Transcript Chapter 1

MBA Economics
Copenhagen 21 – 24 May
Associate Professor Ivar Bredesen
Economics December 2002

Case study


Expanded model of income determination
Essay questions

Essay 1: Economic efficiency

Essay 2: Fiscal and monetary policy, the
ISLM-model
Slide 2
Economics June 2002

Case study


Marginal productivity theory, factor demand
and factor rewards
Essay questions

Essay 1: Economic efficiency

Essay 2: Macroeconomic theory and policy
Slide 3
Economics December 2001

Case study


Price theory, prices and income
Essay questions

Essay 1: Economic efficiency and
economic circulation

Essay 2: Macroeconomic theory,
multipliers and subsidies
Slide 4
Economics June 2001

Case study


Efficiency, consumer demand
Essay questions

Essay 1: Economic efficiency, factor
demand and factor rewards

Essay 2: Fiscal and monetary policy, the
ISLM-model
Slide 5
Economics A

Case study


Price theory, monopoly
Essay questions

Essay 1: Economic efficiency

Essay 2: Fiscal policy, the ISLM-model
Slide 6
Economics B

Case study


Price theory, monopoly
Essay questions

Essay 1: Economic efficiency

Essay 2: Fiscal and monetary policy, the
ISLM-model
Slide 7
Economics C

Case study


Price theory, prices and revenue
Essay questions

Essay 1: Economic efficiency

Essay 2: Fiscal and monetary policy, the
ISLM-model
Slide 8
Economics D

Case study


Costs and supply, equilibrium
Essay questions

Essay 1: Theory of supply

Essay 2: Fiscal and monetary policy, the
ISLM-model
Slide 9
Economics E

Case study


Price theory, monopoly
Essay questions

Essay 1: Economic efficiency

Essay 2: Fiscal and monetary policy, the
ISLM-model, open economy macroeconomics
Slide 10
Economics F

Case study


Theory of costs, capital budgeting
Essay questions

Essay 1: Economic theory, definitions

Essay 2: Fiscal and monetary policy, the
ISLM-model
Slide 11
My advice would be…


In the microeconomics section, you need
to be thoroughly familiar with

Social efficiency

Theory of price determination
In the macroeconomics section, you need
to master

The ISLM-model (which incidentally sums up
many other chapters in this section)
Slide 12
Social efficiency

The purpose of the economic system is to
allocate the scarce resources of the
economy to the production of goods and
services for the use of individuals. This
allocation should be done efficiently

In his Manuel D`Economie Politique
(1906) Pareto laid down some marginal
conditions that must be satisfied if
economic efficiency is to be avoided.
Slide 13
Pareto optimum
http://cepa.newschool.edu/het/essays/paretian/paretocont.htm

A Pareto optimum is defined as a state of
affairs such that no one can be made
better off without at least one other person
being made worse off

A change in the use of resources is said to
constitute a Pareto improvement if at least
one person if at least one person is made
better off without anyone being made
worse off
Slide 14
Pareto optimum

Three basic conditions must be
satisfied if Pareto efficiency is to be
attained
 Efficiency
in the use of outputs in
consumption
 Efficiency
in the use of inputs in
production
 Efficiency
in matching production to
consumption
Slide 15
Rational choices

In economics, we define a rational person as
a person who will choose to do an activity if
the gain from so doing exceeds any sacrifice
involved.

In other words, whether as a producer, a
consumer or a worker, a person will gain by
expanding any activity whose marginal benefit
(MB or MU) exceeds it marginal cost and by
contracting any activity whose marginal costs
exceeds its marginal benefit. Only when MB =
MC can no further gain be made.
Slide 16
Private and social efficiency

When MU = MC, we have private efficiency. In the
absence of externalities, private costs and benefits
match social costs and benefits

Why is social efficiency achieved:

If MU > MC, there would be a Pareto improvement if
there was an increase in the activity. For example, if
the benefit to consumers from additional production
of a good exceed the cost to producers, the
consumers could fully meet the cost of production in
the price they pay, and so no producer loses, and
still there would be a net gain to consumers. Thus
society has gained.
Slide 17
Social (economic) efficiency

Economists argue that under certain
conditions the achievement of private
efficiency will result in social or economic
efficiency also

There must be perfect competition throughout
the economy

There must be no externalities. Externalities
are additional costs and benefits, over and
above those experienced by the individual
producer and consumer
Slide 18
Consumer and Producer Surplus
Price
10
Consumer
Surplus
7
S = MC
Between 0 and Q0
consumers A and B
receive a net gain from
buying the product-consumer surplus
5
Producer
Surplus
D = MU
0
Consumer A
Q0
Consumer B
Consumer C
Between 0 and Q0
producers receive
a net gain from
selling each product-producer surplus.
Quantity
Slide 19
Economic efficiency, contd.

In practice, consumers to not consider just one
good in isolation. They make choices between
goods. Likewise firms make choices as to which
goods to produce and which factors to employ.

