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Chapter 16

ECON 101 Chapter Notes - Chapter 16: Creative Destruction, Marginal Utility, Perfect Competition

Course Code
ECON 101
Robert Gateman

of 8
Economics 101: Principles of Microeconomics
Chapter 16
Governments are necessary to provide law and order and to define property rights
Allowing decentralized decision making is more desirable that a centralized planning body
There are some areas of the economy that can benefit from government intervention
The operative choice is the choice of which mix of markets and government intervention
best suits people's hopes and needs
16.1 Basic Function of Government
The government has a monopoly on violence (incarceration, judicial system)
o There are systems in place to make sure the government is acting adequately as well
o Some countries do not have these monopolies in place and it leads to violence
o Without checks for the system, there may be the misuse of power
When government monopolies of violence are secure and function with effective
restrictions against its arbitrary use, citizens can safely carry on their ordinary
economic/social activities
Property rights enforce the rights and obligations of corporations, organization etc.
More stable and representative political structures lead to stronger economies
Institution building: taking the form of political rather than economic assistance
16.2 The Case for Free Markets
Free markets function and distribute wealth without a central form of leadership
Modern market economies are able to innovate and increase living standards
Formal defence: if all markets were perfectly competitive, and governments allowed prices
to be determined by supply/demand, then price would equal marginal cost
o The economy would therefore be allocatively efficient
Informal defence: markets are an effective mechanism for coordinating the decisions of
decentralized decision makers
o Free markets provide coordination of the actions of decentralized decision makers
o Pursuit of profits provides free markets with innovation and rising standards
o Free markets permit a decentralization of economic power
Automatic Coordination:
Some economists believe free market economies are able to adjust more quickly to changes
Centralized governments force the same patterns on everyone (price-fixing, rationing etc.)
It is difficult to quickly adjust quotas/allocations and there will be shortages/surpluses
In a market system suppliers do not need to understand how the market works
o There is coordination without anyone understanding how the market system works
Innovation and Growth:
Successful entrepreneurs are able to gauge the market and create a product that is needed
A market economy allows for risk taking and innovation to exploit opportunities
Centralized systems have to guess what innovations will be strongly demanded
o Could choice correctly and advance the economy
o If they choice wrongly, all resources have been dedicated to an idea that did not work
Economics 101: Principles of Microeconomics
Decentralization of Power:
Large firms and labour unions have substantial economic power
Creative destruction: market power constrained my competition, new firms and products
Coercion creates opportunities for bribery, allocation and corruption
o Allocate scarce resources to individuals/firms that pay the largest bribes
Economic freedom: the ability to allocate resources through private markets
o Essential to the maintenance of political freedom (Milton Friedman)
16.3 Market Failures
The failure of the market economy to achieve an efficient allocation of resources
Firms that face downward sloping demand curves, have price exceeding MC at equilibrium
o No real market economy has ever achieved perfect allocative efficiency
o Efficiency is often only used as a benchmark to compare the economy
Market failures in the free market, in the absence of government intervention, fails to
achieve allocative efficiency
Allocative efficiency is a positive statement, that is not a value statement
Market Power:
In some industries there is only room for a few firms to operate efficiently
In some industries firms sell differentiated products and have the ability to set prices
Firms that innovate with new products/production methods have a temporary monopoly
o Firms with market power, maximize profit at output when price exceeds MC
o The result is allocative inefficiency even though there are new innovations
Governments must scale advantages of imperfect markets without controlling them
Individual consumers are interested in their own benefit not the benefits of others
Externality: whenever actions taken by firms/consumers impose costs/benefits on others
o The third part effect (parties other than the buyer/seller are affected)
Private cost: the cost faced by the private decision maker (production, advertising etc.)
Social cost: private cost and costs imposed on third parties
o Similar distinction between private and social benefit
Discrepancies between private cost and social cost occur when there are externalities
o Presence of externalities leads to allocatively inefficient outcomes
A positive externality in a competitive free market will produce too little of a good
o Governments may impose a subsidy for these types of externalities
A negative externality in a competitive free market will produce too much of the good
o Creates a justification for government intervention
o Impose a tax levy on pollution or other restrictions on negative externalities
Non-rivalrous and Non-excludable Goods:
Rivalrous (good/service): if one person's consumption of one unit of a good, means that no
one else can also consume that unit
Excludable (good/service): if people can be prevented from consuming it
Economics 101: Principles of Microeconomics
Private Goods:
Most goods/services consumer are both rivalrous and excludable
Private goods: goods that are both rivalrous and excludable
o Pose no particular problem for public policy
Common-Property Resources:
Goods that are rivalrous but non-excludable pose a challenge to public policy
Common property resources: fisheries, common grazing land, wildlife
Private users will tend to overuse a product that has zero price (ex. Water)
o Will be some positive marginal cost to society for using the resource
Tragedy of the commons: social cost associated with the overuse of common resources
Goods that are rivalrous and non-excludable are called common-property resources
o Tend to be overused by private firms and consumer
Excludable but Non-Rivalrous Goods:
Goods that are excludable but not rivalrous (typically provided by government)
o Non-rivalry means the marginal cost of providing one extra is zero
If the marginal cost is zero, the price must also be zero (allocative efficiency)
o When there is congestion this is no longer true
Imposes costs of those already using the good/service
To avoid inefficient exclusion, governments often provide free non-rivalrous but
excludable goods/services
Governments that provide goods with high demand must charge to ration the good
Public Good:
Public goods: neither excludable nor rivalrous
o Sometimes called collective consumption goods (national defence)
o All Canadians are equally provided with national defence
Information is also often a public good (disclosure, recalls, public warnings, defects etc.)
o Once the good is produced it is impractical to make people pay for it
o Free markets may fail to produce public goods at all
The free-rider problem in the private markers will not always provide public goods
o Public goods must be provided by the government in these situations
Governments should continue providing until marginal benefit is just equal to marginal
The optimal quantity of a public good is such that the marginal cost of the good equals the
sum of all users' marginal benefits of the good
Asymmetric Information:
One party in a transaction has special knowledge
o Take advantage of the special knowledge in way that change the natural of the
o Even when information is not a public good, markets for expertise are prone to