying in the market would incur higher losses than exiting.
Profits per unit can be calculated as:
Profit per unit = P − Average Cost
Perfect competition serves as an ideal benchmark for understanding economic principles, and concepts such as sunk costs and profit maximization are critical in evaluating firm behavior in real markets.
These notes cover concepts of profit maximization under perfect competition, shutdown decisions, and long-run competitive equilibrium including various supply curves and cost functions.
The cost function discussed is:
C(q) = 10 + 5q2
Where C represents total cost and q represents the quantity of goods produced.
Profits = Revenues − Costs
Given that revenues are represented as R = P × q and costs as C(q), we can express profits per unit as:
Profits per unit = P − Average Cost
Average cost at a production level q = 3:
For q = 3, this yields:
The optimal production level q* is achieved where:
P = MC
For a price P = 30, equating this to marginal cost gives:
By solving 10q = 30, we find:
q* = 3
Using the values, profits per unit becomes:
Profits per unit = 30 − 18.33 = 11.67
Total profits when producing 3 units:
Total Profits = 3 × 11.67 = 35
Introducing a tax of $10 per unit modifies the cost function to:
C(q) = 10 + 5q2 + 10q
Thus:
MC = 10 + 10q
Setting MC = P for price of 30, we solve:
10 + 10q = 30 ⟹ q* = 2
Calculating new average cost at q = 2:
New profits per unit are:
Profits per unit = 30 − 25 = 5
Thus, total profits:
Total Profits = 2 × 5 = 10
In the short run, a firm may opt to produce zero units; this represents a short-run shutdown decision.
Consider if the price drops to $10 with no tax:
Profits = 10 − (10 + 5) = − 5
If the firm shuts down:
Profits = 0 − 10 = − 10
Thus, as long as total revenue exceeds variable costs, it’s preferable to continue production.
A firm should only shut down when:
P < Average Variable Cost
In the long run, firms enter or exit the market until:
Profits = 0 (Long-run equilibrium)
As firms enter the market, the supply increases:
Higher supply leads to lower prices.
Profits reduce, motivating further entry until profits are zero.
The market supply curve is derived by:
Market Supply = ∑Individual Supply
With an increase in firms, the market supply becomes more elastic.
Understanding that profit maximization leads firms towards zero long-term profits under perfect competition emphasizes the importance of cost minimization. Real-world deviations such as barriers to entry, firm heterogeneity, and variable input prices provide complexities that affect these theoretical predictions.
In economics, the supply and demand framework is fundamental for understanding how markets function. In this lecture, we revisit the concepts explored from our first discussion on supply and demand curves, investigating their origins, shifts, and implications.
The supply and demand curves can be represented on a graph:
The x-axis represents the quantity (Q) of a good.
The y-axis represents the price (P) of the good.
Supply Curve (S): Typically upward-sloping, indicating that as prices increase, producers are willing to supply more of the good.
Demand Curve (D): Typically downward-sloping, indicating that as prices decrease, consumers are willing to purchase more of the good.
The point where the supply and demand curves intersect represents market equilibrium (E). At this point, the quantity supplied equals the quantity demanded, which can be mathematically expressed as:
Qd(P) = Qs(P)
where Qd is the quantity demanded and Qs is the quantity supplied at price P.
Shifts in the demand curve occur due to several factors:
Changes in Tastes or Preferences: If preferences change in favor of a good, the demand increases, shifting the curve to the right D1 → D2.
Income Changes: An increase in consumer income generally shifts the demand for normal goods to the right.
Changes in Prices of Related Goods: If the price of a complementary good rises, the demand for the associated good may decrease.
Market Size: An increase in market size (more consumers) shifts the demand curve to the right.
Expectations of Future Prices: If consumers anticipate a price increase, they may buy more now.
Supply curves can shift due to:
Changes in Input Costs: Increases in the costs of production shift the supply curve to the left.
Technological Advancements: Improvements in technology usually lead to more efficient production, causing the supply curve to shift to the right.
Change in consumer tastes towards SUVs increases the demand for gasoline, shifting demand right (D1 → D2), leading to excess demand and higher prices.
War in oil-producing regions raises production costs, shifting the supply curve left (S1 → S2), which increases prices and reduces quantity sold.
Consumer surplus is defined as the benefit that consumers receive when they pay a price lower than what they are willing to pay. It can be represented graphically as:
Consumer Surplus = ∫0Q*(D(Q) − P) dQ
where P is the market price and Q* is the equilibrium quantity.
The consumer surplus is visually represented by the area above the price level and below the demand curve. If demand is perfectly inelastic, consumer surplus can become infinite as consumers are willing to pay anything for the good.
Producer surplus is the difference between what producers are willing to accept for a good and what they actually receive, mathematically represented as:
Producer Surplus = P − C(Q)
where C(Q) represents the marginal cost of production. The producer surplus is visually represented by the area below the price level and above the supply curve.
The total producer surplus in the market can be found by aggregating the surpluses across all firms:
Total Producer Surplus = ∫0Q*(P − S(Q)) dQ
Welfare economics utilizes the concepts of consumer and producer surplus to evaluate the overall well-being of society in the framework of market efficiency and allocate resources.
Efficiency: A market is efficient when it maximizes total surplus (consumer surplus + producer surplus).
Deadweight Loss: This occurs when the market does not reach equilibrium due to external factors that alter supply or demand, leading to a loss in total surplus.
Understanding supply and demand curves, their shifts, and the resulting surpluses is essential for analyzing market behaviors. These concepts also serve as the foundation for more advanced economic theories and policies.
Welfare economics is divided into two main branches:
Positive Economics: Focuses on the objective analysis of market behavior, understanding supply and demand.
Normative Economics: Involves making judgments about what is desirable or undesirable based on economic activities.
Economic Welfare: Refers to the overall well-being of society, typically measured via consumer surplus and producer surplus.
Consumer Surplus (CS): The benefit that consumers receive when they purchase a product for less than they are willing to pay.
