Econ Section 2

Institutions, Organizations, and Government

One of the central insights of economics is howbmarkets help to convert the actions of self-interested individuals into socially desirable outcomes. As we havebseen, however, this conclusion may not hold when producers have a degree of market power, or when marketbfailures occur because of externalities or circumstancesbthat make it difficult to define private property rights. In these cases, collective decision-making mechanisms may be necessary to overcome the effects of these departures from perfect competition. Understanding how collective decision-making processes have emerged in modern economies is a complex topic, and we can only begin to touch on the most important insights of this branch of economics here. But the topic is, nevertheless, vitally important. Differences in standards of living around the world are vast today, and economists believe that in large part these differences are due to variations in the success with which different societies have dealt with the challenge of organizing collective decision-making. Collective decision-making begins with institutions. Institutions are both formal and informal rules that structure human interaction. Most markets are, in this sense, institutions; so too are marriage and child-rearing practices and norms such as how much to tip a waiter in a restaurant. Like institutions, organizations help to organize human interaction, but do so through formal rules and structures. Commodity and stock exchanges are organizations as are corporations and organized religions. An important limitation constraining institutions and organizations is the need for voluntary cooperation. For this reason, self-interested individuals will conform to social institutions or participate in voluntary organizations only so long as that cooperation makes them better off. Cooperation in some contexts can indeed improve social welfare, but, as we have seen in the case of cartels, there can be powerful incentives to cheat on voluntary agreements. In comparison to private institutions and organizations, government possesses two distinctive powers. The first of these is the ability to tax its citizens. Private businesses can earn revenue only by selling their products. Consumers will only buy their products if they value them more than their prices. In contrast, government can compel the payment of taxes. Of course this power is not absolute. In the United States, citizens are free to move between cities, counties, and states, and they can vote with their feet if they dislike the level of taxation in one area by moving someplace else. Similarly, citizens of any of the member countries of the European Union are free to move from one country to another. Other types of international mobility are more limited. The United States imposes significant restrictions, for example, on legal immigration into the country, as do most other countries. The second distinctive power of government is the legal monopoly on the legitimate use of force. This power is used to restrain criminals, compel military service, and to protect national security. Clearly the government's ability to use force underlies its ability to collect taxes. The government's ability to compel citizens to act in ways that are not in their individual self-interest is also essential to supporting a system of private property on which the whole system of voluntary exchange rests. Government also helps to support a broader range of voluntary cooperation than would otherwise be possible through activities such as the enforcement of contractual obligations. Contracts represent agreements entered into voluntarily because both parties anticipate that they will gain from the agreement. But, subsequent changes may cause one party to regret having entered into the agreement. Without the courts to enforce such agreements, individuals would be far more reluctant to enter into them in the first place. The powers that governments possess are truly awesome. As we have suggested, they can be used to fix problems that prevent private economic actors from achieving efficient outcomes. But government can also be a source of inefficiency and corruption. We must remember that both elected officials and government employees are themselves self-interested economic agents, whose interests may diverge from those of the larger community. Economics can help us to identify and understand these conflicting forces more clearly.

As a result, many of the lessons we learn from analyzing perfectly competitive markets can be applied to less than perfectly competitive markets. Our analysis of perfect competition will also provide a useful benchmark....

...against which to compare the outcomes of other types of markets

While only a few markets precisely conform to the assumptions of perfect competition, many real world markets...

...are characterized by a high degree of competition and can usefully be described in terms of the perfect competition assumption.

Tax

All levels of government use taxes of one sort or another to raise revenue that is used to pay for public expenditures. An important issue that often comes up in public discussion of taxes is who bears the burden of paying the tax. It would seem that government could control the distribution of burdens through legislation, but the results suggest that matters are not that simple. To make matters more concrete, let's consider a tax on mobile phone usage. Figure 18a illustrates the demand and supply in this market before any tax is imposed. In the competitive market equilibrium, cell phone calls cost $0.20 per minute, and consumers make 1 million minutes of calls each day. Suppose that the government decides that mobile phones are a luxury and chooses to impose a tax of $0.10 per minute on consumers. From the perspective of mobile phone users, the cost of a minute of talk is now higher than before—it costs them $0.30 (=$0.20 + $0.10). We can represent the effect of this change in Figure 18b as a downward shift in the market demand curve. Notice that if the market price were $0.10, then consumers would face a cost of $0.20 per minute and would demand the same quantity as they had in the competitive market equilibrium (1 million minutes). So, the demand curve shifts down by $0.10, the amount of the tax. The new market equilibrium occurs at a lower quantity than before, and as a result, the price received by suppliers falls. In this hypothetical example, the new equilibrium price is $0.16 per minute; so suppliers receive $0.16 per minute, and consumers pay $0.26 per minute. Even though the tax is added to the consumers' bill, the actual burdenof the tax is divided between suppliers and buyers. the same time, the tax reduces the equilibrium quantity, lowering total surplus by preventing otherwise mutually beneficial exchange from taking place. Suppose that instead of taxing consumers, the government imposed the tax on suppliers, charging them $0.10 for every minute of talk they supplied. As a result, the revenue that suppliers receive is reduced by $0.10. The effect of the tax on their behavior can be illustrated by shifting the supply curve upward by $0.10. Because of the tax, suppliers will require a market price of $0.30 per minute to supply the quantity they previously supplied at a price of $0.20 per minute. This situation is illustrated in Figure 18c. The new market equilibrium occurs at a market price of $0.26 per minute. At this price, suppliers receive $0.16 per minute. Notice that this is precisely the same outcome as we found when the tax was imposed on consumers. This example illustrates an important point that is true more generally. A tax creates a price wedge between the amount consumers pay and the amount suppliers receive. This price wedge reduces the market quantity, and regardless of who legally pays the tax, both consumers and suppliers share the cost of the tax. Recognizing this fact, we can depict the impact of the tax in a third way, as is illustrated in Figure 18d. Rather than shifting the supply or demand curve, we search for the point where the vertical distance between the demand and supply curves is equal to the amount of the tax. The heights of the supply and demand curves, respectively, at this point identify the prices that suppliers receive and consumers pay. Extending a vertical line downward from this point to the horizontal axis identifies the equilibrium quantity once the tax has been imposed. With regard to consumer and producer surplus, the tax has several effects. By introducing a difference between the price buyers pay and that received by suppliers, the tax prevents some otherwise mutually beneficial transactions from taking place. This is indicated by the small triangle to the right of the new equilibrium quantity and between the supply and demand curves. This is a reduction in social welfare and is called the deadweight loss of the tax. The other effect of the tax is to transfer revenue to the government. The government collects $0.10 on every minute purchased at the new equilibrium. The amount of this revenue is illustrated in Figure 18d by the shaded rectangle. Initially people talked 1 million minutes, but notice that a tax of ten cents per minute generates less than $100,000 ($0.10 × $1 million) in revenue to the government. This is because the tax has caused people to demand fewer minutes of calling than before. As this diagram makes clear, the revenue that the government receives reduces the combined consumer and producer surplus from these transactions by an amount equal to the income that the tax produces for the government. In our hypothetical example, suppliers paid 40 percent of the cost of the tax through reduced revenues, while buyers paid 60 percent of the cost of the tax through an increase in their cost per minute. In general, the distribution of the burden of a tax depends on the relative price elasticities of supply and demand. For any given supply curve, the less elastic the demand is, the greater the share of the tax paid by buyers. This is illustrated for two demand curves in Figure 19a. Figure 19b depicts a similar comparison, showing how the elasticity of supply affects the division of the tax. One final point that emerges from an examination of Figure 19 is that the less elastic the supply and demand curves are, the smaller the effect of the tax on the equilibrium quantity, and therefore the lower the deadweight loss of the tax.

Number of Sellers (Supply Curve)

As more sellers enter the market, the quantity supplied will increase. On the other hand, if a seller decides to leave the market, then the quantity supplied will be reduced.

The Characteristics of Competitive Market Equilibriu

Competitive markets tend to gravitate toward the equilibrium quantity and price. This is a very important feature of markets and has several desirable consequences. First, competitive markets are an extremely effective method of allocating resources. When the market for a good is in equilibrium, the price conveys important information for potential suppliers about the value that consumers place on that good. At the same time, the price informs potential demanders about the opportunity cost of supplying the good. This two-way communication is how markets insure that scarce goods and services are produced at the lowest cost and allocated to the buyers who value them the most highly. The competitive market equilibrium insures that the available supply goes to those buyers who value the good most highly, and that it is provided by those suppliers who have the lowest costs of supplying the good. This fact leads to the second characteristic of the competitive market equilibrium: it maximizes the benefits that buyers and sellers receive from exchange. Let's begin by considering the benefits that buyers receive from participating in the market. The important insight is that the height of the market demand curve at each point reveals the willingness to pay of the marginal buyer, that is the buyer who at that price is just indifferent between buying the good in question or not buying it. To illustrate this, let's consider the highly simplified example presented in Figure 8. The table lists the amount that each of four fans would be willing to pay to purchase a ticket to a Bruce Springsteen concert. The table shows that Barb values attending the concert at $100, and at any price less than that she will purchase a ticket. The other potential buyers place a lower value on attending the concert. If the concert promoter sets the price of tickets at $60, then Steve will not purchase a ticket, since the most he is willing to pay is $50. The other three consumers will all purchase tickets, but the benefit they receive from being able to purchase the ticket for $60 varies. Barb would have paid $100, so attending the concert produces a benefit valued at $40 for her. Since Bob was willing to pay $80, his benefit is $20, and Sharon's benefit is just $10. Adding these amounts together, we see that the three purchasers receive a combined benefit of $70. We call this amount the consumer surplus since it is the surplus value that consumers receive. The demand curve in Figure 8 slopes downward, indicating that as the price falls, more of the fans will be willing to purchase tickets. At any point along this demand curve, its height shows the willingness to pay of the marginal purchaser. Because the height of the demand curve measures buyers' willingness to pay, the difference between the height of the demand curve and a horizontal line drawn at the market price measures the consumer surplus for the marginal buyer at each quantity demanded. More generally, we can use the total area below the demand curve and above the market price as a measure of total consumer surplus. This area, then, provides a monetary measure of how much benefit all of the buyers in a particular market receive from participating in that market. In the same way that the height of the demand curve represents buyers' willingness to pay, the height of the supply curve at each quantity supplied measures the willingness to supply of the marginal seller—that is the seller who would leave the market if the price were any lower. Put somewhat differently, the height of the supply curve measures the opportunity cost to the marginal seller. If the market price exceeds this opportunity cost, the difference is a monetary measure of what is called the producer surplus. And we can measure the combined surplus of all suppliers using the area above the supply curve and below the market price as is illustrated in Figure 9. Combining consumer surplus and producer surplus provides a measure of the total benefits that market participants receive from their transactions. We call this benefit the total surplus. One goal of a benevolent social planner should be to maximize this combined surplus, since this is the outcome that produces the greatest overall good. An outcome that maximizes total surplus satisfies the economist's criterion of Pareto efficiency, since at this point there is no way to make anyone better off without reducing the welfare of someone else. To see that the competitive market equilibrium indeed meets the efficiency criterion and maximizes total surplus, let's consider Figure 10. Suppose first that a quantity Q1, which is less than the equilibrium quantity, was exchanged in the market. At this point, the value of the good to buyers exceeds the cost to sellers of supplying the good. A slight increase in the quantity in such a market would yield an increased benefit to both parties. So Q1, or any other point to the left of the market equilibrium, cannot be efficient. Now, suppose that the quantity traded in the market is Q2, an amount greater than the equilibrium quantity. At Q2 the supply curve is above the demand curve, indicating that the cost to producers exceeds the value to consumers. Such an exchange cannot be accomplished voluntarily, but if it did take place, then buyers or sellers would suffer a loss in welfare. Moving to the left would raise overall well-being. To achieve an efficient outcome, a market planner would need to know the value that each consumer places on the good in question, and the cost of producing each unit, and would have to determine how much should be produced, by whom, and to whom it should be given. While such a task would be extremely difficult, a competitive market achieves the same result simply through the self-interested actions of its participants, responding only to the signals provided by the market price.

