How Economists Think and Things They Think About How Economists Think - PowerPoint PPT Presentation

A simple model – Production Possibilities A i l d l P d ti P ibiliti  Assumed fixed: ▪ Quantities of Resources (e.g. Labor, Capital Equipment, Natural Resources) ▪ State of Technology St t f T h l  Objective: j ▪ Allocate resources to maximize a society’s net benefit from two produced goods: Skateboards and Electric Guitars Guitars

Production Possibilities A 20 19 B 18 17 16 C 15 14 13 ards 12 D 11 11 Skateboa 10 9 8 7 E 6 5 5 4 3 2 1 F 0 0 1 2 3 4 5 Guitars

No money or trade – or prices – in this economy No money or trade or prices in this economy.  Pure resource allocation problem p  Benevolent dictator: how many units of each good to produce to maximize net social benefit l b f  With only two goods costs and benefits are measured  With only two goods, costs and benefits are measured in terms of the other good

 Imagine the labor h l b Grades resources in the Type of Guitar Skateboard economy have the economy have the Person Person Making Making Making Making report cards at right: 1 A F  How to make the first 2 2 B B D D guitar? 3 C C  Use best available 4 4 D D B B guitar ‐ making 5 F A resources first

Production Possibilities A 20 19 2 S B 18 1 G 17 16 C 15 14 13 ards 12 D 11 11 Skateboa 10 9 8 1 st Guitar Costs 2 Skateboards 7 E 6 5 5 4 3 2 1 F 0 0 1 2 3 4 5 Guitars

Marginal Cost 10 en Up) 9 Skateboards Give 8 7 6 Must give up 2 Skateboards to get 1 st Guitar Must give up 2 Skateboards to get 1 Guitar t (Measured in S MC 5 4 3 Marginal Cost 2 1 0 0 0 1 2 3 4 5 6 Guitar

Production Possibilities A 20 19 B 18 17 3 S 3 S 16 C 15 1 G 14 13 ards 12 D 11 11 Skateboa 10 9 8 2 nd Guitar Costs 3 Skateboards 7 E 6 5 5 4 3 2 1 F 0 0 1 2 3 4 5 Guitars

Marginal Cost 10 en Up) 9 Skateboards Give 8 7 6 Must give up 3 Skateboards to get 2 nd Guitar Must give up 3 Skateboards to get 2 Guitar t (Measured in S MC 5 4 3 Marginal Cost 2 1 0 0 0 1 2 3 4 5 6 Guitar

And so on through the fifth guitar And so on, through the fifth guitar …

Production Possibilities A 20 19 B 18 17 16 C 15 14 13 ards 12 D 11 11 Skateboa 10 9 8 5 th Guitar Costs 6 Skateboards 7 E 6 5 5 4 3 2 6 S 1 F 0 1 G 1 G 0 1 2 3 4 5 Guitars

Marginal Cost 10 en Up) 9 Skateboards Give 8 7 6 Must give up 6 Skateboards to get 5 th Guitar Must give up 6 Skateboards to get 5 Guitar t (Measured in S MC 5 4 3 Marginal Cost 2 1 0 0 0 1 2 3 4 5 6 Guitar

Marginal benefit is the maximum amount that f someone is willing to give up one more unit

Marginal Benefit Marginal Benefit 10 Given Up) 9 in Skateboards G 8 8 Willing to give up 8 Skateboards to get 1 st Guitar 7 6 efit (Measured 5 4 3 Marginal Ben 2 1 MB 0 0 0 1 1 2 2 3 3 4 4 5 5 6 6 Guitar

Marginal Benefit Marginal Benefit 10 Given Up) 9 in Skateboards G 8 8 Willing to give up 6 Skateboards to get 2 nd Guitar 7 6 efit (Measured 5 4 3 Marginal Ben 2 1 MB 0 0 0 1 1 2 2 3 3 4 4 5 5 6 6 Guitar

And so on through the fifth guitar And so on, through the fifth guitar …

Marginal Benefit Marginal Benefit 10 Given Up) 9 in Skateboards G 8 8 Willing to give up 0 Skateboards to get 5 th Guitar 7 6 efit (Measured 5 4 3 Marginal Ben 2 1 MB 0 0 0 1 1 2 2 3 3 4 4 5 5 6 6 Guitar

Finding the socially efficient allocation of resources: ff f  If MB > MC allocate more resources  If MB > MC, allocate more resources  If MB < MC, allocate fewer resources ,  When MB=MC, resource allocation is socially efficient

Efficient Allocation of Resources 10 Measured in 9 8 Marginal Cost (M 7 Marginal Cost (MC) eboards) 6 5 al Benefit and M Skate 4 3 2 2 Margina 1 Marginal Benefit (MB) 0 0 1 2 3 4 5 6 Guitars (Total Benefit – Total Cost) is maximized with 3 Guitars. This implies 11 Skateboards.

