REVIEW FOR TESTExternalitiesTypes of externalitiesNegative Production ExternalitySocial cost > Private = PollutionPositive Production ExternalityPrivate cost > Social = Fable of the beesBee keeper keeps bees to make honey. Bees pollinate flowers. Beekeeper doesn’t face cost or benefit from flowers, but other people benefit flowersPositive Consumption ExternalitySocial value > private value = flu vaccinesNegative Consumption ExternalitySocial value < Private value = social willingness to pay is less than private individual’s willingness to pay for consumption of a unitPositive (beneficial) v. negative (harmful)If social value or private cost is higher helpful!Production v. ConsumptionProductionPrivate and social costPrivate cost – cost of producing an additional unit of a good or service, borne by producerSocial cost – cost incurred by producer and by everyone else in societyConsumptionPrivate and social valuePrivate 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 societyWhy do externalities lead to inefficiency?Externalities mean that the market is not where it should be, equilibrium is out of balanceMarkets overproduce with negative externalitiesMarkets underproduce with positive externalitiesMeasuring deadweight loss from externalitiesDeadweight loss triangle, loss of social value when people ought to consume a product, but do not (fire extinguishers)Possible SolutionsTaxes = Government increases cost of a good to deter production and consumptionSubsidies = government decreases cost of a good to ensure production and consumptionPrivate Negotiations = Coase TheoremLead 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:NegotiationEnforcementIf 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 ifNo negotiation/transaction costsClear property rightsEx: Firm’s cost of eliminating pollution = $700Homeowner’s damage from pollution = $1000Homeowner’s would pay firm $700 to eliminate pollutionIssues: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 enforcementPublic Goods and Common ResourcesExcludability – 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. HBORivalry – one person’s use diminishes other people’s use. How others use the good affects how you use itPublic GoodsNon-excludable and non-rivalEx. Defense, public fireworksCommon resourcesNon-excludable but rivalRoute one at rush hourTragedy of the commonsDepletion 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 interestTradeNo trade v. trade with no tariffsNo trade (Pw world price, Pl Island price)No trade v. trade with tariffsNo tradeTrade with tariffTrading leads to more efficient solutions; there are gains from tradeGains from TradeProduction Possibilities Frontier - shows combinations of output an economy can produce given factors of production and technologyExamples 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 inOpportunity Cost - what is given up to get another additional unit of another itemAbsolute 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.Comparative Advantage: producer who requires lower opportunity cost to produce item has comparative advantage in that item.everyone is better off if people specializeThe Consumer’s ProblemBudget Constraint: given how much they can afford, what will they chose to consume.Slope – prices are related to slope of budget constraintIntercept – related to how much income the consumer has and what the prices of the goods areEffects of Income Change – parallel shift in or out in budget constraint, entire BC line shifts in or out.Effects of Price Change – rotation of the budget constraintConsumer optimizes at point on Budget ConstraintDetermined by preferencesWillingness to Pay Curve = demand curveRelationship 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 priceWillingness 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 costA 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 priceSunk Costs: don’t think about them. The cost is sunk. Think rationallyBusinesspeople walk away from projects all the time, despite the sunken costs. Consumers have a much harder time with this.Decisions under UncertaintyExpected Value – the average value of an event based on repeating the situation mayn times.Calculated by taking every possible outcome, multiplying each possible outcome by the probability that outcome will occur, then adding these numbers together.InsuranceExpected value of your housing wealth = (probability of no fire)x(house wealth if no fire) + (probability of fire)x(house wealth if fire)Fair insurance:
View Full Document
Unlocking...