101 Class 16 W2008 - Principles of Economics I Economics...

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Unformatted text preview: Principles of Economics I Economics 101 Announcements Readings: Chapter 6 and 5 today Chapter 5 next week Discussion Sections this week New assignment available on Ctools Quiz will be given in the first 15 minutes of class Exam 2 March 24th Practice Exam available early next week Goldman Sachs Presents "Why Work on Wall Street?" Date: Thursday, March 20 Time: 4:30pm 5:30pm Location: UClub Room, Michigan Union, Corner of State Street and University "Why Work on Wall Street?" is an educational program geared for freshmen, both with an interest in financial services and those with limited knowledge of the industry. Price Elasticity of Demand If Qd = a + b P Price Elasticity of Demand: %Qd / %P = %Q/%P = Q . P P Q = b.P/Q = [(a + bP) a]/Q = 1 a/Q Remember, 0 Q a, so that 0 < < Price Elasticity of Demand P P Small % change Elastic portion of the demand curve Elasticity close to 1 < < Elasticity = 1 Inelastic portion of the demand curve Big % change P 0 < < 1 Elasticity close to 0 Q Big % change Q Q Small % change Price Elasticity of Demand At what point does = 1? = Q . P If = 1 a/Q = 1 Then Q = a/2 P Q = bP/Q = [(a + b P) a]/Q = 1 a/Q Price Elasticity of Demand P a/|b| Elastic portion of the demand curve 1 < < Slope=1/b < 0 a/2|b| = 1 Inelastic portion of the demand curve 0 < < 1 a/2 a Q Elasticity A general concept linking %changes in two variables Example: Price elasticity of supply: = % change in quantity supplied Expect that > 0 % change in price Elasticity A general concept linking %changes in two variables Example: Income elasticity of demand: = % change in quantity demanded > 0: normal good < 0: inferior good % change in income Elasticity A general concept linking %changes in two variables Examples: CrossPrice elasticity of demand: = % change in quantity of X demanded If > 0: X and Y are substitutes If < 0: A and Y are complements % change in price of Y Elasticity A general concept linking %changes in two variables Examples: Wage elasticity of supply: = % change in quantity supplied Expect < 0 % change in wages Example: Income elasticity of demand Suppose Qd = 100 2 P + 10 Y If P = 20 and Y = 10 Then Qd = 160 Income elasticity of demand: %Qd / %Y = (Qd/Y) * (Y/Qd) = 10 * Y/Qd =10 * 10/160 =0.625 Example: Wage elasticity of supply Suppose Qs = 10 + 5 P 4 W If P = 20 and W = 5 Then Qs = 10 + 5(20) + 4(5) = 110 Wage elasticity of supply: %Qs / %W = (Qs/W) * (W/Qs) = 4 * W/Qs = 4 * 10/110 = 0.363636 Efficiency of Markets Earlier claim: The competitive market delivers efficient outcomes When the price adjusts to clear the market then 1. 2. 3. 4. All units of the good for which MV P are demanded All units of the good for which MC P are supplied Qd = Qs Therefore every unit of the good for which MV > MC is produced and also consumed (i.e. efficient output levels) Efficiency of Markets Efficiency depends on a series of important conditions being satisfied: 1. All buyers and seller in the markets are "price takers" Otherwise demand and supply curves don't make any sense Equilibrium isn't an appropriate prediction Efficiency of Markets Efficiency depends on a series of important conditions being satisfied: 2. Property rights must be well defined and protected Otherwise it is impossible to motivate people to trade Equilibrium is unlikely to be attained Efficiency of Markets Efficiency depends on a series of important conditions being satisfied: 3. Informational asymmetries do not exist Otherwise risks associated with trading with better informed agents inhibit trade Equilibrium isn't an appropriate prediction Efficiency of Markets What if 1. 2. 3. These situations give rise to the possibility that market outcomes will not be efficient Buyers or sellers are not price takers? All property rights are not well assigned or enforced? Informational asymmetries exist? "Market failure" Market Failure If 1. 2. 3. Will the market necessarily fail? Is there a role for the state to intervene in the market? What sort of efficiency improvements can we hope for from the state? Buyers or sellers are not price takers; All property rights are not well assigned or enforced; Informational asymmetries exist Market Failure We will try to answer these questions when: But will not have time to examine: Buyers or sellers are not price takers; All property rights are not well assigned or enforced effects of informational asymmetries between traders Market Failure: Part 1 Externalities We investigate a particular set of problems that arise when property rights are not well assigned Example: Rights to the air around us are We cannot trade air the market does not exist Consequently, this is a resource that is inefficiently allocated Not well defined Difficult to enforce, even if they were well defined POLLUTION abounds in inefficiently high quantities Example: Market for electricity from coal generators $/kW/h MCsoc = MC + MD Supply (MC) MCsoc = MVsoc P* Deadweight Loss Marginal Damage from Pollution (MD) Demand (MV) Qeff Q* Q (kW/h) Example: Pollution What's the problem? Transactions involve two parties People other than those two parties are affected by the transaction Interests of those affected by pollution are not represented in the transaction Buyer Seller Seller's decisions do not reflect the full social cost of providing the marginal unit Call the pollution cost and external cost or spillover cost Externalities An external cost (or negative externality or spillover cost) is a cost that accrues to a party outside the market transaction An external benefit (or positive externality or spillover benefit) is a benefit that accrues to a party outside the market transaction Implications of Externalities The parties transacting do not consider externalities when making their decisions Market prices will not reflect the full social costs or benefits at the margin Inefficient allocation of resources Too much provision of a good that provides an external cost Too little provision of a good that provides an external benefit $/immunization Example: Immunization Supply (MC) Deadweight Loss MVsoc = MV + MEB Demand (MV) Marginal external benefit (MEB) Q* Qeff Q (people) Another way of looking at the problem Why does the market fail to deliver the efficient outcome? There is a missing market Imagine we could define the following kind of enforceable rights: These rights could be traded The right to pollute, or the right not to pollute The rights to demand or withhold benefits from immunization Essentially, the right to consume the externality Market price of these rights would reflect the value of the externality Example: Pollution Suppose the right not to consume pollution were guaranteed to the general public If production generates pollution, then to sell a unit of the good the producer must The external cost is "internalized" Bear production cost; and Buy the right not to consume pollution from the public The market price of the right not to consume pollution will be the marginal value of that right: i.e. the marginal pollution cost The producer now faces the full social cost of producing the output. Example: Pollution $/unit MCprod + P MCprod + MCpollutionpollution right = MCsoc MCproduction MCsoc = MVsoc P* Ppollution right MCpollution MVsoc Q* Qeff Q Example: Pollution Suppose the right to generate pollution were guaranteed to the producer If production generates pollution, then to sell a unit of the good the producer must The external cost is "internalized" Bear production cost; and Forgo the opportunity to sell the pollution right to the general public The market price of the right to pollute will be the marginal value of that right: i.e. the marginal pollution cost The producer now faces the full social cost of producing the output. ...
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