1. the logic of maximizing behavior learning objectives 1.explain the maximization assumption that...

Chapter 6

Markets, Maximizers,

and Efficiency

1. THE LOGIC OF MAXIMIZING BEHAVIOR

Learning Objectives1. Explain the maximization assumption that

economists make in explaining the behavior of consumers and firms.

2. Explain and illustrate the concepts of marginal benefit and marginal cost and supply them to understanding the marginal decision rule.

Economists assume that:◦ Tastes and preferences are fixed and given, and

play a large role in decision making.◦ Consumers make choices that give them the

greatest , satisfaction —they maximize their satisfaction or benefit.

◦Utility is the technical term in economics for benefit, satisfaction, or usefulness, so consumers MAXIMIZE Utility.

Utility and Human Nature

Marginal benefit or Marginal utility: the extra utility derived from consuming one more unit of a good or service.

The same formula for “marginal benefit”

Marginal Utility

quantityin change

utility in total change utility marginal

• The difference between total revenue and total cost

Economic Profit

1.1 The Analysis of Maximizing Behavior

• Net benefit is the total benefit of an activity minus its opportunity cost.

• Marginal benefit is the amount by which an additional unit of an activity increases its total benefit.

• Marginal cost is the amount by which an additional unit of an activity increases its total cost.

• The marginal decision rule states that if the marginal benefit of an additional unit of an activity exceeds the marginal cost, the quantity of the activity should be increased. If the marginal benefit is less than the marginal cost, the quantity should be reduced.

• A constraint is a boundary that limits the range of choices that can be made.

Diminishing Marginal Benefit

• At some point the marginal benefit of any activity or any product diminishes as we continue doing one more– Eating 1 burger when hungry– 2nd burger– 3rd burger– 4th burger……

1 hour STATS study vs 2nd hour,

3rd, 4th, 20th ????

The Benefits of Studying

Economics

Note: On Marginal benefit and marginal cost curves we mark the value at the midpoint. The marginal benefit of 1 hour of study here is shown at 18 points

Notes: 5 hours budgeted for study of both Econ and Accounting. MB of both given as expected gains for each hour allotted to each subject.

The Marginal Benefits of Studying Accounting

The Marginal Benefits and Marginal Costs of Studying Economics

Reminder: On Marginal benefit and marginal cost curves we mark the value at the midpoint. The marginal benefit of 1 hour of study here is shown at 18 points

The marginal cost of 1 hour is 0 points

The Benefits and Costs of Studying Economics

The Marginal Benefit Curve and Total Benefit

• The loss in net benefits resulting from a failure to carry out an activity at the most efficient level

Deadweight Loss

Using Marginal Benefit and Marginal Cost Curves to Determine Net Benefit

2. MAXIMIZING IN THE MARKETPLACE

Learning Objectives1. Explain what is meant by an efficient allocation

of resources in an economy and describe the market conditions that must exist to achieve this goal.

2. Define consumer and producer surplus.3. Discuss the relationship between efficiency and

equity.

2. MAXIMIZING IN THE MARKETPLACE

• Efficient allocation of resources is when the net benefits of all economic activities are maximized.

2.1 Achieving Efficiency

• The role of property rights– Property rights are a set of rules that

specify the ways in which an owner can use a resource.

• An exclusive property right is a property right that allows its owner to prevent others from using the resource.

• A transferable property right is a property right that allows the owner of a resource to sell or lease it to someone else.

Demand and Supply and the Efficiency Condition

2.2 Producer and Consumer Surplus

• Consumer surplus is the amount by which the total benefits to consumers from consuming a good exceed their total expenditures on the good.

• Producer surplus is the difference between the total revenue received by sellers and their total cost.

Consumer and Producer Surplus

Net Benefit: The Sum of Consumer and Producer Surplus

2.3 Efficiency and Equity

• In a market that satisfies the efficiency condition, an efficient allocation of resources will emerge from any particular distribution of income

• Different income distributions will result in different, but still efficient, outcomes

• Whatever distribution society chooses, an efficient allocation of resources is still preferred to an inefficient one

3. MARKET FAILURE

Learning Objectives1. Explain what is meant by market failure and the

conditions that may lead to it.2. Distinguish between private goods and public goods and

relate them to the free rider problem and the role of government.

3. Explain the concepts of external costs and benefits and the role of government intervention when they are present.

4. Explain why a common property resource is unlikely to be allocated efficiently in the marketplace.

• Occurs when private decision makers in the marketplace fail to achieve an efficient allocation of scarce resources

Market Failure

The Government’s Role

1. Imperfect Information 2. Externalities3. Public Goods4. Lack of Competition5. Business Cycles

Market Failures As Explanation of roles for Government in the economy

Imperfect information leads to market failures that cause inefficiency.

False information

Asymmetric informationEither the buyer or seller has more or better information than the other

Imperfect Information

Some solutions:

Market Based Solutions: Brand names, franchises, and product warranties

Imperfect Information

Government Solutions: Requiring full and correct disclosure. (Food labels, stock prospectuses, etc.)

Externalities are the costs or benefits of a transaction that are borne by someone not directly involved in the transaction.

