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Term Test Three Study Package.docx

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University of Toronto St. George
Paul Cohen

Term Test Three Study Package (Micro 9-11, Macro 1-3) Chapter 9: Monopoly Rules (Government Regulation, Competition, and the Law) Natural Monopolies create a challenge for policymakers—gain the low-cost efficiencies of economies of scale, but avoid the inefficiencies of monopolies restricted output and higher price. Economies of scale—average total cost falls as quantity of output increases Natural Monopoly—technology allows only single seller to achieve lowest average total cost -Natural monopolies are based on current technology, when technology changes, natural monopoly may change to more competitive market structure Two major policies governments use to deal with challenge of natural monopoly are public ownership and regulation Crown corporations—publicly owned businesses in Canada, Achieve economies of scale, but lac of competition weakens incentives to reduce costs or innovate (Canada Post) Rate of return regulations—set price allowing regulated monopoly to just cover average total costs and normal profits 9.2 Strategic interaction among competitors complicated business decisions, creating two smart choices—one based on trust and the other based on non-trust. Game theory—mathematical tool for understanding how players make decisions, taking into account what they expect rivals to do (Nash, beautiful mind) -Gasoline pricing is a strategic decision that can be understood using game theory Prisoners dilemma—game with two players who must each make a strategic choice, where results depend on other players choice. Nash equilibrium—outcome of game where each player makes own best choice given the choice if the other player Two smart choices exists in a prisoners dilemma game; one based on non-trust and one based on trust -If other player cannot be trusted, smart choices is cheat/confess; all players driven to Nash equilibrium outcome where everyone cheats/confesses -If other player can be trusted smart choice is to cooperate/deny; all players driven to equilibrium outcome where everyone cooperates/denies -The prisoners “dilemma” is that each player (prisoner) is motivated to cheat (confess) yet both would be better off if they could trust each other to cooperate (deny). 9.3 Cartels collude to raise prices and restrict output to increase economic profits. Cartels are unstable because members can increase their individual profits by cheating on the others. Collusion—conspiracy to cheat or deceive others Cartel—association of suppliers formed to maintain high prices and restrict competition OPEC (organization of petroleum exporting countries) is international cartel that acts like a monopoly -Desirable competitive behavior—always an active attempt to increase profits and gain market power of monopoly—is hard to distinguish from undesirable collusive behavior -The Competition Act, introduced by government to prevent anti-competitive business behavior, raises expected costs to business of price fixing (through prison time, fines, legal prohibition) relative to the expected benefits (profits) -Criminal offences (punished by prison time, fines): price fixing, big rigging, false/misleading advertising -Civil offences (punished by fines, legal prohibitions): Mergers, abusing dominate market position, lessening competition, competition tribunal weighs costs of lessening competition against benefits of any increased efficiencies. 9.4 The discipline of market competition eventuality eliminates dangerous products, but in the process people may be harmed. Three major forms of government regulation in Canada address this problem. Caveat emptor (“Let the buyer beware”)—buyer alone responsible for checking quality of products before purchasing Certain products—nuclear power, medicines, poisonous insecticides-regulated by government because average consumer is not capable of knowing products quality Major forms of government regulation in Canada: government departments, government appointed agencies/boards, professional self-governing bodies. 9.5 There are two views of government regulation. The public interest view suggests government action improve market failure outcomes. The capture view suggests government actions produce government failure. Public-interest view—government regulation eliminates waste, achieves efficiency, promotes public interest Capture view—government regulation benefits regulated businesses, not public interest. Evidence mixed on government regulation—some suggests public-interest view, some supports capture view Government failure—regulation fails to serve public interest, instead benefits industry being regulated. -Sometimes market outcome, even with monopoly power, will be better than government regulation outcome if there is significant government failure. -Sometimes government outcome, especially with public interest regulations, will be better than market outcome if there is significant failure. Chapter 10: Acid Rain on Others Parades (Externalities, Carbon Taxes, Free Riders, and Public Goods) Negative or positive externalities make smart private choice different from smart choices -Smart choices require that all additional benefit and additional opportunity costs— including externalities—be counted Negative externalities (external costs)—costs to society from your private choice that affect others, but that you do not pay Positive externalities (external benefits)—benefits to society from your private choice that affect others, but that others do not pay for -Externalities occur when no clear property rights exist -When externalities exist, prices don’t accurately reflect all social cost and benefits, preventing markets from coordinating private smart choices with social smart choices. Market fail: -Producing too much of things we don’t want (second hand smoke, pollution, traffic jams) -Producing to little of things we don’t want (vaccinations, education) 10.2 To coordinate smart private choices that generate negative externalities, with smart social choices, choose the quantity of output where marginal social cost equals marginal social benefit As we reduce pollution, “efficient pollution”, balances additional environmental benefits with additional opportunity costs of reduced living standards Socially desirable amount of pollution is not zero; at some point additional opportunity costs of reduction in pollution are greater than additional benefits For any product/service that generates an externality, rule for a smart choice is: Choose quantity of output where marginal social costs equal marginal social benefit Marginal social cost (MSC) marginal private costs plus marginal external cost Marginal social benefit (MSB) marginal private benefit plus marginal external benefit Markets overproduce products/services with negative externalities; price is too low because it does not incorporate external costs. 