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Economics
Chapter 6 Supply, Demand and Government Policies

When new policies are introduced they may have good intentions to solve particular
problems or help groups of people but new policies generate new incentives and as a result
the consequences may go far beyond those envisaged by the policy makers.
 Price controls are usually enancted when policy makers believe that the market price of a
good or service is unfair to buyers or sellers. Yet as we will see these policies can generate
inequities of their own.
 Policy makers use taxes both to influence market outcomes and to raise revenue for public
purposes.
Subsidy
Payment to buyers and sellers to supplement income or lower costs and which thus
encourages consumption or provides an advantage to the recipient

A subsidy almost works exactly as the reverse of taxes. They are often used to encourage
the supply of a product which is being underproduced and deemed to be in the public
interest. In the case of subsidies, someone has to pay for the subsidy and firms and
consumers may benefit in different ways
Controls on prices
Price ceiling
A legal maximum on the price at which a
good can be sold
Price Floor
A legal minimum on the price at which a
good can be sold
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In a competitive market free of government regulation, the price of a good adjusts to
balance supply and demand: at the equilibrium price, the quantity of ice cream that
buyers want to buy exactly equals the quantity that sellers want to sell.
 The government imposes a legal maximum on the price at which ice cream can be sold.
Because the price is not allowed to rise above this level the legislated maximum is called
a price ceiling or a price cap.
 The government imposes a legal minimum on the price, the price cannot fall below this
level the legislated minimum is called a price floor.
How price ceilings affect market outcomes
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If the price of the good is below the price ceiling it is not binding. Market forces
naturally move the economy to the equilibrium and the price ceiling has no effect on
the price or the quantity sold.
If the price of a good is above the price ceiling it is a binding constraint on the market
 The quantity of one good demanded exceeds the quantity supplied. There is a
shortage of the good
 Sellers could ration their good according to their own personal bias
 Some sellers may not feel it worth while continuing in the market and leave thus
depressing market supply
 When a government imposes a binding price ceiling on a competitive market a
shortage of the good arises and sellers must ration the scarce goods among the
large number of potential buyers
 By contrast the rationing mechanism in a free competitive market is both
efficient and impersonal. Free markets ration goods with prices
How price floors affect market outcomes

Price floors like price ceilings are an attempt by the government to maintain prices at other
than equilibrium levels. Whereas a price ceiling places a legal maximum on prices a price
floor places a legal minimum
 If the equilibrium price is above the price floor the price floor is not binding. Market forces
naturally move the economy to the equilibrium and the price floor has no effect
 I f the equilibrium price is below the price floor the price floor is a binding constraint on the
market. The forces of supply and demand tend to move the price towards the equilibrium
price but when the market hits the floor it can fall no further. The market price equals the
price floor
 Just as price ceilings and shortages can lead to undesirable rationing mechanism so can price
floors and surpluses. In the case of a price floor some sellers are unable to sell all they want
at the market price. In a free market the price serves as the rationing mechanism and sellers
can sell all they want at the equilibrium price
Evaluating price controls

This principle explains whay economists usually oppose price ceilings and price floors. To
economists prices are not the outcome of some haphazard process. Prices are the result
of the millions of business and consumer decisions that lie behind the supply and
demand curves.
 When policy makers set prices by legal decree they obscure the signals that normally
guide the allocation of society resources.
 Price controls are often aimed at helping the poor: price ceilings on rents
 Other ways of helping without controlling prices: Government can make housing more
affordable by paying a fraction of the rent for poor families. Unlike rent control such rent
subsidies do not reduce the quantity of housing supplied and therefore do not lead to
housing shortages
Taxes
Tax incidence
The manner in which the burden of a tax is shared among participants in a market

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All governments use taxes to raise revenue for public projects such as roads schools
and national defence.
But who actually bears the burden of the tax?