Expectations (Supply Curve)

If suppliers expect prices to rise in the future, then they may reduce the quantity they will supply today and store current inventory in expectation of the higher future prices.

Law of demand

If the price of the good is higher, buyers will demand less of the good; if the price is lower, then they will demand more. This is a negative relationship between a good's price and the quantity demanded of the good.

Finding the Firm's Supply Curve

In the example above, Bob is producing 300 loaves of bread each day. How does he choose this level of production? Recall that Bob's objective is to maximize his profits. Some of his costs, such as the opportunity cost of his time and the rent on the building and equipment do not depend on the quantity of bread he produces and cannot be changed in the short run. These are what we call his fixed costs. However, the cost of Bob's labor and materials can be varied in the short run. These are called his variable costs. The table in Figure 23 summarizes information about Bob's costs of production. In the second column, we list his fixed costs. Because these do not depend on the quantity of bread Bob chooses to supply, they do not change. In the third column, we show Bob's variable costs of production. Notice that each time we move down a row, output increases by 50 loaves a day, but the additional cost of producing those additional loaves of bread increases from row to row. The increase in costs that occurs when producing an additional unit of output is referred to as marginal cost. The marginal cost is calculated by dividing the increase in total costs by the increase in the quantity of bread produced. This additional cost is referred to as the marginal cost of production. For example, when Bob increases his production from 50 to 100 loaves, his total costs increase from $358 to $483, and thus his marginal cost of producing these additional loaves is ($483 -$358) / (100 - 50) = $2.50. As you go down the rows in the top section of the table, the change in total cost is increasing, implying that marginal costs are increasing as well. The bottom panel of the table provides the information necessary to determine Bob's profit-maximizing production level. Because Bob can vary his production by amounts smaller than 50 loaves, we have calculated his marginal costs of production for the quantity shown in each row for small changes in the quantity produced at that point. As a result, these values will differ somewhat from the marginal costs you would calculate using the data in the top part of the table. Increasing marginal costs of the type illustrated in Figure 23 are common in economics. Such a relationship usually arises because some of the factors of production are fixed and cannot be increased in the short run. In this case, Bob cannot increase the number of ovens available. As a result, once the ovens begin to fill up, the addition of more workers produces less and less additional output. This is an example of diminishing returns to scale. Bob's marginal cost of production is the opportunity cost of supplying an additional loaf of bread since it measures the amount that Bob must spend to produce that loaf. The benefit that Bob gets from supplying another loaf of bread is the additional revenue that it will produce. This additional revenue is called the marginal revenue. By assumption, the market for bread is perfectly competitive, meaning that the price Bob receives is not affected by the quantity he chooses to supply. From his perspective, the demand curve is horizontal at the market equilibrium price of $4 a loaf. This means that Bob's marginal revenue is equal to $4 regardless of the quantity he chooses to supply. Combining the information about Bob's costs with the information about his marginal revenue, we can now find his profit maximizing output. The necessary information is summarized in the bottom panel of Figure 23. So long as Bob's marginal cost of supplying an additional loaf of bread is less than $4, he can increase his profits by producing and selling that loaf. Reading down the marginal cost column, we see that Bob's marginal cost equals $4 when he is producing 300 loaves of bread. So long as diminishing returns to scale apply, marginal costs will be rising as the firm's output increases. As a result, the profit-maximizing firm's supply curve will be an upward-sloping line.

Most important factors that might cause the supply curve to shift.

Input prices, technology, expectations, number of sellers

Although the assumptions of perfect competition may seem unrealistic at first, why is the resulting model an essential building block for economic analysis?

It is approximately true in many situations and provides an important benchmark against which to compare many other more complicated models.

The Law of Supply

Positive relation, The higher the price is, the greater the quantity that suppliers will want to produce

The quantity demanded of any good

The amount of that good that buyers are willing and able to purchase.

Private Responses to Externalities

The existence of externalities creates incentives for market participants to attempt to solve the problems they create. In the case of the beekeeper and the apple grower, total revenues would increase if the beekeeper expanded his production. This additional revenue could be divided between the two parties so that both increased their profits. Similarly, in the case of the negative externality caused by the paper company, the downstream community could pay the paper company to produce less or to take other steps to prevent the pollutant from entering the river in the first place. Again, such an arrangement would leave both parties better off. Another approach to solving the problem of externalities is to internalize them by combining the activities that produce the externality within a single company. For example, a maker of blue-ray players could purchase a movie studio so as to internalize the externalities that the two businesses generate for each other. As long as the parties involved can negotiate with each other, the private market should be able to resolve the inefficiencies created by externalities. This insight was first reached by Ronald Coase and is often called the Coase Theorem. To illustrate this point, consider the case of two neighbors, Tad and Sue. Tad lets his grass grow long and does not take good care of his yard. Sue must look at the yard from her front porch, which reduces her enjoyment, and it also lowers the value of her house. She can offer to pay Tad to take better care of his yard. So long as the value she places on the appearance of Tad's yard exceeds the cost to him of caring for it, they will be able to negotiate an appropriate payment that makes both of them better off. Of course, if the benefit to Sue is less than the cost to Tad, then they will not reach an agreement, but in this case, that is the efficient solution. Notice that we have assumed that Tad is under no obligation to maintain his yard. Suppose, however, that a local ordinance requires that he do so, and Sue can compel him to do so by reporting him to city officials. In this circumstance, Tad could negotiate with Sue, offering to pay her to put up with his poorly maintained yard. If the value Sue places on having a well-kept yard to look at is less than the cost to Tad of cleaning it up, they will be able to arrive at a bargain where he pays her to put up with his yard. If his cost of cleaning up the yard is less than the value Sue places on having his yard well maintained, then they will not reach a bargain, and he will be obliged to take care of his yard. But in this case, this is the efficient solution. As this example illustrates, Tad and Sue will arrive at the efficient solution regardless of whether Tad is free to ignore the upkeep of his yard or is required to keep it neat. One of the important insights of the Coase Theorem is that the initial distribution of rights does not affect the ability of the parties to come to an efficient agreement. So long as the property rights are clearly defined, the parties will arrive at the efficient solution. Of course, if matters were this simple, then externalities would be only a minor footnote rather than an important topic in economics. The reason they are often a problem is that in many cases property rights are poorly defined, or nonexistent, and the costs of negotiating between the affected parties are prohibitively high. As an example, consider the emission of sulfur dioxide by power plants in the Midwest. The sulfur dioxide combines with water vapor in the atmosphere to create acid rain that falls on the Northeast, damaging lakes and forests. The impact of this pollution is extremely diffuse, affecting millions of people. Because there are a great many people who each suffer a small harm from acid rain, the total effect is quite large. However, none of those affected have much incentive to attempt to negotiate with the sources of the sulfur dioxide. In this instance, the costs of negotiating are prohibitively high, and private parties cannot arrive at a solution.

The central topic of microeconomics

The interaction of supply and demand in markets

Steve's demand schedule (P. 10) PRICE QUANTITY OF GASOLINE DEMANDED $0.50 52.5 $1.00 50 $2.00 45 $3.00 40 $4.00 35 $5.00 30 $6.00 25 $7.00 20 $8.00 15 $9.00 10

The table in Figure 1 illustrates how Steve's purchases of gasoline each month depend on the price per gallon. At $1 per gallon, Steve buys 50 gallons; when the price rises to $2 a gallon, he cuts back to 45 gallons. If the price rises further, to $3 a gallon, he cuts back to 40 gallons.

Substitutes

When a decline in the price of one good causes a reduction in the quantity demanded of another

Complements

When a lower price for one good causes demand for another good to increase

How is the market supply curve obtained?

by adding the quantities supplied at each price by all of the suppliers in the market. This is illustrated in Figure 5 (p. 15) for the case where there are two suppliers. Again, we obtain the market supply curve by adding the individual supply curves horizontally

How do we find the market demand schedule?

Add up the quantity that every consumer will purchase at each possible price. The graph shows that we add the two demand curves horizontally to obtain the market demand.

Natural monopolies

An industry is a natural monopoly when a single firm can supply the market at a lower cost than could two or more firms. This happens when there are large fixed costs that cause the firm's average costs to be falling at a scale of production that can serve the entire market. Railroads, pipelines, and cable television are all examples of markets that are prone to natural monopoly.

