ECONOMICS.ppt

1、Economic Policy: Some Preliminaries,POLS3170 Herzberg,Fundamentals of Economics,The role of scarcity how do we define need in society? virtually no one will ever be fully satisfied economically - wants are relative Thus, scarcity cannot be eliminated scarcity forces society to consider the most effi

2、cient distribution of resources based on differing values held by different people,Fundamentals of Economics,The relationship between alternative uses of scarce resources Every resource has multiple possible competing uses How should we decide where the scarce resources will go? Command economies Fr

3、ee market economies Mixed economies,Welfare Economics,Conditions under which markets maximize social well-being. Rational individuals, pursuing their own well-being; rational business associations, pursuing profit-maximization. Thus, welfare economics asks, “Under what conditions will individual and

4、 organizational maximizing behavior lead to optimal social well-being?” “Doing good by doing well.” Competitive markets for all outputs and all inputs. No market imperfections.,Welfare economics 2,First fundamental theorem of welfare economics: Every competitive equilibrium is Pareto efficient. Seco

5、nd fundamental theorem of welfare economics: “There will always be a set of prices such that each Pareto-efficient allocation is a market equilibrium for an appropriate assignment of endowments.” Implication: issues of efficiency and distribution can be separated.,Fundamentals of Economics,The Role

6、of Prices Information transmission is decentralized allow an entire society to adjust to a change in supply or demand of a resource without ever knowing that change has occurred or why Resources tend to flow to their most valued uses in a market economy In command economy the decisions are made poli

7、tically,Fundamentals of Economics,The Role of Prices Create incentives for the distribution of existing supplies Create incentives for the creation or discovery of new or substitutable supply The role of rationing who should ration? Health care example,Fundamentals of Economics,Manipulating Price Pr

8、ice Ceilings increase demand housing example decrease supply food shortage increase overall prices as producers look for ways around the limitations Equity issues,Fundamentals of Economics,Manipulating Price Price Floors minimum wage laws agriculture price supports Politics of these prices cave of b

9、utter the advantaged ones Difference between goals and the incentives it creates.,How Economics ShapesIndustry and Commerce,Success and loss in business anticipating the next trend dynamics of business intransigence of large and successful companies local versus global information Difficulty of cent

10、rally planning these decisions,Role of Profits,Incentive individuals and firms seek to maximize profit should other goals be considered here? How to measure profit profit on sales profit on investment difference between what consumer pays and cost to produce and distribute role of time on return,Cos

11、ts of production,Economies of scale advantage that comes with increasing volume Diseconomies of scale what level is too big? Cost of coordination Industry differences capacity,Assumptions of Free market model,full information no single individual or firm can control price free entry and exit from in

12、dustry as price falls, firms take investment elsewhere and supply declines as price rises, other firms see advantage of producing the good and enter as competitors,Private and social optimality,An individual seeks to maximize his or her utility. This involves taking actions till the marginal private

13、 cost of further action equals the marginal private benefit of that action. For social optimality the rule is: Taking action till the marginal social cost of further action equals the marginal social benefit of that action. Implication: when private and social costs and benefits diverge, private and

14、 social optimality diverge.,Market imperfections,Deviations from competitive market conditions that lead private individuals and organizations, in pursuing their own private goals, to do things that are not in the social interest. Individuals typically pay attention only to private costs and benefit

15、s, ignoring social costs and benefits. The general corrective is to align private and social goals by creating programs that induce private maximizing individuals to take all social costs and benefits into their own calculations.,Five sources of market imperfection,1. Market power monopoly and monop

16、sony; imperfect competition. 2. External costs and benefits. 3. Public goods. 4. Severe informational asymmetries. 5. Coordination and collective action problems.,Market Power Problems,Monopoly producer controls enough of market to control supply of good and thus, the price natural monopoly high fix

17、ed costs need sufficient sales guaranteed to recoup costs very few and temporary,Market Power Problems,Monopsony single buyer frequently government Strategies for addressing concentration regulation commissions all the problems of socialist decision making antitrust laws how to measure concentration

18、?,WHY MONOPOLIES ARISE,The fundamental cause of monopolies is barrier to entry. Barriers to entry have three sources: Ownership of a key resource. The government gives a single firm the exclusive right to produce some good. Costs of production make a single producer more efficient than a large numbe

19、r of producers.,HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS,Monopoly versus Competition Monopoly Is the sole producer Faces a downward-sloping demand curve Is a price maker Reduces price to increase sales Competitive Firm Is one of many producers Faces a horizontal demand curve Is a price t

20、aker Sells as much or as little at same price,Demand Curves for Competitive and Monopoly Firms,Copyright 2004 South-Western,Quantity of Output,(a) A Competitive Firm,s Demand Curve,(b) A Monopolist,s Demand Curve,0,Price,Quantity of Output,0,Price,THE WELFARE COST OF MONOPOLY,In contrast to a compet

21、itive firm, the monopoly charges a price above the marginal cost. From the standpoint of consumers, this high price makes monopoly undesirable. However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.,Increasing Competition with Antitrust Laws,Two Importa

22、nt Antitrust Laws in the U.S. Sherman Antitrust Act (1890) Reduced the market power of the large and powerful “trusts” of that time period. Clayton Act (1914) Strengthened the governments powers and authorized private lawsuits.,Regulation,Government may regulate the prices that the monopoly charges.

