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Economics Study for Final.docx

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University of Toronto St. George
Avi Cohen

MICRO ECONOMICS STUDY SHEET LAW OF DEMAND – P$ QD QS LAW OF SUPPLY – P$ QS QD Focuses on marginal benefit – Focuses on marginal (additional) cost - Willingness and ability to pay. Price has to cover cost of production. Consumers economize when products Become more expensive. CONSTANT The only thing that changes is price which impact QD & QS (movement along the demand/supply curve line) If other factors change – do not remain Constant law of demand and supply do not hold true DEMAND AND SUPPLY DEMAND (PIENP) SUPPLY (TP PEN) (shift in demand curve) (Shift in supply curve) Influenced by the following factors: Influenced by the following factors:  Preferences D - Technology Improvements S  Income D Normal Goods (Ipods) - Price of Inputs * S costs more to produce D Inferior Goods (Kraft D, jeans)- Price of related productsS  Expected future Prices D (buy now) (produced with same inputs)  Number of Consumers D eg. fall in $ nails will increase Supply piercings  Price of related products: - Expected future Prices S hold off until $ Substitutes $ D - Number of Businesses S Complements $ D * price of inputs (cost of labour, hydro) (price of gas goes up D for big cars goes down) ($Price of hot dogs goes down D for buns goes up) DEMAND DEMAND changes with consumers’ willingness & ability to pay – depends on cost and availability of substitutes. Preference also plays a role in terms of how badly you want something (intensity). Demand is changed by other influences (above) on consumer choice – changes with preference, Income, expected future price, number of consumers and prices of related goods. Quantity Demanded – amount you actually plan to buy at a given price – is only changed by price. Market Demand – Sum of demands of all individuals willing and able to buy a particular product/service. Marginal benefits – additional benefits from next choice (at the margin) which changes with circumstances. The value you place on an activity/thing depends on the margin, and that additional value is the marginal benefit. (eg. May not choose to study tonight if test is in a week vs. test tomorrow – value changes with circumstances.)  Marginal benefit decreases as you buy more  Marginal benefit is the satisfaction you get/Marginal cost is the $ you pay  Explains the Water/Diamond Paradox – Willingness to pay depends on marginal benefit, not total benefit. Water is abundant – marginal benefits is low. Diamonds are scarce – marginal benefit is high. Marginal opportunity costs – additional opportunity costs from the next choice. Implicit costs – opportunity costs of investing your own money or time (eg. Go to university – costs of not working and books have to buy) Negative or Positive Externalities – costs or benefits that affect others external to a choice or trade (eg. Negative – second-hand smoke, Positive – going to university – good for society). SUPPLY SUPPLY changes with a businesses’ willingness to produce a product at a certain price that covers all opportunity costs of production. Quantity Supplied – quantity you plan to supply at a given price Market Supply – sum of supplies of all businesses willing to produce a particular product/service. Marginal Opportunity Cost – any cost relevant to a smart decision. All opportunity costs are marginal costs and all marginal costs are opportunity costs. Marginal benefits – is measured in $ Marginal Cost - Additional opportunity cost of increasing quantity supplied & changes with circumstances . To buy inputs, business must pay price matching best opportunity cost of input owner  Marginal opportunity cost increases as you increase quantity supplied – businesses must pay higher prices to obtain more inputs because opportunity costs change with circumstances & not all inputs are equally productive in all activities – not all workers have same skills (piercings and nails). Where inputs are = productive - Marginal opportunity costs are constant.  Marginal costs of additional inputs like labour are ultimately opportunity costs – the best alternative use of an input (eg. When you work, you are supplying time and the marginal cost of your time increases as you increase quantity of hours supplied). Differences between smart supply choices and smart demand choices:  Supply choice: o Marginal cost - increases as you supply more (eg. Opportunity cost of time) o Marginal benefit – measured in $ (eg. Wages you earn)  Demand choice: o Marginal cost is measured in $ (price you pay) o Marginal benefit - decreases as you buy more and is the satisfaction you get Sunk costs - past expenses that cannot be recovered  same no matter which fork in the road you take, so no influence on smart choices  not part of opportunity costs THREE KEY MAPS TO MAKING SMART CHOICES 1. Choose only when additional benefits are greater than additional opportunity costs 2. Count only additional benefits and additional opportunity costs 3. Be sure to count all additional benefits and costs , including implicit costs and externalities.  Failure to consider external costs will result into much of that activity.  