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Economics 101 - Course Notes (Textbook and Important Lecture Notes).docx

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Department
Economics
Course
ECON101
Professor
J.Scott Beesley
Semester
Fall

Description
Clinton Richardson Economics 101 – Notes 1. Chapter 1 – The Ten Principles of Economics 2. Chapter 2 – Thinking Like an Economist Midterm #1 – 3. Chapter 3 – Interdependence and the Gain From Trade Wednesday, 4. Chapter 4 - The Market Forces of Supply and Demand October-02-13 5. Chapter 5 – Elasticity and its Application 6. Chapter 6 – Supply, Demand, and Government Policies 7. Chapter 7 – Consumers, Producers, and the Efficiency of Markets 8. Chapter 8 – Application: The Costs of Taxation 9. Chapter 9 – Application: International Trade Midterm #2 – 10. Chapter 10 – Externalities Monday, 11. Chapter 11 – Public Goods and Common Resources November-04-13 12. Chapter 13 – The Costs of Production 13. Chapter 14 – Firms in Competitive Markets 14. Chapter 15 - Monopoly 15. Chapter 16 – Monopolistic Competition Final – Friday – 16. Chapter 17 – Oligopoly 2:00pm, December-13-13 17. Chapter 18 – The Markets for the Factors of Production 18. Chapter 20 – Income Inequality and Poverty Final Friday, December-13-13 – 2:00pm Cumulative, but much more heavily weighted on Chapters 14-18,20 . Clinton Richardson Chapter 1 – The Ten Principles of Economics Vocab 1. Scarcity – the limited nature of society’s resources 2. Economics – the study of how society manages its scarce resources 3. Efficiency – the property of society getting the most it can from its scarce resources 4. Equity – the property of distributing economic prosperity fairly among the members of society 5. Opportunity Cost – whatever must be given up to obtain some item 6. Rational People – people who systematically and purposefully do the best they can to achieve their objectives 7. Marginal Changes – small incremental adjustments to a plan of action 8. Market Economy – an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services 9. Property Rights – the ability of an individual to own the exercise control over scarce resources 10. Market Failure – a situation in which a market left on its own fails to allocate resources efficiently 11. Externality – the impact of one person’s actions on the well-being of a bystander 12. Market Power – the ability of a single economic actor (or small group of actors) to have substantial influence on market prices 13. Productivity – the quantity of goods and services produced from each hour of a worker’s time 14. Inflation – an increase in the overall level of prices in the economy 15. Business Cycle – fluctuations in economic activity, such as employment and production Principles Principle #1 – People face trade-offs • Making decisions requires trading off one goal against another • Efficiency vs. Equity • Acknowledging life’s trade-offs likely allows people and societies to make good decisions because they understand the options that they have available Principle #2 – the cost of something is what you give up to get it • Because people face trade-offs, making decisions requires comparing the costs and benefits of alternative courses of action, Principle #3 – Rational people think at the margin • Economists use the term marginal changes • Make decisions based on marginal benefits (an increase in an activities overall benefit that is caused by a unit increase in the level of that activity, all other factors stay constant) and marginal costs (the increase or decrease in the total cost of a production run for making one additional unit of an item) • Marginal decision making can help explain some questions • Goods/items that are plentiful are cheaper no matter the need for them (ex. Water) vs. goods/items that are scarce but not necessary for life are more expensive (ex. Diamonds) • Will only take action if the marginal benefit exceeds the marginal cost Principle #4 – People respond to incentives Clinton Richardson • Incentive – something that induces a person to act. (such as the prospect of a punishment or reward) • Incentives are crucial to analyzing how market works. Ex.) apple prices go up means loss of some consumers but allows more workers in the orchards • The effect of a good’s price on the behaviour of buyers and sellers in the market Principle #5 – Trade can make everyone better off • Countries always compete in trading in the world economy but this can help. • By trading with other people, people can buy a greater variety of goods and services at a lower cost • Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services Principle #6 – Markets in general are efficient and self-correcting, but subject to some fundamental limitations • Communism failed, market economy is now seen in most countries • Invisible Hand Theory – Adam Smith – the prices are the instruments with which the invisible hand directs economic activity • Supply and demand – sellers look at the price when determining how much to demand and sellers look at the price when deciding how much to supply. Principle #7 – Governments can sometimes improve market outcomes • Invisible hand can only work if government enforces law – not a fair assumption to believe everyone will live justly • Rely on government to enforce rights over things we produce • Promotes efficiency and equity • Adjust to market failure and market power. Principle #8 – A country’s standard of living depends on its ability to produce goods and services • Productivity: the quantity of goods