Mid Semester test (L1-19) Flashcards
Scarcity
Not enough to satisfy everyone at zero price
Three basic questions that every economic system answers?
- What to produce?
- How to produce it?
- For whom to produce?
Normative economics
When we make a statement about how things ought to change (economists usually asked to do this in the context of public policy making)
Positive economics
When we describe and explain how an aspect of the economy works
What do economists model?
The effects of market forces. E.g. Competition among businesses, the efforts of consumers to get the most from their budgets.
What do economists study?
The systems ‘societies’ use, to allocate scarce resources, to the production of goods and services, and to distribute these goods and services to consumers.
I.e. How societies manage the use of scarce resources.
Economists build graphical and algebraic models as they are…
▪︎ Useful simplifications of complex phenomenon.
▪︎ Useful simplifications of reality
▪︎ Real world outcomes can have complex causes, we can investigation something complex by breaking it into simpler parts and then work to understand each part.
▪︎ Helps us explain interesting phenomena
Economic rationality
Early economists observed that people seem intent to set up systems that work ‘efficiently’ i.e. they yield the greatest net benefit.
Our ‘system’ is a mix of several systems, what are they?
▪︎ Traditional - follow in the family business, traditional practices in the home…
▪︎ Command (or planned)
◦ Authoritarian - owner/manager of a business or household
◦ Bureaucratic - large companies, local councils, central government (large complex organism)
▪︎ Market
◦ Farmers’ market, supermarkets, George St, Trade-me
Important historic economists
▪︎ Adam Smith
▪︎ David Ricardo
▪︎ Robert Malthus
PPF
A graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology.
Aspects of the production process
Fixed:
▪︎ A fixed level of production technology
▪︎ A fixed amount of ‘plant and equipment’
All other aspects (i.e. inputs) are variable
Resources (A.K.A Factors of Production, Inputs)
▪︎ Natural resources (N) - land, air, sunshine, minerals etc.
▪︎ Human resources (L) - Labour
▪︎ Produced resources (K) - aka ‘capital’ - machinery, expertise, intermediate inputs e.g. car paint and body filler
Interpreting the PPF
▪︎ The curve is a production possibilities frontier (PPF)
▪︎ Can produce any output combination on the curve by altering the amount of resources spent on each activity
▪︎ Doing more of one requires doing less of another
Interpreting the slope of the PPF
Q goods = f(Q services)
▪︎ All else held constant
Slope = (△Q goods)/(△Q services)
i.e. the opportunity cost of producing one more unit of services (goods).
Opportunity cost
The value of the next best activity foregone. (Whatever must be given up to obtain some item).
▪︎ The slope of the PPF shows - the opportunity cost of allocating more resources to the alternative good or service.
▪︎ Scarcity implies opportunity cost
◦ If a scarce resource is fully employed, choosing to do more of one thing has an opportunity cost: less of another thing.
Production possibilities for a country assumptions
▪︎ One country
▪︎ Only two types of product: goods and services
▪︎ A time frame e.g. a year
▪︎ A fixed level or production technology
▪︎ A fixed level of productive resources, all of which are fully employed
▪︎ Resource heterogeneity - each type of resource varies in its characteristics relevant to production of the two goods.
What happens when we increase production of services?
▪︎ Have to re-allocate resources from Goods to Services
▪︎ First those most suited to service production relative to goods production
▪︎ At each step, remaining resources are less suited - takes more resources and therefore each additional unit of services costs more in terms of goods foregone.
▪︎ Therefore, the PPF gets steeper as Services production increases.
▪︎ The ‘marginal’ opportunity cost increases
Interpretation of points on the PPF graph
▪︎ Points on the PPF
◦ combinations of goods and services with all resources fully and efficiently employed (Technically efficient)
▪︎ Points in the area under.to the left of the frontier
◦ combinations of goods and services without fully employing all resources (Technically inefficient - we could produce more goods and/or services with the same resources)
▪︎ Points in the area above/to the right of the frontier
◦ Combinations of goods and services unobtainable with the resources available
Absolute advantage
The ability to produce a good using fewer inputs than another producer (or more goods using the same inputs).