Producer Surplus (PS): The benefit that producers receive when they sell a product for more than the minimum they are willing to accept.
The first fundamental theorem states:
Under certain assumptions, a competitive equilibrium leads to a Pareto efficient allocation of resources.
Mathematically, social welfare W can be defined as:
W = CS + PS
Where:
CS: Consumer Surplus
PS: Producer Surplus
The allocation where supply equals demand maximizes social welfare under market conditions.
Deadweight loss occurs due to inefficiencies in the market, representing the net reduction in welfare from trades that do not occur.
In a scenario where supply shocks (e.g., an oil crisis) drive prices up:
Price Ceilings as Interventions: Government sets P1 to control prices.
Result: Excess demand leads to the quantity Qs provided, creating inefficiencies as not all consumers who wish to buy can find gas at that price.
In instances of market failure due to regulations:
The introduction of services like Uber disrupts the medallion system and offers cheaper alternatives.
The medallion’s worth decreases significantly, affecting owners more than drivers.
Welfare economics strives to identify effective and fair resource allocation strategies. The balance between efficiency and equity represents a critical ongoing challenge in economic policy formulation.
The course has provided tools to understand consumer and producer decision-making.
We will apply these tools to more realistic situations, starting with monopoly.
Reminder: Content covered today is not on the midterm but will be included in the final exam.
A monopoly market has only one firm (monopolist) providing a good.
Real markets typically lie between perfect competition and monopoly, often classified as oligopolies.
Monopolists are price makers, unlike firms in a perfectly competitive market, which are price takers.
A monopolist sets one price for all customers (no price discrimination).
π = R − C
where π is profit, R is total revenue, and C is total cost.
Profits are maximized when marginal revenue (MR) equals marginal cost (MC):
MR = MC
Unlike price takers where MR = P, for monopolists the relationship is more complex.
A monopolist must lower the price to sell additional units, leading to the "poisoning effect."
Marginal revenue can be expressed as:
where dP/dQ is the change in price with respect to quantity.
Let the demand curve be given by:
P = 24 − Q
Thus, total revenue (R) is:
R = P × Q = (24 − Q)Q = 24Q − Q2
Marginal Revenue then becomes:
Assume the cost function is:
C = 12 + Q2
Thus, marginal cost is:
To maximize profits:
24 − 2Q = 2Q
From which we solve:
24 = 4Q ⇒ Q* = 6
For Q* = 6:
P* = 24 − 6 = 18
Market power is the ability to charge a price greater than marginal cost.
Competitive firms have no market power, as P = MC.
Monopolists can exploit their market power to set prices above MC.
Perfect Price Discrimination: A monopolist charges each consumer their maximum willingness to pay. Under perfect price discrimination, social welfare is maximized because there is no deadweight loss.
Partial or imperfect price discrimination occurs when a firm charges different prices based on observable characteristics of consumers (e.g., age, place of purchase).
Airlines with business and economy class.
Charges based on timing of tickets (last minute vs. early bookings).
Restaurants offering early bird specials.
Different prices for the same good based on location or purchasing power.
Consumer surplus is the area above the price and below the demand curve.
Producer surplus is the area between the price and the supply curve up to the quantity sold.
When monopolists produce less than the socially optimal quantity, there are units that could have been produced that are foregone, resulting in deadweight loss (C + E) in the market.
Monopoly leads to market failure as it does not maximize total welfare.
In scenarios with price discrimination, monopolies can potentially reach an efficient outcome by capturing consumer surplus.
Monopolies are one extreme on the market structure spectrum, contrasting with perfectly competitive firms which face a perfectly elastic demand curve and can sell at market price. Monopolists, on the other hand, can set prices but undersupply, resulting in deadweight loss.
Monopolies arise from two primary sources:
Some monopolies stem from inherent cost advantages in the market. These can occur when:
A firm controls a crucial input (e.g., a unique resource).
The average cost of production declines with increasing output, making it unfeasible for additional firms to enter the market.
A natural monopoly exists when:
One firm can produce at a lower average cost than multiple firms for all relevant output levels.
This occurs typically in industries with high fixed costs and low marginal costs (e.g., water utilities). The average cost in such scenarios typically declines due to high initial fixed costs that are spread over a larger quantity of output.
Where FC is fixed cost, VC is variable cost, and Q is quantity produced.
Governments can also create monopolies through various means. This includes:
Granting patents, which provide inventors exclusive rights to produce and sell new products for a specified period (20 years).
Licensing and regulation that create barriers to entry in certain markets.
Deadweight loss arising from monopolies can be illustrated by the following equation:
Where Pm is the monopolist’s price, MC is marginal cost, Qc is the competitive quantity, and Qm is the monopolist’s quantity.
Regulation can have different effects on monopolistic markets. One approach is to set price ceilings to mimic competitive outcomes:
A price ceiling may eliminate deadweight loss by ensuring that monopolists produce closer to the competitive output level.
However, practical challenges arise:
Information Asymmetry: Regulators may lack crucial information about demand and supply curves, making it difficult to set appropriate prices.
Market Failures: Inefficiencies may still persist if the government misestimates competitive prices, leading to larger deadweight losses.
A concept termed "contestable markets" refers to scenarios where a monopoly can exist but without significant market power due to the low barriers to entry. If firms can easily enter and exit the market, this may limit the monopolist’s pricing power despite a single firm operating in the market.
Historically, following the deregulation of the airline industry:
Fares dropped significantly (approx. 1/3).
More routes became available.
Quality of the flying experience deteriorated, with reduced amenities.
Illustrating the outcomes, we find that:
Cheaper flights.
Increased competition led to lower average costs.
Creation of the hub-and-spoke model by airlines, resulting in some monopolistic behaviors at airports.
Monopolies can arise legitimately through cost advantages or government action, as seen with natural monopolies and patents. While regulation can address monopolistic inefficiencies, it faces practical challenges. Contestable markets present an interesting dimension where monopoly does not necessarily mean market power. The discussion on airline deregulation exemplifies these concepts and their real-world implications.
