Externalities, Public Goods, and Market Structures
Chapter 10: Externalities
Definition
1. Externality:
When an individual/firm’s activity affects the well-being of a bystander, but no compensation/remuneration is made/collected.
– Negative Externality: Adversely affects bystanders (e.g., pollution).
– Positive Externality: Positively influences bystanders (e.g., education).
2. Market Outcomes:
Social cost = Private cost + External cost
– Negative externalities: Social cost > private cost.
To maximize total surplus, self-interested sellers and buyers in market trade in Q1. However, market equilibrium is inefficient. In Q1, the cost of producing a good to society > the value received by society. So, market output is higher than socially optimal level. (due to neglected the -ve externality)
Social value = Private value + External value
– Positive externalities: Social value > private value.
To maximize total surplus, self-interested sellers and buyers in market pursue good until Q1 (Private value = cost of good). However, market equilibrium is inefficient. In Q1, the cost of producing a good to society < the value received by society. So, market output is lower than socially optimal level. (due to neglected the +ve externality)
3. Demand and Supply:
Demand curve: The maximum amount a consumer/buyer is willing to pay for each additional unit of good. (demand = private value = social value)
The private value different consumers placed on each additional unit of good
Supply curve: The minimum amount a firm/seller has to receive in order to willing to sell for each additional unit of good. (supply = private cost)
Important Diagrams
1. Negative Externality (e.g., Pollution):
– Social-cost curve lies above the supply/private-cost curve.
– Market output (Q1) > Socially optimal output (Q2).
– Solution: Corrective tax shifts supply curve upward to align/coincide with the social-cost curve. Q1 reduces to Q2. Raising total economic well-being. (correction of market failure)
2. Positive Externality (e.g., Education):
– Social-value curve lies above the private-value curve.
– Market output (Q1) < Socially optimal output (Q2).
– Solution: Subsidize good (education) to shift demand curve upward to align with the social-value curve. Q1 increases to Q2. Improves market efficiency. (correction of market failure)
Examples of Externalities
(Cigarettes) creates [external cost/external benefit], as the (second-hand smoke) leads to (health hazards) for bystander. Social cost [>/<] Private cost. Social [cost/value] curve is higher than [Supply/Demand] curve. Since (smokers) are not required to [compensation/remuneration] to bystanders for this [+ve/-ve] externality, they tend to (consume) too [much/few] on (cigarettes). Market Q is [larger/smaller] than social optimum. (Taxes) are therefore necessary to [increase/reduce] (cigarette consumption).
Government Interventions
1. Command-and-Control Policies:
– Direct regulation of behavior
– Regulators need to have detailed knowledge about various specific industries and the alternative technologies available. It is costly to enforce the regulation.
2. Market-Based Policies:
Corrective Taxes:
– Imposes additional cost to producer who will take account of the social costs resulting with their actions. An optimal tax is aligns with external cost. Reduce production and enhance societal well-being.
– More efficient than direct regulation (different cost = may same reduction at higher cost).
1. set a price
2. assess the cost against the benefit from
3. lower pollution
4. So, more efficient
Tax V.S. CAC:
1. revenue for gov v.s. no revenue to gov
2. develop cleaner tech v.s. lack incentives to further action
3. less effective (need precise knowledge of how responsive firms are to reduce pollution like tax rate) v.s. more effective in controlling
Tradable Pollution Permits:
– Scarce good. Freely traded in the market, this permits allocated to firm which value them the most (firm face high cost in reduce pollution). Reducing overall costs.
1. higher cost/lower cost
2. buyer/seller
3. do less/more
Tax V.S. TPP
Equally efficient. As both rely on the market mechanism (free trade/choice/pricing) to allocated same good, namely the pollution rights.
– perfectly elastic (If the gov has perfectly knowledge of demand = same Q = same econ consequences) v.s. perfectly inelastic
If not = may not match Q = gov need to continuously adjust corrective tax policy to achieve the desired level of pollution.
Effective v.s. More effective. (TPP) regardless of the position of demand curve, the desired level of pollution control Q must be achieved.
Debate: Environmentalists v.s. Economists
Environmentalists:
1. fundamental human right (clean water and air)
2. protect it whatever the cost
3. unethical and educational to allow pp to pollute and pay for their right
Economists:
1. pp face trade-off
2. most effective way to eliminate all pollution is to stop all productions but it is undesirable as the benefits of a completely clean environment do not outweigh the total loss of other economic goods
3. TPP and Tax helps reduce the cost of environmental protection = cleaner environment and improved standard of living
Private Solutions
1. Moral codes and social sanctions
2. Charities
3. Contract or agreement
Coase Theorem: If private parties can bargain without cost over the allocation of resource, they can resolve the prob of externalities on their own. (efficient)
So initial distribution of rights does not matter for the market’s ability to reach an efficient outcome but determines the distribution of the wealth.
Limitations:
– High transaction costs.
– Stubbornness among parties.
– Coordination problem with large groups.
