ECON 1B03 PowerPoint Lecture Notes

ECON 1B03 PowerPoint Lecture Notes

Chapter 1 – Introduction to Microeconomics What is Economics? • Economics is the study of how society allocates its scarce resources to satisfy peoples’ unlimited wants. • Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. • Microeconomics focuses on the individual parts of the economy. • How households and firms make decisions and how they interact in specific markets • Macroeconomics looks at the economy as a whole. • Economy-wide phenomena, including inflation, unemployment, and economic growth • A market economy is one that allocates resources through the decentralized decisions of firms and households. • Households decide what to buy and who to work for. • Firms decide who to hire and how much to produce. • A command or centrally planned economy is one where all production and distribution decisions are made by a central authority, like a government. • Most economies are mixed economies – a combination of both. Canada is a mixed economy. Basic Principles of Economics • A household and an economy face many decisions: • Who will work? • What goods and how much will be produced? • What resources should be used in production? • At what price should goods be sold? • Every economic issue involves individual choice. Resources are Scarce • A resource is anything that can be used to produce something else. • EXAMPLES: land, labour, physical capital (buildings, machinery, etc.) To get one thing, we usually have to give up something else. • Full-time schooling v. full-time employment • Food v. clothing • Leisure time v. work Making decisions requires trading off one goal against another. Opportunity Costs • The opportunity cost of something is what you have to give up getting it. • It is the cost of the best forgone alternative. EXAMPLE • You decide to attend Mac. Your tuition costs $8000, books cost $1000 and your apartment costs $6000. Your total explicit costs are $15000. • You could have spent that money on something else – say, a car.

• That car is a foregone alternative – the opportunity cost of coming to Mac is the car you chose not to buy. • But there are other things you give up when you come to Mac. • Instead of coming to Mac, you could have lived at home for free and held a full-time job that earned you $28000. You gave up the $28000 income – this is an opportunity cost. • So what is the opportunity cost of coming to Mac? • It’s the value of the best foregone alternative the lost wages (value of $28000 versus the $15000 car). Marginal Thinking • Marginal changes are small, incremental adjustments to an existing plan of action. • For example, a firm will wonder “What will happen to my profit if I decide to produce one more good?” • People make decisions by comparing marginal benefits to marginal costs. • Marginal changes in costs or benefits motivate people to respond. • The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs. • For example, if producing one more good adds more to a firm’s revenue than to its costs, the firm will produce that good. • Adam Smith observed that households and firms act as if guided by an “invisible hand.” • If each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell and how to produce it, the market will settle on a product distribution and prices that are beneficial to all the individual members of a community, and hence to the community as a whole. • The reason for this is that greed will drive economic actors to beneficial behaviour. • Efficient methods of production will be adopted in order to maximize profits. • Low prices will be charged in order to undercut competitors. • Investors will invest in those industries that are most urgently needed to maximize returns, and withdraw capital from those that are less efficient in creating value. • Students will be guided to prepare for the most needed (and therefore most remunerative) careers. • And all these effects will take place dynamically and automatically. Markets Move Toward Equilibrium • An economic situation is in equilibrium when there is no incentive for any economic actors – households, firms, governments, etc. – to change their behaviour. • No individual would be better off doing something different. • Markets usually reach equilibrium through changes in prices. • Prices guide decision makers to reach outcomes that maximize the welfare of society as a whole. Gains from Trade • In a market economy, people engage in trade with each other. • Not every family or nation can produce everything it needs efficiently.

• We specialize in tasks we do best and trade with others for the things we need that they can provide. • In this way, we have gains from trade. Efficiency • An economy’s resources are used efficiently when they are used as best as possible to meet society’s goals. • The welfare of society is maximized. • Markets that are left to operate freely usually lead to efficiency. • Market failure occurs when the market fails to allocate resources efficiently. • When the market fails (breaks down) government can intervene to promote efficiency and equity. • Efficiency means society makes the best use of its resources (economic decisions). • Equity involves the fair distribution of resources (political decisions). Market failure may be caused by • An externality, which is the impact of one person or firm’s actions on the well-being of a bystander. • Market power, which is the ability of a single person or firm to unduly influence market prices. • Some goods just aren’t suited to the market – for example, donor organs. The Economist’s Roles • When economists are trying to explain the world, they are scientists. • When economists are trying to change the world, they are policy advisors. Positive Versus Normative Statements • Positive statements are statements that attempt to describe the world as it is. • Called descriptive analysis • Normative statements are statements about how the world should be. • Called prescriptive analysis Positive or Normative Statements? • An increase in the minimum wage will cause a decrease in employment among the least-skilled. POSITIVE • The income gains from a higher minimum wage are worth more than any slight reductions in employment. NORMATIVE Why Economists Disagree • They may disagree about the validity of alternative positive theories about how the world works. • They may have different values and, therefore, different normative views about what policy should try to accomplish.

Economic Models • Economists use models for many reasons. • We try to model human behaviour so we can make accurate predictions about potential economic outcomes. • We use models to help us explain how the economy works. Our First Model: The Circular-Flow Diagram Firms • Produce and sell goods and services • Hire and use factors of production Households • Buy and consume goods and services • Own and sell factors of production The Circular-Flow Diagram Markets for Goods and Services • Firms sell • Households buy Markets for Factors of Production • Households sell • Firms buy Factors of Production • Inputs used to produce goods and services • Land, labour, and capital

Chapter 2 – Production Possibilities The Production Possibilities Frontier • The production possibilities frontier, PPF, is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. • It shows the best an economy can do if it uses all its resources efficiently, given the current technology. • NOTE: the PPF is often called a production possibilities boundary, PPB. Example: Macland • Consider the economy of Macland. It produces only 2 goods: computers and cars. • Macland’s technology is given (it is what it is). • Its resources are fixed. • The following table shows combinations of computers and cars Macland can produce if it uses all its resources, given the current technology: COMPUTERS and CARS A 3000 0 B 2200 600 C 2000 700 D 0 1000 Note that this is only a partial table. Let’s graph these combinations: • Points A, B, C and D on the diagram are productively efficient – to produce these combos all resources are used, given the technology. • Point H lies outside the PPF – it is unattainable. There are not enough resources to produce that combo of goods, or the technology is not good enough or possibly both. • Point K lies inside the PPF. Macland can produce that combo, but it can produce more of one or the other or both, given the technology and available resources. • Point K is feasible, but not efficient. • Every point on the PPF is productively efficient. • However, you could be on the PPF but producing a combination of goods that society doesn’t want – i.e., the wrong combination. • You would be producing at a point that is socially inefficient.

