Final Exam
Chapter 6 - The Visible Hand
How Do Markets Form Equilibriums?
Equilibriums are formed because there is a population of people who are willing to pay various prices for a product and there is a population of firms willing to accept varying prices for that same product.
Firms are still price-takers
If a price is higher than equilibrium price, then less people will be willing to pay for the product, therefore demand decreases.
When quantity demanded is less than quantity supply, a unit surplus occurs. Then, this unit surplus becomes inventory, which must be stored. This storing of inventory is a cost to the firm.
Since firms are profit maximizsrs, they will try to eliminate their inventory cost.
Thus, firms only want to bring the exact number of goods to to the market that they will want to sell. Since this is difficult, firms will bargain with consumers by offering them greater quantities for the same prices. This specific bargain decreases the price per unit to fall until it reaches the equilibrium with no unsold product (P*).
If a price is set below the equilibrium price, then quantity demand is greater than quantity supplied. This results in a unit shortage. In this case, the consumers bargain with producers to pay the same price for lower quantities. This causes the price per unit to rise until it reaches an equilibrium with no shortage (P*)
Until the price is at its equilibrium position, the market will try to rid of any surpluses or shortages
Firms compete any surpluses by causing the price to drop
Consumers compete away shortages by causing the price to rise
Dead Weight Loss
A market not in equilibrium is economically inefficient.
This economic inefficiency refers to the difference in a market’s potential and it’s actual outcome.
A market produces one economically efficient price and one economically efficient quanitity (the pair)
Any price or quantity other than this pair is therefore economically inefficient
When a market clears, then at this specific market price, the quantity supplied satisfies the quantity demanded (goldilocks)
At the market clearing, this is when Consumer and Producer Surplus are maximized
Dead Weight Loss (DWL) is our measure of economic inefficiency.
DWL is the absence of consumer and/or producer surplus that occurs when a market is not at equilibrium
Unit Surplus: Qs > Qd
Unit Shortage: Qs < Qd
When the market is not in equilibrium, either producers or consumers may benefit while the other pays the cost
Whenever a competitve market is not in equilibrium, there will be dead weight loss
The only thing that could move a market out of equilibrium naturally, would be a Market Intervention
Price Controls
Normative Decision: making a judgement about the conditions set by a market
ex: when the government believes a price to be too high or low
The only reason the government should intervene is if it would be more efficient for the government to set a price rather than a market (this is basically never true)
There are two types or price controls:
Price Floors
floors set a legal minimum price that producers are not allowed to go below.
binding once set above the market equilibrium price
creates a unit surplus
Price Ceilings
ceilings set a a legal maximum price that producers are nto allowed to go above.
binding once set below the market equilibrium price
creates a unit shortage
Both Price Floors and Price Ceilings
Price Controls can benefit producers
Price Controls can benefit consumers
Price Controls can make both consumers and producers worse off
In general,
A binding price floor will always hurt consumers
A binding price ceiling will always hurt producers
Example of Price Controls: Cherries
Cherries are important in the Michigan economy
International price of cherries is much lower
Therefore, government intervenes and sets a bidning price floor.
Then, there is a surplus of cherries and farmers cannot give the cherries away, this into price controls not allowing farmers to increase their profits.
Thus, many cherry farmers have exited the market
Example of Price Controls: Minimum Wage
Economic theory shows minimum wage should be a binding price floor, however, this is not true.
One caveat, is that minimum wages are important for groups that face wage discrimination, like women and ethnic minorities
This is because labor markets are not necessarily very compettitive.
Labor markets are ultimately very specific to the regions they exist in, the appropriate minimum wage has to be settled in that region, not federally
Minimum wage is a good example of the limitiations of supply and demand
Taxation
Individual taxes come in two forms
Wealth and Income Taxes - taxes based on spending ability
Usually progressive tax systems, so as income rises so does the percentage of income paid towards tax.
In the US, this is set through tax brackets
Sales and Excise Taxes - taxes based on actual spending
Usually regressive tax systems, meaning that as infome falls the percentage of income going to the tax rises.
We try to avoid regressive taxation as much as possible as a society
Business pay income, sales, and excise taxes
Sales and Excise taxes can be paid when purchasing goods
Income taxes for businesses is based on the size of the company, with corporations paying higher than small businesses
Economists consider society to have an efficiency vs. equity trade off.
You can add equity to the system, but you’re likely to give up efficiency
With taxation, there are two types of equity:
Vertical Equity
argues that as someone’s ability to pay rises, they should pay a larger porition of the revenue collected from taxes
Horizontal Equity
argues that individuals with similar abilities to pay should contribute the same amount to the tax system, ensuring fairness in the distribution of tax burdens.
Public Provision: a modern economic concept where we collect taxes to provide goods and services (public goods)
Public goods have specific features that cause markets to be ill-equipped to efficiently distribut them in society.
