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Competitive Markets: People take prices as given (they do not act as though they can affect prices).
Buying and selling in markets at these prices leads to Pareto Efficient allocations of resources.
A “price” is a rate of exchange of one good in terms of another (e.g. A price of ฿ 30 means you give up 30 baht in exchange for one dish of pad thai. Or ฿ 5 for one moo satay. This implies a price of 6 (moo satay for pad thai), meaning that you give up 6 moo satay in exchange for 1 pad thai).
Can think of a price as the slope of a line in our graphs.
Illustration of Competitive Markets & Pareto Efficiency Person A Person B 0 0 Moo Satay Pad Thai
Because each person is doing as well as s/he can (each is on the highest indifference curve possible) GIVEN the starting position and the price, there is NO role for policy in improving this allocation of resources without hurting one of the participants.
On the producer side, the relationship between price and the amount producers are willing to provide is summarized in the supply curve. The supply curve can be thought of as the cost of providing different amounts of the good.
Producer Surplus: The value that producers receive in excess of their cost. This is the area above the supply curve but below the price.
Illustration of Producer Surplus Price Quantity S P 0 Q 0 Producer Surplus (also called “rent”)
Markets (or, more generally, private arrangements) cannot function without some government (collective action) support:
Enforce property rights
If it is possible (or not too costly) to simply take property, rather than trade for it, then markets will fail.
Agreements often separated by time—time of delivery of a good or service may differ from time of payment. If people can violate (renege) on agreements, then no contracts (arrangements/trades) will be made.
Laws, police, courts are critical societal institutions that allow markets to function.
Public Goods are those that lack either rivalry (they are nonrivalrous) or excludability (they are nonexcludable) or both.
Consider these examples:
Public Goods: Type I Rivalry & Nonexcludability
Fresh Water: We all need water to live, so there is potentially a huge market for it.
Water is rivalrous: My consumption of a certain quantity of water reduces the amount available for someone else to consume.
Water flowing in a river or underground is nonexcludable: In general, it is difficult or impossible to prevent someone from consuming such water.
Leads to the overconsumption of water—the concern that others will use the water if you do not gives people little incentive to conserve and there is insufficient investment in preserving the available supply.
Public Goods: Type I Rivalry & Nonexcludability Quantity of Fresh Water Price of Fresh Water D MPC Includes the cost of gathering and transporting the water and the reduction in stock of water for this individual only. MSC Includes cost of gathering and transporting, but also reflects reduction in stock of water available to all. Q P P P Q S P S Socially optimal consumption Equilibrium private consumption
Potential Policy Response Public Goods: Type I Rivalry & Nonexcludability
Charge a per unit tax that equals the difference between MPC and MSC.
This raises the MPC curve to coincide with the MSC curve.
Leads people to account for their effects on the total supply—and so, to conserve.
D MPC MSC Q P P P Q S P S Tax
Type I Public Good (R, NE) as Prisoner’s Dilemma
Two households sharing a single well.
If both cooperate and conserve water, then each gets 100 Utils (measure of utility (“happiness”)).
If one conserves while other does not; conserver gets 80 Utils and non-conserver gets 110 Utils.
If neither conserves, then each gets 90 Utils.
“ Do Not Conserve” is a “dominant strategy” for each player. Socially optimal result is Conserve. Nash Equilibrium is Do Not Conserve. Household 1 Household 2 Conserve Conserve Do Not Conserve Do Not Conserve 100 100 80 110 110 80 90 90
Public Goods: Type II Nonrivalry & Excludability
Consider a toll road (without congestion):
Nonrivalrous: In the absence of congestion, your consumption of the road does not reduce the amount that is available for others to consume.
Excludable: Access to the road only available if toll paid—preventing consumption.
Because it doesn’t cost any more to supply another person (no congestion), the marginal price of the lecture “should be” zero. But at that price no one would be willing to supply it.
If a positive price is charged, then there is underconsumption of the road—another traveler could use the road at no additional cost.
Leads to a distinction between the cost of supplying an additional person versus the cost of supplying an additional unit of the good.
With a private good (rival and excludable), in order to supply an additional person with the good, one must supply an additional unit of the good.
With a nonrival good, the same quantity can supply many people. So, an additional person can be supplied at no additional cost.
Requires a different method of moving from individual to market demand.
