Session 4

Question 1

Whats the consumer surplus?

Answer 1

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)

Question 2

Whats the equation to calculate the consumer/producer surplus

Answer 2

0.5 x Base x Height

Question 3

What are issues with the Willingness to pay (WTP)?

Answer 3

• 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)

Question 4

Whats the producer surplus?

Answer 4

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

Question 5

Whats the economic surplus?

Answer 5

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

Question 6

What does voluntary exchange mean?

Answer 6

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

Question 7

What is efficient quantity?

Answer 7

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

Question 7

What is allocative efficiency?

Answer 7

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

Question 7

What is production efficiency?

Answer 7

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

Question 8

What are market failures?

Answer 8

Real markets are rife with market failures, where the forces of supply and demand lead to an inefficient outcome

-> Q exchanged ≠ socially efficient level

Question 9

What are types of market failures?

Answer 9

• Market power
• Externalities
• Private Information
• Incomplete contracts
• Irrationality
• Government regulation

Question 10

Whats sellers market power?

Answer 10

The extent to which a seller can charge a higher price without losing many sales to competing businesses.

Question 11

Whats buyers market power?

Answer 11

Monopsony power is the extent to which buyers can offer to pay lower prices without losing suppliers

Question 12

What do suppliers do if they have market power?

Answer 12

When suppliers have market power, they tend to supply less at higher prices, eroding consumer surplus

Question 13

What is a reason for market power to arise?

Answer 13

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

Question 14

Why do you sometimes have to allow market power?

Answer 14

• 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

Question 15

Whats an externality?

Answer 15

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

Question 15

What are negative and positive externalities?

Answer 15

• 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

Question 15

What are the results of negative/positive externalities?

Answer 15

Negative Externalities – marginal social costs exceed marginal private costs  Results in overproduction

Positive Externalities – marginal social benefits exceed marginal private benefits  results in underproduction

Question 16

What are solutions to externality problem?

Answer 16

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

Question 17

What is private information?

Answer 17

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

Question 18

What are incomplete contracts and moral hazards?

Answer 18

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

Question 19

What is irrationality?

Answer 19

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

Question 20

What is a government regulation with regard to market failure?

Answer 20

• 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

Question 21

Whats the deadweight loss (DWL)?

Answer 21

Difference between the actual level of economic surplus and the largest possible economic surplus (at the efficient quantity)

Question 22

What happens if the actual quantity is lower than the effecient quantity? (Explain DWL)

Answer 22

The DWL is a triangle pointing to the right, in the area above marginal cost and below marginal benefit

Question 23

What happens if the actual quantity is higher than the efficient quantity? (Explain DWL)

Answer 23

DWL is the triangle pointing to the left, in the area above marginal benefit and below marginal cost

Question 24

Whats the critque of economic efficiency?

Answer 24

Income inequality

• As inequality rises, economic efficiency captures less of what truly matters.
• In a relatively equal society, WTP is sensible: those who value apples/oranges most buy and consume more apples/oranges
• But as inequality increases, WTP increasingly misleadingly equates ability to pay with actual preference.

Question 25

What is the Marginal social cost (MSC)?

Answer 25

Extra cost paid by the seller and bystanders from one extra unit

Marginal private cost (Supply Curve) + Marginal External Cost = Marginal Social Cost (MSC)

Question 26

What is the Marginal Social Benefit (MSB)?

Answer 26

Extra benefit enjoyed by the buyer and bystanders from one extra unit

Marginal private benefit (Demand curve) + Marginal external benefit = Marginal social Benefit (MSB)

Question 27

What are the 4 types of goods

Answer 27

Pivate goods (Excludable and rival): Cars, smartphones

Club goods (Excludable and non-rival): private parks, Netflix

Common Resources (Non-excludable and rival): fish stock, timber)

Public goods (Non-excludable and non-rival): Security, public roads

Question 28

What is the issue with public goods?

Answer 28

• Public goods are subject to free-rider problem as no one needs to pay = The government has to provide them

Question 29

Whats the issue with common resources?

Answer 29

• Common resources are over-utilized as anyone can freely extract from them. Such over-utilization is called tragedy of the commons

-> The government needs to either assign property rights or regulate (and enforce the regulation of) access.