Principles of Microeconomics-Midterm #3

command and control policies

-the government can remedy an externality by either requiring or forbidding certain behaviors. -the government tasks various agencies with developing and enforcing regulations to protect third parties affected by negative externalities. -the environmental protection agency dictates a maximum level of pollution that a factory may emit and can require some firms to implement certain technologies that can minimize pollution.

notable common resources:

1. clean air and water 2. congested roads 3. fish, whales, and other wildlife

in what two ways do governments respond to externalities

1. command-and-control policies 2. market-based policies

notable public goods:

1. national defense 2. basic research 3. fighting poverty

how would a central planner use the graph to determine the new optimum quantity produced?

1. planner would want to maximize total surplus (value to consumers minus the cost of production) 2. choose the level of production at which the demand curve crosses the social cost curve 3. when the market equilibrium price, the demand curve lies below the social cost curve, thus reducing production below the market equilibrium will raise total economic well-being

excludable goods:

a good that people can be prevented from using without paying

free rider

a person who receives the benefit of a good but does not pay for it (no incentive) example: you can't sell tickets to a fireworks show because you can't exclude people from watching without paying

technology spillover

a positive externality that results from the impact that one firm's research and production efforts on other firms.

condorcet's paradox

a situation in which the preferences of each individual member of a group are transitive, but the collective preferences of the group are not. collective preferences can be cyclic, even if the preferences of individual voters are not cyclic. This is paradoxical, because it means that majority wishes can be in conflict with each other: Majorities prefer, for example, candidate A over B, B over C, and yet C over A. When this occurs, it is because the conflicting majorities are each made up of different groups of individuals.

initial distribution of rights and case theorem

according to the coase theorem, the initial distribution of rights doesn't matter for the market's ability to reach the efficient outcome. distribution of rights is not irrelevant though, it determines the distribution of economic well being.

cost benefit analysis

an estimate of the total costs and benefits of the project to society as a whole. the government must complete this process when determining the total benefit for all those who would use it to the costs of building and maintaining it.

concentrated benefits and diffused costs

because of rational ignorance, it is optimal for politicians to make policies wth concentrated benefits and diffused costs since the costs to an individual are small, you have little incentive to know about or change the policies

challenge of public goods:

because public goods are non excludable, the free rider problem prevents the private market from supplying them. if the government decides that the total benefits of a public good exceed its costs, it can provide the public good, pay for it with tax revenue, and potentially make everyone better off.

private goods:

both excludable and rival in consumption. example: ice cream cone

examples of policy responses to deal with market failures:

emission standards for cars to prevent excess exhaust emissions that are harmful to third party bystanders regulation of the destruction of historic buildings by providing tax breaks to owners who restore them "disturb the peace" laws to prevent unnecessary disruption patent system gives inventors exclusive use of their invention for a limited time to encourage development and knowledge

club goods:

excludable but do not rival in consumption. example: fire protection in a small town one type of a natural monopoly

private solutions to externalities

externalities cause markets to be inefficient however government actions are not always needed to solve the problem. in some situations people can develop private solutions. moral codes, social sanctions, and charities can be sufficient. the private market can often solve the problem of externalities by relying on the self-interest of the relevant parties. integration of different types of businesses can also internalize certain externalities (bee keeper/apple grower) contracts are also sometimes useful to identify and avoid inefficiencies

unanimity

if everyone prefers option X to option Y then X beats Y

transitivity

if option X beats Y, and Y beats Z, then X also beats Z

coase theorem

if private parties can bargain over the allocation of the resources at no cost, then the private market will always solve the problem of externalities and allocate resources efficiently. example of neighbor and barking dog... the neighbors can agree on an arrangement based on the value of the matter. need property rights, low transaction costs, enforcement

miracle of aggregation

if voters errors (lack of knowledge) about policy are random, they will cancel each other out. in this case, informed voters will sway the election leading to a good result. however if voters' errors are systematically biased, we end up with bad policy

median voter theorem

if you want to win a majority of votes, it makes sense to take the most moderate position

negative externality on a graph

in the presence of a negative externality, the social cost of the good exceeds the private cost. the optimal quantity is therefore smaller than the equilibrium quantity. the social cost includes the private costs of producers plus the costs to the bystanders affected. the difference between the two curves reflects the cost of the pollution emitted.

positive externality on a graph:

in the presence of a positive externality, the social value of the good exceeds the private value. the optimal quantity is therefore larger than the equilibrium quantity. because social value is greater than the private value, the social value curve lies above the demand curve. the optimal quantity is found where the social value curve and the supply curve intersect. hence, the socially optimum quantity is greater than the quantity that the private market would naturally reach on its own.