23、 The allocation of resources will be efficient if price is set to equal marginal cost. In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing.,External costs and ben

24、efits,Costs that are an unintended by-product of the profit-maximizing or utility-maximizing actions of one person and that impose these unwanted costs directly onto third parties. Examples: air and water pollution, secondhand tobacco smoke. Problem: from a social point of view, there is too much of

25、 the external-cost-generating activity. Corrective: inducing less of the external-cost-generating activity by having the creator “internalize” the external cost. Benefits that are unintentionally conferred onto third parties by the profit- or utility maximizing actions of one person. Examples: eleme

26、ntary education, pollination services provided to beekeepers by a neighboring apple orchard. Problem: from a social point of view, there is too little of the external-benefit-generating activity. Corrective: public subsidy of the external-benefit-generating activity to encourage more of the activity

27、.,Positive Externalities,They will be underprovided because the value they create for those outside the decision process is not brought into the calculus Examples Flowers in your neighbors yard LoJack safety device on automobiles immunizations,Negative Externalities,They will be overprovided because

28、 the costs they impose are outside the decision calculus Examples Air pollution associated with producing a product Smoking,Public goods,Two characteristics: Very costly for private providers to identify who is consuming the good and how much they are willing to pay. Non-excludability in consumption

29、: consumption of the good or service by one person does not leave less for others to consume. Contrasted to “private goods.” Examples Fireworks display. National defense. Over-the-air broadcasting and telecasting. Most (but not all) information.,Public goods 2,Problem: private providers cannot make

30、a profit by providing a socially optimal amount of the public good or service. As a result, there is too little (from a social point of view) of the public good. “Free riding” and the holdout problem. Correctives: Public provision of the public good, as when municipalities provide fireworks displays

31、 on July 4. Public subsidization of the private provision of the public good or service, as when the government subsidizes fundamental research.,“The best things in life are free. . .”,Free goods provide a special challenge for economic analysis. Most goods in our economy are allocated in markets Wh

32、en goods are available free of charge, the market forces that normally allocate resources in our economy are absent. When a good does not have a price attached to it, private markets cannot ensure that the good is produced and consumed in the proper amounts. In such cases, government policy can pote

33、ntially remedy the market failure that results, and raise economic well-being.,THE DIFFERENT KINDS OF GOODS,When thinking about the various goods in the economy, it is useful to group them according to two characteristics: Is the good excludable? Is the good rival? Excludability Excludability refers

34、 to the property of a good whereby a person can be prevented from using it. Rivalry Rivalry refers to the property of a good whereby one persons use diminishes other peoples use.,THE DIFFERENT KINDS OF GOODS,Private Goods Are both excludable and rival. Public Goods Are neither excludable nor rival.

35、Common Resources Are rival but not excludable. Natural Monopolies Are excludable but not rival.,Four Types of Goods,Copyright 2004 South-Western,Rival?,Yes,Yes,No,Private Goods,Natural Monopolies,No,Excludable?,Common Resources,Public Goods,The Free-Rider Problem,A free-rider is a person who receive

36、s the benefit of a good but avoids paying for it. Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. The free-rider problem prevents private markets from supplying public goods.,The Free-Rider

37、Problem,Solving the Free-Rider Problem The government can decide to provide the public good if the total benefits exceed the costs. The government can make everyone better off by providing the public good and paying for it with tax revenue.,COMMON RESOURCES,Common resources, like public goods, are n

38、ot excludable. They are available free of charge to anyone who wishes to use them. Common resources are rival goods because one persons use of the common resource reduces other peoples use. Some Important Common Resources Clean air and water Congested roads Fish, whales, and other wildlife,Tragedy o

39、f the Commons,The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole. Common resources tend to be used excessively when individuals are not charged for their usage. This is similar to a negative external

40、ity.,Severe informational asymmetries,Two parties to a potential transaction have very different information about some important aspect of the potential transaction. Example: consider the very different knowledge of the true quality of a used car as between the buyer and the seller. Or the differen

41、ces in information about a potential employees true abilities. Why is this a problem? Because fear of uncertainty about the unknown attributes and the sometime inability of the parties to solve those fears themselves may prevent otherwise value-maximizing transactions from taking place. Corrective C

