Transcript Lecture 2 - Illinois State University

 Homework
 Group
#1 Due Thursday
Quiz Next Thursday
 Writing
Assignment Due Oct. 27th
Price of
Good
Marginal
Cost
Equilibrium
Price
Equilibrium
Quantity
Marginal
Benefit
Quantity of
Good
• Static Model
 Time does not matter
 Cost/Benefit Analysis – cutting down trees
 Benefit > Cost => support action
 Cost > Benefit => oppose action
• Dynamic Model
 Account for time
 Cost/Benefit Analysis accounting for time
 Max [B0, B1, B2]
 Present Value – $1 invested today at 10% interested yields
$1.10 a year from now.
 Present Value (PV) of X one year from now is X/(1+r)2
 r is the interest rate (discount rate)
 PV[Bn]=Bn/(1+r)n
 Exclusivity –
• All benefits and costs accrued as a result of owning
and using the resources should accrue to the owner,
and only the owner, either directly or indirectly by
sale to others
 Transferbility –
• All property rights should be transferable from one
owner to another in a voluntary exchange
 Enforceability –
• Property rights should be secure from involuntary
seizure or encroachment by others (ie. eminent
domain)
Price of
Good
Supply
Equilibrium
Price
Demand
Equilibrium
Quantity
Quantity of
Good
Price of
Good
Supply
Equilibrium
Price
Demand
Equilibrium
Quantity
Quantity of
Good
Price of
Good
Supply
Equilibrium
Price
Demand
Equilibrium
Quantity
Quantity of
Good
Price of
Good
Supply
Equilibrium
Price
Demand
Equilibrium
Quantity
Quantity of
Good
 Efficient
Property Rights => Net Benefits
are Maximized
• Consumer Surplus – area under the demand
curve minus the area representing cost
• Producer Surplus – area under the price line that
lies over the marginal cost curve
• Net Benefits = CS + PS
 Exclusivity
– when the owner bears all of
the consequences of his actions
 Externality
– when the welfare of some
agent (individual, household, or firm)
depends on the activities under control of
some other agent.


Negative externalities (external diseconomy)
Positive externalities (external economy)
Price of
Good
Supply
Equilibrium
Price
Demand
Equilibrium
Quantity
Quantity of
Good
Price of
Good
Marginal
Social Cost
Marginal
Private Cost
P*
Market
Price
Demand
Q* Market
Quantity
Quantity of
Good
 Example, when
Duncan Hines produces
brownie mix, it pollutes a small amount of
cocoa powder into the air. This makes
the air smell like brownies, and increase
the MSB from the production of brownies.
 The
Pursuit of Efficiency
• Legislative and Executive Regulation
 Direct Control – Quota
 Cap and Trade
 Pigovian Tax – “polluter pays principle”
 Not always clear who pays
Pigovian Tax Problem
• Suppose the demand function for
gasoline is
• Pd = 6.5 - 0.5 Q where Q represents
billions of gallons of gasoline.
• Suppose the supply function for gasoline
is based on the firms’ marginal private
costs and equals
• Ps=Q
• What is the market equilibrium level of
output and price?
Pigovian Tax Problem
• Suppose the government’s EPA determines the
socially optimal amount of gasoline use is
actually 3 billion gallons of gasoline.
• To reach this socially optimal quantity, the
government is going to implement a per unit tax
on the consumption of gasoline. The tax revenue
from which will go to protecting the environment
as determined by the EPA.
• What should the tax amount be?
• What price will the consumers pay?
• What price will the sellers receive?
• How much money will go to protecting the
environment?
 Common
Goods – rivalrous, nonexcludable
 Public
Goods – non-rivalrous, nonexcludable
 Genetic
Diversity
• critical to species survival
• Useful for cross-breeding to develop superior
strains
 Number
of Species
• Species interdependence
• Provides new sources of food, energy industrial
chemicals, raw materials, and medicines
 Graphically
• non-rivalry means that
 if each of several individuals has a demand curve for
a public good,
 then the individual demand curves are summed
vertically to get the aggregate demand curve for the
public good.

The Illinois Power Authority is considering
updating its transmission substations to use
“smart-grid” technology, which improves
reliability and efficiency in the electric grid.
Each time a new smart-grid meter is installed
Chicago, Naperville, and Rockford customers all
benefit from increased reliability of their
electricity. A study was done to determine the
benefit to each city as follows:
• Chicago – Marginal Benefit=10-0.5Q
• Naperville – Marginal Benefit=5-0.5Q
• Rockford – Marginal Benefit=10-1Q

What is the total benefit when five smart-grid
meters are installed?
 There
are two people in the world
 They both benefit from preserving the
rainforest, with an inverse demand
function
• P=50-2Q
 Preservation
is a public good
 The marginal cost of preserving the rain
forest is $20 per acre.
 Estimate total demand, and the optimal
number of acres to preserve.
If
property rights are welldefined, and no significant
transaction costs exist, an
efficient allocation of
resources will result even with
externalities.
Coase Theorem Problem
• A chemical factory is situated next to a
farm. Airborne emissions from the
chemical factory damage crops on the farm.
The marginal benefits of emissions to the
factory and the marginal costs of damage to
the farmer are as follows
• MB= 360 – 0.4 Q and MC=90+0.2Q
• From an economic viewpoint, what is the
best solution to this environmental conflict
of interest?
• How might this solution be achieved?
 Homework
 Group
#1 Due Thursday
Quiz Next Thursday
 Writing
Assignment Due Oct. 27th