The lecture discusses the market structure of oligopoly, which is characterized by a small number of firms competing with each other, unlike perfect competition or monopoly. Oligopoly markets are marked by barriers to entry that prevent unlimited firms from entering the market.
An oligopoly is defined as a market structure wherein:
There are a few firms competing.
Barriers to entry prevent many firms from entering the market.
An example of an oligopoly is the automobile industry, controlled by a handful of major manufacturers.
Within oligopoly markets, firms can behave either cooperatively (forming a cartel) or non-cooperatively:
Cooperative Behavior: Firms may form a cartel, such as OPEC, which behaves like a monopoly by controlling outputs to keep prices high.
Non-Cooperative Behavior: Firms compete against each other, potentially leading to lower profits, resembling a competitive market.
Game theory is the mathematical study of interaction among rational decision-makers. In non-cooperative oligopolies, the Nash equilibrium is a primary concept:
Nash Equilibrium: No player has an incentive to change their strategy given the strategies of others.
A classic example to illustrate non-cooperativity in game theory is the Prisoner’s Dilemma. The payoff matrix for two prisoners is structured as follows:
| (1, 1) | (5, 0) | |
| (0, 5) | (2, 2) |
Where the outcome represents years in prison:
Both remain silent: each gets 1 year.
One talks: the talker goes free, the other goes to prison for 5 years.
Both talk: each gets 2 years.
In this case, the Nash equilibrium occurs when both players choose to talk, leading to a suboptimal outcome.
Focusing on advertising strategies between two companies, for instance, Coca-Cola and Pepsi, involves similar logic. Assuming:
If both advertise, they will incur specific costs leading to lower profits.
If one advertises while the other does not, the advertiser stands to gain significantly.
The equilibrium is then created where:
If qC is Coca-Cola’s output and qP is Pepsi’s, then:
RevenueC = P ⋅ qC = (339 − qC − qP)qC
The Cournot model describes a non-cooperative oligopoly where firms compete in quantities. The setup involves:
Two firms, maximizing their profit based on their choices and the choices of their competitor.
The residual demand curve for each firm incorporates the output of the other.
Given a demand function P = 339 − Q (where Q = qA + qU), where qA and qU represent the output of American and United Airlines, respectively, the profit-maximizing conditions can be derived:
This leads to the best response functions:
Solving the above simultaneous equations will yield the Cournot equilibrium quantities for both firms.
The lecture emphasizes the importance of game theory in understanding oligopoly behavior. The Cournot model serves as a crucial analytical framework by illustrating how firms strategically interact in an oligopoly setting.
In the study of oligopoly, we distinguish between cooperative and non-cooperative equilibria. A key concept in achieving better outcomes in oligopolistic markets is cooperation among firms, often manifesting as cartels.
Consider the example of two firms (American Airlines and United Airlines). We previously analyzed the demand curve for this market:
P = 339 − Q
where P is price and Q is the quantity of flights.
The marginal cost MC for both firms is given as:
MC = 147
In a monopoly situation (considered as a cooperative equilibrium), the monopolist’s marginal revenue MR can be calculated as:
MR = 339 − 2Q
Setting MR = MC:
339 − 2Q = 147
Solving for Q:
Q = 96
The optimal price then, from the demand curve:
P = 339 − 96 = 243
When these firms cooperate by becoming a cartel, each firm operates at:
QA = QB = 48
Total profits for each firm can be expressed as:
Profit = QA × (P − MC) = 48 × (243 − 147) = 4, 608
In a non-cooperative outcome where each firm operates independently, the total quantity offered can be represented as:
Q = 64
The price would thus be:
P = 339 − 128 = 211
Calculating profits under non-cooperation:
Profit = 64 × (211 − 147) = 4, 096
We see that cooperation improves profits by
Instability of Cartels: Firms in a cartel have an incentive to cheat, maximizing their individual profits by increasing output. If one firm cheats and increases quantity, the market price decreases.
Illegality: Cartels are illegal in many jurisdictions, reducing the incentive to form them.
When a firm, say American Airlines, decides to cheat by increasing its flights to QA = 50, the market price adjusts:
P = 339 − 98 = 241
New profits for American Airlines:
Profit = 50 × (241 − 147) = 4, 700
And for United Airlines:
Profit = 48 × (241 − 147) = 4, 512
This scenario leads to decreased total market profits and eventually leads to the breakdown of the cartel.
Antitrust legislation exists to prevent firms from engaging in cartel behavior. Historical examples include:
The movie industry’s monopolization via ownership of theaters, resulting in federal lawsuits.
Past airline industry collusion attempts and their legal repercussions.
Countries can also create cartels, as seen with Japan’s voluntary export restraint in the 1980s, leading to elevated prices for vehicles in the U.S.
Monopolistic outcomes yield high profits and lower quantities sold, while perfect competition results in zero profits and higher quantities.
The intermediate oligopoly structure results in moderately high profits and quantities.
In Cournot competition, firms fix quantities:
P = MC (for competitive equilibrium)
As the number of firms, n, increases, the markup reduces. The relationship can be expressed as:
In Bertrand competition, firms are price competitors. Notably:
Only two firms are needed to drive prices to marginal cost.
This leads to a lower overall markup and can be more beneficial to consumers.
Firms and producers strive to differentiate their products in Bertrand competition settings. This differentiation enables them to maintain higher prices and potential for increased profits despite competition.
Cereals have evolved into a variety of products, creating a dense market of over 5,000 brands.
Brand loyalty, such as between Nike and Adidas, can lead to higher prices and differentials in perceived product quality.
Understanding the dynamics of oligopolies, cartels, and different competition models allows economists and policymakers to make informed decisions that balance the needs of consumers against the interests of businesses.
In this lecture series, we will explore where input prices, particularly wages (w) and rental rates of capital (r), come from. Factor markets are essential for determining these prices crucial to our economy.
