Markets and Regulations

Economic analysis of law

• application of economic theory to predict effects of legal sanctions on behavior

• Legal sanctions function like prices that influence behavior

• Laws as incentives and prices

  • traditional definition: laws are obligations backed by state sanctions

  • economic perspective: laws create implicit prices for behaviors

Core principles of economics

• efficiency

• welfare

• transaction

Efficiency

A change is efficient if total benefits are greater than total costs

• pareto efficiency: at least one person is made better off while making no one worse off (win-win)

• kaldor-hicks efficiency: an allocation can be efficient even if someone loses, as long as the winners could compensate the losers (potential win-win)

• limitations of efficiency as a goal:

  • efficiency is not equity: focuses on total welfare, not distribution

  • efficiency is not fairness: considers outcomes, not process

  • efficiency is not maximizing happiness: based on willingness to pay, not utility

Welfare

Welfare = utility = satisfying desires

• monetoary or non-monetary

• subjective (similar phenomenon increases welfare for some, decreases for others)

• indifferent (we don’t judge people’s desires)

Transaction

transfer of property rights

• simultaneous economic and legal change:

  • physical/digital transfer of good or service

  • economic transfer of money

  • legal transfer of property rights

• Transaction costs: information, bargaining, decision-making, monitoring, enforcement costs

Measuring costs-benefits

• consider opportunity costs: the value of the next-best alternative foregone

• ignore sunk costs: costs that will be incurred whether or not an action is taken

• use marginal analysis: focus on additional costs and benefits

perfect competition

• many suppliers and consumers

• homogeneous goods

• no transaction costs:

  • perfectly transparent

  • (property) rights defined

  • free entry and exit

• Price is given because it is based on what people are willing to pay/supply and demand

• P=MR because in perfect competition, MR would only equate to the price someone pays for the good (MR is also equal to MC in perfect competition)

Demand

• Demand = consumers

• Demand curve = willingness to pay

• Demand curve decreases (the higher p, the lower q)

price elasticity

how much the quantity demanded of a product changes in response to a change in its price.

• elastic demand: effect on q is large (> -1%) → price increases but demanded quantity decreases strongly

• inelastic demand: effect n q is small (< -1%) → price increases and demanded quantity hardly decreases

profit

revenue - cost

Revenues

price x quantity

• Total Revenue = price x quantity

• MR = Marginal revenue (the revenue you get if you sell one more good)

Costs

• fixed costs: machines or land costs that are given

• variable costs: labor or other factors that can change

Average variable cost curve (AVC)

• Total variable cost (TVC) = average wage rate x number of workers

• Average variable cost (AVC) = TVC/quantity

Average fixed cost curve (AFC)

• TFC = total fixed costs

• independent of production level

• average fixed costs (AFC) declines

• AFC = Fixed Costs (FC)/quantity

Average total cost curve (ATC)

• Total costs (TC) = Total Variable Costs + Total fixed Costs

• Average Total Costs = Total Costs/quantity

• Average Total Costs = Average Variable Costs + Average Fixed Costs

• ATC curve includes payment to shareholders and/or banks (hence profit)

Marginal Cost Curve (MC)

Marginal costs = extra costs when production is expanded with 1 unit (exactly the inverse of MR)

When is profit maximized?

When MR=MC in perfect competition

MC curve as supply curve

• MC until S = supply curve for producer

  • price lower than ATC: loss

  • price below S: shutdown point

• Line of reasoning:

  • P = MR with perfect competition

  • profit is maximized at MR = MC

  • MC = supply curve

Optimal production level

• MR is greater than MC: expand → more profit

• MR is less than MC: expand → less proft

• Optimal: MR = MC

Market demand curve

add up all demand curves

Market supply curve

shows the relationship between price and the total quantity producers are willing to supply.