Comparative advantage
The ability to produce a good at a lower opportunity cost than another producer
What is a ‘market’?
A group of buyers and sellers whose interactions determine the price at which a good or services trades.
Why trade?
Because the productivity of resource varies:
1. across particular ‘resource units’
◦ E.g. Agricultural productivity varies with climate
◦ Workers vary in their skills and interests
2. With the ‘scale of production’
◦ Larger scale of production allows use of specialised inputs that reduce cost per unit of output.
Terms of trade
One thing in terms of another - a relative price
Economies of scale
The property whereby long-run average total cost falls as the quantity of output increases
◦ All inputs are variable
◦ The curve slopes downward but the slope decreases due to diminishing returns
The LRAC curve
◦ The AC curve is a frontier
◦ Cost/quantity combinations:
◦ ON the AC curve represent the minimum cost of production at each Q/t, given input prices and technology
◦ ABOVE the AC curve represent production costs higher than the lowest feasible (in practice costs are usually somewhat higher)
◦ BELOW the AC curve represent unachievable cost/quantity combinations, all else held constant.
◦ MES (Minimum efficient scale) - the output level (scale) that corresponds to the lowest point on the AC curve.
MES (LRAC)
Minimum efficient scale - the output level (scale) that corresponds to the lowest point on the AC curve
Average Cost shifters
AC = f(Q/t, other things)
Other things:
◦ Input prices - AC is the ‘vertical sum’ of input costs, so an increase in an input price, shifts the AC curve up
◦ State of technology - when technology improves:
◦ AC decreases (curve shifts down)
◦ MES likely changes - often to the right
The owner or manager of a business has to decide:
◦ How much to specialise labour and capital
◦ How to allocate each worker to each task (because workers vary in their skill sets and preferences)
◦ How many workers and complementary resources to employ to exploit economies of scale
Why do we use money?
- A UNIT OF ACCOUNT (or common denominator) - simplifies relative price calculations
- A MEDIUM OF EXCHANGE - avoids the necessity of ‘double coincidence of wants’
- A STORE OF VALUE - similar to 2; allows me to sell now, buy something else later.
Interpretation of the upward sloping curve
◦ VERTICAL interpretation - Marginal Cost (MC) curve
◦ MC curve comes from PPF, plot in increasing order, the opportunity cost of producing each successive item/good.
◦ MC = f(Qs), ceteris paribus (where MC is measure in $ and Q units of good are in increasing order of MC)
◦ HORIZONTAL interpretation - Supply curve
◦ Everyone whose marginal production cost is less than the price is willing to sell
◦ The curve plots the Q supplied to the market at each price.
◦ Qs = f(P), ceteris paribus (where Qs is ‘quantity supplied’ and P, price/unit, is measured in dollars. The rationale is that suppliers sell if P > MC)
Interpretation of the downward sloping curve
◦ VERTICAL interpretation - MV (marginal value) curve
◦ comes from the PPF, plot in decreasing order (from right to left), the absolute value of the slope of the PPF (opportunity cost).
◦ MV = f(Qd), ceteris paribus (where MV is measured in dollars and the Q units of the good are in decreasing order of MV)
◦ HORIZONTAL interpretation- Demand curve
◦ Everyone whose marginal value is greater than price is willing to buy
◦ The curve plots the quantity demanded by consumers in the market at each price.
◦ Qd = f(P), ceteris paribus (where Qd id ‘quantity demanded’ and P, price/unit, is measured in dollars. The rationale is that consumers buy if P < MV)
Quantity Demanded
The amount of a good that buyers are willing and able to purchase
Law of demand
Other things being equal, the quantity demanded of a good falls when the price of a good rises.
Normal good
A good for which, other things being equal, an increase in income leads to an increase in quantity demanded.
E.g. Premium bread
Inferior good
A good for which, other things being equal, an increase in income leads to a decrease in quantity demanded.
E.g. Budget bread
Substitutes
Two goods for which, a decrease in the price of one good leads to a decrease in the demand for the other good.