Expectations (Demand Curve)

Changes that you expect to occur in the future may also affect the quantity demanded. For example, if Steve is afraid that he may lose his job next month, then he might cut back on his driving now in anticipation of this future change in his income.

Firm

Economists use the term "firm" to describe the economic actors who are responsible for supplying goods and services in the economy. Firms combine labor, capital equipment, raw materials, and other inputs to produce the products that we want to consume. Up to now, we have used the supply curve to summarize their actions. According to the law of supply, as the price of a good rises, firms are willing to supply a greater quantity. In many cases, this is all we need to know about the behavior of firms. But, in other instances, we need to look more closely at how firms decide what to produce and how to produce it.

Supply curve (Figure 4, p. 14)

Figure 4 illustrates the relationship between price and quantity supplied for Shelly. Again, we plot the price of gasoline on the vertical axis and the quantity supplied on the horizontal axis. Shelly's supply curve is upward sloping, reflecting the positive relationship between price and quantity supplied.

Time Horizon (affect price elasticity)

Fully adjusting to changes in prices may take time. Take the example of gasoline prices considered earlier. At first there is not much people can do to reduce their consumption when the price of gasoline rises. But, over time people will buy more fuel-efficient cars, move closer to their work, and make other changes that will allow them to more significantly reduce their demand.

Inferior goods.

Goods for which the quantity demanded falls as income rises

Normal goods

Goods for which when when income rises, the quantity demanded rises, but when income falls, the quantity demanded falls

Input Prices (Supply Curve)

Inputs are any of the things that suppliers have to purchase to supply a product. For example, the price that gasoline stations must pay their suppliers for gasoline is a major cost of doing business. If this price falls, the quantity of gasoline supplied will increase, causing the supply curve to shift to the right. But, there are other inputs that are important as well. These include labor costs, the real estate costs for the land on which the gasoline station is located, and utilities such as electricity. If any of these input costs increases, it will decrease the quantity supplied at every price, causing the entire supply curve to shift to the left.

Necessities (affect price elasticity)

Items that are regarded as necessities will generally have lower price elasticities of demand than luxuries. Many people must drive to and from work and use their cars to run important errands. As a result, the demand for gasoline has a low price elasticity of demand.

Changes in Market Equilibrium

Now that we have seen how to use the concepts of supply and demand to find the equilibrium price and quantity in a competitive market, we can use our market model to make predictions about how shifts in the economy will affect the market. Let's consider some examples that illustrate how the competitive market model can be used to analyze important issues. One of the defining characteristics of our modern economy is technological progress. New inventions are continually being developed that allow suppliers to produce more at lower costs. One example is the development of synthetic Bovine Growth Hormone (BGH), which allows dairy farmers to increase milk production by between 10 and 15 percent at little additional cost. The direct effects of this innovation are illustrated in Figure 11. As is often the case, the introduction of a new technology has other, more subtle effects, called externalities, that are not immediately obvious from an analysis of the market that is immediately affected. We will discuss how to incorporate externalities into our analysis later in this section of the resource guide. The first panel shows the market equilibrium before the introduction of BGH. The shaded regions indicate the consumer and producer surplus at this equilibrium. The introduction of BGH is illustrated in the second panel of Figure 11. This innovation allows dairy farmers to increase the quantity of milk they supply at any price, so the supply curve for milk shifts to the right. As a result, the point at which supply and demand intersect moves down along the demand curve from point A to point B. In the new equilibrium, the price is lower, and the quantity is higher. It is clear that the total surplus has increased as well, since the shaded area between the supply and demand curves is now larger. Consumers are unambiguously better off as a result of the innovation. Since the market price is now lower, everyone who previously purchased milk receives a larger surplus. In addition, at the lower price consumers purchase additional quantities of milk. The effect on producers is more ambiguous. The increase in sales causes an increase in producer surplus, but the lower price reduces the producer surplus on the quantity that was previously being sold. Whether producers benefit depends on the balance of these two effects. Let's consider another example of how shifts in supply and demand affect market equilibrium. Public health officials have long recognized that cigarette smoking is harmful. As a result, policymakers would like to reduce smoking. One approach is to reduce the demand for cigarettes through public education campaigns and the inclusion of warning labels on packages of cigarettes. Assuming that these efforts do in fact cause buyers to demand fewer cigarettes, what is the effect on the market for cigarettes? The answer can be found by examining Figure 12. To illustrate the effect of public efforts to reduce smoking, Figure 12 shows the demand curve for cigarettes shifting to the left. As a result, the intersection of the supply and demand curves shifts down and to the left along the market supply curve for cigarettes. After this shift, the equilibrium price and quantity both decrease.Elasticity is related to the slope of the demand curve. If two demand curves pass through the same point, the curve that is flatter will have a higher elasticity. It is important to note that as we move down along a linear demand curve, the elasticity will be falling continuously. To see this, note that a linear demand curve must have a constant slope ∆P/∆Q = e, (where we use the Greek letter ∆ to denote the change in price and quantity along the demand curve). The ratio ∆Q/∆P = 1/e, is also a constant.4 Consequently the elasticity of demand is equal to (1/e)·(P/Q ). As we move down and to the right along the demand curve, P is falling and Q is rising, so the ratio P/Q must be decreasing. Since 1/e is constant, the elasticity must also be falling. Figure 13 shows five different possible demand curves illustrating the range of possible elasticities. In the extreme case (a) demand is perfectly inelastic; the quantity demanded does not depend on price at all. The remaining panels show progressively more elastic cases: (b) inelastic, (c) unit elastic, (d) elastic, and the other extreme case (e) perfectly elastic, where the demand curve is completely flat.

Gains from trade

One of the fundamental insights of economics is that exchange makes people better off. It does so by encouraging specialization. When individuals or countries specialize in the activity they do the best, the overall economic pie increases. These gains from trade are the reason that our modern economy is characterized by such a high degree of interdependence. To appreciate the gains achieved from trade, we need to begin by considering an isolated economy. Then, we can consider how the opportunity to trade alters well being.

Within markets, what determines the price at which each product or service sells and the quantity that changes hands?

The actions of buyers and sellers. Individual buyers and sellers respond to market prices in predictable ways.

Monopolies

There are a wide range of different types of imperfectly competitive markets. The simplest case to consider is the extreme situation of a single supplier, a situation called a monopoly. Monopolies arise because there are barriers to entry that prevent competitors from entering the market. The most important sources of barriers to entry are: The ownership of a key resource, Government-created monopolies, and Natural monopolies.

Perfectly competitive market

We say that a market is perfectly competitive if the good or service being bought and sold is highly standardized, the number of buyers and sellers is large, and all of the participants are well informed about the market price. In such a market, buyers and sellers know that they can buy or sell as much as they wish without influencing the market price.

How does the positive relationship between price and quantity supplied reflect the cost-benefit analysis of rational suppliers?

.Gasoline station owners compare the benefits of each gallon sold to the opportunity cost of their time, effort, and expense to supply that gallon of gasoline. As the price rises, it will be rational to devote more resources to supplying gasoline. So long as the price they receive exceeds their opportunity cost, they will be willing to supply gasoline. At higher prices, they will be willing to work longer hours, hire additional help, and expand the size of their stations to boost sales. At lower prices, they will cut back on the time they spend supplying gasoline, reduce the number of their employees, or shift their efforts toward selling other product

Things that can shift the demand curve

Income, Related goods, Expectations, Tastes, Number of Buyers

Technology (Supply Curve)

Changes in technology can affect how businesses operate and hence the quantity supplied. In the case of gasoline, the shift from full-service to self-service reduces labor costs and increases the quantity supplied. Similarly, pumps with credit card readers further reduce labor costs and increase the quantity supplied.

Price Controls

Efforts to legislate minimum or maximum prices are a fairly common kind of policy intervention in markets. For many years, U.S. farm policy established minimum prices of major food crops, such as corn and wheat. The federal government and most states have established a minimum wage, and some communities have gone further, seeking to legislate that employers pay a "living wage." Similarly, New York and some other cities have sought to control residential housing costs by establishing rent controls that limit increases in the rates that landlords can charge. In 1979, when Middle Eastern oil supplies were interrupted and heating oil prices shot up, the federal government imposed a ceiling on prices in an effort to protect low-income families. When the market price appears to unfairly hurt either consumers or suppliers, it is tempting to suggest that government intervention could set a better price. But, such efforts create significant, though not always obvious, social costs. To see these, consider a few examples.

Collective Goods

Goods that have a low degree of rivalry but a high degree of excludability (upper right corner) are termed collective goods. Such goods can easily be privatized, but they are often natural monopolies because non-rivalry in consumption means that the marginal cost of producing them is zero or close to zero. Examples include satellite radio and pay-per-view television. A monopoly can profitably supply these goods, but it has an incentive to set the price too high and supply too little, thus leading to an inefficient outcome. This characteristic may lead to regulation or to government provision of collective goods.

Government-created monopolies (Barrier to Entry)

Many monopolies are created when the government gives the rights to supply a product to a single company. Patent and copyright laws are one mechanism through which such exclusive rights are granted. If the government grants a patent to an inventor who has developed a new technology, he or she is awarded the exclusive right to utilize the technology for twenty years in exchange for revealing the details of his/her innovation. Under copyright law, an author becomes a monopolist over the book he or she has written.

Number of Buyers (Demand Curve)

Market demand is derived by adding up the demands of individual consumers. If there are more consumers, then demand will increase. If your community is growing because people and businesses are moving there, then the market demand for gasoline will be increasing with this growing population.

Income change in demand curve

Suppose Steve's employer reduces his weekly hours of work, and thus his income. Because Steve has less money to spend on all the things he wishes to buy, he will likely reduce his consumption of gasoline. For most goods, demand is positively related to income: when income rises, the quantity demanded rises, but when income falls, the quantity demanded falls

The market demand curve depicts the relationship between the quantity demanded and its price assuming...

That all other factors that might influence the quantity demanded remain unchanged. But many other things can influence the quantity demanded. If one of these factors changes, it causes the entire demand curve to shift. For example, if your community creates a new system of bicycle lanes that make it easier to bike from place to place, the quantity of gasoline demanded will decline at every price. As Figure 3 shows, such a change causes the market demand curve to shift to the left, indicating that at each price a lower quantity is demanded. (p. 13)

What is the mechanism that produces high coordination in the modern economy?