Chapter 11: Public Goods and Common Resources
1.Public Goods: (under-produced = neglected external benefit +ve)
Definition: non-excludable and non-rival in consumption.
Non-excludable: Free rider problem. No fee can be collected from consumers utilizing the public good. Little incentive for private firms to provide.
Non-rival in consumption: MC=0 in serving each additional customer. There are typically significant fixed cost in producing public good.
Zero price but possesses both private and social value
Absence of price signals. Buyers and sellers are not guided to complete and produce good in an efficient manner. Resources are allocated inefficiently.
No private sellers are willing to sell at a zero price. Zero quantity is provided. Market failure. The market has failed to provide an optimal quantity of goods.
Gov provide but may face difficulty in determining the efficient quantity
Measuring the benefit is difficult as pp may refuse to disclose their true values on the good
Benefit is sometimes difficult to be quantified (numerous estimates may be unreliable)
2.Common Resources: (over-consumed = neglected external cost -ve)
Definition: non-excludable but rival in consumption.
Non-excludable: Free rider problem. No fee can be collected from consumers utilizing the public good. Little incentive for private firms to provide.
Rival in consumption: One person’s use reduces other people’s ability to use. Used excessively. Gov intervention is needed to ensure that they are not overused.
The Tragedy of the Commons:
Over-consumed = inefficiency due to -ve externality
1. Rational: Private benefit = Private cost
2. Self-interested: disregard the external cost
Solution:
1. Regulate the use
2. Corrective tax
3. Permits
4. Property right
3.Free-rider Problem: (market failure)
Definition: A person who receives the benefit of a good but does not pay for it.
Supplier cannot collect $, it refuses to provide the good. The outcome is socially inefficient as social value > cost.
+ve externality. Creates external benefits for bystanders but no remuneration. Good tend to be under-produced or not be produced at all. To improve the market outcome, gov provide/subsidize private firm.
4.Excludability: (focus on most common situation)
Excludable Goods: Normally charged. Can prevent someone from using the good.
Non-excludable Goods: Impossible to prevent someone from using the good
5.Rivalry in Consumption: (depend on the condition or utilization of the good)
Rival in consumption: One person’s use reduces other people’s ability to use (e.g., bottled water).
Non-rival in consumption: One person’s use does not reduce other people’s use. (e.g. abundant/can replenish goods)
6.Four different kinds of goods [Excludability, Rivalry in consumption]
[Yes, Yes] Private good
[Yes, No] Club good
[No, Yes] Common resource
[No, No] Public good
7. Property right is well-defined and well-enforced, the private owner would have incentive to put resource to the most efficient use. Over/Under could resolved.
Chapter 14: Production and Costs
1.Accounting and Economic Profit
Accounting profit = Total Revenue (TR) – Total Costs (explicit only) = less useful and relevant in helping pp in decision-making
Economic profit = TR – TC (Explicit Costs + Implicit Costs) = define cost in a broader manner
+ve EP = receiving a reward that exceeds what he could have earned from his other opportunities = continue
-ve EP = paid less than he could otherwise earn from his next best opportunities = discontinue
Explicit costs = outlay of money
Implicit costs = do not require a cash outlay
2.Production and Costs
Production: Transforming inputs into outputs
Production function: Relationship between quantity of inputs and quantity of outputs.
Total cost curve: Relationship between quantity outputs and total cost
Short-run costs:
Fixed Costs (FC): Not vary with the quantity of output produced.
Variable Costs (VC): vary with the quantity of output produce.
Total Costs (TC) = FC + VC
Long-run costs: All costs become variable.
3.Diminishing Marginal Productivity (of labor)
The production function gets flatter = decreasing slope = decreasing mp
Adding more workers reduces the additional products/mp due to shared resources.
Total cost curve gets steeper = more and more workers is required for the same increment in output
4.Long-run ATC curve
Declines as output rises: economies of scale
Increasing specialization among workers
Rises as output rises: diseconomies of scale
Coordination problems
Not vary with the level of output: constant returns to scale
5.MC curve cuts AVC and ATC curves at their minimum.
MC < AC = smaller production cost is added to the average = falling AC
MC > AC = larger production cost is added to the average = rising AC
6.Cost
AFC always declines as output increases
AVC initially falls than rises as output increases (U-shape)
ATC U shape pattern and efficient scale occurs at Q that minimizes ATC
More you buy = lower ATC, BUT will rise eventually due to diminishing marginal productivity
Lower ATC by proceed to a bigger scale due to economies of scale
MC generally increases with Q as principle of diminishing marginal productivity of labor
Change in TC/Change in Q
7.Decision
Short-run: optimum Q in a given scale that minimize ATC
Long-run: optimum Q and scale that minimize ATC
Chapter 15: Competitive Markets
1. Characteristics of Competitive Markets
Many buyers and sellers.
Identical goods: demand is perfectly elastic for a firm’s product. (Assume Perfect inf on market price and quality + Zero transaction cost)
P slightly higher: Qd = 0
P slightly lower: Qd = all
Price takers: buyers and sellers must accept market price.