E.g. Butter and margarine
Complements
Two goods for which a decrease in the price of one good leads to an increase in the demand for the other good.
E.g. Tennis rackets and tennis balls
Variables that affect quantity demanded AND the affect on the demand curve
◦ Price - movement along the demand curve
◦ Income - shifts the demand curve
◦ Prices of related goods - shifts the demand curve
◦ Tastes - shifts the demand curve
◦ Expectations - shifts the demand curve
◦ Number of buyers - shifts the demand curve
Quantity supplied
The amount of a good that sellers are willing and able to sell
Law of supply
The claim that, other things being equal, the quantity supplied of a good rises when the price of a good rises.
Variables that affect quantity supplied AND the affect on the supply curve
◦ Price - movement along the supply curve
◦ Input prices - shifts the supply curve
◦ Technology - shifts the supply curve
◦ Expectations - shifts the supply curve
◦ Number of sellers - shifts the supply curve
Equilibrium
◦ A situation in which supply and demand have been brought into balance.
◦ The market clears
◦ No force for or incentive to change
◦ Full satisfaction
Equilibrium price
◦ The price that balances quantity supplied and quantity demanded.
◦ The market clw
Why does the D curve slope downward?
Diminishing marginal ‘utility’ from consumption
Utility
A measure of happiness or satisfaction
◦ Utility/t = f(L, K), ceteris paribus
Where:
◦ L = variable inputs e.g. Pizza
◦ K = fixed inputs e.g. Gastro-intestinal system
Law of diminishing marginal returns
Given a fixed ‘factor’ of production (e.g. your stomach) additions of a variable factor (e.g. pizza) at some point yield progressively small (diminishing) increases in output (e.g. utility)
Interpretation of the area under the demand curve
The individual’s demand curve show the dollar value that individual receives from each additional unit of product consumed.
The area under the demand curve to that quantity = the total value of consuming any given quantity
Why does the S curve slope upward?
Diminishing marginal returns - increasing marginal cost (due to ‘fixed factors of production’)
Interpretation of the area under the supply curve
The individual’s supply curve shows the dollar cost that individual pays to produce each additional unity of product.
The area under the supply curve to that quantity = the total $ cost of producing any given quantity
Why do supposedly stable prices vary?
Because of ‘shift variables’
Quantities supplied and demanded depend on price, but they also depend on a variety of ‘other things’ (‘shift variables’).
Other influences on demand (‘shift variables’)
Quantity demanded depends on price and ‘other things’:
Qd = f(…
◦ P, price
◦ Nc, number of consumers in the market
◦ Y, income (budget)
◦ Po, price of related good (substitutes and complements)
◦ Pe, expectations about future prices
◦ Ta, idiosyncratic consumer tastes, i.e. preferences
Other influences on supply (‘shift variables’)
Quantity supplied depends on price and ‘other things’:
Qs = f(…
◦ P, Price
◦ Ns, Number of sellers/suppliers
◦ Pi, Price of inputs
◦ Te, Improvements in technology
◦ Pe, Expectations about future prices
Consumer Surplus
A buyer’s willingness to pay minus the amount the buyer actually pays
Producer Surplus
The amount a seller is paid for a good minus the seller’s cost
Under the right conditions, the competitive market allocates product…
- To those consumers with the highest dollar value
- Supplied by those sellers with the lowest opportunity cost of production
- At the surplus-maximising output level
In this sense, the competitive market allocation is ‘efficient’, no other allocation generates greater total surplus! And this is achieved via decentralised decision-making!
Effect on demand from a change in income (budget)
◦ Shifts the D curve rightward if the good is ‘normal’
◦ Shifts the D curve leftward if the good is ‘inferior’
Effects on D from changes in the price of a related good
Increase in price of:
◦ Substitute - shifts the D curve rightward, consumers substitute out of the higher priced alternative.
◦ Complementary - shifts the D curve leftward, the price of on affects demand for the other.
Elasticity
A measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants.