Real efficiency occurs only when all the costs and all the benefits accrue to the buyer and seller

Externalities

External Benefits (Positive externalities) when someone outside the transaction is receiving benefits from the transaction.

◦ If buyers are not receiving all benefits, they will demand less than is optimal.

◦ If sellers are not receiving all the benefits from the sale, they will not produce as much as is optimal.

◦ Examples: New large business in a declining neighborhood, Education, Landscaping and painting a formerly unkempt property, Immunizations

Externalities

External costs (Negative Externalities): when someone outside the transaction is incurring costs related to the transaction.

◦ If buyers are not bearing all the costs of the purchase, they will demand too much.

◦ If producers are not bearing all the costs of production, then they will produce too much.

◦ Example: Pollution by a manufacturer, Second hand tobacco smoke, Smog and traffic congestion from my choice to drive alone.

Externalities

External Costs

Government imposes costs

Government regulates to internalize external costs.

◦ Examples: Smog fees, mandated pollution controls, banns on indoor smoking etc

Solutions to the External Cost Problem?

Government produces or subsidizes the production/consumption of the good.

Government requires the consumption of the good

◦ Examples: required immunizations, public education, student aid, tax breaks to businesses that locate in run-down areas

Solutions to the External Benefits Problem?

Public Goods are goods whose consumption by one person does not diminish the quantity or quality available to other consumers. Specifically, they:– Can be jointly consumed (jointness)

Individuals can simultaneously enjoy consumption of same product or service.

– Are non-excludable (non-exclusion)Consumption of the good cannot be restricted to the customers who pay for it.

Public Goods*

• Non-excludability• If it is produced for some, it is available to all. There is

no way to exclude non-payers.

• No one enjoys a private property right to the public good.

• Functioning Private Property Rights require:

• Exclusivity

• Transferability

Characteristics of a Public Good

• Without private property rights: • People have an incentive to try free ride:

• Free rider: a person who receives the benefits of the good without helping to pay for it.

• Because of the Free Rider Problem, too little will be produced; efficiency is not achieved.

Characteristics of a Public Good

• Examples of public goods: • National defense• Forest fire protection• Broadcast radio and television

stations• Clean air• Unpolluted ground water

Examples of Public Goods

Public Goods and Market Failure

Government production

Government subsidized production

Marketization: Sometimes markets develop ways of providing public goods (e.g. use of advertising to support radio and television).

Solutions to the Public Goods Problem?

Goods owned collectively or not owned at all. ◦Examples: Public Parks, Public highways and roads, Wildlife, River water or underground water.

◦Common Property Goods DO NOT have Jointness or Non-exclusivity.

Common Property Goods

Common Property goods tend to be under-produced & over-consumed.◦Solutions: Marketize them like buffalo in the Midwest

Regulate their use like wildlife Government production & maintenance like city streets and city parks

Common Property Goods

Sellers may gain by restricting output and raising price.◦ Too few units will be produced.◦ Consumers may not be able to get needed goods.

Monopoly: a market with only one producer◦ Example: utility companies

Oligopoly: a market with only few producers (who may operate jointly as a monopolist through a cartel).◦ Example: OPEC

Monopsony: a market with only one buyer

Lack of Competition

Restricting Supply to Raise Prices

S2 Price

Quantity

Anti-trust laws; ban collusion and anti-competitive behavior

License and regulate monopolies

Government provision of the good

Solutions for Lack of Competition

Cycles of Expansion and Contraction create inefficient outcomes:

Expansion, when too rapid or extreme leads to over-production or over-consumption of certain types of goods

Contraction, especially when they lead to recession lead to unemployment of Capital and Labor. Unemployment is not efficient.

Business Cycles

Market Response: natural market responses correct for business cycles in time.

Government Responses to Recession: ◦ Stimulate demand by Fiscal Stimulus – ie; cut

taxes or increase spending◦ Monetary Stimulus – ie; increase money supply or

decrease interest rates

Business Cycles

Government Responses to Excessive Expansion: Reign in inflation◦ Fiscal Contraction – ie; increase taxes or reduce

government spending◦ Monetary Contraction – ie; reduce the money

supply or increase the interest rate

Business Cycles

Public Choice Analysis

• Public Choice Theory: Proposes that government activity in the economy has little to do with market failures.

• Public Choice theory suggests that government may be brought in to benefit specific individuals or groups.

• People may seek government intervention to improve their own profit in comparison to the market outcome.

• This is referred to as rent-seeking—the use of resources to transfer wealth from one individual to another without increasing production or total wealth.

Self-interest directs public sector activity, just as it directs market activity.

Government actions (like price ceilings or floors) are often enacted for political gain, not as a remedy for economic inefficiency.

Government action is likely to create market failure or reduce efficiency.

Public Choice Conclusions

3.2 Public Goods

• A public good is a good for which the cost of exclusion is prohibitive and for which the marginal cost of another user is zero.

• A private good is a good for which exclusion is possible and for which the marginal cost of another user is positive.

• Free riders are people or firms that consume a public good without paying for it.

3.4 Common Property Resources

• Common property resources are resources for which no property rights have been defined

• The difficulty with common property resources

– Individuals may not have adequate incentives to engage in efforts to preserve or protect them

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