Econ 201 (exam 2)

Reductions in Product Quality

*Ordinarily, this would be an opportunity to profit by raising prices, but when prices are controlled, sellers can't raise prices without violating the law. Is there another way that sellers can increase profits? Yes. It's much easier to evade the law by cutting quality than by raising price, so when prices are held below market levels, quality declines.*

price floors create

-Surpluses -Lost gains from trade (deadweight loss) -Wasteful increases in quality -A misallocation of resources

When someone is sick, the patient's decision to take an antibiotic imposes costs on others—it helps bacteria evolve resistance faster. But it also gives free benefits to others: It may slow down the spread of infectious disease the same way that vaccinations do. Thus, antibiotics can create external costs as well as external benefits. In theory, these could cancel each other out, so that just the right amount of antibiotics is being used. But economists think that, on balance, there is overuse of antibiotics, not underuse. Why?

Let's compare the external costs and external benefits of adding a little bit more antibiotic use on top of the amount that patients would choose anyway. If most people with serious infections would be prescribed antibiotics anyway, then on the margin the external benefit of more antibiotic use will be small. On the other hand, the external cost may be large. Imagine, for example, that antibiotics were free. Then people will use them until the private marginal benefits are zero. At this point the external benefits would be zero as well (if the antibiotics aren't doing anything to reduce your infection then they won't stop the spread of the disease either). On the other hand, with so much private use, the external costs at this point would be very large. Since antibiotics are relatively cheap, economists think the external costs outweigh the external benefits. And, of course, many infections for which antibiotics are prescribed do not pose a risk to others.

misallocation of resources

Occurs when a good or service is not consumed by the person who values it the most, and typically results when a price ceiling creates an artificial shortage in the market.

when external costs are significant we know that.... (command and control method)

Qmarket>Qefficient so the most obvious method to reduce the external cost of electricity generation is for the government to order firms to use or make less elctricity

reductions in quality

Sellers have more customers than they have goods; since sellers don't have the ability to raise the price (because of the ceiling), they lower the quality in order to gain more profit.

production chaos

Shortages in one market create breakdowns and shortages in other markets, so the chaos of the price controls expands even into markets without price controls

Fires create external costs because they spread from one building to another. Should governments encourage subsidies to install sprinkler systems or should they just mandate that everyone have sprinklers?

The cost and benefit of sprinklers vary greatly, depending on the building (apartment, house, factory, art gallery, and so on) and location (how close are the neighbors?). A command and control approach would likely create a lot of waste. A subsidy allows for more flexibility—even better would be a subsidy that was larger in more densely populated areas such as cities.

speculation

The way to make money is to buy low and sell high; so you should buy oil today when the price is low, hold the oil in storage, and then sell it next year after war breaks out, when the price is higher

incentive

a positive or negative environmental stimulus that motivates behavior

rent control

a price ceiling on rental housing

tradable allowance

a production or consumption quota that can be bought and sold ex; firms reduce pollutants by a specific quantity

Under provision of public goods

a public good is a good which, if it is produced, provides a benefit to people even if they do not pay for it.

A tax on an ordinary good....

increases deadweight loss

So, knowing what you know now about price controls, are you in favor of setting a $2 per gallon price ceiling on gasoline? Create a pro-price control and an anti-price control answer.

. A plausible pro-price control answer: The people we worry about the most are the poor, and the poor place a low value on their time, so it's less of a waste if they spend hours waiting in gas lines. Thus, while there will be long lines, this might be a reasonable way to redistribute wealth from the rich to the poor. A plausible anti-price control answer: Price controls on gasoline create many kinds of waste: waste from gasoline that doesn't get supplied, waste from people waiting in line, and the waste from the black markets that are likely to arise. Taken together, it's hard to argue that anyone would benefit much from price controls on gasoline and many people will be harmed. It might feel good, but it will probably create bad outcomes that we'll regret.

price ceilings create five important things

1. shortages 2. Reductions in Product quality 3. Wasteful lines and other search costs 4. a loss of gains from trade 5. A misallocation of resources

When a price ceiling is in place, keeping the price below the market price, what's larger: quantity demanded or quantity supplied? How does this explain the long lines and wasteful searches we see in price-controlled markets?