The % change in Qs with each 1% change in P: (%△QS) / (%△P)
Comparative statics
Compares an initial equilibrium to the new equilibrium that follows a change in market conditions.
Elasticity - The flatter the S/D curve the more…
Responsive suppliers/consumers are to a change in price
Elasticity - The steeper the S/D curve the more…
Unresponsive suppliers/consumers are to a change in price
Short run vs. Long-run supply
… Stronger supply and demand responses over time. (S and D curves get flatter)
Strong, but slow, long-run SUPPLY response (so far)
◦ It takes time to source new resources and implement new technologies
Strong, but slow, long-run DEMAND response
◦ It takes a while to develop new technologies and consumers to purchase them.
Price is volatile because…
Supply and demand are both unresponsive to price.
◦ The short-run demand curve is steep
◦ The supply curve is steep ‘on the margin’
◦ Relatively small shifts in D or S can result in big price change
Problems with ∆Q/∆$
◦ It varies with how we measure quantity
e.g. petrol in litres or gallons, gold in ounces, pounds, grams.
◦ Varies with how we measure price
e.g. dollars or yen or euros
◦ (most importantly), It’s very difficult to compare across products
for some products, a $1 change is meaningful, for others, not so much.
ELASTICITY TREATS THESE PROBLEMS (% CHANGE)
Unit elastic supply
Elasticity = 1
An increase in price leads to the equivalent increase in quantity supplied
HOT tip: any linear supply curve with a zero intercept is everywhere unit inelastic xxx
Unit elastic demand
Elasticity = 1
An increase in price leads to the equivalent decrease in quantity demanded
Perfectly inelastic supply/demand
Elasticity = 0
An increase in price, leaves the quantity supplied/demanded unchanged.
Vertical demand/supply curve
Inelastic supply
Elasticity < 1
An increase in price, leads to a smaller increase in quantity supplied
Steep supply curve
HOT tip: any linear supply curve with a negative intercept is everywhere price inelastic xxx
Inelastic demand
Elasticity < 1
An increase in price, leads to a smaller decrease in quantity demanded
Steep demand curve
Elastic supply
Elasticity > 1
An increase in price, leads to a greater increase in quantity supplied
Flat supply curve
HOT tip: any linear supply curve with a positive intercept is everywhere price elastic xxx
Elastic demand
Elasticity > 1
An increase in price, leads to a greater decrease in quantity demanded
Flat supply curve
Perfectly elastic supply
Elasticity = infinity
At exactly $x, producers will supply any quantity. At any price above $x, quantity supplied is infinite. At any price below x, quantity supplied is zero.
Horizontal supply curve
Perfectly elastic demand
Elasticity = infinity
At exactly $x, consumers will buy any quantity. At any price above $x, quantity demanded is zero. At any price below x, quantity demanded is infinite.
Horizontal demand curve
E =
Definition: E = (%△Q)/(%△P)
Arc elasticity (Midpoint formula): E = (△Q/AvgQ)/(△P/AvgP) for when you're given two points on a D or S curve
Point elasticity: E = (△Q/△P)x(P/Q)
to calculate elasticity at a point on a D or S curve
Elasticity’s relationship to revenue
Demand = price inelastic, E < 1: Increase in price, increase in total revenue (the higher price per sales outweighs the relatively small drop in sales)
Demand = price elastic, E > 1: Increase in price, decrease in total revenue (the relatively large drop in sales outweighs the higher price per sale)
Demand = unit elastic, E = 1, no change in TR
Income elasticity of demand
A measure of how much the quantity demanded of a good responds to a change in consumer’s income.
Ey = (%△Qd)/(%△Y)
Inferior goods - negative income elasticities
Normal goods - positive income elasticities
Cross-price elasticity of demand
A measure of how much the quantity demanded of one good responds to a change in the price of another good. (Percentage change in quantity demanded of the first good, divided by the percentage change in price of the second good).
Eo = (%△Qd)/(%△Po)
Substitutes - positive cross-price elasticities
Complements - negative cross-price elasticities
Price elasticity of supply tends to be higher when…
◦ Inputs are in elastic supply i.e. there is spare capacity, elastic supply of labour and materials, product already in inventory.