In chapter 3 we learned that a consumer will
maximise utility from a given income when that
income is allocated to goods and services so
that the marginal utility divided by price is equal
MU N
MU A MU B

 ... 
PA
PB
PN
Slide 20
Marginal Equivalency

We also know that a competitive firm will maximize
profit by producing at a level which price equals
marginal cost
PA  MCA and PB  MCB
Substituting the marginal costs (MC) for price in
the equation for consumer optimality, we get
MU A MU B
MU A MCA

or

MCA MCB
MU B MCB
Slide 21
Marginal Equivalency

Should we have that
MU A MU B

MCA MCB

Whether as a producer, consumer or worker, a person
will gain by expanding activity A relative to activity B
 Activity A is giving greater utility relative to its cost than
activity B
 Also, if for example the marginal utility from to
consumers from good A relative to good B were greater
than the marginal cost to producers from good A relative
to good B, then if more A was produced relative to B,
the additional gain to consumers would be greater than
the additional cost to producers. Thus consumers could
fully compensate the producers (in the price they pay for
A) and still have a net gain.
Slide 22
Perfect Competition
Market
P
D
P
S
Individual Firm
LMC
P0
LRAC
P0
D = MR = P
Q0
Q
q0
Q
Slide 23
Maximizing Profit When Marginal
Revenue Equals Marginal Cost
$ per
unit of
output
MC
P1
P*
AC
P2
Lost
profit
D = AR
MR
Q1
Q*
Q2
Lost
profit
Quantity
Slide 24
Deadweight Loss from Monopoly Power
$/Q
Lost Consumer Surplus
Deadweight
Loss
Because of the higher
price, consumers lose
A+B and producer
gains A-C.
MC
Pm
A
B
C
PC
AR
MR
Qm
QC
Quantity
Slide 25
Externalities

Negative


Action by one party imposes a cost on
another party
Positive

Action by one party benefits another
party
Slide 26
External Cost

Scenario

Steel plant dumping waste in a river

The entire steel market effluent can be
reduced by lowering output (fixed
proportions production function)
Slide 27
External Cost

Scenario

Marginal External Cost (MEC) is the
cost imposed on fishermen downstream
for each level of production.

Marginal Social Cost (MSC) is MC plus
MEC.
Slide 28
External Costs
Price
When there are negative
externalities, the marginal
social cost MSC is higher
than the marginal cost.
The differences is
the marginal external
cost MEC.
MSC
The profit maximizing firm
produces at q1 while the
efficient output level is q*.
Price
MSCI
MC
S = MCI
The industry competitive
output is Q1 while the efficient
level is Q*.
Aggregate
social cost of
negative
externality
P*
P1
P1
MECI
MEC
D
q* q1
Firm output
Q* Q1
Industry output
Slide 29
External Cost

Negative Externalities encourage
inefficient firms to remain in the
industry and create excessive
production in the long run.
Slide 30
Externalities

Positive Externalities and Inefficiency

Externalities can also result in too little
production, as can be shown in an
example of home repair and
landscaping.
Slide 31
External Benefits
Value
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D.
MSB
D
P1
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
MC
P*
Is research and development
discouraged by positive
externalities?
MEB
q1
q*
Repair Level
Slide 32
Public Goods

Public Good Characteristics

Nonrival


For any given level of production the
marginal cost of providing it to an
additional consumer is zero.
Nonexclusive

People cannot be excluded from
consuming the good.
Slide 33
Public Goods

Not all government produced goods
are public goods

Some are rival and nonexclusive

Education

Parks
Slide 34
Efficient Public Good Provision
Benefits
(dollars)
When a good is nonrival, the social marginal
benefit of consumption (D) , is determined by
vertically summing the individual demand
curves for the good.
$7.00
Marginal Cost
$5.50
D2
$4.00
Efficient output occurs
where MC = MB at 2
units of output. MB is
$1.50 + $4.00 or $5.50.
D
$1.50
D1
0
1
2
3
4
5
6
7
8
9
10
Output
Slide 35
Asymmetric Information

When one part in a transaction knows
more about the characteristics of a good
or service than the other party, we have
asymmetric information

This is a very widely used concept in many
transactions

Since buyers (or sellers) may not know what
the good or service is worth, the market will
not secure efficiency.
Slide 36
George Akerlof Wins Nobel Prize
in Economics
Slide 37
The market for lemons

Assume that a used car is either good or bad

In American terminology a good used car is a
”plum” and a bad one a ”lemon”



Assume that the supply of used cars is given at
that the distribution between plums and lemons is
50/50
Assume that plums are worth $10 000 both for
sellers and buyers, while lemons are worth 5000
The market would have secured an efficient
solution had both buyers and sellers had perfect
information.
Slide 38
The market for lemons

Assume that only the seller knows if the car
is a plum or a lemon




Buyers will not offer 10 000 for a car since half
of them are lemons
For the same reason it is unrealistic to offer
5 000
Buyers offer expected value of average price
which is (10 000+5 000)/2 = 7 500
This is insufficient for the owners of plum to sell,
but more than enough for the owners of
lemons. We end up with only lemons being
offered for sale – adverse selection
Slide 39