The mechanism that produces this coordination is the interaction of supply and demand within markets.

True or false: The market supply curve shows the quantity supplied at each price, assuming that all other things remain unchanged.

True

Externalities

A widely cited example of an externality involves beekeepers and apple growers. In the course of producing honey, the bees pollinate the apple trees, increasing the size and value of the farmer's crop. Since the value of the apple crop does not figure in the beekeeper's costs or benefits, it constitutes an externality. Since the farmer benefits from the beekeeper's actions, it is a positive externality. One can easily find many other examples of similar types of interactions. For example, when movie studios release movies on blue-ray discs, they increase consumer demand for blue-ray disc players, which increases the revenue of their manufacturers. In this instance, the externality operates in the other direction as well because increases in the sale of blue-ray players increases consumer demand for the studios' movies. When a new highway interchange is built on a busy freeway, it increases traffic on nearby roads, raising their value as business locations. This is a positive externality for the landowners. Externalities can have negative consequences as well. If one of your neighbors fails to maintain his house, it can have a depressing effect on the value of your home. Pollution is another example of a negative externality. Runoff from farm fields containing traces of fertilizers and pesticides commonly finds its way into nearby rivers. As a result, downstream communities that take their drinking water from these rivers have to spend more money treating this water before distributing it. Concerns about climate change have focused attention on the negative consequences of carbon-dioxide (CO2) emissions. Again, because the businesses and individuals do not take into account the negative impact of their activities on the global climate, this is an externality.

Private Goods

Conventional private goods are characterized by a high degree of rivalry in consumption and a high degree of excludability. This corresponds to the entry in the upper left corner of Figure 29. Examples of such goods are all around us—they include pizza, gasoline, and haircuts.

What is the proper role for the government?

Determining what functions the government should play, how big it should be, and how much it should regulate are normative judgments that must be made on grounds that extend beyond purely economic considerations. Nonetheless, economics helps to illuminate the issues and frame these choices more clearly. Government is not essential to the establishment of a market economy, but the enforcement of the rule of law helps to support a much broader range of transactions than would be possible without it. Most of us are willing to accept the small loss of individual autonomy for the protection of property and the individual security that this entails. But, unconstrained government can become an intrusive force that can substantially reduce individual freedoms. Similarly government can, as we noted earlier, correct market failures arising because of externalities and public goods; however, the ability to rectify these problems also gives rise to inefficiencies. People may genuinely differ in their evaluation of the relative costs and benefits of these trade-offs.

Demand for milk: elastic or inelastic?

Empirical estimates suggest that the demand for milk is relatively inelastic. Milk is a necessity, and it does not have many close substitutes. As a result, declining prices do not induce a large increase in the quantity demanded. On the other hand, the supply of milk is relatively elastic over a time horizon of a year or more. There are a great many dairy farms, and it is easy for these farms to expand or contract their production. In Figure 15 the demand curve is drawn as inelastic at the initial price and quantity pair. As the price of milk falls from an initial level of $2 a gallon to $1.50, the quantity demanded per day rises only from 2,000 gallons to 2,250. In this case, the price has fallen by 25 per- cent, and the quantity demanded has increased by just 12.5 percent, which implies an elasticity of -0.5 (= 12.5 / -25). As a result, total farm revenue falls from $4,000 to $3,375. In aggregate, dairy farmers are now earning significantly less revenue than before. If using BGH reduces farm income, why do dairy farmers adopt this technology? The answer is that in a competitive market they have no choice. Each farmer supplies only a small amount of the total output, and his or her choice about whether to use BGH has no effect on the market price. Given the existing market price, each farmer can increase his or her sales by using BGH. As a result, competition causes them to all adopt the technology, increasing the market supply and driving down prices. As farm revenue falls, it is likely that some farmers will choose to cease producing, allowing the remaining farmers to maintain or increase their standard of living by producing a greater quantity. This is, in fact, more or less what has happened in the farm sector over the past two hundred years. Successive technological innovations have increased the ability of farmers to produce greater quantities of crops, though this advance has been accompanied by a steady decline in the number of farmers.

Substitutes (affect price elasticity)

Goods with close substitutes will tend to have relatively high price elasticities of demand because it is easy for consumers to switch from one product to another. For example, the price elasticity of demand for a particular cola drink is likely quite high because consumers can easily switch to a different brand if the price rises. Conversely, when there are no close substitutes, the price elasticity of demand will tend to be lower.

Comparative Advantage and the Gains from Trade

How can it be that Crusoe, who is better at everything, can be made better off by trading with Robinson? The answer to this question lies in the insight that what matters is not the absolute productivity of either Robinson or Crusoe, but rather their respective comparative advantage. Even though Robinson produces fewer coconuts per hour than Crusoe, he has a comparative advantage in producing coconuts. By changing their allocation of time between fishing and gathering coconuts, Robinson and Crusoe in effect "transform" fish into coconuts. Robinson faces a cost of just 1/3 fish per coconut, while it takes Crusoe one fish to produce a coconut. When Robinson specializes in producing coconuts and Crusoe specializes in producing fish, their collective economy can increase its total production. The principle of comparative advantage offers a profound insight about the opportunities for gains from trade that applies equally to individuals and to nations. So long as trading partners differ in their comparative advantage, they can improve their overall well-being by specializing. The more extensive the markets in which they trade are, the greater the opportunities for specialization and the larger the gains from trade.

Property Rights

Having grown up in a market economy, the existence of private property seems quite natural to most of us. However, the institution of property rights is not a natural occurrence; it is a social innovation. The importance of this innovation becomes clear when we consider what happens when valuable economic resources have no owner. To illustrate the importance of private property, let's consider what happens to property that no one owns in this simple example. A village located next to a lake has six residents, each of whom has $100 in savings that they can use to either purchase a government bond that pays 15 percent interest, or to purchase a fishing boat necessary to catch fish in the lake. The number of fish that each resident can catch depends on the number of residents who catch fish. This relationship is shown in the table in Figure 28. If only one villager purchases a boat, then he/ she can catch $130 worth of fish, and his/her net income is $30 ($130 in income minus the $100 cost of the boat). If two villagers buy boats, then they catch $120 worth of fish each, and each earns a net income of $20. The average value of fish caught declines as additional villagers buy boats because they are all fishing in the same lake, and as each one depletes the fish population, it becomes increasingly difficult for others to find fish. Imagine, first, that the villagers decide one at a time whether to purchase a boat or to invest in the government bond, and that the decisions are public. How many villagers will purchase boats? If a villager purchases the government bond, he/she will earn $15 interest income at the end of the year. He/she should only purchase a boat if his/her income from fishing is $15 or more. From the table, we can see that three villagers will purchase boats. After three boats are purchased, the fourth villager will see that his/her income from fishing will only be $10 and will choose to purchase a government bond. Total income in the village will be $90 per year. Three villagers will earn $15 each from fishing (3·$15 = $45), and three villagers will earn $15 each from bonds (3·$15 = $45). Is this the socially optimal allocation of resources? Suppose that the villagers got together and decided collectively how to allocate their resources? To maximize village revenue, the villagers should invest in fishing boats only if the marginal contribution to village revenue exceeds the marginal cost. In this case, the cost of purchasing a boat is the opportunity cost of not purchasing the government bond, or $15. The table in Figure 28(b) calculates the marginal income from fishing for each additional fisherman. The marginal revenue generated by the first boat is $30. But the purchase of a second boat raises income from fishing only to $40, so the marginal contribution to village revenue is $10. The villagers should purchase just one boat. Total income will be $30 from fishing, plus $75 = 5·$15 from interest income, or $105. When the villagers make their choices independently, they fail to account for the external effects of their fishing on the income of other boat owners. Because the fish in the lake are a common resource, one villager's decision to purchase a boat and catch fish reduces the income that others can earn from fishing. The villagers do better when they decide collectively because they internalize the externality.

Welfare Consequences of Monopoly

If cable TV service in Smallville had been provided by a competitive market with marginal costs equivalent to Local Media's, then the market equilibrium would occur at a lower price and higher quantity, as can be seen from the location of the intersection of the market demand curve with the marginal cost curve. Compared to this hypothetical competitive outcome, the monopoly supplies a lower quantity at a higher price. It may also earn an economic profit. But, because of barriers to entry, there is no competition to drive these profits toward zero. From the point of view of social welfare, the fact that Local Media is a monopoly has two effects. First, there is a transfer of consumer surplus to Local Media because those subscribers willing to purchase service at the monopoly price would have been able to purchase this service at a lower price in the competitive case. Second,there is a reduction in social well-being because Local Media restricts supply to be less than the competitive quantity. The additional output would cost less to produce than its value to consumers. But, Local Media will not supply it because to do so would reduce the revenue it gets from subscribers who place a higher value on the service.

Imperfect Competition

Now that we understand how firms behave in perfectly competitive markets, we can begin to develop an understanding of how markets that are not perfectly competitive work. Although perfect competition is a reasonable approximation for many parts of the economy, the markets for many important products are dominated by a small number of very large firms. Examples include the markets for computer operating systems, commercial airplanes, automobiles, air travel, and mobile phones. In other cases, such as electricity, water, and cable television, there is only a single supplier in any community. Economists call markets with one or only a few suppliers imperfectly competitive. Firms in imperfectly competitive markets have the same objective as firms in perfectly competitive markets: to maximize their economic profits. But unlike firms in a perfectly competitive market, a firm in an imperfectly competitive market can no longer assume that its decision about how much to supply does not affect the price at which its products can be sold. Rather, the demand curve that it faces is downward sloping, meaning that if it chooses to increase its supply, the price it receives will be lower. Firms that face a downward sloping demand curve are said to possess market power, meaning that instead of taking prices as given, they have the ability to choose market prices. Of course, they are not entirely free to choose any price since they are constrained by the combinations of price and quantity determined by the market demand.