Economists use the term tax incidence to refer to the distribution of a tax burden. As
we will see some surprising lessons about tax incidence arise just by applying the
tools of supply and demand
How taxes on sellers affect market outcomes
Step 1
Step 2
Step 3
Implications
The immediate impact of a tax is on the sellers
-the quantity demanded of the product at any
given price is the same thus the demand curve
does not change
-tax makes production of the good less
profitable at any given price so the supply
curves shifts
-because the tax on sellers raises the cost of
producing and selling the good it reduces the
quantity supplied at every price.
-the supply curve shifts to the left (upward)
-we can now compare the initial and the new
equilibrium.
-the equilibrium price of the good rises, the
equilibrium quantity falls
-a tax on sellers places a wedge between the
price that buyers pay and the price that sellers
receive
-the wedge between the buyers´ price and the
sellers´ price is the same and would be the
same regardless of whether the tax is levied on
buyers or sellers
->Buyers and sellers share the burden of the tax
Elasticity and tax incidence
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When a good is taxed buyers and sellers of the good share the burden of the tax. But how
exactly is the tax burden divided?
Only rarely will it be shared equally: Which curve shifts depends on whether the tax is levied
on buyers or sellers. As we have seen this is irrelevant for the incidence of the tax
A tax in a market with a very elastic supply and relatively inelastic demand
 Sellers are very responsive to changes in the price of the good (supply curve is
relatively flat) whereas buyers are not very responsive (so the demand curve is
relatively steep)
 When a tax is imposed on a market with these elasticities the price received by
sellers does not fall much so sellers bear only a small burden.
 By contrast the price paid by buyers rises substantially indicating that buyers
bear most of the burden of the tax
A tax in a market with relatively inelastic supply and very elastic demand
 In this case sellers are not very responsive to changes in the price (so the supply
curve is steeper) while buyers are very responsive (so demand curve is flatter).
 The price paid by buyers does not rise much while the price received by sellers
falls substantially. Thus sellers bear most of the burden of the tax. In this case
sellers know that if they try to pass on the tax to buyers that demand will fall by
a relatively large amount
 A tax burden falls more heavily on the side of the market that is less elastic. Why is this true?
In essence the elasticity measures the willingness of buyers or sellers to leave the market
when conditions become unfavourable. A small elasticity of demand means that buyers do
not have good alternatives to consuming this particular good.
 A small elasticity of supply means that sellers do not have good alternatives to producing this
particular good. When the good is taxed the side of the market with fewer good alternatives
cannot easily leave the market and must therefore bear more of the burden of the tax
How subsidies affect market outcomes

Subsidies are levied when governments want to encourage the consumption of a `good´
which they deem is currently underreproduced. Subsidies are generally given to sellers
and have the effect of reducing the cost of production as opposed to a tax which
increases the cost of production.
 Subsidies exist in a variety of different areas including education, transport etc
Step 1
If the government gives a subsidy of
20Euros per journey to train operators it is
the supply curve for journeys which is
affected
->the demand curve is not affected because
the number of train journeys demanded at
each price stays the same
Step 2
-subsidy to train operators reduces the cost
to the train operators the supply curve
shifts to the right by the amount of the
subsidy
->Train operators are willing to supply more
train journeys at every price
Step 3
-comparing the initial and the new
equilibrium we can see that the equilibrium
price of each train journey is now lower and
the equilibrium number of journeys
travelled increases
-Passangers and train operators both
benefit from the subsidy as passengers can
obtain train tickets at a lower price thant
before the subsidy and have more journeys
available and sellers receive more revenue
than they did before the subsidy allowing
them the potential to invest in the service
they provide
Implications
There is a considerable debate surrounding
the value of subsidies
-altering the incentives for people to travel
on the train rather than on the roads and so
have the benefit of reducing congestion on
the roads as well as reducing possible
pollution that is associated with road use
-subsidies are often financed by the tax
payer but may encourage firms to
overproduce which has a wider effect on
the market
Chapter 8 Application- the costs of Taxation

The effects of taxes on welfare might at first seem obvious. The government imposes taxes in
order to raise revenue, and that revenue must come out of someone´s pocket
 Buyers and sellers are worse off when a good is taxed
The deadweight loss of taxation
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The effect of a tax on a buyer
When a tax is levied on buyers the demand curve shifts downward by the size of the tax.
The effect of a tax on a seller
When a tax is levied on sellers, the supply curve shifts upward by that amount
In either case when the tax is imposed the price paid by buyers rises, and the price received
by sellers falls.
 Taxes place a wedge between the price buyers pay and the price sellers receive. Because of
this tax wedge, the quantity sold falls below the level that would be sold without a tax. A tax
on a good causes the size of the market for the good to shrink.
How a tax affects market participants