and services produced from each hour of a workers time Principle #9 – Prices rise when the government prints too much money • Inflation – an increase in the overall level of prices in the economy • Germany – when government produces large amounts of a nations money, the prices go up Principle #10 – Society faces a short-run trade-off between inflation and unemployment • Business cycle: fluctuations in economic activity such as employment and production Principles 1-4: how to make decisions Principles 5-7: how people interact Principles 8-10: how the economy works as a whole Market limitations • Imperfect information leading to an unfair deal/no deal (Ex – Akerlof’s article about lemons) • Effects on other parties, not accounted for in the market • Too much “market power” on the part of some firms Highly unequal income distributions • The general economic finding is that most initiatives which aim at equalizing incomes tend to reduce efficiency. • This “efficiency vs equity” argument is a fundamental question in micro and macro as well Clinton Richardson How do we adjust outcomes? • Progressive income tax, welfare, guaranteed retirement incomes, subsidies to particular regions and industries, unemployment insurance, public funding of many goods and services (including education), and many other programs. • Western Europe has many adjusting assistances, USA does not, we follow in between along with the UK Chapter 2 – Thinking Like and Economist Vocab 1. Circular Flow Diagram – a visual model of the economy that shows how dollars flow through markets among households and firms 2. Product Possibilities Frontier – a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology 3. Microeconomics – the study of how households and firms make decisions and how they interact in markets 4. Macroeconomics – the study of economy-wide phenomena, including inflation, unemployment, and economic growth 5. Positive Statements – claims that attempt to describe the world as it is 6. Normative Statements – claims that attempt to prescribe how the world should be Circular Flow Diagram Clinton Richardson The Production Possibilities Frontier Economists have natural experiments; hardly ever get to perform a deliberate experiment. What is assumed in the beginning of economics? Perfect Foresight (uncertainty re returns, etc.) Perfect Competition (lots of sellers/buyers) (In one special case that is OK for many markets…) Rationality (people maximize utility) Not technical change (over moderate durations) Monopoly – only one seller Oligopoly - a very limited number of sellers In realistic situations, the core assumptions that we use in first year micro are indeed unrealistic. Despite that they are the only sensible place to start. Production Possibilities Frontier or PPF – a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology Microeconomics • Invest? • Households and firms • Consumption vs. saving Macroeconomics • Work vs. goof off? • The whole economy • Have kids or not? • Unemployment, inflation • Who works, how much? • Growth, trade, tariffs • Firm: produce more or less • Social welfare, transfers • Change prices? • Taxes, interest rates Clinton Richardson • Public goods • Industrial policy Positive Economics – if interest rates are raised the economy will slow. Normative Economics – the Bank of Canada should not raise rates. The best economists are not, in my view, shy about policy, but they should always separate positive and normative. Chapter 3 – Interdependence and the Gains from Trade Vocab 1. Absolute Advantage – the comparison among producers of a good according to their productivity 2. Opportunity Cost – whatever must be given up to obtain some item 3. Comparative Advantage – the comparison among producers of a good according to their opportunity cost 4. Imports – goods and services produced abroad and sold domestically 5. Exports – goods and services produced domestically and sold abroad Comparative Advantage: The Driving Force of Specialization • Economists use the term absolute advantage when comparing the productivity of one person, firm, or nation to that of another • The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good • Rather than comparing inputs required, we can also compare the opportunity costs • Opportunity cost of some item is what we give up to get that item • The opportunity cost measures the trade-off between two different goods that each producer faces • Economists use the term comparative advantage when describing the opportunity cost of two producers • The producer who gives up less of other goods to produce good X has the smaller opportunity cost of producing good X and is said to have a comparative advantage in producing it Wednesday, September-11-13 Economics 101/102 Tutor Centre Tory 8-28 • Mon, Wed, Fri – 9:00am – 3:00pm • Tues, Thurs – 9:30am – 2:00pm Clinton Richardson Chapter 4 - The Market Forces of Supply and Demand Vocab 1. Market – a group of buyers and sellers of a particular good or service 2. Competitive Market – a market in which there are many buyers and many sellers so that each has a negligible impact on the market price 3. Quantity Demanded – the amount of a good that buyers are willing and able to purchase 4. Law of Demand – the claim that, other things equal, the quantity demanded of a good falls when the price of the good rises 5. Demand Schedule – a table that shows the relationship between the price of a good and the quantity demanded 6. Demand Curve – a graph of the relationship between the price of a good and the quantity demanded 