Example: NYC subway transit became a public service as it was impossible to turn a profit and be availabe for all citizens
A society may also choose to tax something if the item creates burdens that are naturally compensated by the market.
This burden that is not naturally compensated is known as a negative externality/negative spillover.
Example: cigrarette smoking, as it damages the health care system and second hand smoke
Why do we tax ourselves?
To reduce negative externalities and internalize the costs associated with activities that harm others, such as pollution or unhealthy behaviors.
Social Contract: Markets are powerful, but we are there to smooth the edges when they are too sharp for civil society
Only informed citizenry can create an efficient tax system that improves social mobility and prosperity without bogging down too much the potential growth of the macroeconomy
Commodity Taxes
Can be anaylzed using supply and demand framework
Comes in Two Forms
Sales Tax - percentage based tax
Excise Tax - per unit based tax (we will focus on this one)
What are the three basic truths of commodity taxes?
1. It does not matter whether consumers or producers are taxed, the result of the tax is the same
2. A commodity tax drives a wedge between the price paid by consumers and the price recieved by producers. This creates DWL and generates tax revenue
3. The burden of a commodity tax represents the loss in consumer and producer surplus from the wedge created by the tax. The buden is determined by the relative elascities of supply and demand. Whichever side of the market is less elastic will be more burdened by the tax.
A tax does not cause the supply or demand curve to actually shift
The tax makes it appear as if that side of the market has shifted
Once a tax is implemented, we expect some consumers to be pushed out of the market and others to stop/decrease consumption
If the price elasticities between supply and demand are equal, then the tax burden will be equal as well
Tax burden = the loss in consumer or producer surplus to tax revenue and dead weight loss
If the price elasticities between supply and demand are different, then the relative tax burdens will also be different.
Whichever side is more elastic in response to the price change, is the side that will experience less of the budren
Example: Cigarette Taxes
Pigovian Taxation: a tax is placed on the product which produces the negative extanility, this naturally reduces the incentive to both produce and consume. Revenue is then used to reduce damage.
Refered to as Sin Taxes
One issue with cigarette taxes is that is affects low-income individuals as smoking is predominantely a habit among low-income households.
Cigarette Taxes are regressive
However, this regressivety can be conciled by the fact the tax revenue can offset increased health care costs for low-income individuals.
Subsidization
There are three types of subsidization
Positive Externalities
Social Welfare
Research and Development
Chapter 10 - Don’t Be Afraid of Failure
Ever Adapting Economics
Economics is a discpline that relies on models
We still utilize economic ideals like Comparative Advantage, Supply and Demand, and Marginality.
Classical & Neoclassical Assumptions
Consumers and Producers are rational, utility maximizing, profit maximizing, and information is attainable without cost
First Fundmental Welfare Theorem
suggests that competitive markets will produce Pareto optimal outcomes as long as ceteris paribus and firms are price-takers
Pareto Optimality implies both economic and social efficiency have been achieved
Free Markets are often held as the platonic ideal for economic systems
importance of government intervention, such as anti trust laws
Modern economics is only beginning to address income inequality, resource exhaustion, and environmental destruction.
Environmental Economics, Ecological Economics, Energy Economics, and Resource Economics are sub fields of economics concerned with understand and analyzing the relationship between the natural world and our economic system.
These fields are taking on more normative considerations of market failures
Health Care Economics and Financial Economics are focused on the problems of Information Asymmetries
Good Systems Align Self-Interest with Public Interest
Historically, until recently, economists treated social and economic efficiency as interchangeable.
Welfare Theorems:
Under neo classical assumptions, competitive markets are Pareto Optimal
If society is at a Pareto Optimal position, it can move to any other Pareto Optimal position through redistribution
Market Power is a Market Failure
When free markets produce DWL, they are not maximizing social welfare
There are market failures that arise because the goods have particular characteristics that prevent free markets from achieving social efficiency
Social Welfare Function
firms maximize profits, consumers utility, while collectively we will assume that society wishes to maximize its SWF
Social Contract: the process by which we as a society use policy to smooth over the rougher edges of a market economy
What are the three different types of SWF?
Utilitarian - only concerned about them selves.
Social Utilitarian - concerned with happiness of society
Rawlsian - try to make the least happy person happier
Pareto Improvement - the ability of society to increase the utility of one person or group of persons, while not harming or making any group worse off
Second Fundamental Welfare Theorem: if society is at any Pareto Optimal point, it can move to any other point by redistribution
Any uncompensated damage is inefficient
Consider damage as negative utility or negative profits
Circular Flow Model does not work because of the First Law of Thermodynamics - energy cannot be created nor destroyed, but can only change forms or be transferred
Negative Externality: when a product or activity creates benefits for one group and damages for another
markets are unable to factor their damage into the value of the good
Consumer or Producer Surplus is higher if society ignores the social damage
The circular flow is a positive feedback loop
Add in graphs of negative externalities
MD: Marginal External Damage - the external damage created by the negative externality
Private Market: The pricing signal is not accurate to reflect the True Social Cost as the external damage is not factored in. Since the producers and consumers do not experience the damage of the good.