The benefit received by buyers in a market is measured by consumer surplus- the
amount buyers are willing to pay for the good minus the amount they actually pay for it.
The benefit received by sellers in a market is measured by producer surplus- the amount
sellers receive for the good minus their costs
Deadweight loss
The fall in total surplus that results from a market distortion such as a tax
 People respond to incentives : When a tax rises the price to buyers and lowers the price
to sellers, however it gives buyers an incentive to consume less and sellers an incentive
to produce less than they otherwise would. As buyers and sellers respond to these
incentives, the size of the market shrinks below its optimum.
 Thus because taxes distort incentives they cause markets to allocate resources
inefficiently
Deadwight losses and the gains from trade

Taxes cause dead-weight losses because they prevent buyers and sellers from
realizing some of the gains from trade
 Thus these trades do not get made once the tax is imposed. The deadweight loss is
the surplus lost because the tax discourages these mutually advantageous trades.
The determinants of the deadweight loss

What determines whether the deadweight loss from a tax is large or small? The
answer is the price elasticities of supply and demand which measures how much
the quantity supplied and quantity demanded respond to changes in the price.

A tax has a deadweight loss because it induces buyers and sellers to change their
behaviour.
 The tax raises the price paid by buyers so they consume less. At the same time
the tax lowers the price received by sellers so they produce less.
 Because of these changes in behaviour the size of the market shrinks below the
optimum. The elasticities of supply and demand measure how much sellers and
buyers respond to the changes in price and therefore deterime how much the
tax distorts the market outcome.
 Hence the greater the elasticities of supply and demand the greater the
deadweight loss of a tax
Deadweight loss and tax revenue as taxes vary
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The effect of a small, medium, large tax holding constant the market´s supply and demand
curves varys
The deadweight loss – the reduction in total surplus that results when the tax reduces the
size of a market below the optimum- equals the area of the triangle between the supply and
the demand curves.
As the size of a tax rises the deadweight loss grows larger and larger
 Rises more rapidly than the size of the tax
 The government´s tax revenue is the size of the tax times the amount of the good
sold.
 For a very large tax no revenue would be raised because people would stop buying
and selling the good altogether
Chapter 10 Externalities

The market failures examined in this chapter fall under a general category called
externalities. An externality arises when a person engages in an activity that influences the
well-being of a bystander (a third party) who neither pays nor receives any compensation for
that effect.
 Negative externality
 Positive externality
 Individuals and groups make decisions which are designed to maximize their individual or
group welfare. In making these decisions there will be private costs and private benefits.
 Social costs are not taken into consideration by people
 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, it also includes the well-being
of bystanders who are affected indirectly. Because buyers and seller neglect the external
effects of their actions when deciding how much to demand or supply, the market
equilibrium is not efficient when there are externalities. That is the equilibrium fails to
maximize the total benefit to society as a whole.
Negative externalities
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How does this externality affect the efficiency of the market outcome?

Because of the externality the cost of society of producing a good is larger than the cost
to the producers of the good.
 For each unit of the produced good, the social (external) costs includes the private costs
of the producer of the good plus the costs to those bystanders that are affected by the
products pollution etc
 The social cost curve is above the supply curve because it takes into account the external
costs imposed on society by the producer
 The social cost curve is the sum of the private costs and the social or external cost
 These two curves reflect the social or external cost of the e.g pollution emitted
 The equilibrium quantity of a product Qmarket is larger than the socially optimal
quantity Qoptimum. The reason for this inefficiencys is that the market equilibrium
reflects only the private costs of production
 A tax would shift the supply curve for one good upward by the size of the tax. If the tax
accurately reflected the social cost of the pollution released inot the atmosphere the
new supply curve would coincide with the social cost curve
 The use of such a tax is calle internalizing an externality because it gives buyers and
sellers in the market an incentive to take account of the external effects of their actions
Internalizing an externality
Altering incentives so that people take account of the external effects of their actions
Positive Externalities
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Some of the productivity benefits of e.g education spill over and benefit other people
as is the case if economic growth is stimulated then this effect would count as a
positive externality as well
Because the social value (or external benefit) is greater than the private value, the
social value curve lies above the demand curve.
The social value curve is the private value plus the external benefit to society at each
price. The optimal quantity is found where the social value curve and the supply
curve (which represents costs) intersect. Hence the socially optimal quantity is
greater than the quantity determined by the private market
To move the market equilibrium closer to the social optimum a positive externality
requires a subsidy. In fact that is exactly the policy governments follow by heavily
subsidizing education
Negative externalities lead markets to produce a larger quantity than is socially
desirable. Positve externalities lead markets to produce a smaller quantity than is
socially desirable. To remedy the problem government can internalize the externality
by taxing goods that have negative externalities and subsidizing goods that have
positive externalities
Private Solutions to Externalities
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People can develope priavate solutions for externalities
Charities
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Colleges and universities get donations from allumni, corporations or
foundations since education has positive externalities for society
 Joint ventures and partnerings
The Coase Theorem
Coase Theorem
The proposition that if private parties can bargain without cost over the allocation
of resources, they can solve the problem of externalities on their own

