Markets and Regulation | Quizlet

What is the difference between economic efficiency and cost-effectiveness?

- economic efficiency: involves balance of costs and benefits, attempts to maximize benefits WHILE minimizing costs

- cost-effectiveness: doesn't care about benefits, only about reducing costs

What is welfare?

- satisfying individuals' desires

- includes monetary and non-monetary desires

- welfare is subjective (different for everyone), but economics doesn't judge (except when one's desires hinder others' rights)

What is a transaction and what are transaction costs?

- transaction = transfer of property rights

- transaction costs = costs associated with making a transaction, (e.g. notary fees)

Neo-classical economic theory

- focuses mainly on production costs

- presupposes rational behavior

Neo-institutional economic theory

- focuses on production costs AND transaction costs

- presupposes bounded rationality, where actors strive for rational decisions, but are hindered by uncertainties (e.g. information asymmetry)

Behavioral economics

- focuses on cognitive costs (= costs of making a decision)

- presupposes predictable irrationality (i.e. people are irrational in a predictable way), e.g. herd mentality

Opportunity cost

Value of the second-best alternative when making a decision

Sunk cost

Costs incurred regardless of whether an action is taken (you have to pay it anyways, so just disregard it when making decisions)

What are the four production factors?

1. land (natural resources)

2. labor (work of individuals)

3. capital (manufactured aids used for production, e.g. machines)

4. human capital (entrepreneurial abilities)

What does a production possibilities frontier (PPF) show?

Various combinations of output the economy can produce given its production factors (assuming fixed resources, fixed technology, and full employment)

How can you extend PPF?

Innovation and/or investment

What does the optimal allocation of resources mean?

Allocation of production factors in a way that welfare is maximized (people are happy, consumer preferences are satisfied)

What are the two ways to achieve optimal allocation of resources? (And which one works?)

1. central planning - definitely doesn't work (USSR, North Korea)

2. markets - definitely better than central planning (Germany, USA)

What is perfect competition?

It requires:

- many suppliers and consumers

- homogeneous goods

- no transaction costs (transparency, defined property rights, free entry and exit)

Perfect competition is unattainable.

What is price elasticity? When is price elastic/inelastic?

The % by which quantity changes if price changes by 1%.

Elastic price: change in q > 1%; inelastic price: change in q < 1%

What does the demand curve represent?

Consumers' willingness to pay

How do you calculate total revenue (TR)?

TR = P x Q

Where P = price; Q = quantity

What is marginal revenue (MR)?

Additional revenue attained by selling +1 product (MR = P)

What is average variable cost (AVC)?

AVC = TVC/Q; TVC = wage rate x number of workers

[TVC = total variable cost]

AVC increases together with Q, because the more you produce the more workers you need.

What is average fixed cost (AFC)?

AFC = TFC/Q

TFC (total fixed costs) is independent from production level. AFC decreases if Q increases, because TFC is spread out evenly among products.

What is average total cost (ATC)?

ATC = AVC + AFC = TC/Q; TC = TVC + TFC

ATC is the sum of variable costs and fixed costs divided by Q.

What is marginal cost (MC)?

Additional cost incurred by producing +1 product. MC is calculated from TC, i.e. if TC for producing 1 product = EUR 150 and TC for producing 2 products = EUR 200, then MC = 200 - 150 = EUR 50

Why does MC curve go through the minimum of ATC curve?

ATC is an average of the values (TC) also used to calculate MC. If MC < ATC it will 'pull up' average, but as soon as MC > ATC it will 'weigh it down' instead.

How to maximize profit? Also, define the supply curve.

Profit is maximized where MR = MC. This is the point where the extra revenue coming from +1 product = extra cost incurred by +1 product. If we stop increasing production where MR > MC we could be producing more without hurting profit, while if we increase production to where MR < MC, our revenue for +1 product will be smaller than the cost incurred.

MR = P (each sold product brings in the same revenue), so we need to find the points where MC = P (= MR).

Points of MC curve each correspond to a P, i.e. MC = P at all points of MC curve. Thus, profit is maximized on MC curve, which makes MC curve the supply curve.

What is the market equilibrium?

Intersection of supply and demand, which determines the market price and quantity of a product (in perfect competition).