◦ Time - the more time, the easier to obtain more inputs. E.g. more factory capacity, specialised labour or equipment.
Price control
When some external body tries to control the price
Price ceiling
A legal maximum on the price at which a good can be sold
A price ceiling binds, only if P(ceiling) is BELOW P(equilibrium)
Placed on commodities that are at risk of high prices, and are important to a large number of people (voters). E.g. Petrol and housing.
Price floor
A legal minimum on the price at which a good can be sold.
A price floor binds, only if P(floor) is ABOVE P(equilibrium)
Placed on commodities that are at risk of seemingly low prices and are important to a large number of sellers (voters) e.g. Unskilled labour. (Minimum wage).
Criticisms of a minimum wage
◦ It increases unemployment among low-skilled labour, reduced Qd and increases Qs
◦ One price usually doesn’t fit all areas
Does the minimum wage bind?
MAYBE NOT - the minimum wage may often be set too low to matter (below Peq). May serve a political purpose whole not causing (negative) impacts.
MAYBE SO - politics in some areas may favour setting a binding minimum wage and even if it’s too low to bind in most labour markets (e.g. high-wage, high-living cost urban areas, it may bind in other low-wage, low-living-cost areas)
IN SUMMARY - not usually for most workers, and maybe not for most low-skilled workers. It probably does bind for some workers in some areas. E.g. Mostly un-skilled and inexperienced youth in low-wage, low-living-cost areas who may suffer short hours rather than unemployment.
Effect sizes varies geographically.
Tax incidence
The study of who bears the burden of taxation.
◦ In general, buyers and sellers effectively split the tax, and the split depends on relative elasticities.
◦ The buyer/seller who responds least to a higher price, pays most of the tax. (If elasticities are similar - split is roughly even).
How does the tax affect market outcomes?
◦ It usually increases equilibrium P (inclusive of tax) and decreases equilibrium Q
◦ By how much, depends on elasticities:
◦ If price elasticities of D and S are high - quantity falls a lot
◦ If price elasticities of D and S are low - quantity falls a little
(Taxation) Upward shift in the supply curve…
(Taxation) Upward shift in the supply curve…
◦ Has the same effect as a leftward shift (i.e. decrease in supply)
◦ Equilibrium P increases and equilibrium Q decreases
◦ Extent depends on elasticities - the higher the elasticities (flatter the curves), the bigger the decrease in Q
◦ The higher the relative elasticity, the higher the proportion paid by the other side of the market. E.g. Supply more elastic, consumers pay more of the tax.
(Taxation) Downward shift in the demand curve…
◦ Has the same effect as a leftward shift (i.e. decrease in demand)
◦ Equilibrium P decreases (exclusive of tax) and equilibrium Q decreases.
◦ But P is the same as with the supply shift tax inclusive, it makes no difference (in equilibrium) who actually pays the tax. I.e. who writes the cheque.
Deadweight loss
The reduction in total surplus that results from a market distortion such as a tax or a monopoly price.
The ‘deadweight loss’ of a tax
Imposition of tax results in:
◦ A higher price for buyers
◦ A lower price for suppliers
This implies LESS SURPLUS PER UNIT TRADED, the rest goes to the government as tax revenue.
It also implies FEWER UNITS TRADED, the surplus generated by these trades is simply lost! This is called ‘deadweight loss’ or ‘excess burden’ of the tax.
Tariff
A tax on goods produced abroad and sold domestically
Import quota
A limit on the quantity of a good produced abroad that can be sold domestically.
Revenue is paid to the import licence holders - licence holders import at the world price and sell at the higher domestic price.
What are the advantages of international trade?
◦ Trade exploits comparative advantage, due to: variation in natural or cultural characteristics (exploitation of economies of scale)
◦ Trade possibly lowers consumer prices by increasing competition, opening domestic markets to foreign suppliers encourages competition that forces domestic firms to produce efficiently to keep costs and prices down.