According to the Coase Theorm the initial distribution of rights does not
matter for market´s ability to reach the efficient outcome.
 Coase Theorm says that private economic actors can solve the problem of
externalities among themselves. Whatever the initial distribution of rights,
the interested parties can always reach a bargain in which everyone is better
off and the outcome is efficient
Why private solutions do not always work
Transaction costs
The costs that parties incur in the process of agreeing and following through
on a bargain

Sometimes the interested parties fail to solve an externality problem
because of transaction costs
 Bargaining simply breaks down. The recurrence of wars and labour
strikes shows that reaching agreement can be difficult and that failing to
reach agreement can be costly
 Bargaining is especially difficult when the number of interested parties is
large because coordinationg everyone is costly
 Asymmetric information and the assumption of rational behaviour
 The situation is further complicated byy the existence of free riders.
 When private bargaining does not work the government can sometimes
play a role. The government is an institution designed for collective
action.
Public Policies towards externalities
1. Command-and-control policies ->regulate behaviour directly
2. Marked-based policies ->provide incentives so that private decision makers will choose
to solve the problem on their own
Regulation

The government can remedy an externality by making certain behaviours either required or
forbidden. For example it is a crime in European countries to dump poisonous chemicals into
water supply
Pigovian Taxes and Subsidies
Pigovian Tax
A tax enacted to correct the effects of a negative externality
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The government can use marked-based policies to align private incentives with social
efficiency.
Economist usually prefer Pigovian taxes over regulations as a way to deal with e.g pollution
because such taxes can reduce pollution at a lower cost to society.
Pigovian taxes are better for the environment. Under the command-and-control policy pf
regulation the factories have no reason to reduce emission further once they have reached
the target of 300 tonnes per year.
The tax gives the companies an incentive to develope cleaner technologies etc
Public/Private Policies towards externalities
Property Rights
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In some cases private solutions to externalities can occur but need some form of legal
back-up to be able to work
 Extending property rights therefore might be one area where externalities can be
internalized. For example if property rights over the air that we breathe can be extended
than any firm polluting the air could face prosecution
 The cost of establishing property rights and getting international agreement on what
they entail is considerable and my counteract the social benefits they might provide
->Complexe negotiations etc
->property owners may also have insufficient knowledge about their rights and exactly
what they mean it is also not a costless exercise to prove that property rights have been
violated
Objections to Economic Analysis of Pollution
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Some environmentalists argue that it is in some sense morally wrong to allow anyone to
pollute the environment in return for paying a fee
Trying to eliminate all pollution would reverse many of the technological advances that allow
us to enjoy a high standard of living
Chapter 11 Public Goods and common resources

When a good does not have a price attached to it private markets cannot ensure that the
good is produced and consumed in the proper amounts. In such cases government policy can
potentially remedy the market failure and raise economic well-being
Three different kinds of goods
Excludability
Rivalry
The property of a good whereby a person can
be prevented from using it when they do not
pay for it
The property of a good whereby one person´s
use diminishes other people´s use
Private goods
Public goods
Common resources
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Goods that are both excludable and rival
Goods that are neither excludable nor rival
Goods that are rival but not excludable
In thinking aobut the various goods in the economy it is useful to group them according to
two characteristics
1. Is the good excludable? Can people who do not pay for the use of the good be prevented
from using the good?
2. Is the good rival? Does one person´s use of the good diminish another person´s ability to
use it?
Category 1
Private goods
-both exludable and rival
Most goods in the economy
are private goods like food
for example
Category 2
Public goods
-neither excludable nor rival
-people cannot be
prevented from using them,
one person´s use of a public
good does not reduce
another person´s ability to
use it
e.g national defence
Category 3
Common resources
-are rival but not excludable
-e.g fish in the ocean
Category 4
Natural monopoly
-when a good is excludable
but not rival
-e.g protection of a small
town
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Because of these external effects, private decisions about consumption and production can
lead to an inefficient allocation of resources and government intervention can potentially
raise economic well-being
Public Goods – The free rider problem
Free rider
A person who receives the benefit of a good but avoids paying for it
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One way to view this market failure is that it arises because of an externality
Because public goods are not excludable the free rider problem prevents the private market
form supplying them. The government however can potentially remedy the problem. If the
government decides that the total benefit exceeds the costs it can provide the public good
and pay for it with tax revenue making everyone better off
Some important public goods
National Defence
Basic Research
Fighting Poverty
The defence of the country from foreign
aggressors is a classic example of a public
good
Once the country is defended it is impossible
to prevent any single person from enjoying
the benefit of this defence
The creation of knowledge is a public good
Profit-seeking firms tend to free ride on the
knowledge created by others and as a result
devote too few resources to creating new
technologies
Anti-poverty programmes are aimed at
helping the poor
Financed by taxes on families that are
financially more successful
-can make everyone better off
The difficult job of cost-benefit analysis
Cost-benefit analysis
A study that compares the costs and benefits to society of providing a public good

