Lecture 7

Economic Decision-Making

• Decisions by parties (buyers and sellers) revolve around

  • Marginal Benefit: The additional benefit derived from an action.

  • Marginal Cost: The additional cost incurred from an action.

• Objective of Transactions:

  • To be left better off.

  • This leads to defining economic outcomes in monetary terms.

Consumer and Producer Surplus

• Consumer Surplus: The benefit consumers get when they pay less than what they are willing to pay for a product.

• Producer Surplus: The benefit producers receive when they sell for more than their minimum acceptable price.

• Both surpluses generate Economic Surplus: The net benefit of market activity.

• Equilibrium in Markets:

  • When markets reach equilibrium, economic surplus is maximized.

  • This presents an optimal outcome for society.

Market Efficiency vs. Market Failure

• Module 5 Conclusion:

  • An efficiently functioning market maximizes societal welfare by reaching equilibrium.

• Introduction to Market Failure (Module 7):

  • Occurs when market operations lead to suboptimal societal outcomes despite equilibrium.

• Key Ideas:

  • Market failure arises when external factors prevent achieving optimal results.

  • Externalities are a key focus in understanding market failure.

Understanding Externalities

• Externalities Defined:

  • Spillover effects from market activities impacting third parties (those not directly involved).

  • Can be positive or negative:

    • Positive Externality: Benefits third parties; e.g., flu vaccinations reducing virus spread.

    • Negative Externality: Costs imposed on third parties; e.g., pollution.

• Examples:

  • Vaccination reduces risk not just for individuals getting vaccinated but also for others in society.

  • Higher education contributes positively by raising workforce productivity and lowering crime rates.

Marginal Costs and Benefits with Externalities

• Marginal Costs and Benefits Definitions:

  • Private Marginal Benefit: Benefits for those directly involved in the market.

  • Social Marginal Benefit: Includes private benefits plus external benefits.

  • Private Marginal Cost: Costs borne by the producer.

  • Social Marginal Cost: Private cost plus any external costs (e.g., pollution).

• Optimal Market Activity:

  • Occurs when social marginal benefit equals social marginal cost.

  • Without recognizing externalities, markets may reach a point of market equilibrium that is not optimal for society.

Effects of Negative Externalities

• Pollution as an Example:

  • Pollution represents a negative externality where production imposes costs on society.

  • The market may fail to account for these external costs, leading to overproduction and societal welfare loss (deadweight loss).

• Social Marginal Cost vs. Private Marginal Cost:

  • Private costs do not reflect the societal costs of pollution, hence the equilibrium point differs from the socially optimal point.

Addressing Market Failures

• Government Intervention:

  • Regulation and taxes can be tools used to correct negative externalities.

  • Examples include taxing pollution or mandating regulations to limit emissions.

• Coase Theorem:

  • Suggests that private negotiations can sometimes lead to market-based solutions for externalities if property rights are clearly defined and transaction costs are low.

Public and Private Goods

• Definitions:

  • Private Goods: Rival and Excludable (e.g., pizza).

  • Public Goods: Non-rival and Non-excludable (e.g., national defense).

• Concerns About Public Goods:

  • Free Rider Problem: Individuals may benefit from the good without paying for it, leading to underproduction.

• Examples of Public Goods:

  • National defense, which provides blanket protection without diminishing availability.

  • Governments often produce public goods to ensure availability and address free rider issues.

Pollution Management and Marginal Analysis

• Pollution Removal Decision-Making:

  • Optimal level of pollution removal is where marginal benefit of cleaning equals marginal cost of cleaning.

  • Initial efforts to remove pollution are cheaper; later efforts incur increasing costs.

• Conclusion on Economic Decisions:

  • Every economic activity and decision should be assessed based on comparing marginal benefits and costs to guide optimal resource allocation.