Opportunity cost is the single most important concept both in economics and for making smart choices in life. Because of scarcity (scarcity exists because of limited money, time & energy), every choice has a trade-off – true cost to every choice  Three Keys do not set your personal values and political views. But once you decide on a political or social goal based on your values, economic thinking helps identify smart policy or personal choices for most efficiently achieving your goals. Opportunity Cost = Give Up Get GAINS FROM TRADE The key to understanding why comparative advantage - specializing and trading makes us all better off – mutually beneficial gains from trade (does not have to be equivalent – but both parties must gain from trade) Comparative Advantage: ability to produce at a lower opportunity cost Absolute Advantage: ability to produce at a lower absolute cost Production Possibilities Frontier (PPF) – Graph showing the maximum combinations of products that can be produced with given inputs and technology (below is not PPF graph – see summary Chapter 1) Jacqueline Bread Jacqueline Wood Samantha Bread Samantha Wood 50 0 40 0 40 20 30 5 30 40 20 10 20 60 10 15 10 80 0 20 0 100 - Samantha produces 40 bread - Jacqueline produces 100 wood - They Trade 20 bread for 20 wood - Jacqueline ends up with 20 bread and 80 wood (Produces 100 – 20 = 80 wood and gets 20 bread through trade) (compared to her original 20 bread and 60 wood) - Samantha ends up with 20 bread and 20 wood (Produces 40 -20= 20 bread and gets 20 wood through trade) (compared to her original 20 bread and 10 wood) Both are better off with specializing and trading ELASTICITY OF DEMAND Elasticity measures how responsive QD is to change in price$ and determines business pricing strategies to earn maximum total revenue ( Price (P) per unit x Quantity(Q) sold. Smart businesses choose their price points depending on how much consumers’ quantity demanded responds to change in price. To earn maximum total revenue:  When demand is ELASTIC - businesses will cut prices to increase total revenue (large response in QD when price rises – high willingness to shop somewhere else) eg. Demand for yellow tennis balls – will buy green tennis balls instead at lower price  When demand is INELASTIC – businesses will raise prices to increase total revenue (small response in QD when price rises – low willingness to shop elsewhere) To measure consumer responsiveness – formula: Price elasticity of demand =% change in QD % change in $P Value is: Elastic – more than 1 Demand is elastic when % increase in quantity is greater than% decrease in $Price – total revenue increases Inelastic if less than 1 Demand is inelastic if % increase in quantity is less than % decrease in $Price – total revenue decreases Eg. If insulin QD changes by 2% and increases price by 100% = _ 2%__ = .02 under 1 so inelastic 100% 3 Variables that will influence elasticity of demand:  Substitutes – more substitutes the more elastic  Time to adjust –the more time to adjust to price change the more elastic  Proportion of Income Spent of Product/Service – greater proportion of income spent the more elastic (willing to shop around more to get a better deal on big ticket purchases such as cars) If a box of baking soda doubles its price from 30 cents to 60 cents – not big impact – inelastic ELASTICITY OF SUPPLY Elasticity of supply measures how responsive quantity supplied is to change in price, and depends on the difficulty, expense, and time involved in increasing production. It allows accurate projections of future outputs and prices helping businesses avoid disappointed customers. 2 variables that influence Elasticity of Supply:  Availability of additional Inputs (inputs are employees, machinery) - the more available inputs – the more elastic supply  Time Production Takes – less time the more elastic supply If businesses can easily and inexpensively increase production (eg. Snow shovelling services) – more elastic; however, if they find it difficult and expensive (eg. Mining gold deposits) – more inelastic Elasticity of supply measures how much quantity supplied responds to a change in price. To measure how responsive supply is to change – formula: Price elasticity of Supply = % change in QS % change in $P Value is: Inelastic Supply: less than 1 Small response in quantity supplied when price rises o Examples — supply mined gold Elastic Supply: more than 1 Large response in quality supplied when price rises Eg. Snow shovelling services COORDINATING DEMAND AND SUPPLY Markets connect competition between buyers, competition between sellers, and cooperation between buyers and sellers. Governments guarantees of property rights allow markets to function. What is a Market – it is the interactions of buyers and sellers (not a physical place) – it is a process o Purchases/Sales are voluntary trade – exchange between buyer and seller – both sides end up better off o Competing bids and offers- $ is the outcome o Sellers better off when price received is at least as great as marginal opportunity cost o Competition between buyers o Competition between sellers o Cooperation and voluntary exchange between buyers and sellers Property Rights – legally enforceable guarantees of ownership of physical, financial and intellectual property. Government sets the roles of the game defining & enforcing property rights necessary for free and voluntary exchange. Shortage or Excess Demand— Shortages – competition between buyers drive prices$ up Surpluses – competition between sellers drives prices$ down Market prices too low (frustrated buyers – not enough product): o shortage/excess demand – create pressure for $ to rise o Rising prices provide signals and incentives for businesses to increase quantity supplied and for consumers to decrease quantity demanded, eliminating the shortage Market prices too high (frustrated sellers – can’t sell product at current price have to lower $): o Surplus/excess supply – creates pressure to lower prices o Falling prices provide signals and incentives for business to decrease quantity supplied and for consumers to increase quantity demanded eliminating the surplus Even when prices don’t change, shortages and surpluses create incentives for quantity adjustments to better coordinate smart choices of businesses and consumers – prices settle at particular numbers due to the interaction or demand and supply Market Clearing Prices – coordinate smart choices of consumers and businesses, balancing quantity demanded and quantity supplied. Equilibrium price – price that balances forces of competition and cooperation. Price signals in markets create incentives – when each person acts only in own self-interest, result is coordinated through Adam