10.3 Government policies can force polluting businesses and individuals to pay the marginal external cots of their pollution. As a result, polluters internalize their externalities/costs into their private choices, creating smart social choices -Without property rights to the environment, businesses have incentives to save money and improve profits but ignoring external costs like pollution and global warming -Governments can remedy market failures from externalities by creating social property rights to environment, making pollution illegal, penalizing polluters. Emissions tax—tax to pay external costs emissions Carbon tax—emissions tax on carbon-based fossil fuels Cap-and-trade-system—limits emissions businesses can release into environment Internalize the externality—transform external cots into costs producer must pay privately to government -By giving pollution a price reflecting marginal external cost of damage done, smart individual and business choices become smart social choices. -Carbon taxes and cap-and-trade systems are smart policies for efficient pollution, but may also be inequitable in hurting lower-income consumers most. 10.4 Positive externalities create a free-rider problem when neither buyers nor sellers are paid for external benefits their exchange creates. The market-clearing price is too high for buyers to be willing to buy the socially best quantity of output, and too low for sellers to be willing to supply Public goods—provide external benefits consumed simultaneously by everyone, no one can be excluded. -Public goods like lighthouses and national defense are extreme examples of positive externalities. -Free-rider—someone who does not have to pay for external benefits For any product/service that generates an externality, rule for a smart choice is: choose quantity of output where marginal social cost equals marginal social benefit Because of free-rider problem, markets under produce products/services with positive externalities -Price charged to buyers is too high -Price received by sellers is to low -Market price does not incorporate external benefits 10.5 Government policies can reward businesses and individuals creating positive externalities. As a result, these businesses and individuals internalize the externalities/rewards, turning smart private choice into smart social choices. Subsides and public provision are government policy tools to get everyone to voluntarily choose output where marginal social befit equal marginal social cost. Subsidy—payment to those who create positive externalities Public provision—government provision products/services with positive externalities, financed by tax revenue Subsides and public provision remove the wedge positive externalities drive between prices for buyers and for sellers, inducing individuals and businesses to voluntarily chose quantity of output best for society Chapter 11: What Are You Worth (Demand and Supply in Input Markets, and Income and Wealth Distributions) Incomes are determined by prices and quantities in input markets. In the input market of the circular flow of economic life, households supply to businesses labor, capital, and land, and entrepreneurships in exchange for wages, interest, rents, and profits. -In input markers, households are sellers and businesses are buyers. -Income—what you earn—is a flow. Flow: Amount per unit of time -Income for labor, capital, and land = price of input x quantity of input -Wealth—total value of assets you own—is a stock Stock: Fixed amount at a moment in time Entrepreneurs incomes are not determined by price x quantity. Entrepreneurs earn profits. Economic profits are a residual—what is left over from revenues after all opportunity costs of production (including normal profits) have been paid for other inputs. 11.2 For maximum profits, businesses should hire additional labor as long as labors marginal revenue product (additional benefit) is greater than wage paid for labor (additional cost) -To hire labor, businesses must pay market wage, which reflects best opportunity cost of person supplying labor, -Businesses demand for labour is derived demand—demand for output and profits business can derive from hiring labor. Marginal Products: Additional oupit from hiring one more unit of labour -When businesses hire additional labourers to work within fixed inputs, there is diminishing marginal productivity—each additional laborer has lower marginal product and previous laborer. Marginal Revenue Product: Additional revenue from selling output produced by additional laborer. -To calculate labourers marginal revenue product Multiply marginal product x price of output -Marginal revenue product diminishes for additional labourers -Rule for maximum profits for business: Hire additional hours of about (or any input) as long as marginal revenue product is greater than wage (or price of input) 11.3 Present value tells you what money earned in the future are work today. Present value compares the price you pay for today’s investment against the investments future earnings. For a smart choice, the present value of the investments future earnings should be greater than the investment price today. Present value: of a future amount of money is the amount that, if invested today, will grow as large as the future amount, taking into account earned interest. Present value = Amount of money available in (n) years ------------------------------- (1 + Interest rate) to the power of (n) -Revenues available in future not work as much as revenues today because today’s revenues earn interest Discount: reduction of future revenues for forgone interest Present value gives you a method to simply future steam of revenues from and investment to a single number today. Converts flow of future revenues into stock concept, a value at a moment in time—today—you can compare with cost today to make a smart choice. For a smart choice, the present value of investments stream of future revenues should be greater than the price of investment today. 