Production Possibilities Start Here A 20 19 B 18 17 16 C 15 14 13 End Here ards 12 D 11 11 Skateboa 10 9 8 7 E 6 5 5 4 3 2 1 F 0 0 1 2 3 4 5 Guitars

Now we introduce prices and decentralized trade in markets …

 The marginal cost curve we derived is a “least opportunity cost that must be paid” curve. ▪ Supply = Marginal Social Cost S l M i l S i l C t ▪ Minimum sell price curve  The marginal benefit curve we derived is a “greatest opportunity cost that would willingly be paid” greatest opportunity cost that would willingly be paid curve. ▪ Demand = Marginal Social Benefit g ▪ Maximum buy price curve

Market Eq ilibri m Achie es Efficient Allocation Market Equilibrium Achieves Efficient Allocation 1200 1000 800 r Guitar Supply = MSC Max Max Dollars Pe 600 Buy Price Equilibrium Price 400 200 Min Sell Demand = MSB Price 0 0 0 1000 1000 2000 2000 3000 3000 4000 4000 5000 5000 6000 6000 Guitars

In the next slide, notice the essential role of the $400 f $ price of a guitar in guiding every individual toward the socially efficient outcome socially efficient outcome

Market Eq ilibri m Achie es Efficient Allocation Market Equilibrium Achieves Efficient Allocation 1200 1000 Each buyer values Guitar ≥ $400 800 r Guitar Supply = MSC Dollars Pe 600 Each seller values Resources > $400 Equilibrium Price 400 Each seller values $400 ≥ Resources Each seller values $400 ≥ Resources Each buyer values $400 > Guitar 200 Demand = MSB 0 0 0 1000 1000 2000 2000 3000 3000 4000 4000 5000 5000 6000 6000 Guitars

Market Eq ilibri m Achie es Efficient Allocation Market Equilibrium Achieves Efficient Allocation 1200 1000 800 r Guitar Supply = MSC Consumer Dollars Pe 600 Gains Surplus From Trade 400 Producer Surplus 200 Demand = MSB 0 0 0 1000 1000 2000 2000 3000 3000 4000 4000 5000 5000 6000 6000 Guitars

Market Eq ilibri m Achie es Efficient Allocation Market Equilibrium Achieves Efficient Allocation 1200 1000 800 r Guitar Consumer Supply = MSC Surplus Dollars Pe 600 400 Producer Surplus 200 Demand = MSB 0 0 0 1000 1000 2000 2000 3000 3000 4000 4000 5000 5000 6000 6000 Guitars

Market Eq ilibri m Achie es Efficient Allocation Market Equilibrium Achieves Efficient Allocation 1200 1000 800 r Guitar Excess Supply Drives Price Down Supply = MSC Dollars Pe 600 Equilibrium Price 400 200 Excess Demand Drives Price Up Demand = MSB 0 0 0 1000 1000 2000 2000 3000 3000 4000 4000 5000 5000 6000 6000 Guitars

Summary of this section: f  A properly functioning competitive market allocates  A properly functioning competitive market allocates resources in a socially optimal manner  The key to this allocation is a price that accurately represents marginal benefits and costs to society

We suspect problems will arise if: f  The price is not permitted to perform its role in  The price is not permitted to perform its role in allocating resources  The price does not accurately represent marginal benefits and costs to society  The entire market – and hence the price – is simply missing missing

Attempting to thwart or bypass market forces through f intervention  Resources still must be allocated but by other methods  Resources still must be allocated , but by other methods  These other methods are generally more costly to society g y y y  The cost is measured as lost consumer and producer surplus ▪ Deadweight Loss

In the following example, we will study a quota that f limits production to 1,000 units