So far we have seen the government provides public goods because the pivate market on
its own will not produce an efficient quantity,
 The government must then determine what kinds of public goods to provide and in what
quantities
 To conduct a study called a cost-benefit-analysis the goal of which is to estimate the total
costs and benefits of the project to society as a whole
 The efficient provision of public goods is therefore intrinsically more difficult tahn the
efficient provision of private goods
 Private goods are provided in the market. Buyers of a private good reveal the value they
place on it by the prices they are willing to pay. Sellers reveal their costs by the prices
they are willing to accept
Common resources
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Common resources like public goods are not excludable: they are available free of
charge to anyone who wants to use them. Common resources are however rival:
One person´s use of the common resources reduces other people´s ability to use it
 Once the good is provided policy makers need to be concerned about how much it is
used. This problem is best understood from the classig parable called the Tragedy of
the Commons
Some important common resources
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Private decision makers use the common resources too much. Government often
regulates behaviour or impose fees to mitigate the problem of overuse
Clean Air and Water
One can view this market failure as an
example of a common-resource problem
Congested Roads
Fish, Whales and other Wildlife
Clean air, water are common resources
like open grazing land and excessive
pollution is like excessive grazing
Roads can be either public good or
common resources
If a road is not congested then one
person´s use does not affect anyone else
In this case use is not rival and the road is
a public good
Yet if a road is congested then use of that
road yields a negative externality
Commercial value (fish)
Chapter 15 Monopoly
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Microsoft is said to have a monopoly in the market for Windows
By contrast a monopoly such as Microsoft has no close competitiors and therefore can
influence the market price of its product. While a competitive firm is a price taker a
monopoly firm is a price maker
 Monopolies cannot achieve any level of profit they want because high prices reduce the
amount that their customers buy. Altough monopolies can control the price of their goods
their profits are not unlimited
 Monopoly firms are unchecked by competition the outcome in a market with a monopoly is
often not in the best interest of society
Why monopolies arise
Monopoly
A firm that is the sole seller of a product without close substitutes
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In reality firms are said to have a monopoly power if they are a dominant seller in the
market and are able to exert some control over the market as a result. In the analysis
that follows however the assumption is that there is only one seller
The fundamental cause of monopoly is barriers to entry: a monopoly remains the only
seller in its market because other firms cannot enter the market and compete with it.
Barriers to entry, in turn, have four main sources:
1. A key resource is owned by a single firm
2. The government gives a single firm the exclusive right to produce some good or
service
3. The costs of production make a single producer more efficient than a large number
of producers
4. A firm is able to gain control of other firms in the market and thus grow in size.
Monopoly resources
The simplest way for a firm to achieve a
monopoly
Government-created monopolies
Natural monopoly
External growth
Monopolies arise because the government has
given one person or firm the exclusive right to
sell some good or service
Sometimes the monopoly arises from the sheer
political clout of the would-be monopolist
->patent and copyright laws
By allowing these monopoly producers to
charge higher prices and earn higher profits the
laws also encourage some desirable behaviour
The benefit of the patent and copyright laws
are the increased incentive for creative activity
These benefits are offset to some extent by the
costs of monopoly priceing which we examine
fully later in this chapter
A monopoly that arises because a single firm
can supply a good or service to an entire market
at a smaller cost than could two or more firms
->In some cases the size of the market is one
determinant of whether an industry is a natural
monopoly
A firm might be able to develop monopoly
power over its rivals and erect barriers to entry
to make it harder for new firms to enter
It is for this reason that governments monitor
such acquisitors to see if there are implications
for competition
How monopolies make production and pricing decisions – Monopoly versus competition