With a rival good, we sum over quantity
With a nonrival good, we sum over price
Market Demand for Rival and Nonrival Goods Rivalrous Good Q P P Q Nonrival Good D 1 D 2 D D 1 D 2 D Market Demand is the horizontal sum (over quantity) of individual demand Market Demand is the vertical sum (over price) of individual demand
Public Goods: Type II Nonrivalry & Excludability Toll Number of Travelers D S When toll road is not congested, supply exceeds demand at a zero price. Everyone can travel for free. But how is the toll road paid for? Charge a toll and accept underconsumption? Tax everyone & allow all to travel? 0
Public Goods: Type II Nonrivalry & Excludability w/ Congestion Toll Number of Travelers D At some point, each additional traveler imposes costs on others. A fee reflecting those costs may be appropriate. But this does NOT solve the problem of how to pay for toll road itself. 0 S P 0
Public Goods: Type III Nonrivalry & Nonexcludability
Nonrivalrous: Ignoring congestion, one person’s watching the display does not reduce the amount available to others.
Nonexcludable: Cannot prevent someone from looking at the sky and watching the display.
At a positive price, there is underconsumption.
Because of nonexcludability, no one is willing to supply the good.
Public Goods: Type III Nonrivalry & Nonexcludability Fireworks Price D 1 D 2 D 3 Total Demand Supply
Optimal provision of fireworks is at Q* where marginal cost (supply) equals total demand.
If knew each person’s individual demand, then could charge individual prices.
Since we don’t know individual demand, could tax to supply the good.
A congested road possibly the result of an initial Type III public good (nonrival and nonexcludable).
A newly-built road likely to have enough capacity for all current users. Thus, nonrival: one person’s use of the road does not reduce the amount available to another (measured in terms of transit time).
With multiple, public accesses, the road is effectively nonexcludable—difficult, or impossible, to prevent additional travelers.
Over time, as population grows and/or economy develops, the road becomes congested. Now the road is Type I (rival, nonexcludable).
Converting the road to a toll road is one option—excludability can reduce congestion.
In New York City (Manhattan) 20 years ago, flat toll to drive into city across George Washington Bridge.
Today, time-of-day pricing: $8 ( ฿ 240) during peak hours and $6 ( ฿ 180) during non-peak hours.
MPC reflects only the costs recognized by the company. If the company ignores pollution, then these costs will fall below Marginal Social Cost.
Too much is produced if the firm utilizes MPC.
May force the firm (or consumers) to bear the cost by imposing a tax on the manufactured good.
MPC (excluding costs of pollution) MSC (including costs of pollution) Q p Q*
Positive Externality: Education Education P S MPB MSB If parents only pay attention to the benefits to them of educating their child, then they are on the Marginal Private Benefit curve, and will choose education level E 0 . However, if education has positive socialization effects (encouraging cooperation, less violence, etc.), then there are benefits which accrue to others. And MSB is the relevant curve. The optimal level of education is then E*. The parents don’t spend enough on education at E 0 . May justify public subsidies for education. E 0 E*
Ronald Coase won the Nobel Prize in Economics in 1991—in part, for work which has become known as the Coase Theorem.
Suppose that a farmer and a cattle rancher operate in close proximity to one another so that occasionally straying cattle will trample some of the crops.
This can be viewed as a negative externality between producers. Traditionally this has been seen as a situation in which government policy must address the issue—perhaps by imposing a tax on cattle production.
Coase’s insight: The farmer and the cattle rancher could negotiate a solution—(1) the farmer could pay the cattle rancher to raise fewer cows, (2) the rancher could pay the farmer to plant elsewhere, (3) the two could share the cost of a fence, etc.
Moreover, Coase argued that the pattern of planting and cattle raising would be the same regardless of the solution negotiated. Indeed, the pattern would be the same irrespective of whether the farmer had the “right” to be free from cattle or the cattle rancher had the right to allow foraging. The “trick” is that the two have an incentive to maximize “joint production.”
Solution requires low “transaction costs”—the costs associated with bargaining and coming to an agreement.
Exercise: Which of the following are externalities?
Neighbor paints house (nice color)
Neighbor allows tree to grow, obstructing view
To reduce global warming, national government joins international treaty committing to end use of petroleum products by 2025.
New technology for making clothing puts professional tailors out of business.