At the socially efficient equilibrium, there is no DWL
With negative externalities, DWL exists at competitive equilibrium
Most markets have negative externalities
most markets rely on fossil fuels in their supply chain
there are many more acute forms of negative externalities, such as mercury and hazardous chemicals.
environmental degradation becomes almost impossible to avoid
The key to policy is to first establish the severity of the problem
There are two types of environmental policy:
Command and Control: policy focuses on standards, limits, and/or bans
best used when degradation is especially costly or damaging to human health
ex: leaded gasoline being removed from the market through regulatory ban
Market-based Mechanisms: policies take advantage of natural market forces to achieve social efficiency in a cost-effective manner
preferred over command and control for pollutants in which a threshold exists before the pollutant begins causing damage.
3 Types: advantage over c&c policies because do not require costly administration fees.
Pigovian Taxation: work to internalize the externality by setting the tax equal to the marginal external damage of the externality
named after Arthur pigovian
sin taxes
corrective taxation
example: cigarette tax revenue to pay for health care systems
By taxing producers, we cause them to internalize the externality and charge them for their damages (negative compensation)
Double Divended: argument of tax revenue being better than government mandating the social efficient quantity to be produced
more cost effective than a command and control mandate
Cap and Trade
Cap: the establishment of a threshold of acceptable pollution
Trade: the use of trade able pollution permits to reach threshold
If trade aspect does not exist, it is an emissions standard.
Coasian Bargaining
one of the most important factors of negative externalities is the efficiency of property rights
three features of Efficient Property Rights:
Complete: Property right matters
Enforceable: property right can be maintained
Transferable: property right can be sold
negative externalities exist bc property rights exist
without the ability to own property and able to earn profits, there is no way to assess the damages to the property
Coarse Theorem: bargaining has no cost, property rights are efficient, and there are only two entities
there is a socially efficient level of emissions
Class Action Lawsuits: shows coasian framework where a large number of individuals who are claiming damages from a very small number of defendants
Coase Theorem is not used for policy solutions, but how to model environmental damages
What are the two types of pollutants?
Fund Pollutants: emissions for which the earth has some absorptive capacity (oxides)
Stock Pollutants: emissions for which there is no absorption (plastic)
Air pollution tends to be very mobile and easily crosses city, state, and even county lines
Water pollution may be mobile if spilled into rivers which spread the pollution, and can also be stationary when spilled into lakes and water tables
For fund and some stock pollutants, there is an acceptable amount of emissions. For instance, we need some CO2 release to have an economy, so we have a social benefit to allow CO2 to exist, but to decrease it in some ways
positive Externlaities arise when the consumption and/or production of a food produces marginal external benefit
implies that others benefit from the market even when they are not involved with it
Ex: Flu Shot
A private market will under-provide the good if it has a positive e externality
A competitive private market will create not enough consumption and production relative to the Truth Social Value
TSV = U + N (u is use-value and n is non-use value)
use-value: the economic benefit of something as it’s being consumed - direct utility value
non-use-value: the value of something either from its option value or its existence value
option value refers to the value you place on the ability to enjoy something at some point in the future
existence value; refers to the value you place on something that you will never consume but still experience utility from its existence
hedonic pricing model: shows the WTP for clean air with homebuyers, which can show policy-makers the value for clean air and how to make cost-effective environmental policy
Clean air is a public good
Public goods are non-rival and non-excludable
when this occurs, private markets will behave similarly to how they do with positive externality, so they under-provide
Public goods suffer from the free-rider problem - someone is able to enjoy the benefits (non-excludable) without contributing to the good’s maintenance (turning it rival)
Common Foods
Public goods become common goods when it becomes rival
Common goods face the tragedy of the commons
resource collapse: due to the inability to prevent consumption, If costs are low enough then you may trigger this unsustainable process
ex:fisheries
because it is relatively inexpensive to catch fish, they are essentially non-excludable goods
then, as fish become less due to over fishing, the price of fish will rise. this causes the incentive to catch fish to rise, which is unsustainable
this is like a bank run in the financial industry
commons goods will not be distributed in a socially efficient manner by a private market
For goods with positive externalities, the preferred policy response would be pigovian subsidy
subsidy set equal to the marginal external benefit
When positive spill-overs are large enough that a good and its benefit becomes public, free rider problem happens
Social efficiency justifies use of public provision for maintenance of the good
ex: public education
For common goods, solution is regulation with command and control.
another option is catch share program
who was the first woman to be awarded the Nobel prize for economics?
Elinor Ostrom
popularized notion of collective action
framework of how society may overcome the collective action problems of free riding, congestion, and resource exhaustion
ex: congestion fees on vehicles for those not using subway/public transit
said even truly selfish people see the benefits of cooperative