42、ompelling information disclosure by punishing failures to disclose, as with respect to latent defects.,Decisionmaking under uncertainty,How to evaluate future outcomes when there are multiple possibilities? Expected value. Weight each possible outcome by its probability and then add them. Suppose th

43、at there are two possible outcomes, $100 and $500, and that they are equally probable. EV = 0.5 (100) + 0.5 (500) = 300. Now suppose that there are two uncertain courses of action. One has an EV of $300. The other has an EV of $400. Should one always choose the course of action with the higher expec

44、ted value? A1: EV = $300 = 0.5 (100) + 0.5 (500). A2: EV = $400 = 0.99 (0) + 0.01 (40,000). People have different attitudes toward risk or uncertainty and these attitudes may influence how they behave when facing uncertain outcomes.,Attitudes toward risk,Three possible attitudes: Risk neutrality. Ri

45、sk aversion. Risk seeking. Risk neutrality. Indifferent between two uncertain courses of action of equal expected value. Risk aversion. Prefers a certain to an uncertain course of equal expected value. Risk seeking. Prefers an uncertain to a certain course of action of equal expected value. The diff

46、erence has to do with the marginal utility of additional income. Risk neutrality implies constant marginal utility of income. Risk aversion implies a declining marginal utility of income. Risk seeking implies an increasing marginal utility of income.,Decisionmaking under uncertainty,Decisionmakers d

47、o not maximize expected value. They maximize expected utility. Subjective expected utility (SEU). Insurance. Allows risk-averse individuals to convert uncertain outcomes into certain outcomes. Two problems: Moral hazard. Adverse selection. Co-insurance and deductibles.,Asymmetric Information,If agen

48、ts do not have perfect and complete information, not all assumptions of perfectly competitive markets are fulfilled and we cannot rely on markets to produce Pareto-efficient results Adverse selection occurs before the transaction Moral hazard arises after the transaction Agency theory analyses how a

49、symmetric information problems affect economic behavior,Adverse Selection: The Lemons Problem,If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality. Sellers of good quality items will not want to sell at the price for average quality. The buyer

50、will decide not to buy at all because all that is left in the market is poor quality items.,Adverse Selection: Solutions,Private production and sale of information Free-rider problem Government regulation to increase information Financial intermediation Mandatory Insurance,Moral Hazard Problems,Call

51、ed the Principal-Agent Problem Separation of ownership and control of the firm Managers pursue personal benefits and power rather than the profitability of the firm. In Insurance, riskier behavior after the individual is insured which results in higher costs,Moral Hazard: Solutions,Cost sharing Ince

52、ntive compatible Monitoring and Enforcement Discourage undesirable behavior Encourage desirable behavior Keep collateral valuable Provide information Financial Intermediation,Game theory,A formal means of modeling strategic interaction. Developed by von Neumann and Morgenstern in the 1940s. Two or m

53、ore players who must choose among various strategies either sequentially or simultaneously. Nash equilibrium. Developed by John Nash, co-winner of the Nobel Prize in 1993, and subject of A Beautiful Mind. A solution in which there is no incentive for either party to play a different strategy. Some g

54、ames have no Nash solution. Some have one. Some have multiple Nash solutions.,Game theory 2,Game theory 3,The solution ($1, $1) is a Nash equilibrium, but it is not the best that the player can do. The strategy “Pay me $1” is called a dominant strategy. It is the best strategy regardless of what the

55、 other player does. Prisoners dilemma. How might they structure an agreement to reach ($5, $5)? One-shot versus repeated games. In a repeated game there is an incentive to develop a reputation for cooperation or trust. But consider a repeated game in which there are only a finite number of repetitio

56、ns. The game may “unravel.” The creditor-debtor relationship as an example.,Equilibrium,Nash Equilibrium: Neither player has an incentive to change strategy, given the other players choice A players best option may be dictated by anticipating the rivals best option,Go back to Prisoners Dilemma:Is th

57、ere a way to generate the cooperative solution?,Not a Nash Equilibrium If Conductor commits to “Dont Confess”, Tchaikovsky has an incentive to confess If Tchaikovsky commits to “Dont Confess”, Conductor has an incentive to confess Role of a contractto commit parties to actions they would not underta

58、ke voluntarily Alternative: Implied contract if there were a long relationship between the parties(partners in crime) are more likely to back each other,Application to Collective Bargaining,Two agent game Uncertainty Each party has to anticipate what the other will do Time limit matters Ability to c

59、ontract affects outcome A long, continuing relationship can enhance the efficiency of the outcome,Complicating the game,Suppose there is a range of outcomes,Wage,Union,Firm,Contract Zone,Wm,WM,WM : Firm maximum wage Wm : Union minimum wage,Where we end up in the contract zone depends on bargaining power,Bargaining power depends on Alternative opportunities if no bargain is reached (outside option) Union: alternative employment Firm: Substitute for union workers Relative cost of delay Union: Strike fund Firm: Inventory, strength of sales d