Factor Demand: General demand for labor and capital.
Factor Supply: Understanding where supply originates.
Equilibrium: Determining how wages and interest rates are established.
Assuming perfectly competitive factor markets:
Many sellers and buyers.
All participants are price takers.
In the short run, capital is fixed, and the firm decides whether to hire an additional worker.
Marginal Benefit (MB): The benefit of hiring an additional worker is the increase in output, measured by the Marginal Product of Labor (MPL).
MB = MPL × P
where P is the price of the product sold.
Marginal Cost (MC): The cost of hiring one more unit of labor is the wage (w).
To optimize labor demand:
MRPL = w
where MRPL = MPL × P. Therefore:
MPL × P = w
The labor supply curve is horizontal in a perfectly competitive labor market.
The labor demand curve slopes downwards due to diminishing returns:
Each additional worker adds less to total output.
In the long run, both labor and capital can adjust. Long-run labor demand is more elastic as firms can optimize both inputs.
Two short-run demand curves at different levels of capital highlight the flexibility in long-run optimization.
Like labor, capital demand is determined by:
MRPK = r
where MRPK = MPK × P.
This indicates:
Firms will demand capital until the marginal product of capital, times the goods’ price, equals the rental rate.
Labor supply at the firm level is perfectly elastic, but market labor supply is not.
Work harder (H) gives more income (Y).
Budget Constraint: Reflecting tradeoffs between leisure (l) and consumption.
H + l = 24
Model leisure as a good:
H = 24 − l
where l is leisure hours.
Indifference curves display preferences between earned wages (consumption) and leisure.
The price of leisure is equal to the wage (w):
Higher wage means you might want to work less.
When wages change:
Substitution effect generally suggests working more.
Income effect may lead to less labor supply if leisure is a normal good.
Illustrating the initial budget constraint.
New budget constraint after a wage increase.
In historical studies, men showed inelastic labor supply while women showed higher elasticity due to increased participation in the workforce.
Discussion about the impact of international trade on child labor dynamics reveals that:
While demand for child labor increases with more production, the wealth effect leads families to invest in education for their children instead of labor.
This creates a complex interaction between economic growth and child labor reduction.
Understanding factor markets is essential for comprehending wages, employment levels, and economic behavior overall. The relationship between wages, labor supply, and social elements is nuanced and requires careful analysis.
Today, we discuss factor markets with a focus on the labor market and the implications of a minimum wage.
In the labor market, we examine the supply and demand for labor, considering workers’ decisions between work and leisure.
Let L1 be the equilibrium quantity of labor supplied with wage W1.
Supply curve (S): typically upward sloping, although it can be backward-bending if income effects dominate substitution effects.
Demand curve (D): typically downward sloping due to diminishing marginal productivity.
A minimum wage W2 set above the market wage W1 creates a binding constraint.
Workers desire to supply Ls amount of labor at W2.
Firms will demand only Ld labor characterized by the condition:
W = MRPL
where MRPL is the marginal revenue product of labor.
Consumer surplus for firms and producer surplus for workers is affected:
Before minimum wage:
Firms’ surplus = A + B + C, Workers’ surplus = D + E
After minimum wage:
Consumer surplus is reduced; some surplus is transferred to workers
Deadweight loss due to fewer jobs: C + E
Thus, applying a minimum wage may increase worker welfare but decrease overall social welfare.
Various studies have shown that employment levels in states raising the minimum wage do not significantly decrease:
Example: Analysis of New Jersey vs. Pennsylvania fast-food workers showed no significant drop in employment in New Jersey after minimum wage increase.
Three potential explanations for finding no decrease in employment:
Minimum wage not binding.
Labor supply is perfectly inelastic.
Non-competitive labor markets (monopsony).
In a monopsony:
Firms have market power over workers.
Wage paid is below marginal revenue product of labor, represented as:
W < MRPL
With a binding minimum wage above what workers earn in a monopsony market, firms may not fire workers due to:
MRPL > Wmin
The result is a mere transfer of surplus from the firm to the worker without deadweight loss.
Capital represents the diversion of current consumption towards future consumption. Its forms include buildings, machines, and financial instruments.
Demand for capital comes from the marginal revenue product of capital MRPK.
Supply of capital is derived from collective household savings decisions.
The equilibrium interest rate reflects the interaction between the demand for capital and the supply provided by savers.
Intertemporal choice concerns how much to consume today versus tomorrow, typically modeled as: - Present Consumption (C1) vs. Future Consumption (C2)
Where r is the interest rate.
If the interest rate rises:
The opportunity cost of consuming today increases (substitution effect).
Higher interest income may lead to increased wealth (income effect).
The net effect on consumption today and saving can be ambiguous.
These discussions on labor and capital markets reveal the complexities of economic principles such as minimum wage impacts and intertemporal choices in savings. Future discussions will delve into further aspects of capital markets.
We continue our discussion of factor markets, focusing on how capital markets impact real-world decisions. Key concepts include:
Firms finance capital through a pool of savings from individuals.
Individuals make choices about consumption and savings over time.
Firms borrow from these savings at an interest rate i to decide on investments.
Present value (PV) is a core concept in evaluating investments over time, which states:
where:
PV = Present value
FV = Future value (the amount of money in the future)
i = Interest rate
t = Number of periods until the payment
The key insight is:
For a stream of future cash flows Ct over n periods:
For example, consider receiving $10 each year for three years at a 10
A perpetuity is a constant stream of cash flows received forever, priced as:
For example, if C = 10 and i = 0.1, the present value is:
Conversely, future value (FV) is calculated as:
FV = PV × (1 + i)t
This means if you save an amount today, it will grow over time due to interest compounding, demonstrating the critical concept of earning interest on interest.
Consider two saving plans:
Plan 1: Save $3,000 annually for the first 15 years, stop saving, and let it grow.
Plan 2: Start saving $3,000 annually after 15 years.
Plan 1 may yield a significantly higher amount due to compounding over time.