how can a social planner achieve optimal outcome?

internalize the externality: altering incentives so that people take into account the external effects of their actions

market based policy #1: corrective taxes and subsidies

market based policies can align private incentives with social efficiency. taxes enacted to deal with the effects of negative externalities are called corrective/pigovian taxes. an ideal corrective tax would equal the external cost from an activity with negative externalities, and an ideal corrective subsidy would equal the external benefit from an activity with positive externalities. economists tend to prefer taxes to regulations because it can solve the problem at a lower cost to society (an equal reduction in emissions for example is not necessarily the least expensive way to clean the water) in essence, the corrective tax places a price on the right to pollute. they also raise revenue for the government and enhance economic efficiency.

summary of externalities

negative externalities lead markets to produce a larger quantity than is socially desirable. positive externalities lead markets to produce a smaller quantity than is socially desirable. to remedy the problem, the government can internalize the externalities by taxing goods with negative externalities and subsidizing goods with positive externalities.

is the market equilibrium efficient when there are externalities?

no- the equilibrium fails to maximize the total benefit to society as a whole.

common resources:

not excludable but do rival in consumption. example: fish in the ocean available to catch Tragedy of the Commons (see definition below)

tragedy of the commons

once a good is provided, policymakers need to be concerned about how much it is used. the core problem is that social and private incentives differ. avoiding the destruction of the land depends on the collective action of the shepherds. no single family has an incentive to reduce the size of its own flock because each flock represents only a small part of the problem. result of an externality.

rival in consumption:

one person's use of a good reduces another person's ability to use it

nirvana fallacy

rejecting realistic solutions because they fail to live up to an imaginary ideal

market based policy #2: tradable permits

relies on the concept of freedom of contract, does not have any external effects because the quantity of the externality remains the same, therefore it ultimately improves social welfare. the market for these permits will eventually develop and be governed by the forces of supply and demand. as long as there is a free market for permits, the final allocation will be efficient regardless of final allocation.

rational irrationality

some voters tend not to change their views even when faced with evidence to show that they are wrong since your vote won't change the election, you have a very low cost of irrationality (which has a negative externality) so you over consume irrationality.

what is the appropriate response in the case of a positive externality?

subsidies

transaction costs:

the costs that parties incur in the process of agreeing to and following through on a bargain. example: neighbors need to hire a translator to solve dispute

independence of irrelevant alternatives

the decision to spend on X or Y should not depend on Z

broken window fallacy

the flaw in the logic where people mistakenly believe that you can create wealth through destruction fail to account for unseen effects of destruction

the law of unintended consequences

the government intervention to resolve a problem in the market will often lead to a secondary, unintended effect that is often bad too

rational ignorance

the idea that it is rational for people to know little about politics because the probability of you ever changing the outcome of an election is so small that it is too time consuming to acquire political knowledge.

graph of a corrective tax:

the supply curve for pollution rights is perfectly elastic (because firms can pollute as much as they want if they pay the tax) and the position of the demand curve determines the quantity of pollution.

graph of pollution permits:

the supply curve for pollution rights is perfectly inelastic (because the quantity of pollution is fixed by the number of permits) and the position of the demand curve determines the price of pollution

moral hazard

the tendency to engage in risky or wasteful behavior when you are not responsible for all costs (insurance)

political economy

the use of economic tools to analyze political science. the key assumption is that politicians are self interested just like consumers and firms

no dictator

there is no one voter who has the power to single-handedly enact his or her own preferences

public goods:

type of market failure neither excludable nor rival in consumption. example: tornado siren in a town lacks resources to be produced at an optimal level without government regulation

Externality

when a person engages in an activity that influences the well being of a bystander but neither pays nor receives compensation for that effect. if the impact is adverse: it is called a negative externality if the impact is beneficial: it is called a positive externality in the presence of externalities, society's interest in a market outcome extends beyond the well being of buyers and sellers who participate in the market to include the well being of bystanders who are affected indirectly.

rent seeking

when businesses ask government for special privileges which benefit them but not society as a whole.

regulatory capture

when the regulator gets taken over by the industry that it is regulating

time-inconsistency problem

when the short-term incentives do not align with long term incentives

principal-agent problem

where the incentives of the principal and the agent do not align. (employer/employee)

arrows impossibility theorem

with three or more options, no voting system can meet all of the following criteria: no dictator unanimity transitivity independence of irrelevant alternatives