Review for Exam 2 Econ 11 13 2012 REVIEW FOR TEST Externalities o Types of externalities Negative Production Externality Social cost Private Pollution Positive Production Externality Private cost Social Fable of the bees Bee keeper keeps bees to make honey Bees pollinate flowers Beekeeper doesn t face cost or benefit from flowers but other people benefit flowers Positive Consumption Externality Social value private value flu vaccines Negative Consumption Externality Social value Private value social willingness to pay is less than private individual s willingness to pay for consumption of a unit o Positive beneficial v negative harmful If social value or private cost is higher helpful o Production v Consumption Production Private and social cost Private cost cost of producing an additional unit of a good or service borne by producer Social cost cost incurred by producer and by everyone else in society Consumption Private and social value Private value benefit from an additional unit of a good or service that the consumer receives aka willingness to pay Social value the benefit enjoyed by consumer and everyone else in society o Why do externalities lead to inefficiency Externalities mean that the market is not where it should be equilibrium is out of balance Markets overproduce with negative externalities Markets underproduce with positive externalities o Measuring deadweight loss from externalities Deadweight loss triangle loss of social value when people ought to consume a product but do not fire extinguishers o Possible Solutions Taxes Government increases cost of a good to deter production and consumption Subsidies government decreases cost of a good to ensure production and consumption Private Negotiations Coase Theorem Lead to solving of an externality through private negotiations no gov Only works under special conditions 1 it isn t costly to conduct the negotiations costless negotiations Fails when property rights aren t clear Ex People might want to buy part of the ocean to protect fish but they cant negotiate with anyone to buy the ocean from Proposition that if private decision makers incur zero transaction costs in bargaining they can efficiently allocate resources and solve the problem of externalities of their own Two steps Negotiation Enforcement If there are 0 transaction costs in bargaining private decision makers can efficiently allocate resources and solve the problem of externalities on their own Only successful if No negotiation transaction costs Clear property rights Ex Firm s cost of eliminating pollution 700 Homeowner s damage from pollution 1000 Homeowner s would pay firm 700 to eliminate pollution Issues Depends on transaction costs at either or both steps Firms may not come up with an efficient solution Negotiation itself is an expense Government is pivotal in negotiating and enforcement Public Goods and Common Resources o Excludability property of a good whereby a person can be prevented from using it You can control the use of the product in some way Ex HBO o Rivalry one person s use diminishes other people s use How others use the good affects how you use it o Public Goods Non excludable and non rival Ex Defense public fireworks o Common resources Non excludable but rival Route one at rush hour o Tragedy of the commons Depletion of a shared resource by individuals acting independently and rationally according to each one s self interest despite their understanding that depleting the common resource is contrary to their long term best interest Trade o No trade v trade with no tariffs No trade Pw world price Pl Island price o No trade v trade with tariffs No trade Trade with tariff trade o Trading leads to more efficient solutions there are gains from o Gains from Trade o Production Possibilities Frontier shows combinations of output an economy can produce given factors of production and technology Examples had PPF as linear it is more likely bowed out not all workers are equally good at tasks Economies sometimes operate inside their PPFs PPFs often shift out over time but can still shift in o Opportunity Cost what is given up to get another additional unit of another item o Absolute Advantage the producer who requires smaller quantity of inputs to produce an item has an absolute advantage in that item One entity can have AA in both o o Comparative Advantage producer who requires lower opportunity cost to produce item has comparative advantage in that item everyone is better off if people specialize The Consumer s Problem o Budget Constraint given how much they can afford what will they chose to consume o Slope prices are related to slope of budget constraint o Intercept related to how much income the consumer has and what the prices of the goods are o Effects of Income Change parallel shift in or out in budget constraint entire BC line shifts in or out o Effects of Price Change rotation of the budget constraint o Consumer optimizes at point on Budget Constraint o Determined by preferences o Willingness to Pay Curve demand curve o Relationship between points of optimization on budget constraint and points on demand curve In consumption space the triangle formed by the budget constraint between two goods Understand the relation between consumption space and demand curve for apples Tradeoff between apples and Pepsi A consumer should choose the quantity of a good such that willingness to pay equals price Willingness to pay is a reworded way of saying My demand curve tells me for a given price how many units am I going to buy The individual continues to buy until the marginal benefit is at least as large as the marginal cost A demand curve is a graph of the relationship between the price of a good and the quantity demanded That is a consumer should choose the quantity of a good such that the willingness to pay equals price o Sunk Costs don t think about them The cost is sunk Think rationally Businesspeople walk away from projects all the time despite the sunken costs Consumers have a much harder time with this Decisions under Uncertainty o Expected Value the average value of an event based on repeating the situation mayn times o Calculated by taking every possible outcome multiplying each possible outcome by the probability that outcome will occur then adding these numbers together Insurance o Expected value of your housing wealth probability of no fire x house wealth if no fire probability of fire x house wealth if fire o Fair insurance insurance you
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