• Efficiency, then, includes productive efficiency (on the PPF) and social efficiency (producing the combo of goods that society wants). • Every choice along the PPF involves a trade-off. • We have to give up some computers to get more cars and vice versa. • The PPF illustrates opportunity costs – how much we have to give up of one good to get more of the other. • To move from 0 cars to 600 cars: To get 600 cars, give up 800 computers To get 1 car, give up 800/600 = 1.33 computers The opportunity cost of a car = 1.33 computers. • To move from 700 cars to 1000 cars: To get 300 cars, give up 2000 computers To get 1 car, give up 2000/300 = 6.67 computers The opportunity cost of a car = 6.67 computers. • We can easily calculate the opportunity cost of a computer along the PPF. • It is the inverse of the opportunity cost of a car moving between the same points on the PPF. • The opportunity cost of a computer = 1/(opportunity cost of a car). • For example, to move from 2000 computers to 2200 computers: To get 200 computers, give up 100 cars To get 1 computer, give up 100/200 = .5 cars The opportunity cost of a computer = .5 cars This is exactly 1/(opp.cost of a car) = ½ = .5 • Notice that as we move down the PPF, the opportunity cost of a car increases. • This explains why the PPF is bowed out – increasing opportunity costs. • In fact, the |slope of the PPF| is the opportunity cost of a car at any point along the PPF. • In general, for any 2 goods X and Y (X is on the horizontal axis), the |slope of PPF| = opportunity cost of X. • Why do opportunity costs increase as we produce more of a good?

• Could be that we’re moving resources from the computer sector which were really good at making computers to the car sector where they aren’t as good. • It is also possible that opportunity costs are constant. • An economy always gives up the same amount of one good for more of another at the same rate. • For example, you always give up 50 bushels of wheat to produce 10 tonnes of carrots. • If opportunity costs are constant, the PPF will be linear. Shifts in the PPF • Any changes to the amount of available resources, their productivity or changes to the available technology will shift the PPF. • Economic growth shifts the PPF to the right. • For example, an improved technology only for computer production becomes available: Another example: • The labour force increases in both sectors and is equally productive: shifts the entire PPF out (right) • A rubber shortage that doesn’t affect computers means fewer tires and other rubber car parts which mean fewer cars can be produced: rotates the PPF in (towards the origin) so that fewer cars can be produced, but no change in the quantity of computers.

Chapter 3 – Comparative Advantage and Gains From Trade • Suppose there are 2 people trapped on an island: Peyton the potato farmer and Rodgers the beef rancher. • Only two goods are produced: potatoes and meat, and each person can produce both goods. • The following table gives information on how much they can produce of each good:

MEAT Peyton 8 oz Rodgers 24 oz

POTATOES 32 oz Thomson Canada Ltd. 48 oz

Suppose Peyton and Rodgers fend for themselves: • Each consumes what they each produce.06 Nelson, a division of Thomson Canada • So, the production possibilities frontier is also a consumption possibilities frontier. • Let’s compute the opportunity costs of producing each good for each person: (let’s ignore the units of measurement for now). For Peyton: • To get 32 potatoes, give up 8 meat Copyright © 2006 Nelson, a division of Thomson Canada Ltd. To get 1 potato, give up ¼ meat The opp.cost of a potato = ¼ meat The opp.cost of a meat = 4 potatoes For Rodgers: • To get 48 potatoes, give up 24 meat To get 1 potato, give up ½ meaton of Thomson Canada Ltd. The opp.cost of a potato = ½ meat The opp.cost of a meat = 2 potatoes. • Let’s compare their opportunity costs:

PEYTON RODGERS

Opp.Cost of a Potato

Opp.Cost of a piece of Meat

¼ meat ½ meat

4 potatoes 2 potatoes

Comparative Advantage • Peyton has a lower opportunity cost of producing potatoes (1/4 meat compared to ½ meat for Rodgers). • We say Peyton has a comparative advantage in potatoes: he can produce them at a lower opportunity cost than someone else. • Rodgers has a lower opportunity cost of producing meat (2 potatoes compared to 4 potatoes: Rodgers has a comparative advantage in meat. • Peyton should specialize in the production of potatoes and trade potatoes for meat. • Rodgers should specialize in producing meat and trade meat for potatoes. • When they trade with each other, they can consume more of both goods! Suppose that when they fend for themselves: • Rodgers produces and consumes 24 potatoes and 12 meats. • Peyton produces and consumes 16 potatoes and 4 meats. • Their PPFs are:

• Now suppose they decide to specialize and trade with each other. • They agree on a price of 15 potatoes for 5 meat – i.e. they will trade 15 potatoes for 5 meat. • The following table shows their production and consumption before and after specialization and trade:

In summary, • When there exists comparative advantage, each individual should specialize in the production of the good in which they have comparative advantage. • They should trade with each other. • There will be gains from trade for both.

• Note that usually textbooks will consider specializing in a good as producing only that good and then trading what they don’t consume. • Our textbook doesn’t. In that way, it’s more realistic about how economies actually function. • Most economies will produce some of both goods and then trade their surpluses. • However, on any tests and the exam, we’ll assume that when a firm specializes in the production of a good, it produces only that good. • Note that if no economy has a comparative advantage (that is, they have the same opportunity costs), there won’t be any trade. • That’s because there would be nothing to gain from trade. Absolute Advantage • Describes the productivity of one person, firm, or nation compared to that of another. • The producer that requires a smaller quantity of inputs to produce a good (is more productive) is said to have an absolute advantage in producing that good. • Productivity can be calculated as Productivity = quantity produced/number of inputs used • Rodgers needs only 10 minutes to produce an ounce of potatoes, whereas Peyton needs 15 minutes. • Rodgers needs only 20 minutes to produce an ounce of meat, whereas Peyton needs 60 minutes. • Rodgers has an absolute advantage in the production of both meat and potatoes. • Rodgers uses fewer inputs – in this case, labour time – to produce the same amount of both goods than Peyton the farmer. • Rodgers the rancher is more productive than Peyton the farmer in the production of both meat and potatoes.

• NOTE: Even though Rodgers has an absolute advantage in both goods, because there exists comparative advantage, there are still gains to be made from trade, as we have seen.