Market equilibrium

• Pe = equilibrium price

• Qe = equilibrium quantity

• (p > Pe → impossible)

• (p < Pe → impossible)

Pareto-efficient market equilibrium

• only one equilibrium price: Pe

• at P1 & q1 (and P2 & q2) both producer and consumer can increase welfare

• continues until pe & qe: consumer and producer surplus is maximal

• At p3 & q3 welfare decreases for both

Surplus

• Consumer surplus: difference between price that consumers are willing to pay and equilibrium price

• Producer surplus: difference between equilibrium price and price that entrepreneurs want to receive

• Total surplus: consumer surplus + producer surplus

  • trading implies that both consumers and producers are better off (both welfare gain)

Changing demand

Demand curve D1 shifts:

• preferences change

• number of consumers changes income distribution changes

• price of another good changes

• less demand: D-curve to the left)

Changing supply

Supply curve S1 shifts:

• price of some production factors changes

• technology changes

• (more supply or lower costs: S-curve to the right)

• (MC decrease or: producing more at similar cost level)

Market structure

the amount of suppliers and consumers dictates whether the market will have perfect competition, monopoly, oligopoly, oligopsony or others

Monopoly

• 1 supplier: price setter

• reasons for monopoly:

  • technical monopoly

  • legal monopoly

  • natural monopoly

    • advantage: low production costs

    • disadvantage: high price

Monopolist’s revenues

• demand curve = price

• MR downward sloping (MR curve hits horizontal axis between O and A)

• TR is maximal when MR = 0

  • this is not maximum profit

Monopolist’s costs

• assumption: cost curves identical to firm under perfect competition

• profit is maximal where MR = MC (in point H)

• Point H gives ATC of point C and price of point B

Monopolist’s profit

• profit per unit is BC

• costs pre unit is QmC

• Sales is OQm

• total (excess) profit: ABCD (namely profit per unit x sales)

Additional welfare costs of monopoly

• rent-seeking: welfare costs of maintaining monopoly position

• X-inefficiency: relatively weak incentive to control costs

• Dynamic inefficiency: relatively weak incentive to innovate

Oligopoly

Few suppliers

• Homogeneous oligopoly (identical products)

• Heterogeneous oligopoly (non-identical/differentiated products

Cartel

oligopolists acting together as monopolist

• unstable because:

  • free riding: produce more than illegally agreed

  • collective-action problem: cartel only enforceable in a small group or firms

  • entry: cartel’s excess profits attract new competitors

Monopolistic Competition: long term

• excess profit attracts newcomers that may take away demand from existing firms

• individual demand curve shifts to the left and ends in point F; P1 = ATC and MR = MC

Monopolistic competition: welfare effect

• prices above MC while perfect competition has P = MC

• production does not occur at minimal cost (and quantity less than under perfect competition) which would be in point G

• Deadweight loss FGH

Sources of market failure

• imperfect competition

• public goods

• external effects

• information asymmetries

government regulation is needed

Types of goods

Can be rivalrous and/or exclusive

What are public goods?

non-exclusive and non-rivalrous goods (no individual can be excluded from its use and the use by one individual does not reduce the availability to others

• causes free-riding (why pay?)

Tragedy of the commons

Refers to the tendency for a resource that has no price to be used until its marginal benefit falls to zero

• solution: regulation

Quasi-public goods

private goods that are partly financed by the government

• health care

• education

External effects

advantages or disadvantages associated with the consumption and/or production of a good that fall on or accrue to other people than the direct users of that good without financial compensation

Positive externalities

• Dp = demand curve paying consumers → quantity qp

• qp has monetary value Pe for non-paying consumers with demand curve De (Free riding)

• total social demand is Dm = Dp + De and optimal quantitiy is qm

• Too little is produced ( qp instead of qm)

• direct (paying) consumers versus indirect consumers (free-riders)

• too low production, because supply is only tuned to direct consumers’ demand

• achieve social optimum by adding demand of indirect consumers

  • consumer subsidy to direct users

  • producer subsidy

  • force free-riders to pay

Negative externalities

• Sm = MC society costs

• Sp = MC producers costs

• Producers take into account Sp instead of Sm because they do not include the social costs (damage) in their MC

• Too much production (qp vs qm) at a price that is too low (Pq vs Pm): socially sub-optimal

• including social cost hence Sm:

  • consumer surplus: GFPm

  • Producer surplus BFPm (if production based on Sm)

    • No negative external effect but firms only consider Sp:

      • consumer surplus: GDPp

      • Producer surplus: BDPp

      • total welfare: BDG minus negative external effect

size of negative external effect

• production according to Sp (instead of Sm): equilibrium D

• at qp social costs of E

• negative external effect: BDE

• total welfare at Sp: BDG - BDE

• Welfare loss at Sp: FDE

Is government regulation always necessary?