Arguments against free trade
◦ ‘Adjustment costs’ and ‘distributional effects’ - lower prices can ‘strand’ assets, such as factories, some workers have to shift to other jobs.
(Good trade agreements eventually improve welfare in aggregate)
◦ Protection of ‘strategic industries - world is full of uncertainties, if things go badly, it might be critical to have domestic back-up supply
◦ Protection of ‘infant’ industries - exploiting comparative advantage often requires investment and learning, it may take time for production cost to fall below world price, temporary protections provide time
Subsidy (per-unit)
A payment from government, to consumers and sellers, for each unit of a good that is bought or sold.
◦ Imposes a vertical wedge between S and D
◦ A subsidy to consumers shifts the demand curve up
◦ A subsidy to suppliers shifts the supply curve down
DWL:
◦ Due to the government needing to tax something else in order to produce the subsidy, money could be spent in other sectors (e.g. education).
◦ MC > MV along the border
Regional
Regional council’s responsibilities
◦ Environmental management
◦ Regional land transport planning
◦ Harbour navigation and safety
◦ Regional emergency management
Territorial council’s responsibilities
◦ Provision of local infrastructure
◦ Environment safety and health (e.g. Building control)
◦ District emergency management
◦ Controlling the (negative) effects of land use
Three economic rationales for government
- To set and enforce the rules - through which maket transactions take place
- To treat instances of ‘market failure’ - i.e. MV ≠ MC at the market price (so there’s DWL)
- To treat ‘distributional’ issues e.g. too much variation in wealth, and employment opportunities and in the effects of economic ‘shocks’
Three inhibitors of efficient market function
- Barriers to competition - e.g. a profit-max monopoly limits the quantity supplied so Pm = MV > MC
- Difficulty excluding access - cant exclude → can’t price so Peq < MC
- Limited information - about prices or product characteristics consumer purchases may not accurately reflect preferences.
Private good
Rival in consumption, Excludable
E.g. Hamburger and other foods, clothes, privately owned car.
Because these goods are excludable, the market allocates them efficiently if…
◦ Market participants have good information about product price and characteristics
◦ The market’s competitive, e.g. easy entry for suppliers, healthy competition, no monopoly suppliers.
Club good
Non-rival consumption, Excludable
E.g. A show at a cinema or theatre, a highlanders game at the stadium, an uncongested golf course.
Because these goods are excludable, the market allocates them efficiently if…
◦ Market participants have good information about product price and characteristics
◦ The market’s competitive, e.g. easy entry for suppliers, healthy competition, no monopoly suppliers.
Public good
Non-rival consumption, Non-excludable
E.g. The atmosphere for breathing, an uncongested road network, general public spaces.
◦ Not at all scarce: if anyone enjoys the good, everyone enjoys it
◦ Hard to exclude - hard to charge for, and therefore hard to recover the costs of supply.
Common-pool resource
Rival in consumption, Hard to exclude
E.g. Fisheries, forests, irrigation systems
◦ Hard to exclude - Hard to charge for and therefore hard to recover the costs of supply
◦ Rival - Not enough for everyone (scarce)
(From an economic perspective, this is a TRAGEDY OF THE COMMONS)
Why government supply?
Two solid rationales for government as suppliers:
◦ Natural monopoly - average production cost falls over the full range of demand so a larger supplier can under-price smaller competitors.
◦ And then as a monopolist, raise the price above costs
◦ The government as owner can limit price to average cost
◦ Public goods
◦ Non-excludable, so access can’t be priced (no revenue, no private production)
◦ The government has the power to force payment via taxation
The Free Rider Problem
◦ If any individual or group supplies a public good, they bear the costs, all other ‘consumers’ enjoy the good, but can choose to pay nothing.
◦ Free riding generally results in under-supply of the good
◦ Marginal social value, MSV > MC at the market equilibrium
Two solid rationales for government as suppliers
◦ Natural monopoly - average production cost falls over the full range of demand so a larger supplier can under-price smaller competitors.