Chapter 4 – Market Forces of Supply and Demand Markets • A market is a group of buyers and sellers of a particular good or service of Thomson • The terms supply and demand refer to the behaviour of people as they interact with one another in markets. • Buyers (consumers) determine demand. • Sellers (firms, producers, suppliers) determine supply. • Market demand refers to the sum of all individual demands for a particular good or service. • Market supply refers to the sum of all individual supplies of a particular good or service. • There are different types of market structures. • A competitive market is one in which there are so many buyers and so many sellers that each has a negligible impact on the market price. • A perfectly competitive market: • All goods are exactly the same • Buyers & sellers so numerous that no one can affect the market price – each is a price taker • In this chapter, we assume markets are perfectly competitive. Demand • Quantity demanded, Qd is the amount of a good or service that consumers are willing and able to buy at a given price, P. • When the price of a good increases, you buy less of that good. • We say price and Qd are negatively related. • As P increases, Qd decreases The Law of Demand Other things being equal (ceteris paribus), when the price of a good rises, the quantity demanded of that good falls. The Law of Demand Other things being equal (ceteris paribus), when the price of a good rises, the quantity demanded of that good falls. Other Determinants of Demand Income 1. When income increases and you buy more of a good, this good is a normal good (or if income falls and you buy less). 2. When income increases and you buy less of a good, this good is an inferior good (or if income falls and you buy more).

• Most goods are normal goods. Examples of inferior goods include Kraft Dinner (as your income increases, you don’t have to eat KD anymore- you can afford steak) and bus rides (as income increases, you can take a cab or buy a car). Prices of related goods 1. If an increase in the price of one good leads to an increase in demand for another good (or vice versa), these goods are substitutes. • Examples: Coke and Pepsi, satellite dishes and cable TV, new cars and used cars. 2. If an increase in the price of a good leads to a decrease in demand for another good (or vice versa), these goods are complements. • Examples: TVs and DVD players, automobiles and gasoline, shoes and shoelaces. Tastes • If peoples’ preferences change towards a good, demand for that good will increase. • Things like advertising and government policy etc. can change preferences. Expectations • What you expect in the future may affect your demand for a good today. • Example: If you expect gas prices to go up tomorrow morning, you’ll fill up your tank tonight – your demand for gas today has increased. Population • An increase in population (and therefore an increase in the number of consumers) will increase demand. • Demand schedules are tables that show the relationship between price and quantity demanded for a good. • Demand curves are graphs of demand schedules. • Let’s do a concrete example: The Demand for Ice Cream Cones • Suppose there are only 2 consumers in the market for ice cream cones – Jerry and Chris. • Their demand schedules are as follows:

To get market demand, we just sum individual Qd at each price. • Now, let’s graph the market demand. • Q always goes on the horizontal axis and P goes on the vertical axis. Copyright © 2006 Nelson, a division of Thomson Canada Ltd.

• Note that when we derived Jerry and Chris’ demand (and therefore market demand), we assumed that income, prices of related goods, tastes and expectations were held constant – non-changing at this moment in time. Market Demand for Ice Cream Cones

Notice that even though Qd depends on P, P is on the vertical axis. • What we actually graph is the inverse demand function where we treat price as a function of quantity. • This representation will make later analysis simple and clear. A Change in Quantity Demanded • A change in quantity demanded is a movement along the demand curve due to a change in price of that good. • The demand curve itself does not move. Change in Qd

Change in Demand • A change in demand is a shift of the demand curve due to a change in a determinant of demand other than price. • An increase in demand will shift the demand curve to the right: demand is higher at every price. • A decrease in demand will shift the demand curve to the left: demand is lower at every price.

Shift Factors for Demand Consumer Income • As income increases, the demand for a normal good will increase – curve shifts to the right. • As income increases, the demand for an inferior good will decrease – curve shifts to the left.

Prices of Related Goods • When a fall in the price of one good reduces the demand for its substitute, the demand for the substitute shifts to the left. • When a fall in the price of one good increases the demand for its complement, the demand for the complement shifts to the right. • Changes in expectations and tastes will shift demand accordingly. • Increases in population will shift demand to the right. Supply • Quantity supplied, Qs, is the amount of a good that sellers are willing and able to sell. • When the price of a good increases, ceteris paribus, selling that good becomes more profitable and firms will want to offer more for sale. • Price and Qs are positively related. • As P increases, Qs increases The Law of Supply Other things being equal (ceteris paribus), the quantity supplied of a good rises when the price of the good rises. Other Determinants of Supply Input Prices • When the price of an input into production (also called a factor of production) like labour costs, raw materials, machinery, energy, etc. increases, producing the good becomes less profitable and firms will offer fewer goods for sale at any price (and vice versa). Technology • Advances in technology which reduce production costs will increase supply. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Expectations • If a firm expects selling P to increase in the future, it will hold off selling now and current supply will decrease. Number of Firms • More firms in the market mean more supply.

The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. The supply curve is a graph of the supply schedule. Let’s look at the supply schedule for Paul and John, the only 2 firms that sell ice cream cones in our market:

A Change in Quantity Supplied • A change in quantity supplied is a movement along the supply curve due to a change in the selling price of the good. • The supply curve does not moves

A Change in Supply • A change in supply is a shift of the supply curve due to a change in any of its determinants except price. • An increase in supply means a shift to the right. • A decrease in supply means a shift to the left. • If input prices increase, the supply curve shifts to the left (and vice versa). • Advances in technology and an increase in the number of firms will shift the supply curve to the right. • Expectations will shift supply according to the expectation. Market Equilibrium

• Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. • Buyers have bought all they want to buy and firms have sold all they want. • There’s no incentive for buyers or sellers to change what they’re doing. • No one is left without and no one has any extra at the prevailing market price – the market clears. • The price at which Qd = Qs is the equilibrium price, also called the market clearing price. • The quantity at which Qd = Qs is the equilibrium quantity. • It is the quantity traded in the market (the quantity that is actually sold). • The equilibrium price is $2.00 per cone. • The equilibrium quantity is 7 cones. Markets Not in Equilibrium Suppose that for some reason, the market price of ice cream cones was $2.50. • At $2.50, consumers will only buy 4 cones, but firms will offer 10 cones for sale. • There will be a surplus, or excess supply at a price above equilibrium price where Qs > Qd. • Firms will want to decrease inventory by lowering P. • As P decreases, consumers purchase more of the good. • Eventually we return to eqm. P where Qd = Qs with no further pressures on price. Suppose that for some reason, the market price of ice cream cones was $1.50. • At $1.50, consumers will want to buy 10 cones, but firms will only offer 4 cones for sale. • There will be a shortage, or excess demand at a price below equilibrium price where Qd > Qs.

