UNEMPLOYMENT (U):
-News publications will often toss around unemployment rates, but very few people actually know what the unemployment rate means, or what a 'good' rate for employment or unemployment is
Increases in output are either caused by
1) more works being utilized (aka an increase in employment) OR
2) each worker being more productive
In the SHORT RUN, changes in productivity usually don't happen (they take a longer time to come to be realized), so only changes in employment affect output
In the LONG RUN, changes in both productivity and employment can affect output (so the Canadian economy could raise it's GDP either by putting more people to work, or by implementing more efficient production processes [like switching to machine-centric production processes which allow each worker to produce more in a shorter amount of time])
Definitions and Terms Surrounding Employment and Unemployment:
LABOUR FORCE: The total number of people who wish to work at any given time (Unemployment + Employment) ***Note: The size of the labour force can grow and shrink depending on how motivated the general populace is to work. Often, higher wages motivate more people to work, so in times where wages are higher, the labour force is also larger
EMPLOYMENT: The total number of workers ages 15 and older who have any kind of job (including part time work, full time work, and self-employment)
UNEMPLOYMENT: The total number of workers ages 15 and older who are willing and able to work, but have NO job
UNEMPLOYMENT RATE (U): UNEMPLOYMENT/LABOUR FORCE
EMPLOYMENT RATE: EMPLOYMENT/POPULATION
NOTICE how unemployment rate and employment rates are calculated differently? Pretty tricky, huh?
TYPES OF UNEMPOYMENT:
Frictional- turnover unemployment (people who are unemployed because their still trying to find a job that works for them, like recent college graduates)
Structural- unemployment due to mismatching (like when there are 20 positions for teachers and 20 unemployed plumbers- there are enough jobs, but they are the wrong kind of jobs for those who are unemployed)
Cyclical- unemployment that results from recessionary gaps
NAIRU = Non-Accelerating-Inflationary-Rate of -Unemployment: The rate of unemployment that exists at full employment
THE HISTORY OF UNEMPLOYMENT:
-Employment tends to increase fairly constantly in line with growth in the labour force
-Unemployment rates peak during recessions. In Canada, they fluctuate from 12% to 4%, but usually average at around 7%
WHY DOES UNEMPLOYMENT MATTER? Unemployment causes stress and unhappiness on an individual level, and creates economic waste on a macro-level. Overall, it's a very bad sort of thing
---------------------------------
PRODUCTIVITY: Real output per unit of input (all five different kinds of inputs)
LABOUR PRODUCTIVITY: Real output per unit of labour input- this can be measured either per worker or per hour worked
HISTORY OF PRODUCTIVITY IN CANADA:
Real GDP per worker has increased at 1.3% per year
Real GDP per hour has increased at 1.1% per year
Per hour is probably the better measure because the number of hours worked per worker can contribute to per-worker productivity (in other words, we aren't necessarily becoming more productive in Canada as much as we are simply working more hours)
Why does productivity increase? Usually because of increases in human and physical capital.
The trend is that both per hour and per worker GDP have been rising gradually in Canada over time.
------------------------------------
INFLATION (P) OR GENERAL PRICE LEVEL: The average price of all goods in the economy (usually expressed at CPI)
Inflation is defined as an increase in P (an increase in the average cost of all products)
CPI is the consumer price index. This is weighted average of all goods and services in a representative basket of goods (where each good is weighted depending on what percentage of their income the average consumer would spend on it). This is used to measure the cost of living.
Problems with CPI:
-It doesn't adjust for quality changes (ie: situations where you would pay the same amount of money but for a much better product)
-It also doesn't adjust for changes in consumption patterns over time
4 steps to construct an index:
1) Determine the goods in the index
2) Find the base year quantity of goods times the base year price of goods
3) Find the current year quantity of goods times the current price of goods
4) The price index: the ratio of current year/base year
Purchasing power = the number of goods that can be purchased per dollar
HISTORICAL TREND: Inflation has caused the general price level to increase to over 6 times its 1960 level. The rate of inflation can fluctuate wildly
WHY INFLATION MATTERS: Inflation diminishes the purchasing power of money, it reduced the value of fixed assets. If inflation is unanticipated, it can have serious macro effects.