Market Failures

Our study of competitive markets has revealed the remarkable way in which they coordinate the self-interested actions of market participants to produce socially desirable outcomes. Market prices ration scarce goods and services so that they go to those consumers who value them most highly. At the same time, the search for economic profits encourages the allocation of scarce resources toward the production of those goods and services that are valued most highly. Of course, not all markets fit the ideal of perfect competition. But, in these cases, the opportunities to profit by facilitating mutually beneficial exchange encourages private actors to move closer to the socially efficient outcome. Monopolists, for example, have an incentive to find ways to price discriminate, while the opportunities for private profit tend to break down efforts by cartels to restrict output. Where these forces are not sufficient, economic theory can help us to evaluate possible policy solutions. There are some circumstances, however, in which competitive markets will fail to produce socially desirable outcomes. These circumstances are called market failures. Most instances of market failure can be grouped into two broad categories. The first type of market failure arises because of externalities. An externality arises when the actions of one person affect the well-being of someone else, but neither party pays nor is paid for these effects. When the effect of these actions is beneficial, it is called a positive externality; when the effect of these actions causes harm, it is called a negative externality. The second type of market failure occurs when the institution of private property breaks down. When it is impossible to establish private property rights in important economic goods or services, we refer to the goods or services in question as public goods. Addressing the problems of externalities and public goods is one of the most compelling roles for government in our economy. Economics allows us to under- stand more precisely how the characteristics of externalities and public goods affect market outcomes and can provide important guidance when considering the options for policies to correct these market failures.

Monopolistic Competition

Perhaps the most common form of imperfect competition is monopolistic competition. As its name suggests, monopolistically competitive markets combine aspects of the perfectly competitive and monopoly models. Specifically, these are markets in which firms produce similar but differentiated products. An example of such a market is book publishing. Each particular title is unique and distinctive, but there are thousands of titles for you to choose from when you are looking for a book. Other examples include restaurants, clothing, breakfast cereals, and many local service industries. Because the product of each firm is differentiated-meaning that you can tell the difference between its product and those of other firms—the firm faces a downward-sloping demand curve. As a result, each firm chooses its output in the same way a monopoly firm does, by finding the point at which its marginal revenue equals its marginal cost. Because the firm's demand curve slopes downward, marginal revenue is less than price, so at this point the market price is greater than the marginal cost of production. We have seen that at the profit-maximizing quantity, a monopolist will earn positive economic profits. In a monopolistically competitive market, however, if firms are earning positive profits this will lead to the entry of new firms supplying similar goods or services. As the range of choices available to consumers expands, existing firms will see their demand curves shift to the left, causing profits to fall. Because there are no barriers to entry in a monopolistically competitive market, entry will continue until profits have been reduced to zero. If at some point profits fall below zero, there will be exit from the industry, which will continue until the zero economic profit equilibrium is restored. A full analysis of the welfare properties of monopolistically competitive markets requires more sophisticated mathematical analysis. But there are several points to note about such markets. First, because price exceeds marginal cost, there is some social inefficiency: there are consumers who value the product at more than the cost of increasing production. The failure to complete these transactions is a failure to fully exploit mutually beneficial exchanges. This failure occurs because of the firm's monopoly incentive to restrain production. Second, the diversification of products that results from the efforts of firms to create a distinctive identity for their product creates benefits for consumers by increasing the range of choices available to them.

Oligopoly

Relatively few industries are true monopolies. In many more cases, a small number of producers supplies the bulk of the market. In the United States, the manufacture of tennis balls, breakfast cereals, aircraft, electric light bulbs, washing machines, and cigarettes are all industries in which production is highly concentrated. Economists call a market with only a few sellers an oligopoly. In comparison to monopoly markets, oligopoly markets are much harder to analyze. The reason for this is that in such markets, producers must consider not only the characteristics of the downward-sloping demand curve that they face, but also the choices that other suppliers will make. In other words, there is an opportunity for strategic interaction between the different suppliers. If the suppliers could agree, for example, to cooperate and behave like a monopolist, total industry profits could be maximized. Such an agreement is called a cartel, and it is illegal under U.S. anti-trust law. There are also significant economic forces at work to undermine efforts by the members of potential cartels to collude. If a cartel is successful in restricting output, then marginal revenue will be greater than the marginal cost of production for

The Prices of Related Goods

Suppose that the price of airline tickets falls. The law of demand says that consumers will purchase more airline travel. Because airline travel is to some extent a substitute for travel by car, people will likely reduce the number of miles they drive and hence the quantity of gasoline they demand at any price. (SUBSTITUTE) Suppose, on the other hand, that the price of automobile insurance falls. Lower insurance costs make it easier for more people to afford to own automobiles; car ownership will increase and so will the number of miles driven. (COMPLEMENTS)

Impact of Price Floor

To illustrate the effect of establishing a price floor, let's consider Figure 17, which shows the market for wheat. The competitive market equilibrium price in this market is $5 a bushel, and the equilibrium quantity is 100 million bushels. Suppose that in an effort to protect family farms, Congress establishes a minimum price of $8 a bushel. Because this price is higher than the current market equilibrium, it is binding. At this higher price, demand for wheat falls to 80 million bushels, and supply rises to 115 million bushels. Farmers cannot sell all the wheat they are producing on the free market. Once again this intervention reduces consumer and producer surplus. There are farmers who would be happy to supply wheat at lower prices and consumers who would be willing to buy from them, but they are prohibited from doing so. Those farmers who find buyers at the higher minimum price benefit from the legislation, but others find they are unable to earn any income and will likely be forced to go out of business.

Economic Profits and Accounting Profits

We assume that a firm's goal is to maximize profits. Profits are defined as the difference between the firm's total revenue and its total costs. The meaning of total revenue is fairly clear: it is the total quantity of output the firm produces for sale multiplied by the price it receives. Measuring total costs is a bit more complicated. Economic costs include the opportunity costs of all resources required for production. In contrast, accounting costs will likely include only actual monetary expenditures. This distinction can be seen more clearly by considering an example. Consider Bob's Bread Company. Bob's is a small bakery that sells a variety of freshly baked breads. All of the baking is done in the back of the store, and Bob operates a retail shop at the front. Suppose that Bob sells 300 loaves of bread a day for $4 each. Total revenues are $1200 a day. Bob's explicit costs include purchasing flour and other ingredients, for which he pays $600 a day; hiring labor to produce the bread costs $300 per day; and renting the shop in which he operates costs Bob $50 per day. These explicit costs total $950, leaving an accounting profit of $250 a day. But, we have not yet included all of the firm's opportunity costs. Bob is a skilled retailer and, if he were no tmanaging his bread company, he could earn $200 a day managing another store in town. Because Bob gives up this income to manage his own business, we must include this forgone income as part of his economic cost. As a result, the true economic profit that Bob's Bread Company earns is $50 per day.

Markets

A market is comprised of all of the buyers and sellers of a particular good or service. Some markets, such as the New York Stock Exchange or the Chicago Mercantile Exchange, are highly organized. Buyers and sellers in such markets come together at a single location, and an auctioneer helps to set a price at which exchanges take place. More often, markets are less formal. Nevertheless, we can think of the interaction between buyers and sellers as constituting a market. For example, consider the market for gasoline in your community. The sellers in this market are all the local gas stations in town, while the buyers consist of all the vehicle owners in the community or passing through it. Each of the sellers in this market posts the prices at which he or she will sell a gallon of gasoline, and buyers will select where to fill their tanks based on price and convenience. The buyers of gasoline are likely to be well informed about prices because gas prices are continually posted at all of the different stations

Rent Seeking

A related source of inefficiency arises because the gains from many government programs are concentrated, while the costs are spread widely. An example of this problem is the current U.S. policy of price supports for domestic sugar producers. These supports combined with restrictions on the importation of cheaper sugar from outside the country keep U.S. sugar prices at nearly twice world levels. The cost to U.S. consumers is over $1 billion a year. Spread across a population of over 300 million, the cost per person is relatively small. But the benefits to the small number of sugar producers are much larger. Sugar growers have a strong and compelling motivation to hire lobbyists and spend money to influence key legislators to continue price supports. Most voters, however, are unaware of this policy, and even those who are aware of it would be unlikely to find it worth the effort to oppose it. Even when the overall benefits of projects exceed their costs, they may generate wasteful resource allocation. Competition to influence the location of expensive federally supported activities can lead to the expenditure of large amounts of money seeking to influence decision makers. In general, socially unproductive activities that seek simply to direct economic benefits to one set of actors rather than another are called rent seeking.

An Isolated Economy

As a starting point, let's consider a highly simplified economy. Robinson is stranded on a tropical island. Each day he works for eight hours to produce food, which he consumes. He can devote his time either to harvesting coconuts or catching fish. Each hour that Robinson spends gathering coconuts is an hour that he does not spend catching fish. The opportunity cost of the additional coconuts that he gathers is the quantity of fish that he does not catch during that hour. We can represent the trade-off that Robinson faces in terms of a production possibility frontier or PPF like that drawn in Figure 20a. In this diagram, we measure the quantity of coconuts Robinson gathers on the vertical axis and the number of fish he catches on the horizontal axis. The graph shows that if Robinson spends all eight hours gathering coconuts, he can collect twenty-four coconuts—this is the height of the curve where it intersects the vertical axis. If he spends all of his time catching fish, then he can catch eight fish—this is the distance from the origin to the point where the PPF intersects the horizontal axis. Robinson can select any point along the PPF, which we have drawn here as a straight line. The slope of this line reflects the opportunity cost of coconuts in terms of fish. Since the PPF has a slope of -3, it indicates that Robinson must give up three coconuts to get one additional fish. All of the points on the PPF are efficient from the perspective of production since along this line there is no way that Robinson can increase the quantity of one good produced without reducing the quantity of the other. The point that Robinson chooses along the PPF depends on his relative preferences for fish and coconut. He will select the combination of fish and coconuts that maximizes his satisfaction. Suppose that he selects a point like A, where he is consuming fifteen coconuts and three fish. From our discussion of the demand curve, we know that at this point if Robinson is a rational consumer, he will get just as much pleasure from one more fish as from three coconuts. If this were not so, then hcould improve his well-being by moving along the PPF. For example, if one fish gave him as much pleasure as two coconuts, he could reduce his consumption of fish by one and increase his consumption of coconuts by three. Since it only takes two coconuts to compensate for the fish he has given up, he would be better off.