What is consumer surplus?

It is the difference between how much consumers are willing to pay and how much they actually have to pay (equilibrium price).

What is producer surplus?

It is the difference between how much producers actually receive (equilibrium price) and the minimum they are willing to accept.

If demand drops, the demand curve shifts to the...

...left. (Demanded quantity is represented on the Q axis, i.e. a change in demand entails a move along Q.)

If production costs decrease, the supply curve shifts to the...

...right. (If production costs are lower, suppliers can produce a higher Q at the same P, thus the shift along Q.)

What is pareto-efficiency?

A pareto-efficient transaction is where both parties are made better off. E.g. buyer values car at 15,000 and seller values it at 10,000. If the seller sells the car for 12,500 both of them 'win', so the transaction is pareto-efficient.

Why is the equilibrium pareto-efficient?

In equilibrium, both consumers and producers attain the maximum level of surplus possible. I.e. left of the equilibrium, producers can sell more and consumers can buy more while increasing welfare (could be better for both). Right of the equilibrium, consumers have to pay a higher price than they want, while suppliers have to accept a lower price than they want (bad for both).

As such, there is no possibility for pareto-efficient improvements in the equilibrium.

Which governance mechanism is better, market or firm? (Also explain Coase's Theory of the Firm)

Trick question! According to the theory of the firm, firms exist to integrate the market's high transaction costs into firms, thus reducing them.

However, firms have their own transaction costs associated with them, so sometimes it is more beneficial to make transactions in the market instead (outsourcing).

What are the two types of government intervention in markets? What are their characteristics and two examples of each?

1. market-friendly intervention

- welfare-increasing intervention

- does not hamper the price mechanism

- taxes, subsidies

2. market-unfriendly intervention

- welfare-decreasing intervention

- affects the price mechanism

- price ceiling, price floor

Who 'ends up paying' taxes in (1) inelastic demand; (2) elastic demand? (producer v. consumer)

With taxes, the S curve shifts upwards. (Costs more to produce the same Q.)

1. In inelastic demand, the D curve is close to vertical. As such, there is (almost) no effect on Q, but only on P, which is borne by the consumers (who demand the same Q at a higher price).

2. In elastic demand, due to the downward sloping D curve, only a fraction of price increase is 'felt' by consumers, the rest is borne by the producers.

Is minimum price effective in protecting producers' revenue?

Depends on elasticity of demand. TR = P x Q, so in elastic demand (where a small increase in P results in a large decrease in Q) minimum price hurts producers more than it helps. However, in inelastic demand the Q does not drop so much when P is increased, thus it can be beneficial to producers. In any case, there will be a milk lake.

Can you undo 'damage' caused by minimum price by removing it?

Nope, it's just inefficient altogether.

What is the result of maximum prices?

Humongous excess demand, i.e. shortages;)

Did liberalizing the notary service work out for the NL in terms of efficiency gains?

It was a moderate success, competition barely increased as a result.

1. What is a monopoly?

2. What are the reasons for/types of monopoly?

3. Is monopoly always bad?

1. A monopoly is a market structure with only one supplier ('price setter'), but many consumers.

2. technical monopoly (e.g. gas's unique availability), legal monopoly (e.g. patents), natural monopoly (networks, e.g. energy, telecommunication)

3. Nope, economists like natural monopolies, because they have scale advantages, whereby ATC is lowest when production reaches maximum market size. (I.e. it is not worth it to build an entire electricity network just to supply 2 households.)

True or False: The monopolist maximizes profit at MR=MC.

True. While the MR curve is downward sloping, unlike in perfect competition, it still intersects the MC curve.

True or False: The monopolist ('price setter') sets the price at MR=MC.

False. While the monopolist's profits are maximized where it produces the Q at MR=MC, due to the downward sloping MR curve, this point is 'below' the D curve. I.e. consumers are willing to pay more than the P at MR=MC.

Is there a welfare gain or loss in a monopoly compared to perfect competition?

There is a loss in total welfare (= deadweight loss) resulting from a monopoly.

Other than a loss of surplus, what welfare costs does a monopoly have?