11.4 Income for any input in inelastic supply, for example land or superstar talent, is economic rent, which is determined by demand alone. Economic rent: Income paid to any input in relatively inelastic supply. E.g.- land -For inputs like land in inelastic supply, prices effectively determined by demand alone. -For most products/services, high input prices cause high output prices -For inputs in inelastic supply, high output prices cause high input prices—high economic rents. 11.5 Government polices to address the markets unequal distributions of income and wealth involve trade-offs between efficiency and equality. -“What are you worth?” is a positive question; depends on quantities of inputs you on and prices markets place on those inputs -“What should you, or any person, be worth?” is a normative question you must answer as a citizen. -Poverty result from no owning labour skills or assets the market values, or from not getting a high enough price for what you do own. -Policy options to reduce inequality and poverty: education, training, progressive tax and transfer system. -Improving human capital through education and training addresses underlying cause of poverty: lack of inputs the market values. Human Capital: Increased earning potential from work experience, on-the-job training, and education. -Federal and provincial tax systems use progressive taxes—tax rate increases as income increases Regressive taxes: tax rate decreases as income increases Proportional (flat rate) taxes: tax rate same regardless of income. Marginal tax rate: rate on additional dollar of income Transfer payments: payments by government to household -Due to incentive effects, “A more equally shared pie may be a smaller pie” -Efficient market outcome not necessarily fair or equitable. May include (poor) people unable to pay for basic necessities like shelter, food, and medical care. -Governments can directly reduce poverty and inequality using tax and transfer system to take from rich and give to poor (Robin Hood Principle). -Costs and benefits policies to help the poor apply to different people. How you feel about Robin Hood’s mottos depends on whether you are being taken from or given too. Macro Chapter 1: Are your smart choices smart for all? (Macroeconomics and Microeconomics) 1.1 Smart microeconomic choice by individuals may or may not add up to smart macroeconomic outcomes for the economy as a whole. The key question about the relationship between microeconomic and macroeconomics is, “if left alone, do markets quickly self-adjust?” -The great recession of 2008-09 and the great depression of 1929-33 involved financial bubbles that burst, high unemployment, failing living standards, bankruptcies, as well as government policy mistakes. Macroeconomics: analyzes the performance of the whole Canadian economy and global economy—the combined outcomes of all individual microeconomic choices. Microeconomics: analyzes choice that individuals in households, individual businesses, and governments make and how those choices interact in markets. Fallacy of composition: what is true for one is not true of all; whole is greater than the sum of the parts Paradox of thrift: attempts to increase savings cause aggregate savings decrease because of galling employment and incomes. -The circular flow diagram reduces the complexity of the Canadian economy to three sets of players—households, businesses, and government’s. -Input markets determine incomes; households are the sellers businesses are the buyers -Output markets determine the value of all products/services sold; households are buyers and businesses are sellers Business cycles: ups and downs of overall economic activity. -The fundamental macroeconomic question “if left aone by government, does the price mechanisms of market economies adjust quickly to maintain steady growth in living standards, full employment and stable prices?” -“Yes” answer based on Say’s Law—supply creates its own demand. -“No” answer from John Maynard Keynes, founder of macroeconomics in 1930’s. 1.2 “If left alone, do markets quickly self-adjust?” The “yes” and “no” camps differ on the fallacy of composition, cuases of business cycles, risk of government failure versus market failure, role of government, and the political spectrum. Market failure—market outcomes fial to serve in public interest Government failure: government policy fails to serve the public interest. -“government policy fails to serve the public interest. -“Yes”—left alone markets will quickly self-adjust” camp believes Macroeconomic and microeconomic outcomes are the same External events or government policy causes business cycles Government failure is worse than market failure Government should be hands-off -“No”—Left alone, markets fail to quickly self-adjust” camp belives Fallacy of composition—macroeconomic and microeconomic outcomes different Markets cause business cycles through coordination failures, roles of money banking, and expectations. Market failure is worse than government failure. Government should be hands off. -Politicians on the right tend to be “Yes” camp, government as hands-off -Politicians on left tend to be in “No” camp, government as hands on. 1.3 The most important outcomes measures the performance of the Canadian economy are living standards (related to GDP per person), unemployment, and inflation. -Gross domestic product (GDP)—Value of al final products and services produced annually in Canada -You are unemployed if not employed and actively seeking work. Inflation: rising average prices and falling value of money. 1.4 The five groups of macroeconomic players are consumers, businesses, governments, Bank of Canada and the banking system, and the rest of the world. Each group has different choices. Consumer choices: -Spend income or save. -Buy Canadian products/services or imports. Business choices: -Investment spending—busi
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