A price ceiling will make quantity demanded larger than quantity supplied. Those extra demanders wait in long lines and waste effort searching for scarce goods.

Suppose that Maria is willing to pay $40 for a haircut, and her stylist Juan is willing to accept as little as $25 for a haircut. What possible prices for the haircut would be beneficial to both Maria and Juan? How much total surplus (i.e., the sum of consumer and producer surplus) would be generated by this haircut?

Any price greater than $25 will make Juan better off; any price lower than $40 will make Maria better off. No matter what the price is, the sum of consumer and producer surplus (the total gains from trade) will be $15.

Before Coase presented his theorem, economists who wanted economic efficiency argued that people should be responsible for the damage they do—they should pay for the social costs of their actions. This advice fits nicely with notions of personal responsibility. Explain how the Coase theorem refutes this older argument.

Coase explained that the polluter and the pollutee are both responsible for creating the externality. If we keep this in mind, we can see that sometimes it will be cheaper to eliminate the problem by reducing the pollution directly (the traditional approach) but sometimes it will be cheaper to eliminate the problem by having the pollutee move or adjust in some other way. If transaction costs are low, bargaining will reach the efficient solution, whatever it is. But if transactions costs are high and we need a political solution, it can still be helpful to remember that the problem is jointly created—thus, Coase's insight is of general importance.

Taxes

Fees for the support of government required to be paid by people and businesses.

As in the chapter, let's assume that winter oil demand is higher in New Jersey than in California. If there had been no price controls, what would have happened to the prices of heating oil in New Jersey and in California and how would "greedy businesspeople" have responded to these price differences?

If the demand for heating oil rose in New Jersey, then the price in New Jersey would rise relative to that in California. This would encourage greedy business people to ship the gasoline on trucks or in pipelines from California to New Jersey until prices equalized. This would reduce the shortage in New Jersey.

Successful economies are more likely to have many failing firms. If a nation's government instead made it impossible for inefficient firms to fail by giving them loans, cash grants, and other bailouts to stay in business, why is that nation likely to be poor?

If the most inefficient firms are kept from failing, then many people are spending their days producing less than they would at a more efficient firm. Less production implies that, on average, people will have less to consume. Thus, the country produces less output for any given level of investment of resources.

price controls can also put goods in the wrong time as well. If there are price controls on gasoline, can you think of some periods during which the shortage will get worse

Oil refiners and truck drivers won't have an incentive to deliver the extra gasoline that people are demanding during holiday periods, so some people will wait in long lines for scarce gas just at the time when they most want to travel.

When the government expands the number of pollution allowances, does that increase the cost of polluting or cut it? What about when the number of pollution allowances is cut back?

Pollution allowances work just like a supply curve: If the government creates more of them, supply shifts out, so demanders bid down the price of an allowance, which reduces the marginal cost of polluting. Conversely, a smaller supply increases the price of an allowance, which increases the price of polluting.

wasteful lines and other search costs

Price controls on an item (such as oil) can cause intense shortages and lines.

In our Uber example, we said that after a spike in demand around Madison Square Garden, the number of Uber rides increased by more than 75% in the surrounding area, but when it starts to rain, Uber rides increase by the still substantial but lesser amount of 25%. Can you suggest one reason why the supply response is different in the two situations? (Hint: Think about elasticities of supply.)

The elasticity of supply is probably larger for a surge in a local area than it is for the larger New York City area. Why? The Madison Square Garden example is a local increase and can be met by more Uber drivers coming from other parts of NYC to the area around Madison Square Garden. In contrast, when it's raining, it's probably raining in most of NYC, so the supply response must come from Uber drivers who work longer hours when it's raining or from "opportunistic" Uber drivers who turn on Uber and start to drive when the surge price is high. Sometimes economists refer to the intensive margin (Uber drivers working more) and the extensive margin (more Uber drivers). Thus, we are suggesting that the supply response is larger on the intensive margin than on the extensive margin, at least in the short run.