Inflation affects the real value of money over time. The nominal interest rate i can be adjusted to find the real interest rate r:
r = i − π
where π is the inflation rate. This adjustment is crucial in decision-making:
If inflation rises, the purchasing power of returns decreases, altering investment value assessments.
For a savings decision of $100 at a nominal interest rate of 10%, with 10% inflation, the real interest rate is zero:
FVadjusted = 100 × (1 + i) = 110
In this situation, any future gains must be assessed with respect to what they can purchase.
Firms evaluate investment opportunities through net present value (NPV), calculated as:
where Rt is the revenue received, and Ct is the costs incurred. Investments are pursued if NPV > 0.
Higher interest rates decrease NPV because they increase the discount applied to future cash flows, making investments less attractive. Thus, firms may choose to hold cash rather than invest.
When a firm considers investment, they must consider the opportunity cost:
What would I earn by choosing the next best investment? This informs the discount rate used in PV calculations.
Investing in education is akin to other investments, with costs and benefits evaluated over time.
Assuming:
College costs $35,000 per year for 4 years.
High school graduates earn
The opportunity costs include future earnings sacrificed alongside the immediate costs of college. The NPV of the human capital investment is influenced by interest rates, and potential earnings growth emphasizes this investment’s long-term nature.
Finally, the decision regarding college education is an investment in human capital that should be evaluated using present value principles, taking into account all costs and potential returns.
Savings is a critically important element of economic growth. An increase in savings leads to an increase in the capital supply, shifting the capital supply curve outward. This can be represented graphically as:
Capital Supply ↑ ⟹ Interest Rates↓
As the interest rates fall, the Net Present Value (NPV) of investments increases:
where C is cash flow, r is the interest rate, and t is the time period.
With lower interest rates, firms are incentivized to invest more, thus fostering economic growth.
The current U.S. savings rate is between 3% to 5%, significantly lower than Europe and Japan’s rates of over 15%. To encourage savings, public policies include tax incentives for retirement savings, such as:
Employer-sponsored pensions
401(k) plans
Individual Retirement Accounts (IRAs)
Taxation on savings, represented as:
After-tax return = r × (1 − τ)
where τ is the tax rate.
The advantage of tax-deferred savings accounts is clear: delaying taxation allows for compound interest to accrue more effectively.
Common investment options in a 401(k) include:
Money Market Funds: Invest in government securities with low yields (approx. 1-3%).
Bond Funds: Invest in corporate bonds, generally yielding 4% to 5%.
Stock Funds: Higher risk but higher potential returns (approx. 7%).
The risk-return trade-off states that riskier investments tend to yield higher returns.
The key recommendation is diversification. Avoid putting all your savings into your employer’s stock due to the risk of losing both your job and your investment.
International trade involves the exchange of goods and services across nations, consisting of exports (goods sold to other countries) and imports (goods bought from other countries). The U.S. currently has a trade deficit, notable at around $800 billion.
A trade deficit occurs when imports exceed exports. For example, trading one Pikachu for one Jigglypuff creates a Pikachu deficit but enhances the overall welfare of both parties involved.
The concept of comparative advantage is vital for understanding international trade. It is based on the idea that:
A country should specialize in goods it can produce at a lower opportunity cost than other countries.
Even if one country is more efficient in the production of both goods, they should still specialize in the good for which they have the comparative advantage.
For example, if the U.S. is better at producing computers and Colombia is better at producing roses, we can express this as:
Opportunity Cost of Computers in U.S. < Opportunity Cost of Computers in Colombia
The PPF illustrates the maximum possible output combinations of two goods that can be produced using available resources. For two countries, the PPF can be depicted with the following equations, assuming linearity for simplicity:
U.S. PPF: Computers = 2000 − 0.5 × Roses
Colombia PPF: Roses = 2000 − 2 × Computers
When trade is allowed, each country specializes in the production of the good they have a comparative advantage in, resulting in increased total output. This leads to new consumption possibilities outside the initial PPF bounds.
For example, if the U.S. only produces computers and Colombia only produces roses, the new total production could be represented with a new combined world PPF:
New World Outputs: 2000 Computers, 2000 Roses
International trade enhances overall efficiency and expands the production possibilities for participating countries. The trade-off is between the welfare of consumers benefiting from cheaper imports and producers who may lose jobs due to increased competition from abroad.
This lecture continues the discussion of international trade, focusing on:
Comparative Advantage
Welfare Implications of International Trade
Trade Policy
Comparative advantage refers to the ability of a country to produce a good at a lower opportunity cost than another country. The key insights include:
When countries specialize based on comparative advantage, they can trade to benefit all involved parties.
Specialization leads to efficiencies and larger outputs, represented by an outward-bending Production Possibility Frontier (PPF).
Comparative advantage can arise from:
Factor Endowments:
Some countries have an abundance of certain resources (e.g., Canada’s forests for lumber).
Labor costs are a critical factor, explaining why textiles are often produced in countries with cheaper labor.
Technology:
Technological advancements can create comparative advantages (e.g., Japan’s automotive industry).
Countries that innovate gain first-mover advantages in producing certain goods.
Economists advocate for international trade due to its positive effects on welfare.
In a domestic market for roses:
Consumer Surplus (CS) before trade is determined by the area under the demand curve above the price level.
Producer Surplus (PS) is the area above the supply curve and below the price.
When trade is introduced at a lower world price, the market adjusts:
Increased consumer surplus due to lower prices.
Reduced producer surplus.
Total welfare gain can be visualized as the area gained by consumers minus the area lost by producers.
When comparing before and after trade:
With imports: Total roses consumed increases, domestic production decreases, but overall social surplus rises.
With exports: The opposite occurs, yet total welfare generally increases.
Total Social Surplus = Consumer Surplus + Producer Surplus
Welfare Increase = (W + X + Z) − (X + Y) = Z
This shows that consumers gain more than the losses faced by producers, leading to increased overall welfare.