Smith’s invisible hand of competition – miracle of continuous, ever-changing production of products we want – unintended consequence of competition WHEN DEMAND AND SUPPLY CHANGE Market- clearing prices and quantities change. The price changes cause businesses and consumers to adjust their smart choices. Well-functioning markets supply the changes products and services demanded. o Change in Demand (caused by preferences, income, expected future prices, number of consumers, prices of related products)  Increase in Demand causes rise in market-clearing prices and increase in QS  Decrease in Demand causes a fall in market-clearing prices and a decrease in QS o Change in Supply (caused by change in technology, prices of inputs, prices of related products, expected future prices, number of businesses)  Increase in Supply causes a fall in market-clearing price and increase in QD  Decrease in Supply causes a rise in market-clearing price and deacrease in QD D MC$ QS D MC$ QS S MC$ QD S MC$ QD Price and Quantity changes are a result (not the cause) of economic events – no variables changing (like above). Always identify what is changing the product or effecting the change in a product. Advantages of market systems (Adam Smith) o ‘division of labor’ allows individuals, businesses, countries to specialize, increasing productive capacity o provide incentives for investments and innovations — rising productivity, wages and living standards Markets rely on self-interest, avoiding need for central coordination. PRICES, GOVERNMENT CHOICES, MARKETS, EFFICIENCY AND EQUITY Policy talks a lot about efficiency vs equity and trade-offs. GOVERNMENT FIXING PRICES When government fixes prices, quantities adjust – choices of consumers and businesses are not coordinated – quantity supplied no longer = quantity demanded -- MISMATCH. Either consumer or business will be frustrated with supply. Make it illegal to charge a higher price – can no longer coordinate price – there are usually better solutions than fixing prices. When price is fixed below market-clearing:  Shortage – QD > QS and consumers are frustrated  Quantity sold = QS only  Businesses will supply less at lower $ creating shortage = frustrated consumers When price is fixed above market-clearing:  Surplus – QS > QD and businesses are frustrated  Quantity sold = QD only  Businesses are willing to supply, but consumers won’t buy – consumers look for substitutes or reduce usage Governments can fix prices, but they can’t force businesses to produce or consumers to buy at that fixed price. Businesses can reduce output or move resources elsewhere. Consumers can reduce purchases or buy something else (substitute). RENT CONTROLS (eg. of PRICE-CEILING - set below market-clearing – cause Shortage) Rent controls fix rents below market-clearing levels and quantity adjustment takes the form of apartment shortages. The unintended consequences are reduced quantity of housing supplied and subsidized well-off tenants. All price ceilings are below equilibrium $ - buinsess will supply less because can not adjust $ - shortage – frustrated consumers. Governments benefit from fixing prices as they don’t have to spend $ and look like that are doing something to resolve issue of affordability/helping less fortunate (political PR). Rent controls sometimes justified by Robin Hood principle – take from the rich (landlords) and give to the poor (tenants). Rent controls are examples of PRICE CEILING – max price set by government making it illegal to charge higher price. Rent controls have unintended/undesirable consequences:  Create housing shortages – gives landlords upper hand over tenants (eg. Can discriminate on who they choose as tenants, let buildings deteriorate, charge tenants to fix things, may shift to developing condos).  Subsidize well-off tenants willing and able to pay market-clearing rents. Alternative policies to help homelessthat do not sacrifice market flexibility are:  Government subsidies to help those who can not affort to pay rent.  Government-supplied housing (building housing) These would cost the government $ (come from tax payers) – trade-off All policies have an opportunity cost – trade-off. MINIMUM WAGE (eg. of PRICE FLOOR – set above market-clearing – cause Surplus) Minimum wage laws fix wages above market-clearing levels and quantity adjustment take the form of a surplus of workers. The benefits of these laws is higher wages to the employed, but the unintended consequence is fewer are employed. Quantity of labour supplied by households will be greater than quantity of labour demanded by businesses – creating unemployment. As wages rise less hours supplied – surplus of workers. Minimum wage laws eg. of PRICE FLOOR minimum set by government making it illegal to pay a lower price. There used to be differences in min wage for men and women as men were seen as bread- winners of family. Living Wage – estimated at $10/hour defined to be enough to allow an individual in Canada to live above poverty line. When prices are fixed and can not adjust it creates issues with Supply:  Price-Floor - fixed above market-clearing – surplus – frustrated businesses can not sell  Price-Ceiling - fixed below market-clearing- shortage – frustrated consumers – not enough supplied Setting Min wage above market clearing Fixing Rents below market clearing Quantity of unemployment created by raising min wage depends on elasticity of business demand for unskilled workers:  Inelastic – when demand for unskilled labour – few substitutes- when rise in minimum wages produces small response when decrease in quantity demanded.  