7. Normal Good – a good for which, other things equal an increase in income leads to an increase in demand 8. Inferior Good – a good for which, other things equal an increase in income leads to a decrease in demand 9. Substitutes – two goods for which an increase in the price of one leads to an increase in the demand for the other 10. Complements – two goods for which an increase in price of one leads to a decrease in the demand for the other 11. Quantity Supplied – the amount of a good that sellers are willing and able to sell 12. Law of Supply – the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises 13. Supply Schedule – a table that shows the relationship between the price of a good and the quantity supplied 14. Supply Curve – a graph of the relationship between the price of a good and the quantity supplied 15. Equilibrium – a situation in which the price has reached the level where quantity supplied equals quantity demanded 16. Equilibrium Price – the price that balances quantity supplied and quantity demanded 17. Equilibrium Quantity – the quantity supplied and the quantity demanded at the equilibrium price 18. Surplus – a situation in which quantity supplied is greater than quantity demanded 19. Shortage – a situation in which quantity demanded is greater than quantity supplied 20. Law of Supply and Demand – the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for the good into balance What is a Market? Clinton Richardson • A market is a group of buyers and sellers of a particular good or service. The buyers as a group determine the demand for the product, and the sellers as a group determine the supply of the product • Markets take many forms – some markets are highly organized and some are less organized What is Competition? • Price and quantity are determined by all buyers and sellers as they interact in the marketplace • Markets are perfectly competitive. To reach this highest form of competition, market must have two characteristics: (1) the goods offered for sale are all exactly the same, and (2) the buyers and sellers are so numerous that no single buyer or seller has any influence over the market price. The Demand Curve: The Relationship between Price and Quantity Demanded • Because the quantity demanded falls as the price rises and rises as the price falls, we say that the quantity demanded is negatively related to the price. This is known as the Law of Demand Market Demand vs. Individual Demand • Market demand is the sum of all individual demands for a particular good or service Shifts in the Demand Curve • Income – the wealth effect can shift the demand curve much like changes in income can • Prices of related goods • Tastes • Expectations – your expectations about the future may affect your demand for a good or service today • Number of Buyers The Supply Curve: The Relationship between Price and Quantity Supplied • Because the quantity supplied rises as the price rises and falls as the price falls, we say that the quantity supplied is positively related to the price of the good Market Supply vs. Individual Supply • Market supply is the sum of the supplies of all sellers Shifts in the Supply Curve • Inputs – the supply of a good is negatively related to the price of the inputs used to make the good • Technology – technology for turning the inputs into the good is another determinant of supply • Expectations • Number of Sellers – market supply depends on all those factors that influence the supply of individual sellers Supply and Demand Together • Equilibrium – a situation in which the price has reached the level where quantity supplied equals quantity demanded Clinton Richardson Chapter 5 – Elasticity and its Application The Price Elasticity of Demand and Its Determinants • Elasticity – a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants • Price elasticity of demand – a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price • Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price • Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price • Availability of close substitutes, necessities versus luxuries, definition of the market, time horizon are general rules that effect price elasticity Computing the Price Elasticity of Demand percentagechange∈quantitydemanded • priceelasticityof demand= percentage change∈price • All price elasticities are represented as positive numbers The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities • The standard way to compute a percentage change is to divide the change by the intial level. By contrast, the midpoint method computes a percentage change by dividing the change by the midpoint (or average) of the initial and final levels. Clinton Richardson Q2+Q1 (Q1−Q2)/[ 2 ] • priceelasticityof demand= (P2−P1)/[ P2+P1 ] 2 The Variety of Demand Curves • Demand is elastic when the elasticity is greater than 1, so that quantity moves proportionately more than the price. • Demand is inelastic when the elasticity is less than 1, so that quantity moves proportionately less than the price. • If the elasticity is exactly 1, so that quantity moves the same amount proportionately as price, demand is said to have unit elasticity • The flatter the demand curve that passes through a given point, the greater the price elasticity of demand • The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand Total Revenue and the Price Elasticity of Demand • Total Revenue – the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold P×Q=Revenue • • When demand is inelastic (price elasticity less than 1), price and total