A tariff is a tax on imported goods, raising their prices.
Quotas limit the quantity of a product imported.
With tariffs:
Price rises leading to reduced consumer surplus (areas A, B, C, and D lost).
Producer surplus rises (area A gained).
Government gains revenue from tariffs (area C).
The net welfare loss is represented by:
Deadweight Loss = B + D
Restrictions can lead to retaliation from trading partners (e.g., tariffs on US goods from Colombia).
Often, policymakers do not compensate the losers from trade (e.g., workers in affected industries).
Economists argue for coordinated international responses rather than unilateral trade policies.
Understanding international trade through the lens of comparative advantage highlights the benefits to welfare via trade, despite challenges in redistribution among different economic groups. Trade policies such as tariffs often have unintended consequences, leading to net losses in societal welfare.
The focus of this lecture is on decision making under uncertainty, a topic we have not extensively covered yet. Previous models assumed full knowledge and certainty when making decisions, however, many real-world decisions involve uncertainty. This leads us to introduce the concept of Expected Utility Theory.
1. Studying for a Final Exam:
In previous models, students could optimize their studying based on known probabilities of topics on the exam. In reality, students face uncertainty regarding what will be tested and must decide how to allocate their study time accordingly.
2. Everyday Decisions:
Decisions like bringing an umbrella, betting on sports, or making significant life choices (e.g., mortgages, insurance) involve inherent uncertainty.
Expected Utility Theory provides a way to approach decisions where outcomes are uncertain. It is grounded in the notion that what individuals care about is not the monetary outcome but the utility derived from that outcome.
The formula for expected value (EV) of a gamble can be expressed as:
EV = P(Win) × Value if Win + P(Lose) × Value if Lose
Expected Utility (EU) modifies the expected value to account for individual preferences:
EU = P(Win) × U(Value if Win) + P(Lose) × U(Value if Lose)
where U(x) represents the utility function.
Utility is often characterized by diminishing marginal utility:
Additional units of wealth provide less additional utility (hence the utility curve is concave).
Losing
Consider a gamble where:
Heads: Win $125
Tails: Lose $100
Analyzing the expected value:
EV = 0.5 × 125 + 0.5 × ( − 100) = 12.5
Despite having a positive expected value, we must consider expected utility.
Let’s assume the utility function is
If starting consumption c0 = 100,
Winning leads to cwin = 225 (U(225) = 15)
Losing leads to close = 0 (U(0) = 0)
Calculating expected utility:
EU = 0.5 × U(225) + 0.5 × U(0) = 0.5 × 15 + 0.5 × 0 = 7.5
Given EU < U(c0), it’s rational to decline the bet, demonstrating risk aversion.
Risk Averse: Prefers certain outcomes over risky ones. Displays diminishing marginal utility.
Risk Neutral: Indifferent to risk, where expected utility equals expected value.
Risk Loving: Prefers risky outcomes, possessing increasing marginal utility.
The nature of these preferences can change based on the size of the gamble relative to wealth.
People are willing to pay a risk premium to avoid uncertainty. The utility with and without insurance can be formulated as:
Expected utility without insurance:
EUno insurance = P(No Accident)U(c0) + P(Accident)U(c0 − Cost of Accident)
Expected utility with insurance, priced at x:
EUinsurance = U(c0 − x)
Setting these equal allows us to solve for x, providing an understanding of risk premiums.
Insurance is driven by risk aversion, with individuals willing to pay more than expected costs to secure peace of mind against unforeseen events.
Despite the negative expected value (e.g., spending $1 with an expected payout significantly less than that), people still participate in lotteries. Theories for this behavior include:
Entertainment Value: People enjoy the thrill of anticipation.
Ignorance: Many underestimate the odds against them.
Understanding decision making under uncertainty through expected utility and associated concepts like risk aversion is crucial for both theoretical and practical applications. Future discussions could include behavioral economics, further exploring human psychology in economic decision-making.
Economic discussions often prioritize efficiency (maximizing social welfare) over equity (fair distribution of resources).
Example: Both perfect competition and a perfectly price-discriminating monopolist maximize welfare but distribute surplus differently.
The challenge: Assessing fairness in outcomes that have the same efficiency.
Special cases arise where equally efficient outcomes lead to different equity consequences, but often, making distributions more equal introduces inefficiencies.
This relationship can be illustrated by Arthur Okun’s leaky bucket analogy:
Imagine a bucket where money is transferred from the rich to the poor, but it leaks during transportation. The water represents wealth, while the leakage symbolizes the efficiency loss associated with redistribution.
The social welfare function represents society’s collective well-being, often described as:
W = U1 + U2 + U3 + … + UN
where W is social welfare and Ui is the utility of individual i.
Utilitarian Social Welfare Function: A straightforward approach where each individual’s utility is summed. This approach treats everyone equally, regardless of their initial condition.
Optimal resource allocation occurs when marginal utilities are equal.
Rawlsian Social Welfare Function: A different perspective that prioritizes the well-being of the worst-off individual in society:
W = min (U1, U2, …, UN)
Nozick’s Perspective: Redistribution is only justified when opportunities are unequal, not outcomes. Post-equal opportunity, outcomes should be left to chance.
Income distribution is often segmented into quintiles, revealing profound inequalities.
Example: The richest 20% of Americans make more than half of the total income.
Poverty Line: Defined to assess absolute deprivation and the minimum income required to maintain basic living standards.
Current Poverty Line:
Poverty Line = Food Costs × 3 (originally, adjusted for inflation)
Administrative costs: Overhead associated with running welfare programs.
Taxation efficiency costs: Distortion of incentives to work as a result of taxation.
Transfer efficiency costs: Reduced incentives for recipients to work when they receive benefits.
Redistribution can potentially shrink the overall economic pie while addressing inequality.
The fundamental question: Is the benefit (equity improvement) worth the cost (efficiency loss)?
Technologies such as the social welfare function help quantify these trade-offs.