Elastic – when businesses can easily substitute demand for unskilled labour with machines – rise in min wages produces large response in decrease of quantity demanded. Total Revenue Test - for businesses in Output Markets – PxQ= total revenues – if inelastic (few substitutes) then increase total wages – increase total revenue -- if elastic must decrease total wages – in order to decrease total revenue Minimum wages help the working poor if gains from workers who remain employed and whose incomes go up are greater than losses of incomes of workers who lose their jobs. GAINS>LOSSES Alternative Policies to help working poor that do not sacrifice flexibility of market:  Training programs – help unskilled workers get higher paying jobs  Wage supplements Again, more expensive to government – increase taxes – trade-off. All policies have opportunity costs. EFFICIENCY VS. EQUITY TRADE-OFFS The outcomes of well-functioning markets, while efficient are not always equitable. Government may choose policies that create more equitable outcomes, even though it may mean less efficient as a trade- off. In well-functioning markets that produce products we value – go to those most willing and able to pay. Efficient market outcomes may not be fair or equitable. Efficient market outcome – coordinates choices of businesses and consumers so outputs produced at lowest cost (prices just cover all opportunity costs of production) and consumers buy and get biggest bang for their buck (marginal benefit is greater than price). 2 Types of consumers who do not buy at market clearing prices are:  Unwilling because marginal benefit is less than price – even though they could afford to buy  Unable to afford – even though they would be willing to buy (marginal benefit greater than price) Allowing markets to operate without government interaction – has opportunity cost – unfair, inequity, or inequality. Trade-off between efficiency and equity.  US health care – private market – outcome efficient but less fair/equitable – people are refused or do not have health care  Canadian style health care system – public – more equitable – access to health care for everyone – trade-off – less efficient – longer wait times Left-Winged Government (Equal Outcomes)  equity over efficiency  everyone should have same amount in the end Right-Winged Government (Efficient Outcomes)  efficiency over equity  everyone has the same opportunity/chance at the start POSITIVE VS. NORMATIVE STATEMENTS Positive Statements: are empirical statements about what is; can be evaluated to be true or false by checking facts. Normative Statements: (Norm – standard) involve judgement or opinions which depend on values, standards or ethics – about what you believe should be. Can not be evaluated as true or false. Usually use word “should” OPPORTUNITY COSTS, ECONOMIC PROFITS ANDLOSSES AND MIRACLE OF MARKETS COSTS AND PROFITS Accounting profits = revenues – all obvious costs, including depreciation Accounting profits miss hidden, implicit and opportunity costs of business owner’s time and money. Obvious Costs (explicit costs) – costs a business pays directly – depreciation(spreading cost over lifetime of long-lasting equipment – decrease in value due to wear and tear/become obsolete), hydro, rent, labour, advertising, phone, web-hosting , etc. Implicit Costs (hidden costs) – what a business owner could earn elsewhere with time and money (opportunity cost of time – best alternative use of time, opportunity cost of money – best alternative use of money invested – must include compensation for risk – the more risk the more interest paid to attract eg. long-term global bond market Greece is 21% riskier Example of Risk Compensation: Invest $30000 in business – alternative could have invested elsewhere Investment $30,000 @ 5% interest $1500 + risk comp 15% = $4500 =TOTAL RIST $6000 expect OR Guaranteed investment from bank guaranteed $1500 Smart businesses return at least Normal Profits – what a business owner could earn from best alternative uses of time and money. There are economic profits over and above normal profits, when revenues are greater than all opportunity costs of production, including hidden opportunity costs. Difference between accountants and economists – economists subtract hidden opportunity costs when calculating profits – economic profits are less than accounting profits. Normal Profits  compensation for business owner’s time and/or money or  sum of hidden opportunity costs (implicit costs) or  what business owner must earn to do as well as best alternative use of time and money Economic Profits (GREEN LIGHT – BUSINESSES EXPAND AND ENTER INDUSTRY)  Revenues – al) opportunity costs  Revenues – (Obvious Costs + Hidden Opportunity Costs)  Revenues – (Obvious Costs + Implicit Costs)  Revenues – (Obvious Costs +Normal Profits) When businesses make economic profits they expand and new businesses enter industry, supply increases which pushes quantities sold up and prices down, until prices just cover all opportunity costs of production and economic profits are 0. Changes in economic profits trigger changes in supply, changing price and bringing demand and supply into balance. On supply side – economic profits key signal coordinating smart choice of business with smart choices of consumers. ECONOMIC PROFITS DIRECT THE INVISIBLE HAND – SIGNAL BUSINESS. Economic Losses (RED LIGHT – BUSINESSES LEAVE INDUSTRY) – negative economic profits – not even earning normal profits. If revenues are less than all opportunity costs, business owner has not made a smart decision – would be better off doing alternative use of time and money. Business leave industry – Supply decreases – pushes quantities sold down and $prices up – until prices just cover all opportunity costs of production and economic profits are 0. Breakeven Point – (YELLOW LIGHT – BUSINESSES JUST EARNING NORMAL PROFITS ) – market equilibrium is 0 economic profits or losses. No tendency for change. Simplest rule for business – chose only when economic profits are positive. Economic profits and losses serve as signal for smart business decisionsl Market Equilibrium: quantity demanded = quantity supplied, economic profits 0, no tendency for change. The price consumers are will to pay just covers all opportunity costs of production (including normal profits). 