Week 4

spillover (4.3)

- A market exchange that affects a third party who is outside or "external" to the exchange; sometimes called a "spillover". - For example, when an electrical power plant produces electricity from a coal-burning plant, it can release a lot of particles and smoke into the atmosphere if there are no emissions-reducing equipment on board. Because the power plant does not have to worry about the medical costs (spillover costs) from their pollution on those who live downwind, they will overproduce the electricity.

marketable permit program (4.3)

- A permit that allows a firm to emit a certain amount of pollution; firms with more permits than pollution can sell the remaining permits to other firms. - aka cap and trade program

negative externalities (4.3)

- A situation where a third party, outside the transaction, suffers from a market transaction by others. - The good is overproduced and the equilibrium output will be greater than the efficient output. - Negative externalities result in an over-allocation of resources.

pollution charge (4.3)

- A tax imposed on the quantity of pollution that a firm emits; also called a pollution tax.

key ideas (4.3)

- An externality occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. - An externality, which is sometimes also called a spillover, can have a negative or a positive impact on the third party. - If those parties imposing a negative externality on others had to account for the broader social cost of their behavior, they would have an incentive to reduce the production of whatever is causing the negative externality. If they do not, then markets would tend to overproduce output. - Marginal analysis can be utilized to determine the socially appropriate level of pollution control.

positive externalities (4.4)

- Beneficial spillovers to a third party or parties. - Positive externalities occur when a third person, or persons, is affected by the transaction in a positive way. The good is under-produced when positive externalities are present. The equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer's individual marginal benefit, but no more.

social costs (4.3)

- Costs that include both the private costs incurred by firms and also additional costs incurred by third parties outside the production process, like costs of pollution. - Economists illustrate the social costs of production with a demand and supply diagram.

key ideas (4.2)

- Economic efficiency occurs when the situation cannot be improved without imposing a cost upon another. - In the demand and supply model, efficiency is achieved when the optimal (equilibrium) amount of each good and service is produced and consumed. - In a market system, government intervention is often not necessary to achieve the optimal (equilibrium) amount.

weeks 3+4 wrap-up

- Elasticity measures the responsiveness to a change in price. - Elasticity of supply will increase when it becomes easier to substitute one factor of production for another in a manufacturing process. - The more choices, or substitutes one has, the more elastic it is. - Cross-elasticity of demand measures how sensitive consumer purchases of one product are to a change in the price of some other product. - If cross elasticity of demand is POSITIVE, then the sales of X move in the same direction as a change in the price of Y. - X and Y are substitutes. - For example, some consider Coke and Pepsi to be substitutes (we know better). - Therefore, in theory, if the price of Coke increases, the calculation would bear out that the increased price for Coke will increase sales for Pepsi. - When cross elasticity is NEGATIVE, then X and Y are complements. - An increase in the price of one decreases the demand for the other. - For instance, if a 10% increase in the price of product X causes the demand for product Y to decrease by 15%, then X and Y are complements. - Remember, if the price of ice cream increases, my demand for hot fudge, sprinkles, whipped cream, etc., will decrease. Don't let the X and Y distract you.

point (4.4)

- If the private sector does not have sufficient incentive to carry out R&D, one possibility is for the government to fund such work directly. Government spending can provide direct financial support for R&D conducted at colleges and universities, non-profit research entities, private firms, and government-run laboratories. - A complementary approach is to give firms a reduction in taxes depending on how much R&D they do. The federal government refers to this policy as the research and experimentation (R&E) tax credit. Studies find that each dollar of foregone tax revenue through the R&E Tax Credit causes firms to invest at least a dollar or more in R&D.

command-and-control regulation (4.3)

- Laws that specify allowable quantities of pollution and that also may detail which pollution-control technologies one must use. - Government can implement command-and-control regulation that would require companies to increase their costs by installing anti-pollution equipment.

property rights (4.3)

- The legal rights of ownership on which others are not allowed to infringe without paying compensation.

social benefits (4.4)

- The sum of private benefits and external benefits. - The social benefits of an innovation account for the value of all the positive externalities of the new idea or product, whether enjoyed by other companies or society as a whole, as well as the private benefits the firm that developed the new technology receives.

key ideas (4.1)

- When government does intervene in a market either to prevent the price of some good or service from rising "too high" or to prevent the price of some good or service from falling "too low," there are often known and unknown consequences. - Sometimes the consequences undermine the intent of government intervention.

private rate of return (4.4)