• Too many buyers will bid up P and firms will start to supply more. • As P increases, firms supply more and consumers purchase less of the good. • Eventually we return to eqm. P where Qd = Qs with no further pressures on price. Law of Supply and Demand The price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance. The market returns to equilibrium if it is left to operate freely. Analyzing Changes in Equilibrium • Often, events can happen which will shift demand or supply or both. • This will lead to a change in eqm. P and Q. • We can use our diagrams to see what happens (this is called comparative statics). • Decide whether the event shifts the supply or demand curve (or both). • Decide whether the curve(s) shift(s) to the left or to the right. • Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity. Example: A change in demand. Suppose a heat wave increases the demand for ice cream. • D will shift right. • New intersection of D and S • Eqm. P increases and Q increases • We have a change in demand and a change in quantity supplied (D shifts, but we move up the S curve).

Example: A change in supply. Suppose the price of sugar, a key input into ice cream production, rises. Copyright © 2006 Nelson, a • Costs of production increases, S decreases • New intersection of D and S • Eqm. P increases and Q decreases • We have a change in supply and a change in quantity demanded (S shifts, movement up the demand curve). Changes in Both Demand and Supply

• When an event or events shift both D and S at the same time, what happens to eqm. P and Q depends on the size of the relative shifts. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. • For example, we have a simultaneous increases in D and increases in S • Q will increase, but we don’t know what will happen to P – the change in P is ambiguous and depends on the relative magnitudes of the shifts in D and S. Using Equations • Most of the time, we will be representing demand and supply using equations. • In first year, we simplify and assume that both demand and supply are linear equations. • EXAMPLE: The Candy Bar Market • The demand and supply equations for the candy bar market are: • Demand: Qd = 1600 – 300P • Supply: Qs = 800 + 700P Copyright © 2006 Nelson, a division of Thomson Canada Ltd. • In equilibrium, Qd = Qs 1600 - 300P = 800 + 700P 800 = 1000P P* = .80 is eqm. price Substitute P* = .80 into either D or S equation to solve for eqm Q, denoted Q*: • I’ll use the equation for Qs: Qs = 800 + 700(.80) = 1360 = Qd = Q* • Therefore, in equilibrium, price = $.80 and quantity traded = 1360 candy bars. • Now suppose that the candy industry declares that it is officially Chocolate Month. All firms decide to keep candy bar price frozen at $.50 a bar as a special promotion. • Since price is below eqm. P*, we know there will be excess demand for candy bars. Let’s calculate the shortage: • At P = .50, Qd = 1600 – 300(.50) = 1450 Qs = 800 + 700 (.50) = 1150 Excess demand = Qd – Qs = 1450 –1150 = 300 There is a shortage of 300 candy bars. • If the candy bar market is left to operate freely, eventually we’ll see a return to equilibrium P and Q. • Too many candy bar demanders will lead to upward pressure on price. • Candy bar suppliers will supply more as price increases. • We’ll end up at the original P* and Q*.

Chapter 5 – Elasticity Elasticity • is a measure of how much buyers and sellers respond to changes in market conditions.

• measures how responsive Qd or Qs is to changes in price, income or prices of related goods. • allows us to analyze supply and demand with greater precision. Elasticity of Demand • Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. • Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. • The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. • We’ll denote price elasticity by Ep. • Ep = percentage change in Qd percentage change in P = % change in Qd/% change in P • The number we get from our calculations is called the coefficient of elasticity. • The size of the coefficient, Ep, will tell us how elastic the good is – how responsive demand is to a change in price. • Since elasticity will vary, we can define different types of elasticity. Types of Price Elasticity • People respond to changes in price differently depending on various factors. • Are there a large number of substitutes? • Is the good a luxury or a necessity? • How narrowly defined is the market? • What about the time period? Inelastic Demand • Quantity demanded does not respond strongly to price changes. • The % change in Qd < % change in P • Ep < 1 • The demand curve would be fairly steep. • Example: required textbooks. Your only option to buying a new book is to find a used copy, which may be difficult. Elastic Demand • Quantity demanded responds strongly changes in price. • The % change in Qd > % change in P • Ep > 1 • The demand curve would be fairly flat. • Example: most manufactures.

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Perfectly Inelastic Demand • Quantity demanded does not respond price changes at all. • Ep = 0 • The demand curve is vertical. • Example: prescription heart medication. If you need it to stay alive, price is not even an issue. Perfectly Elastic Demand • Quantity demanded changes infinitely with any change in price. • Ep => infinity • The demand curve is horizontal. • Example: wheat. If a supplier raises her price, you’ll find a cheaper supplier because wheat is wheat – she won’t sell any wheat, so she faces a perfectly elastic demand for her wheat

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Unit Elastic • Quantity demanded changes by the same percentage as the price • Ep = 1 • The demand curve is non-linear. • Example: none really exist, so think of unit elasticity as simply a dividing point between elastic and inelastic. • NOTE: The more price - elastic the demand for a good, the flatter the demand curve will be. Calculating Elasticity • If we are given percentage changes in price and the corresponding changes in Qd, we use the formula Ep = % change in Qd / % change in P • For example, The price of milk increases by 2% and Qd decreases by .5% Ep = -.5/2 = -.25 • Another formula we use is the midpoint formula. • The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. • We use it when we are given two prices and their corresponding Qd values. • The midpoint formula is: Ep = (Q2 – Q1) / ([Q2 + Q1] / 2) / (P – P ) / ([P + P ] / 2) • Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

• P1 = 2.00 • P2 = 2.20 • Q1 = 10 •Q=8 Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 2 Ep = (8 – 10) / (8 + 10) /2 (2.20 - 2.00) / (2.20 + 2.00) /2 = -2 /9 .20 / 2.10 = - .22 / .095 = -2.32 • In both examples, we have an elasticity coefficient that has a negative sign. • But, remember the law of demand: as P increases, Qd decreases. The coefficient will always be a negative number. • Since we’re smart economists and know this, when we calculate price elasticity, we drop the negative sign (we know it will always be negative). • So, in our milk example, Ep = .25 • Since Ep < 1, the demand for milk is inelastic. • Demand does not respond strongly to changes in price. • In our ice cream example, Ep = 2.32 • Since Ep > 1, the demand for ice cream is elastic. • Demand responds strongly to changes in price. Generalities About Elasticises and Their Determinants 1. Goods that are necessities tend to have inelastic demand. • Example: the demand for insulin would be perfectly inelastic (no matter how much price changes, if you have to have insulin, you’ll buy it). • Example: the demand for dentist visits would be inelastic (if price went up, you may try to wait or shop around, but you’ll still go to get rid of the pain). 2. Goods that are luxuries tend to have elastic demand. • Example: the demand for plasma TVs (if the price is right, you may buy one, but you likely won’t buy one if the price is too high for your budget). • Example: vacations abroad (same reason as above). 3. Goods that have close substitutes tend to have elastic demand. • Example: Coke and Pepsi (if the price of Coke goes up, many consumers will switch to Pepsi). • Example: Eggs don’t really have a close substitute (their demand is pretty inelastic). 4. Goods tend to have more elastic demand over longer time horizons. • You can find substitutes in the long run where you can’t in the short run. 5. How you define the market makes a difference. • Example: Food – inelastic Vegetables – more elastic