1. rent-seeking: the costs of maintaining monopoly position (e.g. lobbying)

2. X-inefficiency: weak incentive to control costs ("you can just cover increased costs by monopoly profits")

3. dynamic inefficiency: no incentive to out-innovate competitors (due to lack of competitors)

1. What is an oligopoly?

2. What are its types?

1. Oligopoly is a market structure where there are only a few suppliers, but many consumers.

2. homogeneous oligopoly (identical product, e.g. crude oil), heterogeneous oligopoly (differentiated products, e.g. cars)

What is the difference between a Cournot duopoly and a Bertrand duopoly?

SYKE -- I have no idea, someone explain pls:(((

1. What is a cartel?

2. Why are cartels unstable?

1. Cartel is a group of oligopolists acting together as a monopolist (illegally, i.e. NOT through a merger).

2. Cartels are inherently unstable due to (1) free-riding (producing more than agreed upon), (2) collective-action problem (cartels are difficult to enforce, providing room for opportunistic behavior), and (3) market entry (excess profit attracts new competitors).

Who is a 'price leader'?

A price leader is a member of a cartel that sets the price for entire sector (maximizing its own profits). A price leader acts as a monopolist for its own market share.

What happens if you just let monopolistic competition play out?

1. Monopolist will make monopoly profits (huge excess profit).

2. Excess profit attracts competition, potential entry by new firms.

3. Newcomer(s) 'eat up' demand from the monopolist, who will loose its excess profits and instead will only make normal profits (boooo).

1. What is innovation competition?

2. What is the dilemma of innovation competition?

1. New innovations can sometimes result in a temporary monopoly position. Thus, firms strive to out-innovate their competitors and get an advantage out of it.

2. Innovation competition decreases consumer welfare because of excess profits of temporary monopolies. However, monopoly profits lead to better/cheaper products (through innovation), which in turn increases consumer welfare.

What are the 4 types of market failure?

1. imperfect competition

2. public goods

3. externalities

4. information asymmetries

Why do public goods need to be created?

There is existing demand for public goods (i.e. consumers are willing to pay). However, individual demand does not cover costs (D curve does not reach S curve, which is the MC curve). Solution: government collects money from consumers (tax), and adds up different levels of willingness to pay in order to cover costs.

1. What are common pool goods?

2. What is the Tragedy of the Commons?

1. Common pool goods are rivalrous, non-exclusive goods. (E.g. fish in the oceans, anyone can fish (non-exclusive) but no one can catch the fish you caught (rivalrous)).

2. Tragedy of the commons is the tendency of exploiting a resource with no price until its marginal benefit falls to 0. I.e. fishing can be increased until MR=MC, but MC is very low, so by the time MR falls that level there will be no fish left.

What are quasi-public goods (+examples)?

Quasi-public goods are private goods that are financed by the government. Such as healthcare, education.

What are (negative/positive) externalities?

Negative externalities are damages caused to others without compensation (e.g. noise, pollution). Positive externalities are profits incurred by others without paying (e.g. getting vaccinated).

What are the results of positive externalities?

1. D curve for goods with positive externalities includes a curve for paying consumers and one for non-paying.

2. However, producers will only regard the D curve of paying consumers; thus, supply does not meet social demand.

How can you solve positive externalities (achieve social optimum)?

1. Force free-riders to pay (difficult to enforce), or

2. subsidize producers (lowering S curve so that paying customers cover the costs of total social demand), or

3. subsidize paying consumers (same effect as subsidizing producers, but instead moves D curve up).

What are the results of negative externalities?

1. There are two S curves, one is MC curve of producer, the other is MC curve of society.

2. Producers will only consider their own MC curve, which entails a Q higher than social optimum. This is because they don't have to directly bear social costs.

Three options for internalizing externalities:

1. Coasean (market-based) approach

2. direct regulation

3. liability law

What is the Coase Theorem (for externalities)?

According to the Coase Theorem, if property rights are clearly defined, actors in the market will negotiate until they internalize externalities. Some regulation is still needed to assign property rights.

E.g. emissions trading: regulator defines property rights (emissions allowances), which are then traded between firms.

How does direct regulation internalize externalities?

In cases where negotiation with the one producing externalities is difficult/impossible, the government can step in to impose rules for internalizing externalities.