3 Time Frames for Market Adjustments – Albert Marshall: 1. Short Run – no changes in demand or supply, shortages/surpluses causes adjustments to equilibrium, single industry or market. 2. Medium Run- start in equilibrium position – consequence due to change in Supply or Demand cause to end up with new equilibrium (shift in demand or supply) 3. Long Run – pursuing economic profits – resources move across industries – problem becomes larger – economy-wide industries and markets – changes in prices and quantities lead to 0 economic profits everywhere. MONOPOLY & COMPETITION A business’s market power - ability to set prices - ranges from maximum-price maker (monopoly) to minimum (extreme competition)-price taker. Businesses aim to seek economic profits and market power of monopoly. Competitors usually push businesses toward normal profits – except extreme competition who are price takers. Setting prices depends primarily on the state of competition: Monopoly (Price Maker – Inelastic Demand): the only seller of a product/service; no close substitutes available (eg. Xerox monopolized photcoping) Oligopoly (Price Maker – Inelastic Demand): few big sellers who control most of the market eg. cell phone providers, cola companies, gaming hardware (Ninetendo, Microsoft) Monopolistic Competition (Price Maker – Elastic Demand): Many small businesses who make similar but slightly different products/services eg. restaurants, dry cleaners, hair salons. No barriers to enter market Extreme Competition (Price Taker – Elastic Demand): Many sellers producing identical products. Zero power to set prices. Eg. wheat, meat – consumers can shop around for best price – very elastic Mash-ups of market structure: Oligopoly and Monopolistic competition Elasticity of Demand :  High Market power – lower elasticity of demand  Low Market power – higher elasticity of demand Businesses can set price, but cannot force consumers to buy - Even monopoly price makers live by law of demand - max consumers are willing to pay and min price sellers are willing to accept. Market Structure- Pricing power depends on competitiveness of market structure - characteristics affecting competition and pricing power:  Availability of substitutes  Number of competitors – fewer competitors more pricing power  Barriers to entry of new competitors – legal (patents, copyrights) or economic (economies of scale – average cost of producing falls as quantities increase) How you define the market:  Broader definition of market = more substitutes and competitors – more competitors =lower price power  Narrower definition of market = fewer substitutes and competitors –fewer competitors=more price power Product Differentiation: Attempt to distinguish product/services from competitors’ products by: o Reduces competition, increase market power o Actual or perceived differences: Barriers to entry - Legal or economic barriers preventing new competitors from entering market:  Legal barriers - Patents and copyrights — exclusive property rights to sell or license creations protecting against competition  Economic barriers — economies of scale — average cost of producing falls as quantity increases eg. water companies, electricity and cable – huge initial cost of distribution – network of pipes or cables (sunk costs) when network is in place and take on more customers – ongoing costs relatively low to supply service. Natural monopolies — one business can supply entire market at lower costs than can two or more businesses; often regulated by the government In moving across market structures from pure monopoly to extreme competition: Pricing power moves from price maker to price taker. To compete: Quest for economic profits and market power of monopoly generates action; Cutting costs, improving quality, innovating, advertising, buying competitors etc.. Competition is: active attempt to increase profits and gain market power of monopoly. While a market economy provides economic freedom — to make decisions, to invest and spend to choose occupations — as sellers who depend on markets to earn a living we must play by the market’s competitive rules. Creative destruction: Competitive business innovations generate economic profits for winners, improve living standards for all, but destroy less productive or less desirable products and production methods. Competitive actions by businesses can have unintended consequences of business cycles- ups and downs of overall economic activity. MARGINAL REVENUE AND MARGINAL COST Marginal Revenue: additional revenue from selling one more unit or from extension of sales (eg. staying open later). Marginal revenue depends on:  Market structure (how competitive industry is)  Whether business is price taker or price maker Marginal revenue equals price for price taking businesses in extreme competition Marginal revenue less than price for price-making businesses in other market structures Fixed Cost (sunk costs): do not change with changes in quantity of output (eg. rent, insurance) One-price rule: products easily resold tend to have single price in market (must charge customers same price not just on new sales) o When price-making business lowers price, must lower price on all units sold, not just new sales o Reason why marginal revenue less than price for price makers Marginal Costs: As output increases, marginal cost (variable) increases for business operating near capacity or when businesses’ additional inputs cost more. Marginal cost is usually constant for businesses not near capacity. Smart business decisions for max profits: quantity decisions is: produce all quantities for which marginal revenue is greater than marginal cost. Price decision is: set highest price that allows you to sell that quantity. Recipe for Maximum Profits:  Make quantity decisions first then price decision  Increase in quantity yields increase în profits if marginal revenue is greater than marginal cost  Stop increasing quantity when marginal revenue less than marginal cost  Set highest price that allows sale of target quantity Price discrimination Strategy: is a business strategy that diivides customers into groups in order to make higher profits. Businesses increase profits by lowering price to attract price sensitive customers (elastic demanders), without lowering price to others (inelastic demanders).  