revenue move in the same direction • When demand is elastic (price elasticity greater than 1), price and total revenue move in opposite directions • If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes Elasticity and Total Revenue along a Linear Demand Curve • Although the slope of a linear demand curve is constant, its elasticity is not. • Low price and high quantity = inelastic • High price and low quantity = elastic Income Elasticity of Demand • A measure of how much the quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income percentagechange∈quantitydemanded • Incomeelasticityof demand= percentagechange∈income • Normal goods have positive income elasticities • Inferior goods have negative income elasticities The Cross-Price Elasticity of Demand • A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good Clinton Richardson percentagechange∈quantitydemandedof good1 • cross priceelasticityof demand= percentagechange∈priceof good2 • Substitutes have positive cross-price elasticity • Complements have negative cross-price elasticity The Elasticity of Supply • The price elasticity of supply measures how much the quantity supplied responds to changes in the price change∈quantity supplied • priceelasticityof supply= change∈price • Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the price • Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the price percentagechange∈quantity supplied • Priceelasticityof supply= percentagechange∈price Chapter 6 – Supply, Demand, and Government Policies We have covered supply and demand equilibrium without any restrictions/constraints. We now need to consider possible restrictions (price ceiling, price floor, the imposition of a tax) Controls on Prices • Price Ceiling – a legal maximum on the price at which a good can be sold • Price Floor – a legal minimum on the price at which a good can be sold How Price Ceilings Affect Market Outcomes Clinton Richardson • When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers How Price Floors Affect Market Outcomes Evaluating Price Controls • Economists usually oppose price ceilings and price floors because one of the ten principles of economics is that markets are usually a good way to organize economic activity • Price controls are often aimed at helping the poor, but sometimes hurt those they are trying to help Taxes • Tax incidence – the manner in which the burden of a tax is shared among participants in a market • When a good is taxed, buyers and sellers share the burden of the tax Clinton Richardson Chapter 7 – Consumers, Producers, and the Efficiency of Markets One of the basic tools of analysis is deciding whether or not to intervene in a market is the use of consumer and producer surplus Welfare Economics – the study of how the allocation of resources affects economic well-being Consumer Surplus Willingness to Pay • The maximum amount that a buyer will pay for a good • Consumer surplus – a buyer’s willingness to pay for a good minus the amount the buyer actually pays for it Using the Demand Curve to Measure Consumer Surplus • Because the demand curve reflects buyers’ willingness to pay, we can also use it to measure consumer surplus • The area below the demand curve and above the price measures the consumer surplus in a market What Does Consumer Surplus Measure? • Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it • Consumer surplus is a good measure of economic well-being if the policymakers want to respect the preferences of buyers • Economists normally presume that buyers are rational when they make decisions and that their preferences should be respected. In this case, consumers are the best judges of how much benefit they receive from the goods they buy Cost and the Willingness to Sell • Cost – the value of everything a seller must give up to produce a good • Producer surplus – the amount a seller is paid for a good minus the seller’s cost of production Using the Supply Curve to Measure Producer Surplus • At any quantity, the price given by the supply curve shows the cost of the marginal seller, the seller who would leave the market first if the price was any lower • Because the supply curve reflects sellers’ costs, we can use it to measure producer surplus • The area below the price and above the supply curve measures the producer surplus in a market The Benevolent Social Planner Consumersurplus=value¿buyers−amount paidbybuyers • Producer surplus=amount receivedby sellers−cost ¿sellers • Clinton Richardson • Totalsurplus=value¿buyers−cost¿sellers • Efficiency – the property of a resource allocation of maximizing the total surplus received by all members of society • Equity – the fairness of the distribution of well-being among the members of society Evaluating the Market Equilibrium • The total area between the supply and demand curves up to the point of equilibrium represents the total surplus in a market • Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay • Free markets allocate the demand for goods to the sellers who can produce them at least cost • Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus • Laissez-faire refers to “allow them to do” and is a policy of leaving the market outcome just as it is Market Efficiency and Market Failure • Forces of supply and demand allocate resources efficiently • Analysis assumes that markets are perfectly competitive • Analysis assumes that the outcome in a market matters only to the buyers and sellers in that market Tax Avoidance (Evasion) 1. Hiding personal consumption in business expenses 2. Not reporting revenue at