The key difference between a competitive firm and a monopoly is the monopoly´s ability to
influence the price of its output. A competitive firm is small relatively to the market in which
it operates and therefore takes the price of its output as given by market conditions
 Because a monopoly is the sole producer it can alter the price
 One way to view this difference between a competitive firm and a monopoly is to consider
the demand curve that each firm faces
 Because a competitve firm can sell as much or as little as it wants at this price the
competitive firm faces a horizontal demand curve
 In effect because the competitive firm sells a product with many perfect substitutes the
demand curve that any one firm faces is perfectly elastic
 Because a monopoly is the sole producer in its market its demand curve is the market
demand curve. Thus the monopolist´s demand curve slopes downward for all the usual
reasons
 The quantity of output it sells the price of its output increases
 By adjusting the quantity produced the monopolist can choose any point on the demand
curve but it cannot choose a point off the demand curve
A monopoly´s revenue
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The monopolist´s total revenue equals the quantity sold times the price
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Average revenue: the amount of revenue the firm receives per unit sold. We compute
average revenue by taking the number for total revenue and divide it by the quantity of
output in the first column
 A monopolist´s marginal revenue is always less than the price of its good
 For a monopoly marginal revenue is lower than price because a monopoly faces a
downward sloping demand curve. To incease the amount sold a monopoly firm must
lower the price of its good.
 The output effect: More output is sold so Q is higher which tends to increase total
revenue
 The price effect: The price falls so P is lower which tends to decrease total revenue
 By contrast when a monopoly inceases production by 1 unit it must reduce the price it
charges for every unit it sells, and this cut in price reduces revenue on the unit it was already
selling.
 A monopoly´s marginal revenue is less than its price
Profit Maximization

Thus the monopolist´s profit-maximizing quantity of output is determined by the intersection
of the marginal revenue curve and the marginal cost curve.
 In following this rule for profit-maximization competitive firms and monopolies are alike. The
difference between these types of firms: the marginal revenue of a competitive firm equals
its price whereas the marginal revenue of a monopoly is less than its price
 Competitive firm : P=MR=MC
 Monopoly: P>MR=MC
 We can now see a key difference between markets with competitive firms and markets with
a monopoly firm
 In competitive markets price equals marginal cost
 In monopolized markets, price exceeds marginal cost. As we will see in a moment
this finding is crucial to understanding the social cost of monopoly
The welfare cost of monopoly

From the standpoint of a cónsumer this high price makes monopoly undersirable. At the
same time however the monopoly is earning profit form charging this high price.
 From the standpoint of the owners of the firm, the high price makes monopoly very
dersirable
 As in that chapter we use total surplus as our measure of economic well-being. Recall total
surplus is the sum of consumer surplus and producer surplus
 Consumer surplus is consumer´s willingness to pay for a good minus the amount they
actually pay for it
 Producer surplus is the amount producers receive for a good minus their costs of producing
it. In this case there is a single producer the monopolist
The deadweight loss
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Keep in mind that total surplus equals the value of the good to consumers minus the
costs of making the good incurred by the monopoly producer
We can evaluate welfare effects of monopoly by comparing the level of output that the
monopolist chooses to the level of output that a social planner would choose

The deadweight loss caused by monopoly is similar to the deadweight loss caused by a
tax. Indeed a monopolist is like a private tax collecter. A tax on a good places a wedge
between consumer´s willingness to pay and producer´s costs
 Because a monopoly exerts its market power by charging a price above the marginal cost
it places a similar wedge. In both cases the wedge causes the quantity sold to fall short of
the social optimum.
 The difference between the two cases is that the government gets the revenue from a
tax whereas a private firm gets the monopoly profit
The monopoly´s profit: A social cost

In other words the monopoly´s profit itself does not represent a shrinkage in the size
of the economic pie, it merely represents a bigger slice for producers and a smaller
slice for consummers
 The problem in a monopolized market arises because the firm produces and sells a
quantity of output below the level that maximizes total surplus. The deadweight loss
measures how much the economic pie shrinks as a result
 This inefficiency is connected to the monopoly´s high price
 Consumers buy fewer units when the firm raises the price above the marginal cost
 If the high monopoly price did not discourage some consumers from buying the good
it would raise producer surplus by exactly the amount it reduced consumer surplus
leaving total surplus the same as could be achieved by a benevolent social planner
Price discrimination
Price discrimination
The business practice of selling the same good at different prices to different
customers