Charge different customers different prices for same product/service (tend to be services which can not be resold – eg. movie theatres, airlines)  Price discrimination breaks one-price rule, possible only when business can: o Prevent low-price buyers from reselling to high-price buyers o Control resentment among high-price buyers (use discounts – seniors, coupons – make it appear to be fair) Price discrimination increases profits by: o Changing lower price demanders (lower willingness to pay) o Changing higher price to inelastic demander (higher willingness to pay) Price-discrimination- separate each group, estimate marginal revenues and marginal costs for each group, set quantities and then set prices that allow the sale of all quantities for which MR is greater than MC. MONOPOLY RULES – GOVERNMENT REGULATION, COMPETITION AND THE LAW Natural Monopoly & Regulation: Natural monopolies create a challenge for policymakers — gain the low-cost efficiencies of scale, but avoid the inefficiencies of monopoly’s restricted output and higher prices. Problem of natural monopolies is if you allow one seller to rule the market – monopoly sets prices to maximize profits. To avoid this government steps in to regulate in order to try protect consumer (avoid high costs) – service industries usually – Government to get lowest single cost and regulate 1 company to run. Economies of Scale - Average total costs fall as quantity of output increases eg. cable networks, water, electricity Natural Monopoly: Technology allows only single seller to achieve lowest average total cost. Natural monopolies are based on current technology – when tech changes – natural monopoly may change to more competitive market structure. Regulated natural monopolies tend to earn higher rates of return than average rate or profits (eg. cable TV earns more than 10%) 2 Major policies governments use to deal with challenge of natural monopoly are:  Public ownership (100% owned by government) – crown corporations – publicly owned business – achieve economies of scale but lack of competition weakens incentives to reduce costs or innovate eg. Cable networks, water, electricity, Go Transit, Via Rail, Canada Post (equity of service across the country), BC Hydro, Canadian Broadcasting Corporation  Regulation (regulated private monopoly)– Rate of return regulation – set price allowing regulated monopoly to just cover average total costs and normal profits (incentive to exaggerate their reported costs) eg. Banks, CRTC, Air transportation, including airports, Railway and road transportation across borders, Telephone, telegraph and cable systems, Grain elevators, feed and seed mills, Uranium mining and processing, Fisheries as a natural resource Cooperate or Cheat - Prisoners’ Dilemma and Cartels: Strategic interaction among competitors complicates 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. (gasoline wars, OPEC oil cartel, nuclear arms races between countries) Prisoners’ Dilemma - Game with two players who must each make a strategic choice, where results depend on other players choice (each player is motivated to confess (cheat) but both would be better off if they could trust each other and deny (cooperate). Nash Equilibrium - Outcome of game where each player makes own best choice given the choice of the other player. Think of the Adam Smith’s invisible hand and clip from ‘a beautiful mind’ – pursues self-interest which will lead to common good – trust all will not go for the blonde – can you trust competitors? Or is it just a decoy to get what you really want? Two smart choices exist in prisoners’ dilemma game: one based on non-trust and one based on trust:  if other player cannot be trusted, smart choice is cheat/confess; all players driven to Nash equilibrium outcome where everyone cheats/confesses  if other player can be trusted, smart choice – 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 each would be better off if they could trust each other to cooperate (deny). . Can explain gas station cycles of high prices (cooperate) and price wars (cheat) . Tension between Nash equilibrium outcome (no trust) and better joint outcome (trust) All players driven to equilibrium outcome where everyone cooperates! Denies if everyone cheats then the price decreases (oil monopoly) Cartels, Collusion, Cheating, Competition (LAW) Cartels collude to raise prices and restrict output to increase economic profits. Cartels are unstable because members can increase individual profits by cheating on others. Cartel - Association of suppliers formed to maintain high prices and restrict competition  OPEC (Organization of Petroleum Exporting Countries) international cartel that acts like a monopoly – since recession of 1981 OPEC cartel has behaved as game theory predicts Collusion - Conspiracy to cheat or deceive others (eg. fix prices) Desirable Competitive behaviour - active attempts to increase profits and gain market power of monopoly - Hard to distinguish from undesirable collusive behaviour. The Competition Act(1986): Introduced by government in order to maintain and encourage competition in Canada in order to promote the efficacy and adaptability of the Canadian economy:  To prevent anti-competitive business behaviour  Raises expected costs to business of price fixing (by prison time, legal fines, legal prohibition) relative to expected benefits (profits) o Criminal Offences - . Price fixing, bid rigging, false/misleading advertising . Punish by prison time, fines o Civil Offences – . Mergers, abusing dominant market position, lessening competition . Punish by fines, legal prohibitions . Competition Tribunal for civil offenses weighs costs of lessening competition against benefits of any increased