all 3. Property transfer tax – not reporting transaction at all 4. Capital gains – labour income treated as capital gains 5. Capital gains not reported 6. Paying your spouse for being hot – splitting income 7. Corporate – transfer of pricing 8. Barter (farmers) Chapter 8 – Application: The Costs of Taxation The Deadweight Loss of Taxation • When a tax is enacted, the price paid by buyers rises, and the price received by sellers falls. In the end, buyers and sellers share the burden of the tax, regardless of how it is levied • A tax on a good causes the size of the market for the good to shrink How a Tax Affects Market Participants Clinton Richardson T ×Q • Government gets a total tax revenue of Changes in Welfare • The change in total welfare includes the change in consumer surplus (which is negative), the change in producer surplus (which is also negative), and the change in tax revenue (which is positive) • The losses to buyers and sellers from a tax exceed the revenue raised by the government • Deadweight loss – the fall in total surplus that results from a market distortion, such as a tax Welfare with and without a tax: Clinton Richardson Deadweight Losses and the Gains from Trade • Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade • When the government imposes a tax on a good, quantity sold falls. As a result, some of the potential gains from trade among buyers and sellers do not get realized. These lost gains from trade create the deadweight loss The Determinants of Deadweight Loss • Price elasticities of supply and demand, which measure how much the quantity supplied and quantity demanded respond to changes in price determine whether the deadweight loss from a tax is large or small • A tax has a deadweight loss because it induces buyers and sellers to change their behaviour. The tax raises the price paid by buyers, so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less. Clinton Richardson Because of these changes in behaviour, the size of the market shrinks below the optimum • The greater the elasticities of supply and demand, the greater the deadweight loss of a tax Deadweight Loss and Tax Revenue as Taxes Vary • The deadweight loss is the reduction in total surplus due to a tax. • Tax revenue is the amount of the tax times the amount of the good sold Laffer Cuve: Chapter 9 - Application: International Trade The Determinants of Trade The Equilibrium without Trade • When an economy cannot trade in world markets, the price adjusts to balance domestic supply and demand The World Price and Comparative Advantage • World Price – the price of a good that prevails in the world market for that good • Trade is beneficial because it allows each nation to specialize in doing what it does best • By comparing the world price and the domestic price before trade, we can determine whether a country is better or worse at producing an item than the rest of the world The Winners and Losers from Trade The Gains and Losses of an Exporting Country • Trade forces the domestic price to rise to the world price • After trade is allowed, consumer surplus is the area between the demand curve and the world price Clinton Richardson • After trade is allowed, producer surplus is the area between the supply curve and the world price i • When a country allows trade and becomes an exporter of a good, domestic producers of the good are better off, and domestic consumers of the good are worse off • Trade raises the economic well-being of the nation in the sense that the gains of the winners exceed the losses of the losers Clinton Richardson The Gains and Losses of an Importing Country • Once trade is allowed, the domestic price falls to equal the world price • When a country allows trade and becomes an importer of a good, domestic consumers of the good are better off, and domestic producers of the good are worse off • Trade raises the economic well-being of a nation in the sense that the gains of the winners exceed the losses of the losers The Effects of a Tariff • Tariff – a tax on goods produced abroad and sold domestically Clinton Richardson • A tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade • A tariff causes a deadweight loss simply because it is a type of tax Other Benefits of International Trade • Increased variety of goods – goods produced in different countries are not exactly the same • Lower costs through economies of scale – some goods can be produced at low cost only if they are produced in large quantities • Increased Competition – opening up trade fosters competition and gives the invisible hand a better chance to work its magic Clinton Richardson • Enhanced flow of ideas – the transfer of technological advances around the world is often thought to be linked to the trading of the goods that embody those advances The Arguments for Restricting Trade • The jobs argument – opponents of free trade often argue that trade with other countries destroys domestic jobs • The national-security argument – when an industry is threatened with competition from other countries, opponents of free trade often argue that the industry is vital for national security • The infant-industry argument – new industries sometimes argue for temporary trade restrictions to help them get started • The unfair-competition argument – a common argument is that free trade is desirable only if all countries play by the same rules • The protection-as-a-bargaining-chip argument – another argument for trade restrictions concerns the strategy of bargaining Chapter 10 – Externalities Externalities and Market