A review of the jargon: Is the minimum wage a "price ceiling" or a "price floor?" What about rent control?

The minimum wage is a price floor, while rent control is a price ceiling.

What is the opportunity cost of the economics profession?

The opportunity cost of the field of economics is the next best thing that economists could be doing with their time. If economics didn't exist, perhaps some potential economists would go to Wall Street to become financiers, many would go to law school, many would go to engineering or physics or biochemistry. In any of these fields, they'd probably create some value. So, to tell whether the field of

The government decides to make health insurance affordable by requiring all health insurance companies to cut their prices by 30%, what will probably happen to the number of people covered by health insurance?

This is just another price ceiling: It will create a shortage in health insurance, and not all people demanding health insurance will be covered.

does uber price gouge?

Uber, in setting the price for each ride considers local information about supply and demand. If the demand is high the prices will rise.

external benefit

a benefit that an individual or firm confers on others without receiving compensation

external cost

a cost paid by people other than the consumer or the producer trading in the market

black market

a market in which buying and selling take place at prices that violate government price regulations

prediction market

a speculative market designed so that prices can be interpreted as probabilities and used to make predictions

Pigouvian subsidy

a subsidy on a good with external benefits

Subsidies

a sum of money granted by the government or a public body to assist an industry or business so that the price of a commodity or service may remain low or competitive.

Pigouvian Tax

a tax imposed on an activity that creates a negative externality

use the wedge shortcut to answer these questions: a. If a tax of $2 were imposed, what price would buyers pay and what price would suppliers receive? How much revenue would be raised by the tax? How much deadweight loss would be created by the tax? b. If a subsidy of $5 were imposed, what price would buyers pay and what price would suppliers receive? How much would the subsidy cost the government? How much deadweight loss would be created by the subsidy?

a. Deadweight loss is less,subsidy is less b. Deadweight loss is more, subsidy is more

a. The price you pay for an iTunes download b. The benefit your neighbor receives from hearing you play your pleasant music c. The annoyance of your neighbor because she doesn't like your achingly conventional music d. The pleasure you receive from listening to your iTunes download e. The price you pay for a security system for your home f. The safety you enjoy as a result of having the security system g. The crime that is more likely to occur to your neighbor once a criminal sees a "Protected by alarm" sticker on your window h. The extra safety your neighbor might experience because criminals tend to stay away from neighborhoods that have a lot of burglar alarms

a. Private cost b. External benefit c. External cost d. Private benefit e. private cost f. Private benefit g. External cost h. External benefit

elasticity = escape

because someone with high elasticity is someone who can easily escape to another market, either as a supplier or as a demander.

social surplus

consumer surplus plus producer surplus plus everyone else's surplus

Coase Theorem

if transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even when there are externalities

Speculator

person who risks money in order to make a large profit

end of price ceiling

price controls were lifted for most goods in april 1974 for oil it was january 1981

Shortages occur when

prices are held below the market price, the quantity demanded exceeds the quantity supplied

externailities (external cost or external benefit)

products such as antibiotics for which some of the costs or benefits of the product fall on bystanders.

A tax on a good with an external cost...

reduces deadweight loss and raises revenue

When the government taxes an activity

resources such as labor, machines, and bank lending will tend to gravitate away from the activity that is taxed and will tend to gravitate toward the activity that is not taxed.

When the government subsidizes an activity

resources such as labor, machines, and bank lending will tend to gravitate toward the activity that is subsidized and will tend to gravitate away from the activity that is not subsidized.

transaction costs

the costs that parties incur in the process of agreeing to and following through on a bargain

Surpluses

the extra funds available because government revenues are greater than its expenditures

deadweight loss

the fall in total surplus that results from a market distortion, such as a tax; with a price ceiling in place the quantity supplied is Qs and together the lost consumer and producer surplus are lost gains from trade

efficient equilibrium

the price and quantity that maximizes social surplus

efficient quantity

the quantity that maximizes social surplus

internalized externality

when a firm takes into account the external costs (or benefits) to society that occur as a result of its actions

price ceiling

when the maximum price that can be legally charged is below the market price