- When the estimated rates of return go primarily to an individual; for example, earning interest on a savings account. - The investment in education, or human capital, requires a certain upfront cost with an uncertain future benefit. The idea is that higher levels of educational attainment will eventually serve to increase the person's future productivity and subsequent ability to earn, their private rate of return.

social rate of return (4.4)

- When the estimated rates of return go primarily to society; for example, providing free education. - What does society gain from investing in the education of another student? After all, if the government is spending taxpayer dollars to subsidize public education, society should expect some kind of return on that spending. The social rate of return on schooling is also positive. The positive externalities to education typically include better health outcomes for the population, lower levels of crime, a cleaner environment and a more stable, democratic government.

market failure (4.3)

- When the market on its own does not allocate resources efficiently in a way that balances social costs and benefits; externalities are one example of a market failure.

surplus (4.1)

- a situation in which quantity supplied is greater than quantity demanded - excess surplus - refer to figure 2

shortage (4.1)

- at the existing price, the quantity demanded exceeds the quantity supplied; also called excess demand - refer to figure 1

price ceiling (4.1)

- maximum prices that can be charged on a good - set on goods that are considered to be necessities, but the equilibrium price is so high that many people are unable to purchase the item - to be effective, the price ceiling must be set below the equilibrium price - when price ceilings are placed on a good, this creates a chronic shortage, which makes it difficult to determine how to ration the limited output for all of the consumers who are willing and able to buy the good - meant to protect buyers

price floors (4.1)

- minimum prices that can be charged for a good - price floors are placed on goods that are considered to be necessities, but the equilibrium price is so low that it discourages the production of the good - min wage is example - to be effective, the prices must be set above the market price, and this creates persistent surpluses in the market - meant to protect sellers. so they can make a profit and stay in businesses

2. For each of your answers to Question 1, will equilibrium price rise or fall or stay the same? (4.3) A: Firms in an industry are required to pay a fine for their emissions of carbon dioxide. B: Companies are sued for polluting the water in a river. C: Power plants in a specific city are not required to address the impact of their emissions on the quality of air. D: Companies that use fracking to remove oil and gas from rock are required to clean up the damage.

- price will rise - price will rise - price will stay the same - price will rise

consumer surplus figure 1 (4.2)

- refer to figure 1 and make sure it is understood - As you can see in the graph below (Figure 1 ), the somewhat triangular area labeled by F shows the area of consumer surplus , which shows that the equilibrium price in the market was less than what many of the consumers were willing to pay. The somewhat triangular area labeled by G shows the area of producer surplus , which illustrates that the equilibrium price received in the market was greater than what many of the producers were willing to accept for their products.

figure 2a (4.2)

- refer to figure 2a - reduced social surplus from a price ceiling - In graph (a) below (Figure 2), the original equilibrium price is $600 with a quantity of 20,000. Consumer surplus is T + U, and producer surplus is V + W + X. A price ceiling is imposed at $400, so firms in the market now produce only a quantity of 15,000. As a result, the new consumer surplus is T + V, while the new producer surplus is X.

figure 2b (4.2)

- refer to figure 2b - reduced social surplus from a price floor - In graph (b) above (Figure 2), the original equilibrium is $8 at a quantity of 1,800. Consumer surplus is G + H + J, and producer surplus is I + K. A price floor is imposed at $12, which means that quantity demanded falls to 1,400. As a result, the new consumer surplus is G, and the new producer surplus is H + I.

figure 4 marginal analysis (4.3)

- refer to figure 4 - We can use the tools of marginal analysis to illustrate the marginal costs and the marginal benefits of reducing pollution. The marginal cost rises as pollution is reduced more and more and at some point the marginal cost is higher than the marginal benefit. Additional actions to reduce pollution will therefore lower society's well-being because total costs will rise more than total benefits. The optimal amount of externality reduction—in this case, pollution abatement—occurs at QB, where society's marginal cost, MC, and marginal benefit, MB, of reducing the spillover are equal (Figure 4 below).

figure 4 marginal analysis cont. (4.3)

- refer to figure 4 - When the quantity of environmental protection is low so that pollution is extensive, for example, at quantity Qa, there are usually numerous relatively cheap and easy ways to reduce pollution, and the marginal benefits of doing so are quite high. At Qa, it makes sense to allocate more resources to fight pollution. However, as the extent of environmental protection increases, the cheap and easy ways of reducing pollution begin to decrease, and one must use more costly methods. The marginal cost curve rises. Also, as environmental protection increases, one achieves the largest marginal benefits first, followed by reduced marginal benefits. As the quantity of environmental protection increases to, say, Qb, the gap between marginal benefits and marginal costs narrows. At point Qc, the marginal costs will exceed the marginal benefits. At this level of environmental protection, society is not allocating resources efficiently, because it is forfeiting too many resources to reduce pollution.