Broccoli – even more elastic • The more narrowly defined the market, the more elastic the demand for that good. 6. How much of your budget you spend on a good determines elasticity. • If you spend a large proportion of your budget on a good, demand for that good will tend to be elastic. • If you only spend a small proportion of your budget on a good, demand will tend to be inelastic. • Elasticity is not constant along a linear demand curve. • Elasticity is not the same as slope. • Slope measures rates of change. • Elasticity measures percentage changes. • We can illustrate different elasticises along the demand curve: Optional – For Calculus Lovers • Technically, elasticity measures marginal changes in Qd when price changes. • This is point elasticity, and the formula for a demand curve specified as Q = f(p) is • Ep = dQ/dp * p/Q • Since p and Q are different combinations at different points on the demand curve, that’s why elasticity changes along the demand curve. • Since dQ/dp is the slope of the demand curve, that’s why we can “see” elasticity by the steepness of the curve. Price Elasticity and Total Revenue • A firm wants to maximize its profit. Other things being equal, it will want to maximize its total revenue. • The firm would like to sell as much as it could at the highest price it could get. But, it wouldn’t want to charge a price so high that it loses customers and its revenue drops. • Here’s where knowing the price elasticity of demand for its good is handy for a firm. • Total revenue, TR, is defined as TR = PQ (Price times the quantity traded) • Diagrammatically, • With an inelastic demand curve, an increase in price leads to a decrease quantity that is proportionately smaller.

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• The gain to TR from the P increase will outweigh the loss to TR from a decrease in Q. • A firm would only lose a few sales but make up for it by getting a higher price for the sales it does make. • TR will increase if P increases if demand is inelastic. • So, if a firm wants to increases TR and demand for its good is inelastic, it should increases P. • With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. • The gain to TR from the P increase will be outweighed by the loss in TR from lost sales. • A firm would lose so many sales that even with a higher price on the sales it does make; it still ends up with less total revenue. • TR will decrease if P increases if demand is elastic. • So, if a firm wants to increases TR and demand for its good is elastic, it should decreases P. • If demand is unit elastic, the gain to TR from a P increase will be exactly offset by the decrease in Q. • TR will not change if P increases and demand is unit elastic. • TR will not change if P increases and demand is unit elastic. • No change in P will decreases TR, so • TR must be at a maximum when Ep = 1. Income Elasticity of Demand • Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. • It is computed as the percentage change in the quantity demanded divided by the percentage change in income. • Income elasticity is denoted EI • If we are given percentage changes in income and the corresponding changes in Qd, we use the formula EI = % change in Qd % change in I • If we are given 2 levels of income and their corresponding Qd, we use the midpoint formula. • The midpoint formula is: EI = (Q2 – Q1) / ([Q2 + Q1] / 2) / (I2 – I1) / ([I2 + I1] / 2) Here, the plus or minus sign matters. • If EI > 0 - The good is a normal good Copyright © 2006 Nelson, a division of Thomson Canada Ltd. - As I increase, Qd increase • If EI < 0 - The good is an inferior good - As I decrease, Qd increase • If EI is between -1 and 1, the good is income inelastic.

• If EI is greater than 1 or less than -1, the good is income elastic. Goods consumers regard as necessities tend to be income inelastic. • Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. • Examples include sports cars, jewellery, Buffalo Bills season tickets and expensive foods. • Example: Consumer incomes decrease from $45 000 to $40 000. Demand for instant mashed potatoes increases from 100 boxes to 102 boxes per year. • Q1 = 100 • Q2 = 102 • I1 = $45 000 • I2 = $40 000 • EI = (102-100) / (102 + 100) / 2 (40000 - 45000) / (40000 + 45000) / 2 = .02 /- .117 = -.17 Instant mashed potatoes are income inelastic (elasticity is a fraction) and inferior (elasticity is negative). Cross-Price Elasticity of Demand • Denoted Eab, cross-price elasticity measures the response of Qd of a good “a” to a change in price of good “b”. • Eab = % change in Qd of good “a” % change in P of good “b” • The midpoint formula is: Eab = (Q2a – Q1a) / (Q2a + Q1a) / 2 / (P2b – P1b) / (P2b + P1b) / 2 • The plus or minus sign matters. • If elasticity is > 0, an increase in P of “b” will lead to an increase in Qd of “a” - The goods are substitutes • If elasticity is < 0, an increase in P of “b” will lead to a decrease in Qd of “a” - The goods are complements • Example: The price of a soft drink increases from $1.99 to $2.49 per 2-litre bottle. Demand for a fruit juice increases from 500 to 1000 bottles. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Q1a = 500 Q2a = 1000 P1b = 1.99 P2b = 2.49 Eab = (1000 - 500) / (1000 + 500) / 2 (2.49 -1.99) / (2.49 + 1.99) / 2 = .67 / .22 = 3.05 • Elasticity is positive so the goods are substitutes.

• NOTE: if cross-price elasticity equals 0, the goods are not related. Elasticity of Supply • Price elasticity of supply, Es, is a measure of how much the quantity supplied of a good responds to a change in the price of that good. • Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price. • Since P and Qs always move in the same direction, Es will always be > 0. • Es = % change in Qs % change in P • The midpoint formula is: Es = (Q2 – Q1) / ([Q2 + Q1] / 2) (P2 – P1) / ([P2 + P1] / 2) Where Q = quantity supplied. • Just as we did for price elasticity of demand, we can categorize types of elasticity of supply: Copyright © 2006 Nelson, a division of Perfectly Inelastic Supply • Es = 0 • Supply curve is vertical. • Examples: agricultural products, rare art.