Price discrimination is not possible when a good is sold in a competitive market
Deadweight loss is the usual inefficiency that arises whenever a monopolist
charges a price above the marginal cost
 Price discrimination is a rational strategy for a profit-maximizing monopolist
 By charging different prices to different customers a monopolist can increase its
profit
 In essence a price-discriminating monopolist charges each customer a price closer to
his or her willingness to pay than is possible with a single price
 Price discrimination requires the ability to separate customers according to their
willingness to pay
 In particular one such force is arbitrage the process of buying a good in one market
at a low price and selling it in another market at a higher price in order to profit from
the price difference
 Price discrimination can raise economic welfare.
The analytic of price discrimination

Without price discrimination the firm charges a single price above the marginal
cost. Because some potential customers who value the good at more than
marginal cost do not buy it at this high price, the monopoly causes a deadweight
loss. Yet when a firm can perfectly price discrimination each customer who
values the good at more than marginal cost buys the good and is charged his
willingness to pay.
 There is no deadweight loss
 The entire surplus derived from the market goes to the monopoly producer in the
form of profit
 Firms price discriminate by dividing customers into groups
 The analysis of these pricing schemes is quite complicated ant it turns out that
there is no general answer to this question. Compared to the monopoly outcome
with a single price, imperfect price discrimination can raise lower or leave
unchange total surplus in a market
 Price discrimination raises the monopoly´s profit
Public policy towards monopolies
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Monopolies produce less than the socially desirable quantity of output and
as a result charge prices above marginal cost. Policy makers in the
government can respond to the problem of monopoly in one of four ways
1. Trying to make monopolized industries more competitive
2. Regulating the behaviour of the monopolies
3. Turning some private monopolies into public enterprises
4. Doing nothing at all
Competition legislation covers three main areas
1. Acting against cartels and cases where businesses engage in restrictive
business practices which prevent free trade
2. Banning pricing strategies
3. Monitoring and supervising acquisitions and joint ventures
Regulation
This solution is common in the case of natural monopolies such as utility
companies like water, gas, etc
Companies are not allowed to charge any price they want. Instead
government agencies regulate their prices
Public ownership
Government can run monopoly itself.
Private owners have an incentive to minimize costs as long as they reap part
of the benefit in form of higher profit. If the firm´s managers are doing a bod
job of keeping costs down, the firm´s owners will fire them
By contrast if the government bureaucrats who run a monopoly do a bad job
the losers are the customers and taxpayers whose only recourse is the
political system
Chapter 22 Frontiers of Microeconomics
How do economists try to expand their understanding of human behaviour and society?
Three approaches:
1. Asymmetric information: many times in life people are better informed than others, and this
difference in information can affect the choices people they make and how they deal with
one another.
2. Political economy: the government policy aims to improve the market -> market failure
3. Behavioural economics: insights from psychology, offers a view of human behaviour that is
more subtle and complex than that found in conventional economic theory
Asymmetric Information

Information asymmetry: difference in access to relevant knowledge
 Hidden action: A worker knows more than his employer about how much effort he puts
into his job
 Hidden characteristic: a seller of a used car knows more about its condition than its
buyer
Hidden Actions: Principles, Agents and Moral Hazard
Moral hazard
The tendency of a person who
is imperfectly monitored to
engage in dishonest or
otherwise undesirable
behaviour

Agent
A person who is performing an
act for another person, called
principle
Principle
A person for whom another
person, called the agent is
performing some act
The phrase moral hazard refers to the risk, or hazard of inappropriate or otherwise immoral
behaviour by the agent
 Moral hazard can lead to adverse selection -> market process may end up with bad outcomes
because of asymmetric information
 Employers can respond to this problems in various ways:
1. Better monitoring
 Parents hiring nannies or au pairs have been known to plant hidden video cameras in
their homes to record the individual´s behaviour
2. High wages
 According to efficiency wage theories some employers choose to pay their workers wage
above the level that equilibriates supply and demand in the labour market. A worker who
earns above-equilibrium wages is less likely to shirk
3. Delayed payment
 Firms can delay part of a worker´s compensation so if the worker is caught shirking and is
fired he suffers a larger penalty
Hidden Characteristics: Adverse selection and the lemons problem
Adverse selection
The tendency for the mix of unobserved attributes to become undesirable from the standpoint of
an uninformed party