Free enter and exit the market
+ve economic profit = enter
-ve economic profit = exit
Firms earn zero economic profit in the long run.
2. Demand Curve in Competitive Markets
Market demand curve: downward-sloping (Law of Demand).
Individual firm demand curve: horizontal (perfectly elastic).
3. Profit Maximization
Total Revenue (TR) = Price (P) × Quantity (Q) = AR = MR
Profit is maximized when TR – TC = greatest / MR = MC
MR > MC increase production
MR < MC decrease production
(P – ATC) * Qmax
Economic profit/economic loss
The MC curve pass through ATC at its minimum
[Profit maximizing/Loss minimizing] is MR = MC
P and ATC at Qmax.
Profit: P > ATC = (P – ATC) * Qmax
Loss: P < ATC = (ATC – P) * Qmax
4. Sunk Costs:
Costs that has already incurred and cannot be recovered and is deemed irrelevant in decision making
5. Shut Down vs. Exit
Short-run shutdown: temporary decision not to produce anything during a specific period of time because of current market conditions
P < AVC / TR < VC
Long-run exit: permanent decision to leave the market
P < ATC / TR < TC
6. Supply Curve
Individual firm:
Short-run supply curve = MC curve above AVC
Long-run supply curve = MC curve above ATC
Market:
Short-run supply curve: Sum of all firm’s MC curve
Long-run supply curve: Horizontal
P > ATC: New firms to enter = market supply increased
P < ATC: Existing firms will exit = market supply decreased
P = ATC: Zero economic profit (P = MR. So, MC = ATC to maximize the profit (MR = MC). MC meets ATC curve only at the minimum) = long run must operating at the efficient scale
Slope upward:
Firms have different cost
Cost rises as firms enter the market (scarce resources)
Chapter 16: Monopoly
1. Why is There Monopoly?
– Monopoly: A firm that is the sole seller of a product with no close substitutes.
– Main Causes of Monopoly: Barriers to entry:
1. Monopoly Resources:
– A single firm owns a key resource (e.g., DeBeers owning 80% of diamond mines).
– Rare in practice due to international trade and availability of substitutes.
2. Government-created Monopolies:
– Exclusive rights granted (e.g., patents, copyrights).
– Patents: Exclusive production rights for new drugs (20 years).
– Copyrights: Exclusive sale rights for novels.
3. Natural Monopolies:
– Occurs when a single firm can supply the entire market at a low cost due to economies of scale.
– Examples: Toll bridges, town gas supply.
– High fixed costs discourage new entrants.
2. Monopoly vs. Competitive Market
– Competitive Market:
– Firms are price takers; demand curve is perfectly elastic.
– MR = P (Marginal Revenue = Price).
– Monopoly:
– Market demand curve = monopolist’s demand curve (downward sloping).
– Monopolists are price searchers.
– MR < P (to sell more, the monopolist lowers P).
3. Monopoly’s Revenue
– Key Terms:
– Total Revenue (TR) = P × Q
– Average Revenue (AR) = TR / Q (equals P)
– Marginal Revenue (MR): Change in TR when Q increases by 1 unit.
– Important Points:
– MR < P (due to the “price effect”).
– Selling more units requires lowering the price, reducing revenue from previous units sold.
4. Profit Maximization
– Profit-maximizing quantity: Where MR = MC.
– Price: Determined from the demand curve at Qmax.
– Profit = (P – ATC) × Qmax.
– Monopoly profit leads to inefficiency (deadweight loss).
5. Welfare Cost of Monopolies
– Socially Efficient Quantity: Where P = MC.
– Monopoly Quantity: Where MR = MC (less than the efficient level).
– Deadweight Loss (DWL):
– Due to P > MC.
– Some consumers who value the good more than MC do not purchase it.
6. Price Discrimination
– Definition: Selling the same good at different prices to different customers.
– Types:
1. Perfect Price Discrimination:
– Charge each buyer their willingness to pay (WTP).
– Eliminates consumer surplus and DWL.
2. Real-world Examples:
– Cinemas: Students/elderly charged less.
– Airlines: Weekday vs. weekend ticket prices.
– Online shops: Promo codes for price-sensitive buyers.
– Efficiency:
– Price discrimination increases total surplus and encourages production at the efficient quantity.
7. Public Policy Towards Monopolies
1. Antitrust Laws:
– Promote competition by prohibiting anticompetitive practices (e.g., price fixing, mergers).
– May reduce competition synergies (e.g., cost savings from mergers).
2. Regulation:
– Common for natural monopolies (e.g., electric companies).
– Challenges:
– P = MC may force firms to operate at a loss.
– P = ATC leads to a deadweight loss.
3. Public Ownership:
– Government-run monopolies avoid private profit motives.
– Issues: Public ownership lacks cost-saving incentives.
4. Do Nothing:
– Sometimes the cost of regulation outweighs the benefits.