figure 1 +2 (4.4)

- refer to figures 1 + 2 - Big Drug faces a cost of borrowing of 8%. If the firm receives only the private benefits of investing in R&D, then we show its demand curve for financial capital by DPrivate, and the equilibrium will occur at $30 million. Because there are spillover benefits, society would find it optimal to have $52 million of investment. If the firm could keep the social benefits of its investment for itself, its demand curve for financial capital would be DSocial and it would be willing to borrow $52 million. (The firm's private demand curve would be the same as society's demand curve.) But, unless there is a way for the company to fully enjoy the total benefits, then it will borrow less than the socially optimal level of $52 million. - Big Drug's original demand for financial capital (DPrivate) is based on the profits the firm receives. - The social benefit of the drug takes into account the value of all the drug's positive externalities. If Big Drug were able to gain this social return instead of other companies, its demand for financial capital would shift to the demand curve DSocial, and it would be willing to borrow and invest $52 million. However, if Big Drug is receiving only 50 cents of each dollar of social benefits, the firm will not spend as much on creating new products. The amount it would be willing to spend would fall somewhere in between DPrivate and DSocial.

figures 1+2 (4.3)

- refer to figures 1+2 - make sure to understand it

What are consumer and producer surplus? How is it illustrated on a demand and supply diagram? (4.2)

- refer to figures 3+4 - The consumer surplus is the extra benefit consumers receive from buying a good or service, measured by what the individuals would have been willing to pay minus the amount that they actually paid. The consumer surplus is illustrated on the demand and supply below in the area labeled F, which is the area above the market price and below the demand curve. - The producer surplus is the extra benefit producers receive from selling a good or service, measured by the price the producer actually received minus the price the producer would have been willing to accept. The producer surplus is illustrated in the demand and supply diagram below in the area labeled G, which is the area between the market price and the segment of the supply curve below the equilibrium.

1. Identify whether the market supply curve will shift right or left or will stay the same for the following: (4.3) A: Firms in an industry are required to pay a fine for their emissions of carbon dioxide. B: Companies are sued for polluting the water in a river. C: Power plants in a specific city are not required to address the impact of their emissions on the quality of air. D: Companies that use fracking to remove oil and gas from rock are required to clean up the damage.

- supply shifts to the left - supply shifts to the left - supply stays the same - supply shifts to the left

consumer surplus (4.2)

- the extra benefit consumers receive from buying a good or service, measured by what the individuals would have been willing to pay minus the amount that they actually paid - is the difference between the maximum prices consumers are willing to pay for a product and the lower equilibrium price - think about buying a new car - if you walk out of the dealership paying $2,000 less than the maximum price you were willing to pay, then you have a surplus of $2,000 - a consumer surplus will always be above the equilibrium price

producer surplus (4.2)

- the extra benefit producers receive from selling a good or service, measured by the price the producer actually received minus the price the producer would have been willing to accept - again, if you think about being the seller of a car, you have an idea of the lowest possible price that you will accept - if you receive a price that is higher than this lowest possible price, then you have a surplus or extra benefit - the producer surplus will always be below the equilibrium price

deadweight losses (4.2)

- the loss in social surplus that occurs when a market produces an inefficient quantity - are reductions of combined consumer surplus and producer surplus - quantity levels that are either less than or greater than the efficient quantity create efficiency losses - underproduction will always be to the left of the equilibrium point - overproduction will always be to the right of the equilibrium point

productive efficiency (4.2)

- when it is impossible to produce more of one good (or service) without decreasing the quantity produced of another good (or service) - is achieved because competition forces producers to use the best available technology and best combination of resources available

allocative efficiency (4.2)

- when the mix of goods produced represents the mix that society most desires - is achieved because the correct quantity of product is produced relative to other goods and services

copyright (4.4)

A form of legal protection to prevent copying, for commercial purposes, original works of authorship, including books and music.

patent (4.4)

A government rule that gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time.