Dealing with Monopolies

Because of the negative effects that monopolies create, government policymakers have adopted a variety of responses intended to reduce the impact of monopoly. Beginning with the passage of the Sherman Anti- Trust Act in 1890, the federal government has sought to use legislation to increase market competition. As a result, large mergers and acquisitions must be reviewed by government regulators to insure that they do not reduce competition in key markets. Anti-trust regulators can also break up companies, as happened when AT&T was split up in 1984, or take other steps to restrict anti-competitive practices, such as the requirements that Microsoft unbundle Internet Explorer from the Windows operating system. Another widely used approach is regulation. Many natural monopolies are allowed to exist but are closely regulated. Public utilities such as electric power companies and cable television providers cannot freely set prices, but must have rates approved by public oversight agencies. A third approach to the problem of monopoly is public ownership. Local water, sewer, and sanitation services are often operated by municipal governments, for example.

Entry, Exit, and the Market Supply Curve

Bob is, of course, only one possible supplier of bread. Other potential producers are likely to notice that Bob is making an economic profit of $100 a day. Recall that we have already accounted for the opportunity cost of Bob's time. The opportunity to earn extra profits will induce some of these producers to rent shops and equipment and begin producing bread as well. The addition of more producers has the effect of shifting the market supply curve outward. And, this in turn will cause the equilibrium price to fall. The entry of additional producers will continue as long as there are positive economic profits to be earned in the market. Only when economic profits have reached zero will entry cease. In the same way, if economic profits were to fall below zero at some point—say because of a shift in preferences that reduced the demand for bread—producers would begin to leave the market, shifting to other activities that offered greater opportunities. Two points are worth emphasizing about this conclusion. First, in a competitive market business owners earn zero economic profits. They will, however, be content, because they are earning their opportunity wage. In other words, this remains their best alternative. Second, in addition to their role in rationing scarce goods, prices serve a second important function: they allocate productive resources between different activities. If prices exceed production costs in some activity, then the existence of positive economic profits acts as a signal that additional resources should be deployed to that activity to increase production.

Adding the Opportunity to Trade

Crusoe lives on a nearby island, where she too gathers coconuts and catches fish. In Figure 20b we show her PPF. Looking at her production, we can see that Crusoe is better at catching fish than Robinson, and she is better at gathering coconuts. In an eight-hour day, she can catch thirty-six fish or gather thirty-six coconuts. Because Crusoe's PPF is above and to the right of Robinson's at every point, we say that she has an absolute advantage. The slope of her PPF is -1, indicating that the opportunity cost of one fish is one coconut. Crusoe can select any point along her PPF. But by the same logic we used before, we know that at that point she will value one fish the same as one coconut. Let's suppose that Crusoe is initially consuming eighteen fish and eighteen coconuts at point B. One day, Robinson finds a boat and sails to Crusoe's island. They begin to talk about their respective consumption patterns, and Robinson proposes that if they agree to trade, they can both be better off. Crusoe is skeptical at first since she produces more fish and more coconuts than Robinson, and so she cannot see how they could find an opportunity to trade. But Robinson persists. He points out to her that at the moment they are producing a total of thirty-three coconuts (Robinson's 15 plus Crusoe's 18) and twenty-one fish (3 + 18). But, if Robinson were to devote eight hours to gathering coconuts, he could produce twenty-four. Meanwhile, if Crusoe were to spend two more hours fishing, then she could produce twelve coconuts and twenty-four fish. Together their combined production would be thirty-six coconuts (three more than before) and twenty-four fish (three more than before). If they split this extra production, they could each increase their consumption by 1.5 coconuts and 1.5 fish.

Impact of Price Ceiling

Figure 16 illustrates the impact of imposing a price ceiling on the housing market. In this example, the competitive market equilibrium occurs at a rent of $400 per month. At this price, consumers rent two thousand apartments each month. Now suppose that landlords are told they may charge no more than $300. At this price consumers wish to rent 2,100 apartments, but landlords only supply 1,900 apartments. Those tenants lucky enough to be able to find an apartment benefit from the lower rental rates, while landlords find themselves with lower incomes. Meanwhile, other renters lose their apartments. One effect of rent control, then, is to increase the consumer surplus of some renters while reducing the producer surplus of landlords and thus negatively affecting other renters. A second consequence is that total surplus is reduced since rent control prevents some mutually beneficial transactions from taking place. There are landlords who would like to rent their apartments for more than $300 per month, and there are consumers who would be willing to pay a higher price. Less immediately apparent is the disruptive effect of rent controls on the allocation of apartments. In the competitive market equilibrium, apartments are rationed by price. Everyone who values an apartment as much or more than the market price is able to rent one, and landlords who are willing to supply apartments at or below the market price are able to rent them. Now, however, landlords are in a position to select tenants. They may require people to pay a finders fee, they may choose to rent to their friends, or they may discriminate based on personal characteristics that they value or dislike. As a result, apartments may no longer go to the individuals who value them most highly, producing a further inefficiency in the market. Historical experience points to further negative effects of rent controls. In the short run, both the supply of housing in a city and the demand for housing may be highly inelastic. As a result, rent controls mainly lower the price without creating a large excess demand. But, over time, both supply and demand become more elastic. Landlords will cut back on maintenance costs, allowing apartments to deteriorate, and eventually removing them from the available housing stock. Meanwhile, low prices will attract more residents to the city. With these changes, the problem of excess demand and non-market rationing will become increasingly significant.

The Political Economy of Trade

If trade increases a nation's well-being, then why is there so much public opposition to international agreements designed to promote freer trade? While free trade expands the overall size of the economy, it also implies shifts in the size of different industries. In the previous example, Robinson and Crusoe simply reallocated their time. But when countries become increasingly specialized, the costs and benefits of trade fall on different groups of people. As a result, even though the gains from free trade exceed the losses, those citizens who will experience losses are likely to oppose freer trade. To see this, let's consider the impact of free trade in more detail. We will begin by considering a small economy that is isolated from international markets because trade is prohibited. As a result, the domestic equilibrium is determined by the intersection of the country's supply and demand curves as depicted in Figure 21a. Suppose that the world price is PW, illustrated by the horizontal line above the domestic equilibrium price. Consumer surplus is equal to the sum of the areas marked A and B; producer surplus is equal to the area C. If the law prohibiting trade is removed, this country will become an exporter, since its cost of supply is below the world price. To simplify the analysis, we assume that the country is so small relative to the world market that its additional supply will not alter the world price. The equilibrium quantity will occur where the world price intersects the country's market supply curve. At PW, domestic consumers reduce their consumption. The difference between domestic consumption and the quantity supplied is exported. Consumer surplus falls because the price rises, and consumers purchase less of the good. The value of their surplus is represented by the area labeled A. Producer surplus increases, however.It is equal to the sum of the areas marked B, C, and D. So, producers benefit and consumers suffer when a country becomes an exporter. In total, however, social welfare increases from the area A+B+C to the area A+B+C+D, yielding a net increase equal to the area denoted by D. For a country that becomes an importer, social welfare again increases, but now it is consumers who benefit, while producers suffer losses. This situation is illustrated in Figure 22, where the domestic equilibrium price is above the world price. When trade is allowed, the domestic price falls to the world price, and the quantity consumed rises. Domestic producers, however, respond to the lower price by reducing their supply. The difference between the quantity produced domestically and the quantity consumed domestically is made up by imports. Producer surplus declines from the areas B+C to B, while consumer surplus increases from A to A+C+D.

The Effect of Externalities on Resource Allocation

In general, there will be too little of an activity that generates positive externalities and too much of an activity that generates negative externalities. To see this, let's consider the example of a paper plant. As a by-product of producing paper, the plant also produces polluted waste that it dumps untreated into a nearby river. Figure 26a shows the market for the plant's primary product: paper. The firm's supply curve is upward sloping, reflecting the fact that its marginal costs are increasing as production rises. The demand curve is drawn as downward sloping. As we have seen, the competitive market equilibrium occurs at the point where the demand and supply curves intersect. This is the quantity the profit-maximizing firm will choose to supply. But this decision does not take account of the social costs that the firm's actions impose on the downstream community. For simplicity's sake, let's assume that the cost of removing the pollutant produced by the paper company is a constant amount of $15 per unit of paper that it produces. The true social cost of the firm's production is equal to the firm's marginal cost plus the cost of treating the pollution it produces. We can represent the true social cost of production, then, by drawing a new supply curve that is shifted up by $15 at every point. This is illustrated in Figure 26b. Notice that the curve representing total social costs intersects the demand curve above and to the left of the private market equilibrium. The socially optimal level of production is lower than the amount supplied by a profit-maximizing firm because the firm fails to take account of the external costs. An important implication of the analysis illustrated in Figure 26 is that the optimal level of a negative externality is not zero. Rather, there is likely to be some positive level of the externality that will be consistent with maximizing consumer and producer surplus. This is true because the activity that generates the externality has a positive value, and the cost of reducing this activity too greatly will outweigh the additional benefits of reducing the externality. We can use a similar approach to analyze a case of positive externalities. Figure 27 illustrates the market for honey that a beekeeper faces. Here the demand curve reflects only the value that consumers place on the honey the beekeeper supplies. But, since each unit of honey also results in an increase in the value of the crop of nearby orchards, the true social value of the activity is shifted up by the amount of this increase. As this analysis suggests, the resulting equilibrium occurs above and to the right of the equilibrium when the externality is not accounted for.

Public and Private Goods

In the example we just considered, private ownership of the lake solves the allocation problem created by a common resource. But private ownership may not always be a feasible solution. Some resources like the oceans or the atmosphere are not easily privatized. Recent developments in economic theory have helped to clarify the characteristics of goods that can easily be privatized versus those that cannot. To understand this distinction, we need to differentiate goods along two dimensions. The first of these dimensions is the extent of rivalry in consumption. Most goods have the characteristic that one person's consumption of them reduces the amount that is available for others. For example, if you consume a slice of pizza, then there is one less slice available for your friend. We say that pizza is a rival good. On the other hand, when you listen to a radio broadcast, your enjoyment of it does not diminish the ability of other listeners to enjoy it as well. The radio broadcast is a non-rival good. Note that rivalry is not always a black or white condition. On a lightly traveled highway, the presence of one driver may not interfere with the value of the road to other drivers. But as congestion increases, and traffic approaches the road's capacity, then additional drivers will begin to have a negative effect. The second dimension is the degree of excludability. This describes the ability to control who consumes the good. National defense is a non-excludable good. If the military protects the country from invasion, all of its citizens benefit from this protection. Similarly, if your city puts on a fireworks display on the Fourth of July, it is difficult to prevent people from seeing it. In contrast, it is easy to exclude someone from consuming a slice of pizza by simply not giving it to them. Figure 29 summarizes this two-way categorization.