◦ And then as a monopolist, raise the price above costs
◦ The government as owner can limit price to average cost
◦ Public goods
◦ Non-excludable, so access can’t be priced (no revenue, no private production)
◦ The government has the power to force payment via taxation
Tragedy of the commons
A parable that illustrates why common resources get used more than desirable from the standpoint of society as a whole.
The “tragedy” occurs because: Access to a ‘scarce’ resource is unrestricted (i.e., open).
Why is access to some resource open (unpriced)?
◦ Sometimes no ‘rules’ have yet been established (only recently become scarce)
◦ Sometimes rules require that access be open (i.e., rule that there are no limits on access)
◦ Sometimes rules exist, but are difficult to enforce (e.g. local rules vs. national rules)
◦ Sometimes the cure seems worse than the illness, the cost of limiting access seem higher than those of the tragedy
The economist’s recommended treatment for Common’s Tragedy: PRICE
◦ The fundamental problem is unpriced access to a scarce resource
◦ If people use too much of an unpriced resource then, if possible, price it
◦ The main appeal of pricing is that it minimises ‘abatement’ costs
◦ Those who can abate most cheaply, abate the most.
Externality
The uncompensated impact of one person’s actions on the wellbeing of a bystander.
Deadweight Social Loss
A poor trade-off between quantity of goods and quality of environment
How does an excise tax improve market outcomes?
As the environment is ‘owned’ collectively and the government represents the collective, they can legitimately charge for the private use of resources owned collectively.
Therefore, the tax prices the previously un-priced input.
The charge could be levied as a $ tax per unit output - shifting the supply (MC) curve upward.
The resulting higher price better reflects total opportunity cost and eliminates the deadweight social loss.
In these circumstances, the tax is a corrective.
Government as regulator
A public entity is given the mandate to ‘regulate’ i.e., to tell people how they have to act.
E.g. Ministry for the Environment, Otago Regional Council
The common approach to managing pollution
◦ Step 1: Choose an “ambient standard” for environmental quality (level not harmful to death)
◦ Step 2: impose requirements on resource users to meet the standard e.g., equipment that meets performance standards
Nudge as a strategy
E.g. Suppose the government wants to encourage people to save for their retirement.
◦ Enrols everyone in a savings plan, but allows them to ‘opt out’
E.g. Sky TV wants to encourage customers to subscribe to additional channels.
◦ Offer a cheap deal
◦ Then raise the price - customer has to ‘opt out’
This type of nudge exploits the ‘status quo’ bias - evidence suggests people tend to keep things as they are i.e., they like to maintain the status quo. Even when things have changed to make an alternative preferable, and the costs of changing are low.
The ultimatum game
There are two players: A and B
Player A has to decide how to split a sum of money - e.g. $100 with player B
◦ Whatever player A decides is binding - there’s no negotiation!
◦ But player B can veto A’s Decision
In which case both players get $0.
If A and B are both economically rational, A will keep $99, leaving $1 for B.
In practice, player B rejects miserly amounts - worth giving up small amount to punish the perceived ‘injustice’. In reality, A foresees how B might react and offers $30-$40.
If B has no veto, A usually offers $20-$30.
Results suggest that we, on average, have a sense of, or preference for, FAIRNESS.
Why? People:
◦ Satisfice rather than optimise
◦ Dislike losses more than similarly-sized gains (loss aversion)
◦ Care more than about fairness than seems ‘rational’
Implications for government policy
◦ People aren’t always perfectly sensible (i.e. rational) - the government can help us do they right thing.
(However, there are limits to heavy-handed state regulation - on some matters, the state can ‘nudge’).
A potentially unfair outcome of efficient markets
Variation in income, wealth and well being
◦ Pay differentials guide resource allocation
The market corrective
Demand shifts rightward in one labour market, the wage has to rise to attract additional workers, most come from other labour markets, shifting supply curves leftward in those markets.
So wages tend to converge - a rise in one market tend to increase wages in others.
But there remain ‘compensating differentials’ - wage differentials compensate for training requirements or for difficult, dangerous, or unpleasant work.