Inelastic Supply • Es between 0 and 1 (a fraction). • Supply curve is fairly steep. • Example: lakefront property.

Elastic Supply • Es > 1 • Supply curve is fairly flat. • Example: most manufactures.

Perfectly Elastic Supply • Es => infinity • Supply curve is horizontal. • Example: any good for which a decrease in selling price means a firm will not supply any

amount. This would be the case if the price fell to a point where all suppliers would lose money if they produced the good. Unit elastic supply • Es = 1 • Example: any good for which a percentage change in price leads to the same percentage change in quantity supplied. No, I don’t know of a real world example. • A key determinant of supply elasticity is time. • Supply is usually more elastic in the long run than in the short run. • In the long run, firms can build or close factories, enter new markets, etc. • In the short run, it may be hard to adjust production amounts (especially in agriculture). • Note: just like demand, the flatter the supply curve, the more elastic is the supply of the good. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Applications: Case 1 • Suppose that we have a supply curve. We have 2 demand curves – a flatter, elastic demand curve, DE and a steeper, inelastic demand curve, DI. • Now suppose supply increases: • If D is inelastic, P* decrease to PI and Q* increase to QI • If D is elastic, P* decrease to PE and Q* increase to QE • If D is inelastic, an increase in S will decrease P by more and increase by less than if demand was elastic.

Q

Applications: Case 2 • Suppose that we have a demand curve. We have 2 supply curves – a flatter, elastic supply curve, SE and a steeper, inelastic supply curve, SI. • Now suppose demand increases. • If S is elastic, P* increase to PE and Q* increase to QE • If S is inelastic, P* increase to PI and Q* increase to QI • If S is inelastic, an increase in D will increase P by more and increase Q by less than if supply was elastic.

Chapter 6 and 8 – Price Control and Taxes

• Recall: In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. • While equilibrium conditions may be efficient, it may be the case that not everyone in society is satisfied and the government may want to get involved. • Now we’ll look at government policies and how they affect supply and demand. Price Controls • are usually enacted when policymakers believe the market price is unfair to buyers or sellers. • The government will freeze prices at a predetermined level that they feel will make members of society better off. Price Ceilings • A price ceiling is a legal maximum on the price at which a good can be sold. • The price ceiling is not binding (not effective) if it is set above equilibrium price. • The price ceiling is binding (effective) if set below equilibrium price, leading to a shortage. • Example: Rent Control • The government’s goal: to help the poor by making housing more affordable. • It sets a maximum price (rent) for housing that is below equilibrium price. • In the SR, the number of apartments is fixed, so Supply of housing is inelastic. • Potential renters may not be highly responsive to rents because they take time to adjust their housing arrangements (eg. give notice to current landlord), so Demand for housing in the SR is relatively inelastic. • In the LR, low rents can mean that landlords may convert to condos, get out of the rental business and/or won’t maintain existing apartments, so Supply is elastic. • Low rents encourage people to look for housing (move out from your parents if the price is right), so Demand is elastic. • In the LR, the housing shortage is large. • Where rent controls exist, landlords must resort to non-price rationing of housing. • Can keep long waiting lists. • Can discriminate (no children, pets, etc.). • Some take bribes (key money).

• Some may convert existing apartments to condominiums, making the shortage even greater. Numerical Example • The equations for demand and supply for 1-bedroom apartments in Glanbrook are: Copyright © 2006 Nelson, a division of Thomson Canada Ltd. ▫ Qd = 1700 – 2P ▫ Qs = 2P – 900 What is equilibrium rental price and apartments rented? In eqm., Qd = Qs Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 1700 – 2P = 2P – 900 4P = 2600 P = 650 Qd = 1700 – 2(650) = 400 = Qs = Q* What if the province imposes a rent ceiling of $500? Copyright © 2006 Nelson, a division of Thomson Canada Ltd. If P = 500 Qd = 1700 – 2(500) = 700 Qs = 2(500) – 900 = 100 Shortage = Qd – Qs = 600 Price ceilings can lead to: Shortages that worsen over time. Inefficient allocation to consumers. • People who want the good badly may not get it while those who care less do. Wasted resources • You spend a lot of time trying to find an apartment, leave work early… Inefficiently low quality • No incentive for landlords to keep up apartments if they have to rent them cheaply. Black Markets • Example: “I’ll rent you an apartment if you slip me an extra $500 a month under the table.” • Illegal, but they often occur.

• At Q ceiling, consumers would be willing to pay up to the black market price for housing. • The landlord would legally claim rent = rent ceiling and charge the renter the difference under the table. Price Floors • A price floor is a legal minimum on the price at which a good can be sold. • The price floor is not binding if set below the equilibrium price. • The price floor is binding if set above the equilibrium price, leading to a surplus. • Example: Minimum Wage • The government’s goal: to ensure at least a certain wage for workers. • It sets a minimum price of labour (wage) that is above equilibrium wage-usually, only affects low paid workers. • At a wage above equilibrium wage, S of labour > D for labour • There’s an excess supply of labour, a surplus i.e., unemployment • Excess supply = Qs – Qd Critics of minimum wages argue that it causes • Unemployment to increase • Encourages teens to drop out of school • Prevents unskilled workers from getting on-the job training • It isn’t high enough to really relieve poverty for the working poor • The minimum wage in Ontario is $9.50 per hour and will increase to $10.25 on March 31, 2010. Numerical Example • The equations for demand and supply in the labour market are: Copyright © 2006 Nelson, a division of Thomson Canada Ltd. • Qd = 22 – 2W • Qs = 3W – 18 W = wage, the price of labour Labour is measured in ‘000s of hours • What is equilibrium employment? In eqm., Qd = Qs 22 – 2W = 3W – 18 40 = 5W W=8

wage

and

Qd = 22 – 2(8) = 6 = Qs = Q* (6,000 hours)