Common Resources

In the lower left-hand corner of the table in Figure 29 are goods that have a high degree of rivalry in consumption, but a low degree of excludability. These are common resources that suffer from the problem of the tragedy of the commons: because no one owns them, they will tend to be over-utilized. Fish in the ocean provide an illustration. Every fish that is caught by one person is not available to be caught by someone else. But, because it is difficult to limit access, it is difficult to make the fish a private good. Goods that are rival in consumption but not owned are the source of externalities. As we discussed earlier, there are strong incentives for private actors to find ways to internalize these externalities. When these incentives are insufficient, however, public policy can seek to establish property rights or use taxes and other types of regulatory controls to address the inefficiencies created by a common resource.

Price Discrimination

In the monopoly example we considered before, we assumed that Local Media charged the same price to all of its customers. But, what would happen if it could charge different prices to different customers? If Local Media could charge each customer a price equivalent to the value that customer placed on its service, then it could avoid the negative effect of expanding sales on the revenue earned from existing customers. By charging different prices, Local Media's marginal revenue curve would be identical to the market demand curve, and it would choose to supply a quantity equivalent to the competitive market outcome. Such a strategy is called perfect price discrimination. While companies can rarely discriminate perfectly between customers, it is easy to identify examples of ways that firms seek to separate customers into groups who value their product differently. One way that cable companies can price discriminate, for example, is by offering different packages of channels. Those who value the service most highly are likely to buy a large package at a higher price. There are many other examples of price discrimination. Many movie theaters offer lower priced tickets for children and senior citizens, consumers who are likely to have a lower willingness to pay. Airlines typically charge lower prices for travelers who stay over a Saturday night. While leisure travelers will accept this condition in ex- change for lower fares, business travelers, whose willingness to pay is higher, will not. College need-based financial aid is another price discrimination strategy. Price discrimination further increases monopoly profits by allowing the monopoly to capture a greater fraction of the benefits produced by each transaction. But, price discrimination also has the positive effect of increasing social welfare by moving the market closer to the socially efficient quantity.

Pork Barrel Politics

Pork barrel politics refers to the proclivity of elected officials to introduce projects that steer money to their communities. Such projects are often popular with the voters who matter for the particular legislator, but the combined effect of these projects is to increase the cost of government. To understand this problem, it may help to think about an experience you may have had before. You have gone out with four of your friends to a restaurant and agreed that to simplify matters you will split the bill evenly. When the waiter asks if you want dessert, you look at the menu and see that you can purchase a hot fudge sundae for $4. You value the sundae at no more than $3, so if you were dining alone you would skip dessert. But you do the math and realize that if you order the sundae your share of the bill will only increase by $0.80 ( = $4/5). As result, you order it. Not surprisingly, your friends make a similar calculation for themselves, and you wind up paying an additional $4 each. A similar logic is at work in the legislative process. A member of the House of Representatives might, for example, be able to introduce an amendment to a bill that will bring $100 million in benefits to his/her district. The cost of the program to the federal government is $150 million (so clearly the costs outweigh the benefits). But the cost to the community is just a small fraction of this, since it will be supported by all taxpayers, not just those in the affected community. For the representative's constituency this is a terrific deal. They get $100 million in benefits for a small fraction of this amount in increased taxes. Of course the legislation has to get the support of a majority of the House members to be passed into law. Why would a legislator representing another district support legislation that will increase the cost to his constituents without producing any benefits? The answer is that by supporting his/her colleague's pet project the legislator can win support for his/her own pet project. This vote trading activity is commonly called logrolling, and much like the restaurant example above, it accounts for a certain amount of wasteful government spending.

Tastes

Remember that the quantity demanded reflects a comparison of the benefits of consumption with the opportunity costs of purchasing the good. If the perceived benefits of consumption change, then so will the quantity demanded. For example, suppose that concerns about the environmental impacts of driving cause people to be more concerned about pollution. The likely impact will be a reduction in the demand for gasoline.

Elasticity/ Price Elasticity of Demand

The competitive market model we have developed allows us to predict the direction in which equilibrium price and quantity will change in response to changes in market supply or demand. But to fully understand the impact of these changes, it is important to be able to measure the size of the changes in prices and quantities as well as their direction. To do this, we need to introduce the concept of price elasticity. The price elasticity of demand measures how much the quantity demanded responds to a change in price. We calculate the price elasticity of demand using the following formula: Price elasticity of demand = (Percentage change in quantity demanded) / (Percentage change in price) Recall that because of the law of demand, the quantity demanded of a good is negatively related to its price, so this ratio will always be negative. It is conventional to ignore this sign when discussing the elasticity of demand. In other words, in practice, we use the absolute value of the price elasticity of demand. The price elasticity of demand reflects how responsive consumers are to changes in the price of a good. The greater the elasticity, the greater the proportionate change in the quantity consumers demand due to any given change in the price. Demand is said to be elastic if a one percent change in price results in a greater than one percent change in the quantity demanded. Demand is said to be inelastic if a one percent change in price results in a less than one percent change in the quantity demanded. And demand is said to be unit elastic if a one percent change in price results in a one percent change in the quantity demanded. Economists use elasticity because it provides a measure of the responsiveness of demand to price changes that is independent of the units of measurement. For example, if we express the quantity of gasoline demanded in liters, then we will find that the demand curve has a different slope from the one that would result if we measured demand in gallons. However, the elasticity will be the same in both cases. Measuring the actual elasticity of demand for particular products is an important activity of applied economics. Nonetheless, we can state some general guidelines about the factors that influence the price elasticity of demand.

The Effects of Private Ownership

The example we have just considered is a version of a problem that is often referred to as the tragedy of the commons. When a resource is owned jointly, no one takes account of the negative externalities caused by overuse. We have seen in the previous section that taxes or other regulations can ameliorate the effects of externalities. But a simpler solution is to create property rights in the resource. Suppose that in the previous example we allow for one of the villagers to purchase the lake. The owner can then decide how many boats to allow on the lake. We have seen that the most profitable choice is to allow a single boat on the lake, which generates an income of $30. So, if the lake is privately owned, resources will be allocated in the most efficient manner. How much would one of the villagers be willing to pay to purchase the lake? Since the opportunity cost of investing in the boat is the $15 forgone interest, the owner of the lake would earn $15 profit if he or she could use the lake for free. The most one of the villagers would be willing to pay to purchase the lake is $100. At this price, the purchase of the lake yields the same return as buying a government bond. If the villagers invest the $100 paid by the purchaser in a government bond, then they can divide the additional income that it generates, thus raising all of their incomes.

Public Goods

The final category of goods combines non-rivalry invconsumption with non-excludability. These are true public goods. Because it is difficult to exclude consumers, it isvdifficult for private actors to charge for these goods. And,vbecause they are non-rival in consumption, the marginalvcost of their provision is close to zero. Many public goods are provided by the government. But, in some instances public goods, such as television and radio broadcasts, are supported in other ways—such as through advertising or private donations. It is likely, however, that when public goods are supplied this way that the quantity supplied will be too low. One illustration of this is the vastly greater number of channels available via cable and satellite TV than via over the air broadcast. Because subscribers to cable or satellite providers pay directly for programming, a much greater variety of content is available than can be supported by advertising alone.

Steve's demand curve (on page ten)

The graph in Figure 1 shows another way of representing Steve's demand schedule. The downward-sloping line in this graph is called Steve's demand curve. Notice that we plot the points of Steve's demand schedule with the quantity demanded on the horizontal axis and the price on the vertical axis. To read this graph, find a price on the vertical axis (say $3 per gallon) and then draw a line horizontally until it intersects the demand curve. Now draw a line vertically downward from that point until it intersects the horizontal axis. The point at which this line intersects the horizontal axis (40 gallons) is the quantity Steve demands when the price is $3 per gallon. When the market price changes, we find Steve's quantity demanded by moving up or down along the demand curve until we reach the height corresponding to the new market price. For example if the price were to rise from $3 to $5 a gallon, Steve's quantity demanded would decline from 40 gallons a month to 30 gallons a month. This movement is illustrated in Figure 1 by the arrow pointing up and to the left along the demand curve.

The law of demand is a result of what? Explain and give and example.

The law of demand is a result of the cost-benefit analysis that rational decision-makers use when deciding how to allocate their resources. As the price of a good increases, the opportunity cost of consuming that good also increases since consumers must cut back on their consumption of other goods to afford the higher price. If, for example, the price of gasoline rises, people will likely find ways to reduce the amount that they drive. They might do this by planning their trips more carefully or choosing to take the bus or ride a bicycle rather than drive

The ownership of a key resource (Barrier to Entry)

The market for residential electricity supply is a monopoly in most communities because a single company owns the retail electricity distribution system. It would not be possible for a competitor to establish another distribution system. Another example is the market for diamonds. Until recently the DeBeers company owned mines from which 80 percent of the world's diamonds are produced. Because diamonds can be mined in only a few places, ownership of these places allows for the establishment of what is effectively a monopoly.

Market Definition (affect price elasticity)

The price elasticity of demand will depend on how we define the market. The broader the market definition, the fewer close substitutes there will be and the lower the elasticity of demand. The price elasticity of demand for soft drinks will be lower than the price elasticity of demand for any particular brand of cola drink.

Price elasticity of supply

The price elasticity of supply is defined analogously to the price elasticity of demand. It is calculated as: Price elasticity of supply = (Percentage change in quantity supplied) / (Percentage change in price) The elasticity of supply reflects the ease with which suppliers can alter the quantity of production. We can establish some general guidelines that allow us to identify factors that are likely to affect this responsiveness. As was the case with the price elasticity of demand, if two supply curves pass through the same point, the flatter curve will be the more elastic one. Figure 14 illustrates the variety of supply curves that are possible. Again there are five cases. In the extreme case (a) the supply is perfectly inelastic, indicating that the quantity supplied will not change at all as the price changes. The supply of Van Gogh sunflower paintings is perfectly inelastic since there is no way to produce more of these. The remaining cases illustrate (b) inelastic supply, (c) unit elastic supply, (d) elastic supply, and the other extreme case (e) perfectly elastic supply.