E.g. hospital patients need rest, but can't individually negotiate with drivers going tooottooot by the hospital, so the government imposes prohibitive rules on drivers.

How does liability law internalize externalities? (+ two types of liability law)

Liability law internalizes externalities through compensation (thus incentivizing damage prevention). Its types:

1. Strict liability imposes a duty to cover externalities resulting from a certain conduct, regardless of precaution taken.

2. Negligence rules impose liability on those taking insufficient care, thus causing negative external effects.

What are the consequences of information asymmetries? (Explain through used cars)

1. Sellers have information advantages. Thus, they are more likely to sell low quality cars than high (they can convince buyers). Buyers know this, and know that the cars on used market are more likely bad quality than good.

2. As a result, buyers are willing to pay less (they suspect bad quality). This lowers the prices compared to those in perfect information (D curve shifts downwards).

3. With lower prices, owners of high quality cars are incentivized to keep cars instead of selling them under value, further lowering average car quality.

What are the three goals of macroeconomic policy?

Economic growth, stable prices, full employment

1. What is GDP?

2. How do you calculate it?

1. GDP is the market value of final goods and services produced in a country within a certain time period.

- given period = usually a year

- final goods and services = products sold to the consumers (not ingredients)

- market value = value determined by supply and demand

2. Two methods:

a. add up market value of all goods and services produced (total production)

b. add up total amount spent by consumers and subtract money spent on imports (total expenditure)

How do you calculate total expenditure (for GDP)?

Formula: Y = C + I + G + NX, where

- Y = GDP

- C = consumption

- I = investment

- G = government purchases

- NX = net export (= total export - total import)

1. What is economic growth?

2. How do you measure it?

1. Economic growth is the real growth of GDP.

2. You can determine growth using real GDP values. Real GDP = nominal GDP adjusted for inflation.

How do you calculate real GDP?

When making the calculation, use the quantities of the year you're calculating, but multiply them not by prices of that year but by prices of base year.

What are the causes of economic growth?

1. technological innovation (lowers production costs), can be labor savings (less workers for same output) or capital savings (less equipment for same output)

2. innovative legislation (lowers transaction costs)

How is recession defined?

Recession is a period of two quarters where the GDP decreases.

What is inflation and deflation?

- inflation = strong increase (>2%) of prices

- deflation = strong decrease of prices

What is the Consumer Price Index (CPI)?

CPI shows the cost of living in comparison to a base year.

It is calculated by dividing the base-year-value of a 'basket' by nominal value of the same basket in the year in question.

How do you calculate inflation?

Inflation is the annual change in CPI.

Inflation = (CPI{year2} - CPI{year1})/CPI{year1}

How do you adjust prices for inflation?

Real value = nominal value/CPI

Does inflation redistribute wealth?

Yes; the loss of ones turns into the gain of others (e.g. workers' loss is the employers' gain).

However, it isn't fair:(

What is the money supply?

Public money not in the hands of banks and monetary institutions.

How did bonuses contribute to the 2008 financial crisis?

Prior to 2008, the design of bonuses was such that managers received bonuses for risk-taking behavior, but regardless of profits. This structure incentivized reckless behavior, causing a 'gambling bonanza', which in turn increased the instability of the financial system.

What are the main reasons behind the COVID-19 crisis' economic side?

1. Lockdowns reduced consumer demand and disrupted the global supply chain, bringing the economy to a halt

2. NCBs tried fighting this by keeping interest rates low, which increased debt

3. Governments did not have enough liquid money to provide buffers for companies and individuals, which lead to the issuing of bonds, which entails an even higher debt for future governments

What are the phases of the business cycle?

1. Recession:

- decrease in consumption, production, employment

- interest rates are lowered to stimulate investment

2. Expansion:

- the low interest rates of recovering from recession stimulates investment, which triggers expansion

What are the three macroeconomic policy instruments? What policy goals do they aim to achieve?

1. budgetary/fiscal policy: growth and employment

2. legal policy: growth and employment

3. monetary policy: price stability

What are the aggregate demand (AD) and aggregate supply (AS) curves?

1. AD curve represents the total demand for all goods and services in a country

2. AS curve represent the total supply of all goods and services in a country

When can the AS curve shift?