• What if the province imposes a minimum wage of $10 per hour? • If W = 10, Qd = 22 – 2(10) = 2,000 hrs. Qs = 3(10) – 18 = 12,000 hrs. • The surplus of labour hours = Qs –Qd = 12 -2 = 10,000 hrs unemployment = 10,000 hrs Price floors can lead to: Surplus production • Producers will want to supply more at the higher price. • Surpluses may be stored, destroyed, exported, given away. • Can’t sell surpluses on the domestic market or selling price will fall below the floor level. Inefficient allocation of sales • Those willing to sell the good at a lower price aren’t always the ones that manage to sell it. • eg. You’re willing to work below min wage but don’t get hired while a student has a job she doesn’t really care about but thinks the wage is worth it. Wasted resources • You may spend a lot of time looking for work. Inefficiently high quality • Fancy packaging, added bells and whistles to make the good really attractive to consumers who’d be happy to pay less for lower quality merchandise. Illegal activities • “I’ll work under the table for less than minimum wage if you hire me.” Quotas A quota is a quantity control. • An upper limit on the quantity of a good that can be sold. • The government usually issues quota licences that give producers the right to produce a specified amount of a good. • Examples: the number of taxis in a city amount of fish you can catch and sell (often seen with agricultural and dairy products)

• In an unregulated market, eqm P = $1 and Q = 13 million litres per week. • The Canadian Dairy Association decides to limit output to increase prices received by producers and avoid surplus production. • It makes sure the gov’t backs it up by imposing tariffs on imports of milk from the US. This will make milk expensive enough so that consumers won’t buy US milk. • The quota is set at 9 million litres per week. • At Q = 9 million, consumers are willing to pay $1.80 per litre (this is the demand price). • But, at that Q, producers would normally be happy to receive $ .60 per litre. • The difference between these 2 prices is the quota rent: quota owners receive an additional $1.20 per litre per week. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. This is also the value of the quota. • Someone who wanted to produce milk would be willing to pay up to $1.20 per litre per week to acquire the rights to produce milk, sell it at $1.80 and net $.60 per litre per week. Taxes • Governments levy taxes to raise revenue for public projects. • Tax incidence is the distribution of a tax burden. • Do buyers or sellers bear the burden when the government imposes a tax? A Tax on Consumers • Example: The Market for Beer • P is the price per bottle. • Q is the number of bottles sold per week at a very small bar in a farming community. • In equilibrium, P = $3.00 and Q = 100 • Now, suppose the government imposes a tax of $ .50 per bottle on consumers of beer. • Consumers will demand less beer. • The gov’t doesn’t care what the eqm price is, and the $ .50 tax will apply no matter what the price of beer happens to be. • Consumers will want less beer at any price. • This means the demand curve will shift down by the amount of the tax. • Now there’s a new eqm at P = $2.80 and Q = 90. • But, the consumers must pay the $ .50 tax. • They end up paying a price P = $3.30, while the C firm (the bar) receives PF = $2.80. • The government receives $.50 x 90 = $45.00 in tax revenue. • Notice that the burden of the tax doesn’t fall equally on consumers and sellers.

• Before the tax, the consumers paid $3.00 and sellers received $3.00 per bottle. After the tax, • Consumers pay $ .30 more per bottle. • Sellers receive $ .20 less per bottle. • In this case, the consumers bear the larger burden of the tax: $.30 versus $.20. A Tax on Suppliers Now, suppose instead that the government levies the tax on bar owners. • Sellers react by supplying less beer at every price. • The supply curve will shift up by the amount of the tax. • Again, there’s a new eqm P = $3.30 and Q = 90. • Consumers pay PC = $3.30 • Sellers receive P = $2.80 (they get $3.30 from F the consumer and remit $ .50 to the government for a net take of $2.80) • The gov’t receives $ .50 x 90 = $45.00 in tax revenue. • The burden of the tax is the same. • Consumers pay $ .30 more than before. • Sellers receive $ .20 less than before. • The consumer bears the larger burden of the tax. To summarize, • Taxes on consumers and taxes on suppliers are equivalent – the end result doesn’t matter on whom the tax is levied. • Taxes reduce the quantity traded, increase the price consumers pay and lower the price suppliers receive. • In our example, the consumers bore the larger burden of the tax. • That’s because the demand curve is actually steeper than the supply curve. • This turns out to be a general rule: The side of the market which is more inelastic (steeper curve) bears a larger burden of the tax. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Why inelastic? • Less responsive to change • Can’t adjust to compensate to any great extent • You get stuck with a larger share of the tax

Elastic Supply, Inelastic Demand

Elastic Demand, Inelastic Supply

The Deadweight Loss of Taxation Ch. 8 • Since a tax places a burden on consumers and suppliers, this suggests that they lose some of the benefits they would have received from market equilibrium. • The government’s tax revenues are a benefit for them and a benefit for the recipients when the gov’t spends that revenue on social programs. • Ultimately, consumers and producers lose out. Changes in Welfare • A tax on a good reduces consumer surplus and producer surplus.

• On the following diagram, total surplus is the area of triangle ABC. • A tax reduces the quantity traded, increases the price consumers pay and decreases the price suppliers receive. • The new CS is triangle A on the following diagram. • The new PS is triangle F. • The tax revenue is the sum of rectangle B (lost CS) and rectangle D (lost PS) • The area of triangle C and triangle E is surplus no one gets because of the tax. • Consumers used to get triangle C and suppliers used to get triangle E before tax. • Triangle C + triangle E represent the deadweight loss due to taxation, DWL = the loss in total surplus that results from a tax

the

Determinants of the Deadweight Loss What determines the size of the deadweight loss from a tax? • It depends on how much the quantity supplied and quantity demanded respond to changes in the price. • This depends on the price elasticises of supply and demand. The following examples show what happens to deadweight loss when the size of the tax remains the same and the Copyright © 2006 Nelson, a division of Thomson Canada Ltd. • Demand curve is the same but supply elasticity changes. • Supply curve is the same but demand elasticity changes. The greater the elasticises of demand and supply: • The larger the decline in equilibrium quantity and • The greater the deadweight loss of a tax. • With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax. • For the small tax, tax revenue is small. • As the size of the tax rises, tax revenue grows.