A Prod ction Q ota A Production Quota 1200 Production Quota at 1,000 Units 1000 Deadweight Loss = Lost Gains 800 r Guitar From Trade Supply = MSC Dollars Pe 600 Gains From Trade 400 200 Demand = MSB 0 0 0 1000 1000 2000 2000 3000 3000 4000 4000 5000 5000 6000 6000 Guitars

In the next example, we will study a price control that prevents the price from rising above $200  Producers respond to this by only supplying 1,000 units  For the 1,000 th unit: ▪ Willingness to pay is $800 g p y ▪ Price explicitly paid is $200  Notice that a price of $800 paid by buyers would cause the quantity demanded to be exactly 1,000 units …

A Price Control A Price Control 1200 Consumer Surplus 1000 Deadweight Loss = Lost Gains 800 r Guitar From Trade Excess Supply = MSC Search Willi Willing ‐ Dollars Pe 600 Costs ness To Add To Pay Dead ‐ 400 weight Loss 200 Price Ceiling at $200 Producer Demand = MSB Surplus 0 0 0 1000 1000 2000 2000 3000 3000 4000 4000 5000 5000 6000 6000 Guitars

Summary of this section: f  Resource allocation is not likely to be socially optimal if  Resource allocation is not likely to be socially optimal if intervention prevents the price from performing its role in allocating resources g

Market failure f  Situations where free private markets  Situations where free private markets – without without intervention – yield socially inefficient outcomes  Not due to a failure of market forces but rather to an absence of market forces – distorted or missing prices

So far: So far:  Demand has reflected the MSB  Supply has reflected the MSC Externalities are benefits and costs that affect a third party to a transaction a transaction  Private supply does not include external costs to society pp y y

A pollution example  Chemical firm and households share a lake  Chemical firm and households share a lake  External costs reduces housing values g

An External Cost and Overproduction 120 cals 100 100 er Ton of Chemic MSC = MC + MEC 80 Deadweight Loss Marginal External Cost (MEC) Marginal External Cost (MEC) nds of Dollars Pe Efficient Equilibrium 60 Supply = MC 40 Market Equilibrium Market Equilibrium Thousan 20 Demand = MSB 0 0 1000 2000 3000 4000 5000 6000 Chemicals (Tons)

The problem is a missing market  Nobody owns the lake and the right to either  Nobody owns the lake and the right to either pollute it or keep it free from pollution  One way to deal with this is through Pigovian taxes

Correcting For An External Cost: Pigovian Tax = MEC 120 cals 100 100 er Ton of Chemic Supply + Tax = MSC 80 Per Unit Tax Marginal External Cost (MEC) Per Unit Tax = Marginal External Cost (MEC) nds of Dollars Pe Efficient Equilibrium 60 Supply = MC 40 Thousan 20 Demand = MSB 0 0 1000 2000 3000 4000 5000 6000 Chemicals (Tons)

Coase Theorem (Ronald Coase, 1961) ( )  If transactions costs are low assignment of property  If transactions costs are low , assignment of property rights results in a socially efficient allocation  In terms of achieving the socially efficient allocation of resources, it doesn’t matter to whom the property rights are assigned!

Residents Own The Lake 120 cals 100 100 er Ton of Chemic Supply Including Payment of Damages = MSC 80 Firm Pays Damages MEC Firm Pays Damages = MEC nds of Dollars Pe Efficient Equilibrium 60 Supply = MC 40 Thousan 20 Demand = MSB 0 0 1000 2000 3000 4000 5000 6000 Chemicals (Tons)

Chemical Factory Owns The Lake 120 cals Supply Including Opportunity Supply Including Opportunity 100 100 er Ton of Chemic Cost of Reduced Rents = MSC 80 Opportunity Cost of Reduced Rents MEC Opportunity Cost of Reduced Rents= MEC nds of Dollars Pe Efficient Equilibrium 60 Supply = MC 40 Thousan 20 Demand = MSB 0 0 1000 2000 3000 4000 5000 6000 Chemicals (Tons)

Marketable Permits to pollute  Create a market for the right to pollute  Create a market for the right to pollute