efficacies When businesses buy or merge with other competitors in their markets they can increase their profits and pricing power by eliminating substitute products. Competition may be reduced. But if merger provides economies of scale that lowers costs or allows business to better compete internationally that promotes efficiency and adaptability. REGULATORY AGENCIES IN CANADA The discipline of market competition eventually eliminates dangerous products, but in the process people may be harmed. Caveat emptor (“let the buyer beware”) — buyer alone responsible for checking quality of products before purchasing. Certain products — nuclear power, medicines poisonous insecticides — regulate by government because average consumer not capable of knowing product’s quality. Three major forms of government regulation in Canada address this probIem: o Government departments (Ministries headed by Ministers eg. Ministry of Labour) o Governments-appointed agencies/boards (government appoints eg. Atomic Energy Control board, Commissions, Boards, Tribunals) o Professional self-governing bodies (regulate themselves – eg. Canadian Medical Association, Canadian Bar Association) MARKET FAILURE OR GOVERNMENT FAILURE There are 2 views of government regulation: o Public-Interest View – suggests government actions improve market failure outcomes o Government regulation eliminates waste, achieves efficiency, promotes public interest o Capture view – suggest government actions produce government failure. o Government regulations benefits regulated businesses, not public interest o Most economists agree Competition Act serves public interest well Evidence is mixed on government regulation depending on which regulated industry is being examined — some supports public-interest view, some supports capture view Government Failure - Regulation fails to serve public interest, instead of industry being regulated.  Market outcome, even with monopoly power, may be better than government regulation outcome if significant government failure  Government outcome, especially with public interest regulations, may be better than market outcome it significant market failure Market failure:  Natural monopolies with economies of scale  Monopolistic collusion among competitors  Unscrupulous behaviour among profit-seeking businesses – consumers call upon government for action EXTERNALITIES, CARBON TAXES, FREE RIDERS & PUBLIC GOODS MARKET FAILURE WITH EXTERNALITIES Negative or positive externalities make smart private choices different from smart social choices. Smart Social choices require that all additional benefits and additional opportunity costs – including externalities are counted.  Negative Externalities (external costs): Costs to society from your private choice that affect others, but that you do not pay (eg. cell phones – nose pollution on GO train – no one wants to listen to someone speak loudly) o When social costs>private costs there are negative externalities + overproduction of product/service o Negative externalities are social costs = private costs + external costs  Positive Externalities (external benefits): Benefits to society from your private choice that affect others, but that others do not pay you for. (eg. getting a college/university education – less training for employers and less apt to be involved in criminal activity) Externalities occur when no clear property rights exist – prices don’t accurately reflect all social costs and benefits, preventing markets from coordinating private smart choices with social smart choices. Markets fail by:  Producing too much of things we don’t want (second-hand smoke, pollution, traffic jams)  Producing too little of the things we do want (vaccinations, education). Free-Riders do not pay for external benefits WHY RADICAL ENVIRONMENTALISTS DISLIKE ECONOMISTS NEGATIVE EXTERNALITIES & EFFICIENT POLLUTION To coordinate smart private choices that generate negative externalities with smart choices, choose the quantity of output where marginal social costs equals marginal social benefits – doesn’t eliminate them all together as environmentalists would like. ‘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. Economically speaking, the “efficient” level of pollution is the output where the marginal benefits of pollution control – the marginal costs of pollution control = 0. RULE: For any product/service that generates an externality, smart choice is: choose quantity of output where marginal social costs = marginal social benefit Marginal Social Costs (MSC) = Marginal Private costs (directly paid by producers) + Marginal External Costs (price of preventing or cleaning up damage to others) When there are negative externalities, MSC are greater than private marginal costs Marginal Social Benefìt (MSB) = Marginal Private Benefit (directly received by consumer) + Marginal External Benefit (benefit enjoyed by others) When there are positive externalities, MSB are greater than Marginal private benefits When social costs are greater than private costs there is an overproduction of products and are negative externalities Markets overproduce products/services with negative externalities - Price too low because does not include external costs eg. pollution POLICIES TO INTERNALIZE THE EXTERNALITY Government policies can force polluters to pay the marginal external costs of their pollution. As a result, polluters internalize externalities /costs into their private choices, creating smart social choices. Without property rights to the environment business have incentives to save money and improve profits by ignoring external costs like pollution and global warming. Governments can remedy market failure from externalities by creating social property rights to environment, making polluting illegal, penalizing polluters through:  Emissions tax: Tax to pay for external costs of emissions – cost for preventing or cleaning up damage to others from emissions o Carbon Tax: emissions tax on carbon-based fossil fuels (oil, gas, coal) o Cap-and-trade system: limits emissions businesses can release into the environment. Common objection to cap-and-trade is that it gives businesses the right to pollute. The advantage it gives businesses choice of reducing pollution or buying permits.  