• But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market. Working with Equations The market for pizzas is represented by the following equations for demand and supply: Qd = 20 – 2P Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Qs = P - 1 In eqm, Qd =Qs 20 – 2P = P – 1 P = $7 Q=6 • Now suppose a tax on trans fats results in a $3 tax per pizza for pizza firms. • The new supply curve is Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Qs = P – 4 • For consumers, Pc is determined where the new Qs = Qd P – 4 = 20 – 2P P = $8 • For pizza firms, we need to know what the new Q will be first, and then we can solve for the price they receive. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. • To find Q, substitute P = 8 into either the new Qs or Qd: (I’ll use the new Qs) Qs = P – 4 Qs = 4 So, with the tax, only 4 pizzas are traded in the market. • Now, substitute Q =4 into the old Qs to get the price firms receive: Qs = P – 1 4=P–1 PF = $5 • So, consumers pay $8 and firms receive $5. • The government’s tax revenue is $3 x 4 = $12 • Let’s graph our results: Suppose we wanted to compare CS before and after the tax. • We need the P-intercept for the demand curve. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. • Set Qd = 0 in eqn for demand: 0 = 20 – 2P

P = 10

Chapter 7 – Consumer and Producer Surplus Revisiting the Market Equilibrium • Do the equilibrium price and quantity maximize the total welfare of buyers and sellers? • Market equilibrium reflects the way markets allocate scarce resources. • Whether the market allocation is desirable can be addressed by welfare economics. Welfare Economics • Welfare economics: the study of how the allocation of resources affects economic wellbeing. • Buyers and sellers receive benefits from participating in the market. • Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product. Consumer Surplus • Every buyer in an economy is only willing to pay up to a certain amount for a good or service. We define: • Willingness-to-pay: the maximum amount that a buyer will pay for a good. - measures the value the buyer places on the good - Also called reservation price • When a buyer actually pays less than he/she is willing to pay, they enjoy a benefit. We define:

• Consumer surplus: the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. • The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. - It depicts consumers’ willingness-to-pay. • Suppose the market price of a good is $50.

Producer Surplus

• Producer surplus = the amount a seller is paid for a good minus the seller’s cost. • It measures the benefit to sellers participating in a market. • Cost is a measure of the seller’s willingness-to sell = the lowest price a supplier will take to produce a good and offer it for sale. -when a producer receives more than they are willing to take to produce a good, they enjoy a benefit. • Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve. - The supply curve reflects a producer’s costs. • The area below the selling price and above the supply curve measures the producer surplus in a market.

Market Efficiency • Consumer surplus and producer surplus may be used to address the following question: Is the allocation of resources determined by free markets in any way desirable? Consumer Surplus = Value to buyers – Amount buyer pays and Producer Surplus = Amount sellers receive – Cost to sellers Since amount buyer pays = amount sellers receive Total Surplus = Consumer Surplus + Producer Surplus or Total Surplus = Value to buyers – Cost to sellers • If an allocation of resources maximizes total surplus, we say that allocation is efficient. • If an allocation of resources leads to well-being that’s fairly distributed among society’s members, that’s equity. • We can illustrate total surplus for market equilibrium: Three Observations Concerning Market Outcomes Free markets • allocate the supply of goods to the buyers who value them most highly (have the highest willingness to pay). • allocate the demand for goods to the producers who can produce them at least cost.

• produce the quantity of goods that maximizes the sum of consumer and producer surplus. • Because the equilibrium outcome is an efficient allocation of resources, a social planner can leave the market outcome as he/she finds it. • This policy of leaving well enough alone goes by the French expression laissez faire.

Chapter 9 – International Trade

Chapter 10 – Externalities Externalities • Sometimes there are benefits and costs that arise in the market that go uncompensated. • These are called externalities. • A positive externality is a benefit that is enjoyed by society, but society doesn’t pay to receive it. • Example: I enjoy the shade from my neighbour’s tree, and it doesn’t cost me anything. • A negative externality is a cost suffered by society, and the instigator isn’t made to pay for the damage they do. • Example: my neighbour’s nasty dog barks all night and keeps me awake, and my neighbour doesn’t compensate me for my lost sleep. So, externalities • are created when a market outcome affects individuals other than buyers and sellers in that market. • cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers. • can lead to inefficient markets if buyers and sellers do not take them into account when deciding how much to consume and produce. • Negative externalities lead markets to produce more than is socially desirable. • Positive externalities lead markets to produce less than is socially desirable. Consider the market for steel: • If steel factories emit pollution, the cost to society of producing steel is larger than the private costs of the producers.

• The social cost includes the private costs of producers plus the cost to the public adversely affected by pollution. • The socially optimal level of output is less than the market equilibrium level of output. • In other words, if we don’t account for the costs of pollution, we end up producing too much of the good. • “Bad” pollution takes away from the benefits of buying and selling steel. • It takes away from total surplus in the market for steel.

• The brown triangle represents the loss of surplus due to the negative externality from pollution. • We call this loss of surplus a deadweight loss due to the externality. • The government can internalize an externality by imposing a tax on the producer to get them to produce less – to produce the socially desirable quantity. • This tax is known as a Pigovian Tax, levied on each unit of output sold (we’ll see taxes in the next chapters). • The government can also regulate the amount of pollution a firm may produce. • It may sell permits to firms allowing them a certain amount of pollution. • Firms which can reduce pollution at lower costs can sell these permits to other firms which can only reduce pollution at high costs and may not even bother to try. Positive Externalities • Now, consider the discovery of penicillin as treatment for STDs.

• The drug not only helps those with an STD but also benefits all of society by limiting their exposure to disease. • The discovery and production of penicillin has a positive externality. • The social value of the drug includes not only the private value to those who take the drug, but also includes the value to the rest of society. • The socially desirable level of output is greater than the market equilibrium level of output. • In other words, we are not producing enough of the good. • If we produced more, there would be greater benefits for society. • We could increase total surplus in the market.

• The government can internalize the externality by subsidizing the production of the good – get firms to supply more. • Government action is not always necessary. • The private sector can sometimes solve the problems of externalities. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Examples include: • Moral codes and social sanctions • Charities • Contracts between parties The Coase Theorem • This is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the externalities problem on their own. • However, property rights have to be well defined for bargaining to work. • A property right is the exclusive authority to determine how a resource is used, whether that resource is owned by government or by individuals. • Private property rights have two other attributes in addition to determining the use of a resource: • One is the exclusive right to the services of the resource. • For example, the owner of an apartment with complete property rights to the apartment has the right to determine whether to rent it out and, if so, which tenant to rent to; to live in it himself; or to use it in any other peaceful way. • That is the right to determine the use. • If the owner rents out the apartment, he also has the right to all the rental income from the property.

• That is the right to the services of the resources (the rent). • Second, a private property right includes the right to delegate, rent, or sell any portion of the rights by exchange or gift at whatever price the owner determines (provided someone is willing to pay that price). • If I am not allowed to buy some rights from you and you therefore are not allowed to sell rights to me, private property rights are reduced. • If it is unclear who has the rights to a resource, how can you determine how to allocate it or who decides how to allocate it? • How can you bargain over any compensation for incurring a negative externality if it is unclear who is responsible? • Even if bargaining can take place, sometimes the costs of bargaining (called transaction costs) can be so high that private agreements aren’t possible.