Market determined price of a marketable permit $30 Total permits disbursed l i di b d 2000 2000 Firm A's MC $20 Firm B's MC $40 P i Price per ton of chemicals t f h i l $60 $60 Firm A buys 1 permit from firm B and increases its production by 1 ton Firm B sells 1 permit to firm A and decreases its production by 1 ton Firm A Firm B Revenue gain from selling Revenue loss from selling +$60 ‐ $60 1 more ton of chemicals 1 more ton of chemicals 1 less ton of chemicals 1 less ton of chemicals MC paid by producing MC saved by producing ‐ $20 +$40 1 more ton of chemicals 1 less ton of chemicals ‐ $30 +$30 Price paid for permit Price received for permit +$10 +$10

A public good is  Nonrival in consumption  Nonrival in consumption ▪ More than one person can consume simultaneously simultaneously  Nonexcludable ▪ Free rider problem

A Public Good: Nonrival and Nonexcludable 24 20 MSB = Vertical Sum of Alice’s and Bill’s Demands eet Light 16 Deadweight Loss Deadweight Loss Dollars Per Stre 12 Efficient Equilibrium Supply = MSC 8 Alice’s Demand = 4 Bill’s Demand 0 0 0 1 2 3 4 5 6 Street Lights Private Market Equilibrium Quantity With Free Rider Problem

Asymmetric Information f  A missing market for information  A missing market for information  The market for lemons (George Ackerloff, 1970) ( g , )

The Market For Good Used Cars 60 Supply 50 Per Good Car 40 sands of Dollars 30 Efficient Equilibrium 20 Thous 10 Demand 0 0 0 2000 4000 6000 8000 Good cars

The Market For Lemons 60 50 Per Lemon 40 sands of Dollars S Supply l 30 20 Thous 10 Efficient Equilibrium Demand 0 0 1000 2000 3000 4000 5000 6000 7000 8000 Lemons

 A problem of asymmetric information arises if f f f buyers cannot tell good cars from lemons  The seller knows, but the buyer does not. After the sale, the buyer knows, but it is too late , y ,

 Pooling equilibrium – both types of used cars are combined in one market  Price reflects probability of buying a good car or a lemon  The pool of used cars contains an inefficiently high  The pool of used cars contains an inefficiently high proportion of lemons – the good cars are under supplied and the lemons are over supplied pp pp

The Market For All Used Cars – Pooling Equilibrium 60 50 rs Per Car 40 usands of Dolla 30 Supply 20 Tho Market Equilibrium 10 Demand 0 0 2000 4000 6000 8000 All Cars

The Market For Good Cars In Pooling Equilibrium 60 Supply 50 Per Good Car 40 Deadweight Loss sands of Dollars 30 Efficient Equilibrium 20 Thous Equilibrium For 10 Good Cars at Pooling Equilibrium Price Demand 0 0 0 2000 4000 6000 8000 Good cars

The Market For Lemons In Pooling Equilibrium 60 50 Per Lemon 40 sands of Dollars S Supply l Equilibrium For 30 Lemons at Pooling Equilibrium Price 20 Thous 10 Deadweight Loss Efficient Equilibrium Demand 0 0 1000 2000 3000 4000 5000 6000 7000 8000 Lemons

Solution to the lemon problem: a signaling mechanism Solution to the lemon problem: a signaling mechanism  Related examples where lower quality products or assets p q y p are overrepresented ▪ Insurance ▪ Loans ▪ Financial Assets

Last example: The Prisoners’ Dilemma – game theory Last example: The Prisoners Dilemma game theory  Strategies that are individually optimal lead to g y p socially inefficient outcomes Nash Equilibrium (John Nash, 1950) h l b ( h h )  Each player chooses his/her best strategy given the  Each player chooses his/her best strategy given the other player’s strategy

Remember these folks? Remember these folks?

Grade Distribution With Studying 0.045 Hernandez 0.04 0.035 0.03 Mora Vargas ncy 0.025 Frequen 0.02 0.015 30% C C 0.01 Kawa Vázquez 20% 20% D B 0.005 15% 15% F A 0 0 10 20 30 40 50 60 70 80 90 100 Student Scores

The Nash equilibrium is socially inefficient The Nash equilibrium is socially inefficient  Given Kawa’s strategy to study, the others choose to study t d  Given that the others choose to study, Kawa chooses y, to study  Similarly for each of the others Similarly for each of the others  Nobody has any incentive to deviate from a strategy y y gy that delivers a socially inefficient outcome