Becky and Sarah are sisters who share a room. Their room can easily get messy, and their parents are always telling them to clean it up. Here are the costs and benefits to both Becky and Sarah, of taking the time to clean their room: If both Becky and Sarah clean, they each spend two hours and get a clean room. If Becky decides not to clean and Sarah does all the cleaning, then Sarah spends 10 hours cleaning (Becky spends 0) but Sarah is exhausted. The same would occur for Becky if Sarah decided not to clean—Becky spends 10 hours and becomes exhausted. If both girls decide not to clean, they both have a dirty room. Unfortunately, we know that the optimal outcome will most likely not happen, and that the worst one will probably be chosen instead. Explain what it is about Becky's and Sarah's reasoning that will lead them both to choose the worst outcome. (4.4)

Both girls reason that if the other one foregoes cleaning, their best option is to not clean as well. Similarly, if the other one cleans, their best option is not to. Not cleaning is the dominant strategy, and so the room will likely remain dirty. Of course, this assumes that the girls have no way to tell if the other is helping, cannot collude and cannot clean the room only partially.

When a neighborhood is cleaned up and kept neat, there are a number of positive spillovers: higher property values, less crime, happier residents. What types of government policies can encourage neighborhoods to clean up? (4.4)

Government programs that either pay for neighborhood clean-up directly or that provide reduced tax payments for those who clean up or fix up their own property could be enacted. It is also easy to imagine how a city might allow its businesses to form a group that would pay for and manage neighborhood cleanup.

key ideas (4.4)

In the case of a positive externality, the third party obtains benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, then markets would tend to under-produce output because suppliers are not aware of the additional demand from others.

From an economic perspective, is it sound policy to pursue a goal of zero pollution? Why or why not? (4.3)

It is not, because the costs of not polluting at all would be far higher than the benefits. We would have to abandon virtually all modern technology in order to achieve such a goal, which would have devastating economic consequences, whereas a small amount of pollution necessary for modern life is a comparatively small cost.

Ronald Coase (4.3)

Ronald Coase (1910-2013), who won the 1991 Nobel Prize in economics (Figure 3) stated that a clarified and strengthened idea of property rights can strike a balance between economic activity and pollution. This became known as the Coase theorem: under the right conditions, private bargaining can solve externality problems; thus government intervention may not always be necessary.

Why do supply-side market failures occur? (4.3)

Supply-side market failures occur because there are extra costs associated with producing the good, but the extra costs are not reflected in the supply. Remember the previous example of the coal-burning power plant: The firm running the plant pays for the land, labor, capital, and entrepreneurship that it uses to generate electricity, but it does not pay for the smoke it releases into the atmosphere and the damage that it causes to the atmosphere. This is a market failure where too much electricity would be produced because the market could not weigh the social costs and social benefits in which some of the costs are unaccounted for.

Becky and Sarah are sisters who share a room. Their room can easily get messy, and their parents are always telling them to clean it up. Here are the costs and benefits to both Becky and Sarah, of taking the time to clean their room: If both Becky and Sarah clean, they each spend two hours and get a clean room. If Becky decides not to clean and Sarah does all the cleaning, then Sarah spends 10 hours cleaning (Becky spends 0) but Sarah is exhausted. The same would occur for Becky if Sarah decided not to clean—Becky spends 10 hours and becomes exhausted. If both girls decide not to clean, they both have a dirty room. What is the best outcome for Becky and Sarah? What is the worst outcome? (It would help you to construct a prisoner's dilemma table.) (4.4)

The best outcome for each girl individually is for the other one to do all the cleaning, but the best outcome for them jointly is to share the cleaning. The worst outcome would be for neither girl to clean so the room remains dirty.

Most government policy decisions have winners and losers. What are the effects of raising the minimum wage? It is more complex than simply producers lose and workers gain. Who are the winners and who are the losers, and what exactly do they win and lose? To what extent does the policy change achieve its goals? (4.1)

The minimum wage is a price floor that prevents the price of labor from falling below a certain level. Like all binding price floors, this creates a surplus of labor, also known as unemployment. Those who do not offer enough productive value to earn the minimum wage will lose out on job opportunities they might otherwise have had. On the other hand, those who do manage to keep their jobs will benefit from higher wages. In this way, minimum wages make some workers better off, but actually harm those with the least education or skills, who cannot compete for jobs at the higher wage level.

The Junkbuyers Company travels from home to home, looking for opportunities to buy items that would otherwise be put out with the garbage, but which the company can resell or recycle. Which will be larger, the private or the social benefits? (4.4)

When the Junkbuyers Company purchases something for resale, presumably both the buyer and the seller benefit-otherwise, they would not need to make the transaction. However, the company also reduces the amount of garbage produced, which saves money for households and/or for the city that disposes of garbage. So the social benefits are larger than the private benefits.

____________ are enacted when discontented sellers, feeling that prices are too low, appeal to legislators to keep prices from falling. (4.1)

price floors