The discussions surrounding equity and efficiency illustrate the complexities economists face when attempting to create a fair system. The use of various social welfare functions provides frameworks to grapple with these trade-offs, affirming that policies must balance economic efficiency against the pursuit of equity.
This lecture discusses the trade-offs between equity and efficiency, particularly in relation to taxation and redistribution policies in the United States. It highlights several economic principles, including tax incidence, the elasticity of demand and supply, and the implications of different taxation systems.
The equity-efficiency trade-off emphasizes the inherent tension between redistributing wealth (equity) and maintaining economic efficiency. Redistribution via taxation can generate what is known as a "leaky bucket," where some resources are lost in the process.
This analogy illustrates inefficiencies in taxing individuals (raising money) and transferring funds (distributing money). The fundamental idea is that while aiming for fairness requires taxpayer money, the actual implementation can reduce overall economic welfare.
When analyzing taxation in the US, two key aspects emerge:
Tax incidence refers to the analysis of the effects of a particular tax on the distribution of economic welfare.
A crucial insight is that the burden of the tax can differ from the party that pays it.
Let us examine a
Original Quantity = 100 billion gallons
After the tax, the price consumers pay increases to $1.80, leading to a new quantity supplied of:
New Quantity = 90 billion gallons
This yields: - Consumer Burden:
ΔPconsumers = Pnew − Pold = 1.80 − 1.50 = 0.30
- Producer Burden:
Preceived = Pnew − tax = 1.80 − 0.50 = 1.30 ⇒ ΔPproducers = 1.50 − 1.30 = 0.20
Thus, consumers bear part of the tax burden (
The tax wedge is defined as the difference between what buyers pay and what sellers receive after tax:
Tax Wedge = Pnew − (Pnew − tax) = 0.50
The effects of a tax depend critically on the elasticities of supply and demand:
Inelastic Demand: Consumers bear more of the tax burden.
Elastic Demand: Producers bear more of the tax burden.
Inelastic demand results in consumers easily absorbing the tax burden (e.g. gas prices).
Elastic demand allows producers to transfer the tax burden to the consumers less effectively, typically resulting in reduced prices or sales.
The ongoing debate centers on whether to tax income or consumption:
Income Tax: Taxes savings and consumption simultaneously.
Consumption Tax: Encourages savings and does not penalize savings.
Taxing consumption fosters savings, which leads to more capital for investment and economic growth.
Transfers may inadvertently create disincentives for work (substitution effects) because receiving transfer payments can reduce the impact of earned income: -
Transfer = max (0, 10, 000 − Income)
Categorical transfers can mitigate inefficiencies:
They target specific groups (e.g. families with disabled children).
In-kind transfers (e.g. food stamps, housing) aid those in need without incentivizing avoidance of work.
The EITC represents a positive solution to the leaky bucket issue:
It is a conditional cash transfer that incentivizes employment.
A structure where government provides $0.40 for every dollar earned up to a limit, promoting labor force participation.
At lower incomes, the EITC boosts labor supply by increasing income.
Results in a more significant participation in the labor force without disincentivizing ongoing work.
In summary, the lecture highlights the importance of understanding taxation structure, tax incidence, and the distinction between income and consumption taxation. Furthermore, programs like the EITC not only provide financial assistance but also stimulate economic activity, countering the challenges of redistributing wealth efficiently.
An externality occurs when the actions of one party affect another party, and the first party does not bear the costs or benefits of that impact.
Two types of externalities:
Negative Externality: A cost imposed on a third party who does not agree to the action causing the cost.
Positive Externality: A benefit received by a third party who does not pay for the benefit.
The First Fundamental Theorem of Welfare Economics asserts that perfectly competitive markets will lead to welfare-maximizing outcomes.
Markets are considered efficient unless there are externalities, monopolies, or information asymmetries.
Consider a steel plant that produces sludge waste:
Each unit of steel (S) produced results in one unit of sludge (W).
Sludge negatively impacts fishermen by decreasing fish population downstream.
S → W
The fishermen bear the costs of the pollution without receiving any benefits.
Classic example: Smoking.
Smoking results in negative effects (e.g., secondhand smoke) that others bear.
Social marginal benefit decreases, leading to a lower optimal consumption level of cigarettes.
Regulation: Directly limit the quantity produced or consumed (e.g., capping emissions).
Corrective Taxation: Charge firms and consumers a tax equal to the perceived external costs.
For the steel plant, a tax of $100 per unit of steel aligns private marginal costs with social marginal costs.
For cigarettes, a tax (e.g., $0.40 per pack) decreases consumption to the socially optimal level.
Environmental policies (e.g., carbon taxes) aim to address externalities like pollution.
Health policies for smoking, drinking, and illegal drug usage must consider external costs and societal impacts.
Ronald Coase argued that externalities can be internalized through private negotiation; this is often idealized.
Practical limitations arise due to complexities like global warming or local nuisances (e.g., noise pollution).
Understanding externalities is crucial for designing effective public policy.
Recognizing that the market can fail due to externalities reinforces the importance of government intervention.
Definition: An externality occurs whenever one party’s actions make another party better or worse off, without the first party bearing the consequences.
Market failure exists when the competitive market does not maximize total social welfare due to barriers.
Types of barriers include:
Imperfect competition
Imperfect information
Externalities
Consider the following scenario:
A steel plant produces steel and dumps sludge into a river.
The sludge kills fish, affecting fishermen downstream.
Each unit of steel produced results in one unit of sludge.
Social Marginal Cost (SMC) = Private Marginal Cost (PMC) + Marginal Damage (MD)
The market equilibrium:
Demand = Marginal Willingness to Pay = Marginal Benefit
Supply = Private Marginal Cost
The social optimum occurs at where:
Social Marginal Benefit = Social Marginal Cost
Deadweight loss triangle: Area where social marginal cost exceeds social marginal benefit.
Direct negative consumption externality: Secondhand smoke impacts non-smokers.
Raises health costs for society (shared across health insurance).
Example externalities:
Environmental damage from production.