Inefficiency • Externality – the uncompensated impact of one person’s actions on the well- being of a bystander • If the impact on the bystander is adverse, it is called a negative externality; if it is beneficial, it is called a positive externality. • In many cases, some decision maker fails to take account of the external effect of his or her behaviour. The government responds by trying to influence this behaviour to protect the interests of bystanders Welfare Economics: A Recap • In the absence of government intervention, the price adjusts to balance the supply and demand for an item Negative and Positive Externalities • We can measure the value of increase in economic well-being using the concept of deadweight loss Clinton Richardson • Internalizing the externality – alter incentives so that people take account of the external effects of their actions • Negative externalities lead markets to produce a larger quantity than is socially desirable • Positive externalities lead markets to produce a smaller quantity than is socially desirable • To remedy the problem, the government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities Clinton Richardson Public Policies toward Externalities • Command and control policies regulate behaviour directly • Market based policies provide incentives so that private decision makers will choose to solve the problem on their own Market-Based Policy 1: Corrective Taxes and Subsidies • Corrective taxes – taxes enacted to correct the effects of negative externalities (pigovian) • Although regulation and corrective taxes are both capable of reducing pollution, the tax accomplishes this more efficiently • Corrective taxes alter incentives to account for the presence of externalities and thereby move the allocation of resources closer to the social optimum. Thus, while corrective taxes raise revenue for the government, they also enhance economic efficiency Market-Based Policy 2: Tradable Pollution Permits • One advantage of allowing a market for pollution permits is that the initial allocation of pollution permits among firms does not matter from the standpoint of economic efficiency Clinton Richardson Objections to the Economic Analysis of Pollution • The lower the price of environmental protection, the more the public will want it • The economic approach of using pollution permits and corrective taxes reduces the cost of environmental protection and should, therefore, increase the public’s demand for a clean environment Private Solutions to Externalities The Types of Private Solutions • Moral codes and social sanctions • Charities • Integration of different types of businesses • Interested parties to enter into a contract The Coase Theorem • The proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own • The coase theorem says that private economic actors can solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient Why Private Solutions Do Not Always Work • Transaction costs – the costs that parties incur in the process of agreeing and following through on a bargain • The coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement Clinton Richardson • When private bargaining does not work, the government can sometimes play a role Conclusion • The invisible hand is powerful but not omnipotent • A market’s equilibrium maximizes the sum of producer and consumer surplus • When there are external effects, evaluating a market outcome requires taking into account the well-being of third parties as well • Invisible hand of the marketplace may fail to allocate resources efficiently • The coase theorem suggests that the interested parties can bargain among themselves and agree on an efficient solution • When people cannot solve the problem of externalities privately, the government often steps in • Corrective taxes are designed to internalize the externality Chapter 11 – Public Goods and Common Resources The Different Kinds of Goods • Excludability – the property of a good whereby a person can be prevented from using it • Rival in Consumption – the property of a good whereby one person’s use diminishes other people’s use • Private Goods – goods that are both excludable and rival • Public Goods – goods that are neither excludable nor rival • Common Resources – goods that are rival but not excludable • Natural Monopoly Public Goods The Free-Rider Problem • Free Rider – a person who receives the benefit of a good but avoids paying for it • Because public goods are not excludable, the free-rider problem prevents the private market from supplying them • If the government decides that the total benefits exceed the costs, it can provide the public good and pay for it with tax revenue, making everyone better off Clinton Richardson Some Important Public Goods • National Defence • Basic Research • Fighting Poverty The Difficult Job of Cost-Benefit Analysis • Cost-Benefit Analysis – a study that compares the costs and benefits to society of providing a public good • The efficient provision of public goods is more difficult than the efficient provision of private goods Common Resources The Tragedy of the Commons • Common resources are rival in consumption: one person’s use of the common resource reduces other people’s ability to use it • Tragedy of the Commons – a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole • When one person uses a common resource, that person diminishes other people’s enjoyment of it. Because of this negative externality, common resources tend to be used excessively •
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