1. AS curve can shift to the right due to technological innovation (production costs down) and innovative legislation (transaction costs down)

2. AS curve can shift to the left due to increase in production costs (e.g. high energy prices)

When can the AD curve shift?

1. AD curve can shift to the right when consumers have 'more money' to spend (e.g. income tax lowered)

2. AD curve can shift to the left when consumers have 'less money' to spend (e.g. income tax raised)

What is the Keynesian budgetary policy?

1. Keynes presupposes that AS curve is given.

2. The higher the GDP, the higher the employment rate.

3. In order to increase GDP (with fixed supply) the government must stimulate demand by e.g. increasing government expenditure and lowering taxes to stimulate private expenditure.

What is the supply side budgetary policy?

1. Governments must lower taxes in order to increase GDP.

2. Lowering taxes will have an effect both on AD and on AS (AD shifts right, AS shifts down).

3. As a result, there will be a large increase in GDP, and only a small increase in the general price level.

Do lower taxes result in lower government revenue? Explain the Laffer curve (and its critiques).

1. According to the Laffer curve, a certain level of lowering taxes will actually lead to higher government revenues, because lower taxes stimulate production, and as a result more products are sold than the decrease in taxes.

2. The Laffer effect exists, but to a much lower extent than Laffer anticipated. (I.e. only a very small lowering of taxes will lead to increased government revenue.)

Critiques of Keynesian and supply side oriented policies:

1. The Keynesian approach only works with the perfect amount of stimulation: too little stimulation of AD has no effect, but too much leads to inflation and deficit.

2. The supply side oriented policy has an insufficient effect on AD.

What is legal policy as a macroeconomic instrument?

Legal policy is the coordination of legislation in order to reduce transaction costs and thus stimulate the economy. It usually happens by finding the law between the parties with the lowest transaction costs and implementing it collectively.

What are the degrees of economic integration? (Examples as well)

1. free trade association: no import tariffs between members (EFTA)

2. customs union: no import tariffs between members, common import tariffs towards third parties (MERCOSUR)

3. economic and monetary union: no import tariffs between members, common import tariffs towards third parties, unification of certain policies (e.g. budgetary, monetary, etc.) (EU)

What is cascading protectionism?

Cascading protectionism is the practice of taking a protectionist measure in order to counter the effects of a previous (failed) protectionist measure.

What is the Fischer equation of exchange?

M V = P T, where

M = money supply; V = velocity of money changing hands; P = general price level; T = number of transactions

The equation essentially explains that the value of of money flow = value of the flow of goods.

How does inflation relate to money supply (M)?

1. Central Banks can increase M by lowering interest rates.

2. If interest rates are increased, borrowing becomes more attractive, raising M (and thus M*V).

3. If M V increases, P T must also increase. If number of transactions (T) cannot increase further, general price level (P) will increase instead, causing inflation.

How do Central Banks operate? (Example of ECB)

1. ECB maintains a structural deficit (= there is less money circulating than demanded), causing commercial banks to borrow money, which they have to pay back at the refinancing rate.

2. The ECB can adjust the refi rate, thus influencing the commercial banks' (and indirectly consumers' and firms') willingness to borrow. (The higher the refi rate, the less the demand for credit.)

3. In a recession, ECB lowers refi rate to stimulate borrowing (which increases M*V), prompting T to also increase, which in turn stimulates the economy.

4. To fight inflation, the ECB raises refi rate to decrease M*V, thus also decreasing P (countering general price increase).

What was the ECB's policy response to (1) the 2008 crisis, and to (2) the war in UA?

1. After 2008, to recover from recession, the ECB lowered interest rates in order to stimulate transactions and thus growth.

2. In 2022, the ECB started raising interest rates to counter the inflation caused by a stagnant demand but decreasing supply (shortage).

What is the dilemma of globalization?

Globalization is the engine of economic growth, but also the accelerator of economic crises.

What are the dangers of government response to crises?

1. Over-regulation: too many rules and procedures make difficult the supporting of companies and consumers

2. Protectionism: weakens the mutual gains of international trade, thus hindering growth

3. Limiting market forces: rules and regulations intended to support companies and consumers have competitive drawbacks (make the markets less free)