Internalize the externality o Transform external costs into costs producer must pay privately to government By giving pollution a price reflecting marginal external cost of damage, 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. FREE RIDING ON POSITIVE EXTERNALITIES Positive externalities create a free-rider problem when neither buyers nor sellers are paid for external benefits their exchange creates. The market clearing price 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. Businesses can not make a profit on public goods so do not enter market. Public goods (eg. lighthouse, national defence, education, vaccinations, public transit) – provide external benefits consumed simultaneously by everyone; no one can be excluded. Smart choice rule for any produce/service that generates an externality: choose quantity of output where marginal social cost equals marginal social benefit MSC=MSB Because of free-rider (does not pay for external benefit) problem, markets underproduce products/services with positive externalities:  Price charged to buyers is too high  Price received by sellers is too low  Market price does not incorporate external benefits WHY YOUR TUITION IS CHEAP: SUBSIDIES FOR THE PUBLIC GOOD Government policies can reward businesses and individuals creating positive externalities. As a result, they internalize the externalities/rewards, turning smart private choices into smart social choices. Markets fail when there are positive externalities – market-clearing prices do not reflect the external benefit cost. Subsidies and public provision are government policy tools to get everyone to voluntarily choose output where marginal social benefit = marginal social costs:  Subsidy - Payment to those creating positive externalities (eg. tuition, grants)  Public provision - Government provision products/services with positive externalities, financed by tax revenue (eg. education, public transit) When positive externalities are wide-spread and important for citizens – difficult to collect revenue so government pays cost. Subsidies and public provision remove the wedge positive externalities drive between prices for buyers and for sellers, inducing individuals and businesses to voluntarily choose quantity of output best for society. . “Industrialists are interested not in the social, but only in the private net product of their operations” . Created policies to correct externalities or “spillovers” called Pigovian Taxes . Free markets generate prices at which consumers and businesses equate private costs and benefits and an efficient outcome But for the best outcome for society, “what is needed is a balancing of social costs and social benefits. Free markets don’t lead to such a balancing. Whenever spillover effects are present ... the overall outcome that the market economy produces is neither efficient nor socially desireable. The market fails..” DEMAND AND SUPPLY ININPUT MARKETS, INCOME AND WEALTH DISTRIBUTIONS PRICES AND QUANTITIES IN INPUT MARKETS Incomes are determined by prices and quantities in input markets. In input markets, household supply to businesses labour, capital, land, and entrepreneurship in exchange for wages interest, rent and profits. In input markets, households are sellers and businesses are buyers:  Income (PxQ) is — what you earn — is a flow (eg. hourly rate x number of hours worked in a week). o Flow: amount per unit of time o Income for labour, capital and land = price of input x quantity of input  Wealth — value of assets you own — is a stock o stock: fixed amount at a moment in time INPUT INCOME  Labour Wages  Capital ($) Interest  Land (& other resources)  Rent  Entrepreneurship Profits (normal & economic) Entrepreneurs incomes are not determined by P xQ formula as they earn profits. Economic profits are residual – what’s left over from revenues after all opportunity costs of production (including normal profits) have been paid for other inputs.  Normal profits = compensation for entrepreneur’s time and money  Economic profits — over and above normal profits LABOUR AND MARGINAL REVENUE PRODUCT For maximum profits, businesses should hire additional labour as long as labour’s marginal revenue product (additional benefit) is greater than the wage paid for labour (additional cost). To hire labour businesses must pay market wage = best opportunity cost of person supplying labour Business demand for labour is derived demand - demand for output and profits businesses can derive from hiring labour Marginal product - Additional output from hiring one more unit of labour. When businesses hire laborers to work with fixed inputs, there is diminishing marginal productivity each additional labourer has lower marginal product than previous labourer. Marginal revenue product - Additional revenue from selling output produced by additional labourer. To calculate labourer’s marginal revenue product - MP x P(Marginal Product x Price of Output (constant)). MRP diminishes as business hires additional labourers. Rule for maximum profits for business: Hire additional hours of labour as long as marginal revenue product is greater than wage (or price of input). INTEREST ON CAPITAL AND PRESENT VALUE Present value shows what money earned in future is worth today. Present value compares price paid for today’s investment against investment’s future earnings. For smart choice, present value of investment’s future earnings should be greater than investment’s price today. The present value of a future amount of money is the amount that, if invested today, will grow as large as the future amount, taking account of earned interest. Present Value = amount of money available in n years (1 + interes
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