Example: market for used cars
When markets suffer from adverse selection, the invisible hand does not necessarily work its
magic. In the used car market, owners of good cars may choose to keep them rather than sell
them at the low price that sceptical buyers are willing to pay.
 In the labour market wages may be stuck above the level that balances supply and demand
resulting in unemployment.
 In insurance markets buyers with low risk may choose to remain uninsured because the
policies they are offered fail to reflect their true characteristics.
Signalling to convey private information

It also motivates some individual behaviour that otherwise might be hard to explain. Markets
respond to the problems of asymmetric information in many ways.
 One of them is signalling which refers to actions taken by an informed party for the sole
purpose of credibly revealing his private information
 What does it take for an action to be an effective signal?
 It must be costly, if a signal were free everyone would use it and it would convey no
information
 The signal must be less costly, or more beneficial to the person with the higher quality
product. Otherwise everyone would have the same incentive to use the signal and the
signal would reveal nothing.
Screening to induce information revelation
Screening
An action taken by an uninformed party to induce an informed party to reveal information

Example: A person buying a used car may ask that it be checked by a car mechanic before
sale. A seller who refuses this request reveals his private information that the car is a lemon
Asymmetric information and public policy

The study of asymmetric information gives us new reason to be wary of markets. When some
people know more than others, the market may fail to put resources to their best use.
 People with high-quality used cars may have trouble selling them because buyers will be
afraid of getting a lemon.
 Although asymmetric information may call for government action in some cases, three facts
complicate the issue.
1. The private market can sometimes deal with information asymmetries on its own using a
combination of signalling and screening
2. The government rarely has more information than the private parties
3. The government itself is an imperfect institution
Political economy

The field of political economy applies the methods of economics to study how governments
work.
The Condorcet Voting Paradox
Condorcet paradox
The failure of majority rule to produce transitive preferences for society
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
Most advanced societies rely on democratic principles to set government policy.
But democratic outcomes do not always obey this property. Pairwise voting might produce
transitive preferences for society depending on the pattern of individual preferences but it
cannot be counted on to do so.
 There are more than two options, setting the agenda can have a powerful impact on the
outcome or a democratic election. The broad lesson is that majority voting by itself does not
tell us what outcome a society really wants.
Arrow´s impossibility theorem
Arrow´s impossibility theorem
A mathematical result showing that under certain assumed conditions there is no scheme for
aggregating individual preferences into a valid set of social preferences

Arrow´s impossibility theorem is a deep and disturbing result. It doesn´t say that we
should abandon democracy as a form of government. But it does say that no matter
what voting scheme society adopts for aggregating the preferences of its members, in
some way it will be flawed as a mechanism for social choice.
The median voter is king
Median voter theorem
A mathematical result showing that if voters are choosing a point along a line and each voter
wants the point closest to his most preferred point then majority rule will pick the most preferred
point of the median voter

Voting is how most societies choose their leaders and public policies often by majority
rule. The next step in studying government is to examine how governments run by
majority rule work. That is, in a democratic society, who determines what policy is
chosen?
 Majority rule will produce the outcome most preferred by the median voter. The median
voter is the voter exactly in the middle of the distribution.
 One implication of the median voter theorem is that minority views are not given much
weight.
Behavioural economics
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
The fields of economics and psychology usually proceed independently in part because they
address a different range of questions.
But recently a field called behavioural economics has emerged in which economists are
making use of basic psychological insights.
People aren´t always rational

Studies of human decision making have tried to detect systematic mistakes that people
make.
1. People are overconfident
2. People give too much weight to a small number of vivid observations
3. People are reluctant to change their minds
4. People have a natural tendency to look for examples which confirm their existing view or
hypothesis.
5. People use rules of thumb-heuristics
 Anchoring: the tendency for people to start with something they are familiar with or
know and make decisions or adjustments based on this anchor
 Availability: decisions are made based on an assessment of the risk of the likelihood of
something happening
 Representativeness: people tend to make judgements by comparing how representative
something is to an image or stereotype that they hold.
6. People care about fairness
7. People are inconsistent over time
 Some economists believe that the consumption-saving decision is an important instance
where people exhibit this inconsistency over time. Spending provides a type of instant
gratification. Saving requires a sacrifice in the present for a reward in a distant future