No - Cosean (market-based) approach: if property rights are clear, parties can negotiate so that the efficient outcome will emerge

Coase theorem

Bargaining leads to the (same) efficient outcome - damage is prevented or compensated irrespective of who has (or receives) the property rights. Must have:

• no or low transaction costs

• no public good

• parties have sufficient means to compensate

• clear property rights

Asymmetric information

Seller has more/better information than potential buyer = information asymmetry. Consequences:

• the reservation price of potential buyers falls

• lower prices than if there was perfect information

• owners of quality goods have an incentive to keep them rather than sell for less than they’re worth

• this causes the average quality of used goods to decline eve further

What is the effect of the minimum price Pmin on the quantity supplied and the quantity demanded?

Effect minimum (or: floor) price Pmin:

• supply = q(K)

• demand = q(R)

• Oversupply q(RK) = milk lake

• should the government buy it up?

What is the effect of the minimum price on milk producers’ revenues?

effect minimum price on producers’ revenues:

• in equilibrium revenue = Pe x q(B)

• now higher revenue: Pmin x q(R)

Do milk consumers gain or lose from a minimum price?

Consumer pays twice:

• higher price for milk (smaller consumer surplus)

• Extra tax money needed to buy up milk lake

Would a minimum price for milk be efficient or inefficient for society at large?

• at Pmin demand is at qmin

  • consumer surplus is EFPmin

  • producer surplus is HKFPmin

• Welfare loss is KCF, hence: (Pareto) inefficient

• Minimum price for milk could be seen as fair (for producer) or as unfair (for consumer); but: consumer pays twice…

• Minimum price for milk is inefficient due to welfare loss for society at large

How many floors should the judge allow to ensure an efficient allocation of rights?

Efficient allocation is realized with 5 floors where MR=MC, namely where marginal profit is equal to or at least still higher than marginal damage (or: where the difference between total profit and total damage is the biggest)

Suppose the judge allows 3 floors: will the project developer comply or build more floors in case of a liability protection of local residents?

When the judge allows 3 floors, the project developer will still build 5 floors, because he can increase his profit by building 2 extra floors even though he has to compensate the damage for the local residents

Emissions trading is a market-based instrument to achieve an emission reduction target cost-effectively by allowing companies to buy and sell emission allowances. In the EU, companies are legally obliged to cover their yearly CO2 emissions with (an equal amount of) emission allowances.

Prior to 2013, electricity producers received their tradable emission allowances for free, but they passed through the market value of those rights in the electricity price.

Consumers then accused producers of making ‘windfall profits’ and argued in favour of more competition in the oligopolistic electricity market to stop or at least reduce those windfall profits.

Will more competition in the electricity market reduce or even make an end to those windfall profits from free allowances?

The opportunity costs of free emission allowances will be passed through to consumers irrespective of the electricity market structure.

However, more competition implies a bigger electricity price increase (hence a larger pass-through rate of the opportunity costs) which policymakers (non-economists) strangely refer to as higher “windfall profits”

Reason: in a (perfectly) competitive market, prices are more aligned with costs (P = MC)

More competition is good for consumers because the electricity price will be lower when competition increases

Passing through opportunity costs is economically correct. “windfall profits” are inherent to emission allowances being allocated for free, because their opportunity costs have to be passed on to consumers

Windfall profits can be avoided if politicians don’t like it: emissions allowances should then be auctioned to energy firms - which was actually done as of 2013

A higher electricity price as result of emissions trading is efficient if a previously unpriced externality, such as CO2 is not priced

What is a property right?

A bundle of rights:

• right of use

• right of enjoyment

• right of exclusion

• right of disposition

• right to split this bundle of rights

3 key messages by Coase

1: social cost = externalities such as environmental pollution

• problem: by negotiating over rights externalities can be internalized, so that social costs cannot exist in the classic, micro-economic model

• extra assumption necessary for social cost: the existence of transaction costs

2. Irrelevance of the allocation of rights: to whom the rights are allocated does not matter for efficiency because without transaction costs, parties can negotiate to internalize the externality

3. Validity of Coase theorem is limited due to transaction costs such as:

   1. finding information and searching for contract party

   2. negotiating and drafting a contract

   3. verifying behavior and, if needed, enforcing the contract