Supply (Demand Curve)

The quantity supplied of any good is the amount that sellers of that good are willing and able to produce. Many factors influence the quantity supplied, but the most important is the price that suppliers receive. The higher the price is, the greater the quantity that suppliers will want to produce

How is the market for gasoline highly competitive?

There are many buyers and sellers even in a relatively small community, and none of these market participants trades more than a small fraction of the gasoline that changes hands. As a result, no one buyer or seller influences the price of gasoline, or the quantity sold. Rather, the price and quantity sold are determined by the combined actions of all the buyers and sellers in the market. The owner of each gas station knows that there are other stations selling a very similar product, so if the owner raises his or her price above the going price, then customers will go elsewhere. On the other hand, the owner has no reason to lower the price significantly below the going price because this will simply reduce his or her income. In much the same way, because each buyer purchases only a small amount of gasoline compared to the total market, no one buyer can influence the price

Monopoly Supply

To illustrate the supply decision of a monopolist, let's consider the example of the market for cable television services in Smallville, which is served by a single provider Local Media. The table in Figure 24 shows that the demand for cable television service is negatively related to the price of a monthly subscription. At a price of $20, no one will purchase the service, but when the price falls to $19 a month, 100 households will subscribe. As the price falls further, demand increases. Local Media can choose to supply at any combination of price and quantity along the demand curve. Its total revenue at that point is equal to the price times the quantity. What happens to the company's revenues as it selects different points along the demand curve? For example, consider moving from point A in the graph in Figure 24, where price equals $16 and the quantity is 400, to point B where the price is $15. The additional subscribers generate more revenue, but to achieve this, the company must lower its price to existing subscribers. At point A total revenue is $6,400, and at point B it rises to $7,500. Lowering the price and increasing supply increases total revenue, but the marginal revenue—the incremental increase in revenues produced by each additional subscriber—is less than the price of service. Here the additional 100 subscribers generate just $1,100 in additional revenue, an increase of $11 per subscriber, even though the price of a monthly subscription is $15. The difference is attributable to the fact that Local Media must lower the price it charges its existing subscribers to attract additional customers. What price should Local Media choose and how much should it supply at this price? The profit-maximizing strategy that we identified for a firm in a competitive market—increase supply until marginal cost equals marginal revenue—still applies for a monopolist. As long as marginal revenue is greater than marginal cost, increasing supply causes economic profits to increase, but increasing supply beyond this point causes profits to begin to decline. Figure 25 illustrates the application of this strategy. Local Media's marginal cost curve is drawn as upward sloping, reflecting the fact that adding additional subscribers requires the extension of the network, which requires increasingly costly equipment. Local Media's marginal cost curve intersects the marginal revenue curve at a quantity of 700 subscribers. At this quantity, the marginal cost and marginal revenue are both $7, and the height of the demand curve indicates that demand equals 700 when the price is $13 per month. Local Media's profit-maximizing choice is to set the price at $13 and provide 700 subscriptions.

Total Revenue

To see how measurements of elasticity can be used, let's return to the example of the introduction of Bovine Growth Hormone that we considered earlier. As a starting point, we need to consider how the elasticity of demand affects total revenues available to producers in this market. Total revenue is the equilibrium price multiplied by the equilibrium quantity: Total Revenue = P × Q The total revenue can be depicted graphically as in Figure 15. As the price falls, we move down along the demand curve: the height of the box is reduced as its width increases. If the demand is elastic, total revenue will increase since the proportionate change in quantity will be greater than the proportionate increase in the price. But, if demand is inelastic, then total revenue will decrease when prices fall.

Equilibrium

What will the price of gasoline be? How many gallons will be sold? To answer these questions we need to put the information about the market demand and market supply together. There is, as we will see, only one combination of price and quantity at which the market is at equilibrium, and it is at this point that the market will settle. Equilibrium is a widely used concept in both the physical and social sciences. It is defined as a point at which all the forces at work in a system are balanced by other forces, resulting in a stable and unchanging situation. In economics, a market is in equilibrium when no participant in the market has any reason to alter his or her behavior. The market equilibrium occurs at the combination of price and quantity where the market supply and demand curves intersect. Because the supply curve is upward sloping and the demand curve is downward sloping, there is only one possible point of intersection. Figure 6 illustrates the market equilibrium for gasoline. In this hypothetical example, the equilibrium price is $2.50, and the equilibrium quantity is 10,000 gallons of gasoline per month. At this point, we can say that the buyers and sellers in this market are all satisfied, in the sense that buyers are able to purchase as much gasoline as they would like at a price of $2.50 a gallon, and suppliers can sell as much gasoline as they would like at this price. There are, no doubt, buyers who complain that the price of gasoline is too high and would like the price to be lower, and similarly suppliers who complain that the price is too low and would like it to be higher. An important feature of market equilibrium is that the market has an automatic tendency to gravitate toward this combination of price and quantity. Figure 7 illustrates this point. We start (Figure 7a) by supposing that the price is higher than $2.50. At a price of $4 a gallon, for example, suppliers would like to sell 10,600 gallons, but buyers only wish to purchase 8,500 gallons a month. In other words, there is an excess supply. No one can force people to buy more gasoline than they want, so suppliers find that they have too much gasoline on hand, their storage tanks are filling up, and they cannot unload their inventory. Under these circumstances, suppliers have an incentive to lower their price a little bit. If one station posts a price of $3.90 a gallon, it will attract buyers from other stations, and its surplus will be reduced. But once the other stations see that they are losing customers, they will be forced to lower their prices as well. The pressure to cut prices and attract business will not go away until the price has reached the equilibrium level of $2.50 a gallon. Now suppose that the price is below the equilibrium price. Figure 7b illustrates this situation. At a price of $1.50 there is an excess demand for gasoline. Buyers wish to purchase 11,000 gallons of gasoline, but suppliers are willing to sell only 9,600 gallons. Now there are shortages: some drivers cannot find any gasoline, and others have to wait in long lines to purchase gasoline. Buyers might be tempted to offer to pay a little bit extra to be sure to get what they need, and sellers will see that they can raise prices without sacrificing sales. The pressure to raise prices will continue until the price has reached the equilibrium level. Only at this point will buyers and sellers have no desire to change their behavior.

Government Regulation of Externalities

When private bargaining fails, governments can sometimes step in to resolve the matter. Since the problem of externalities arises because the actions of private parties do not fully reflect the social costs or benefits of their actions, one solution is to use taxes or subsidies to correct this problem. An example of the use of taxes to address externalities is the introduction of a congestion charge in London in 2003. Under this law, drivers entering a well-defined area of central London must pay a fee of about $16. At the time the congestion charge scheme was introduced, London had the worst traffic congestion of any city in Europe. It was estimated that drivers spent nearly fifty percent of their time idling and that the economic value of time lost due to congestion was between $3 and $6 million each week. Although congestion remains a significant problem in London, the introduction of the fee has reduced vehicle traffic in the original congestion charging zone by over 20 percent. Using taxes to remedy the effect of externalities is most effective when it is possible to estimate the value of the externality. In many cases, this information is not readily available. So it may be more effective to reduce a negative externality by establishing a quota limiting the activity that produces the externality. If such an approach were to be used to reduce traffic congestion, then a target number of vehicles would be set and only that many permits would be issued. Of course, a problem with this approach is that the drivers who get permits may not be those who value them most highly. But, this can be re- solved by creating a market in which drivers can buy and sell permits. The United States Environmental Protection Agency (EPA) has used this approach to deal with sulfur dioxide emissions. After establishing a maximum level of emissions, the EPA auctioned off the rights to emit sulfur dioxide to the highest bidders. The owners of these permits are allowed to trade them if they discover that they can reduce pollution at a cost that is lower than other potential polluters value the right to emit pollutants.

Creative Destruction: The Profit Motive and the Sources of Economic Change

When we considered the entry and exit of producers in a competitive market in the previous section, we came to the somewhat surprising conclusion that even though producers in a perfectly competitive market would earn zero profits, they would be satisfied with this result. In part this is a consequence of our definition of economic profits, which factors in the opportunity cost of all of the resources employed, including the business owner's time. Economic profits, then, are an additional payment above and beyond the compensation that can be earned in the next best alternative activity. We should not be surprised, then, that self-interested economic agents should seek to identify or create opportunities to earn economic profits. One important way that they can do this is by escaping the constraints of competitive markets. When producers can create barriers to entry, they can create situations of imperfect competition in which they are able to earn economic profits. As we saw earlier, in comparison to a hypothetical competitive market outcome, imperfectly competitive markets create inefficiencies because producers restrict supply as part of their effort to maximize profits. But, this comparison of different market structures fails to capture an important aspect of the actual way in which economies evolve over time. One of the important routes that firms take to establish market power is innovation. Entrepreneurs are individuals who take on the risk of attempting to create new products or services, establish new markets, or develop new methods of production. The rewards of entrepreneurship are the economic profits that can be earned by being the first to market with a new product. In the case of scientific innovation, entrepreneurs can obtain a legal monopoly through patents; but in other cases market power arises because of theirbability to differentiate the goods or services they produce from other products in the market. Entrepreneurs can differentiate their product by defining the desirable characteristics of their product or by the possession of trade secrets. At the same time that innovation helps to create barriers to entry that reward the innovator with economic profits, it also serves to break down existing market imperfections because the existence of profits encourages efforts to invent around existing barriers to entry. Examples of this include the development of satellite television in competition with the monopoly of cable television and the efforts of mobile phone manufacturers to imitate the Apple iPhone. The continued development of new and improved products is one of the key sources of long-run improvements in well-being, a fact that economist Joseph Schumpeter sought to capture when he described the impact of entrepreneurs as a type of "creative destruction." The essential catalyst of creative destruction is the opportunity to earn economic profits. But, the inefficiency in resource allocation that creates these economic profits is—in the view of many economists—small in comparison to the benefits of the innovation to which it gives rise.