Healthcare costs due to smoking-related illnesses.
Drunk driving accidents.
Equilibrium at where:
Private Marginal Benefit = Private Marginal Cost
The social optimum reflects the external costs from smoking.
Total social benefit of a good can be realized through corrective taxation.
Tax = Marginal Damage
Application shifts private marginal cost to social marginal cost.
Application of subsidies may encourage beneficial activity (R&D, education).
Rising CO2 levels and their implications.
Governments propose corrective measures, such as carbon taxes.
Smoking, obesity, and their impact on society.
Taxation, penalties, and illegality as potential tools to manage externalities.
Balance between private and public interests is critical to maximize societal welfare.
Potential for deadweight loss due to unaddressed externalities illustrates the need for government intervention.
Social insurance refers to government-provided insurance programs that mitigate risks associated with uncertainties in life. It represents the largest category of government expenditure in the United States.
Insurance is essential due to people’s aversion to risk and uncertainty. The private insurance market in the US, including health, auto, life, property, and casualty insurance, totals approximately $1.5 trillion annually.
While private insurance exists, there are circumstances leading to market failures that necessitate government involvement. One key reason is information asymmetry, where different parties have varying levels of information.
Information asymmetry can lead to market failures, particularly in insurance markets.
Definition: Information asymmetry occurs when one party in a transaction possesses more or better information than the other party.
George Akerlof’s (1970) "lemons problem" illustrates how information asymmetry can prevent a market from functioning optimally.
Example: In a 1970s used car market, sellers have information about the quality of the car, while buyers do not.
Buyers will only pay an average price, fearing that they could buy a "lemon," or a poor-quality car.
As a result, sellers of high-quality cars may exit the market, leading to a market collapse.
In the insurance context, the information asymmetry is flipped.
The buyer (insured) knows their health risk better than the insurer (insurance company).
Adverse selection occurs when those most likely to need insurance (i.e., higher risks) are the ones who seek it out, while healthier individuals opt out. This leads to insurers facing higher-than-expected costs.
Let Ch represent expected costs for healthy individuals and Cs for sick individuals:
Expected costs for an insurer that doesn’t differentiate between healthy and sick individuals can lead to losses and an eventual market failure.
Various solutions exist to mitigate adverse selection in insurance markets, including:
Subsidization: Providing tax credits to encourage healthy individuals to buy insurance.
Mandates: Laws requiring everyone to buy health insurance (as seen with the Affordable Care Act).
Direct Government Provision: Programs like Social Security, Medicare, and unemployment insurance.
Each solution comes with limitations:
Subsidization can be costly but encourages participation.
Mandates can create dissatisfaction among healthier populations.
Direct provision is less popular due to its high cost to taxpayers.
Moral hazard refers to the idea that individuals may undertake riskier behavior when they are insured.
Lower Efficiency: With insurance, individuals may reduce their efforts to avoid risks, leading to inefficiencies.
Increased Taxation: More benefits necessitate higher taxes, which can create further disincentives for work.
The Social Security program offers an example of a social insurance program designed to provide income after retirement, funded by a 12.4% payroll tax.
The U.S. incentivizes delayed retirement with higher monthly benefits (6.7% increase per year delayed).
In other countries, like the Netherlands, there are less favorable terms for working, leading to lower labor participation rates.
The government plays a crucial role in insurance markets due to the information asymmetries and adverse selection risks that plague private insurance. However, the challenge lies in designing systems that balance coverage while mitigating moral hazard effects.
Externalities are key to understanding market failures. The first fundamental theorem of economics states that competitive markets maximize total social welfare. However, this can be hindered by several barriers, one of which is externalities.
An externality occurs when one party’s actions affect the well-being of another party without that party’s consent. Mathematically, we can express this as:
Externality = Impact on Party A ≠ Costs/Benefits borne by Party A
Externalities can be categorized into negative and positive externalities, and can occur in both production and consumption contexts.
A classic example involves a steel plant that produces sludge as a byproduct. This sludge harms fishermen downstream who rely on clean water for their livelihood.
Let Qs be the quantity of steel produced, and the relationship is:
Sludge produced ∝ Qs
The external cost to fishermen occurs because the steel plant does not account for the economic damage caused.
The market produces steel at the intersection of the private marginal cost (PMC) and the private marginal benefit (PMB). However, socially optimal production occurs when the social marginal cost (SMC) equals the social marginal benefit (SMB).
Social Marginal Cost = Private Marginal Cost + Marginal Damage
The optimal outcome at this point leads to overproduction, resulting in a deadweight loss, represented graphically as: - The deadweight loss triangle can be illustrated between points A, B, and C, where marginal social cost exceeds marginal social benefit.
Negative consumption externalities occur when an individual’s consumption reduces the utility of another individual without compensation.
When an individual smokes, they may affect others through secondhand smoke or increased healthcare costs.
Externalities can also be positive, whereby the actions of one party benefit others.
Investments in R&D not only benefit the firm but also create societal benefits due to knowledge spillovers. The social benefit is often higher than the private benefit.
For firms:
Social Marginal Benefit > Private Marginal Benefit
Firms tend to underinvest in R&D due to these spillover benefits.
To address externalities, governments can implement:
A corrective tax can internalize negative externalities by aligning private costs with social costs.
For example: A tax equal to the marginal damage from pollution helps align the firm’s private marginal cost with society’s social marginal cost.
For positive externalities, governments can incentivize behavior that creates external benefits through subsidies.
Another approach is regulatory mandates that directly control the level of goods produced or consumed, like production quotas on pollution.
Addressing climate change is crucial. Current models suggest implementing a carbon tax that accurately reflects the marginal cost of carbon emissions to combat climate change.
Smoking induces significant health costs on society, and measures like information campaigns, taxation on cigarettes, and illegalization of certain products could be emphasized to mitigate these externalities.
Understanding externalities is critical for assessing the efficiency and equity of market outcomes and formulating effective government policies for intervention.