Session 4 Flashcards
Whats the consumer surplus?
the economic surplus you get from buying something
- For a single transaction, consumer surplus=marginal benefit – price
- For the whole market, consumer surplus = area below demand curve and above the price
Marginal benefit = Willingness to pay (WTP)
Whats the equation to calculate the consumer/producer surplus
0.5 x Base x Height
What are issues with the Willingness to pay (WTP)?
- Sometimes, the price tells us something about the quality of the good, such that we may update our WTP after talking to the vendor
- Generally, people find it easier to think about WTP for goods they buy regularly (which is what economists hope to rely on WTP for)
Whats the producer surplus?
The economic surplus you get from selling something
- For a single transaction, producer surplus= price – marginal cost
- For the whole market, producer surplus= area above the supply curve and below the price
Whats the economic surplus?
the sum of consumer and producer surplus (CS+PS)
- For a single transaction, economic surplus = marginal benefit – marginal cost
- For the whole market, economic surplus = area above the supply curve and below the demand curve
What does voluntary exchange mean?
Buyers or sellers trade only if they both want to.
-Buyer buys only if the marginal benefit ≥ price
-Seller sells only if price ≥ the reservation price
=Seller’s reservation price: the
minimum price a seller will accept
for a product or service
-Voluntary exchange ensures both buyer and seller enjoy gains from trade
What is efficient quantity?
The quantity that produces the largest possible economic surplus.
- Occurs where marginal benefits = marginal costs
- In our model, efficient quantity is at the market equilibrium, because in a competitive market:
-> Supply curve = marginal cost curve
-> Demand curve = marginal benefit curve
What is allocative efficiency?
When it’s not possible to increase consumer surplus by imposing allocations of goods that are different to the market equilibrium allocations.
- Efficient allocation maximizes benefits
- Again, price plays a key role: it serves as a coordination device, allowing consumers to optimally divvy up goods without direct communication
What is production efficiency?
When it’s not possible to increase producer surplus by imposing production plans that are different to the market equilibrium plans
- Efficient production minimizes costs
- Price plays a key role here: it serves as a coordination device, allowing firms to optimally divvy up total production without direct communication
What are market failures?
Real markets are rife with market failures, where the forces of supply and demand lead to an inefficient outcome
-> Q exchanged ≠ socially efficient level
What are types of market failures?
- Market power
- Externalities
- Private Information
- Incomplete contracts
- Irrationality
- Government regulation
Whats sellers market power?
The extent to which a seller can charge a higher price without losing many sales to competing businesses.
Whats buyers market power?
Monopsony power is the extent to which buyers can offer to pay lower prices without losing suppliers
What do suppliers do if they have market power?
When suppliers have market power, they tend to supply less at higher prices, eroding consumer surplus
What is a reason for market power to arise?
product differentiation
- Some restaurants can charge more for pasta because their pasta (or service) is different
- If we want product differentiation, some market power is unavoidable
Why do you sometimes have to allow market power?
- Sometimes, allowing market power is the only way for certain industries to exist (private sector). Example: Natural monopolies like tap water, telecommunications)
- Allowing market power may be necessary to incentivize innovation
-> Pharmaceutical companies receive exclusive patent rights for their newly developed drugs lasting several years
Whats an externality?
A side effect of an activity that affects bystanders whose interest aren’t taken into account.
- Essentially, consequences of a transaction on people who are not directly involved
->Because these consequences are not included in the price, the quantities traded≠society’s best interest
->Consequences often occur after transaction, but when they happen doesn’t matter
What are negative and positive externalities?
- Externalities can negative (harm the bystanders, Example: pollution) or positive (benefit the bystanders, Example: voting, vaccination)
->For negative externalities, society will be better off with less trade/consumption
->Opposite for positive externalities
What are the results of negative/positive externalities?
Negative Externalities – marginal social costs exceed marginal private costs Results in overproduction
Positive Externalities – marginal social benefits exceed marginal private benefits results in underproduction
What are solutions to externality problem?
Corrective taxes/subsidies (also known as Pigouvian taxes/subsidies). Tax or subsidy designed to induce people to take account of the externalities they cause. Example: Corrective tax on gas to correct the negative externality of the air pollution.
There are also non-monetary corrective taxes:
- Peer punishment (Don’t eat popcorn)
- Ostracism (employee who spreads gossip won’t be invited for lunch
- Social recognition (Employee of the month)
- Warm glow (I voted Badge)
Cap-and-trade: quantity regulation implemented by allocating a fixed number of permits, which then can be traded (Example: Emission-Permits)
- More efficient form of quantity regulation
- Enables efficient allocation of emissions among firms through trading
Unifying idea: realign incentives so people internalize (take account of) the effects of their actions on bystanders
What is private information?
Either seller or buyer have relevant information they would not want to disclose:
-Assymetric information: Example insurance companies
- private information lead to adverse selection (tendency for the mix of goods to be skewed toward more low-quality goods when one side of the market can’t observe quality)
- Adverse selection can lead to market unravelling = no transactions happening in the equilibrium
What are incomplete contracts and moral hazards?
Incomplete contracts: situations where some product conditions are too intricate or costly to specify (Example: Car Insurance contracts don’t specify how drivers should drive, rely on driver’s common sense)
Moral hazard: actions you take because they are not fully observable and you are partially insulated from their consequences
What is irrationality?
Sometimes people make decisions that don’t seem in their best interest
-> Time-inconsistent preferences: when individuals value decisions differently over time, leading to potential regret about past choices
What is a government regulation with regard to market failure?
- Government intervenes in the market primarily to raise revenue or to regulate social and economic behaviour
- Even with well-intentioned objectives to correct market failures, things can go very wrong