------------------------------
INTEREST RATES (i): The cost of borrowing money
-"The" interest rate is the mean of all of the different interest rates
-The prime rate is the rate which chartered banks charge to preferred customers
-The bank rate is the rate which the bank of Canada charges to chartered banks
The nominal interest rate is the current rate of borrowing (the real interest rate + inflation)
The real interest rate is the nominal interest rate corrected for changes in purchasing power (so if the current interest rate is 5% and inflation is currently 5%, then the real interest rate is 0% [nominal minus inflation])
----------------------------
EXCHANGE RATES (e): These are the same as they were in micro
Foreign Exchange = Actual Foreign currency
Foreign Exchange Market = The Market for Foreign Currency
External Value = The price of domestic currency
Exchange Rate = The price of foreign currency
Appreciation = rise in external value and fall in the exchange rate (when domestic currency becomes worth more relative to foreign currencies)
Depreciation = fall in external value and rise in exchange rate (when domestic currency becomes worth less relative to foreign currencies)
BALANCE OF PAYMENTS (BOP) = a measure of the money going in and out of any country
BALANCE OF TRADE = Exports minus Imports = net exports = NX
Historically, our imports and exports have both increased over time, but our net exports are positive (The US's net exports are negative right now).
Our exchange rate has fluctuated greatly over time. It's reached parity with the US a few times (like in 2008).
Growth and Fluctuations (Business cycles) are different!
Friday, January 8, 2010
Wednesday, January 6, 2010
Introduction to Macroeconomics
Here we go!
MACROECONOMIC MODELING: There are two different ways to model the economy.
-Bottom up modeling uses all of the principles of microeconomics (such as profit and utility maximization) and analyzes the choices made by workers, firms, consumers, and others to create a model of the economy. A bottom-up model assumes that the economy works, and thus wages and prices are flexible within a bottom-up model.
-Top down modeling is a macroeconomic aggregation (summation) which analyzes the collective behavior of larger groups (as opposed to individual actors). Thus, top down modeling focuses on total demand and supply within an economy, and also assumes wage and price rigidity.
OUR course follows the Top Down approach to macroeconomic modeling. We do not explicitly rely on microeconomic foundations here, and we are initially assuming wage and price rigidity.
REMEMEBER:
-Macroeconomics is concerned with the 'big picture'
-Macroeconomics studies aggregates and how government policy affects them (ie: the government can manipulate the economy)
-The concepts of price and quantity which we learned in Microeconomics now become the general price level (P) and the national income or production or Gross Domestic Product (Y)
-Two issues of major importance are BUSINESS CYCLES and GROWTH of Y
BUSINESS CYCLES: The cycles of the national income in the medium term
GROWTH of Y: The long term trend of national income
Macroeconomics studies FISCAL and MONETARY policy
FISCAL POLICY: Government policies regarding taxation and spending
MONETARY POLICY: Government policies regarding interest rates and the money supply
There are 5 different variables which we have to learn for macroeconomics. Y, U, P, i, & e (we call these the YUPie varaibles in Gateman's class). For each of these different variables, we will be learning what exactly the variable refers to, what historical trends have we observed regarding the variable, and why the variable is important.
-----------------------------------------------
Y: OUTPUT AND INCOME
****REMEMBER: Output generates income!
DEFINITION OF Y: Final market value of all goods and services produced in the economy during a defined period of time (usually a fiscal year).
Final- refers to the fact that intermediate goods do not count towards GPD (so you cannot count both a car and the steel needed to produce that car both as contributors to national income)
Market Value- This refers to the value of products as determined by supply and demand
Good and Services- Both concrete goods (like tomatoes) and immaterial goods (like economics classes) contribute to GDP
Produced in the economy- this refers to the fact that 'flipping' products does not add to the GDP, so a stock broker who makes a small fortune from buying and selling stocks is not technically contributing to the GDP. On the other hand, if this broker were were to create a financial brokerage service for others, this WOULD contribute to the GDP (because the broker could be seen as offering a service to others for money)
A fiscal year in Canada is usually from April of one year until April of the next year, because that is when the government unveils the budget (their plan regarding spending and taxation)
Nation Income (Y) is the 'target' at which we aim the economy- in other words, it is the variable which we seek to manipulate directly in order to make changes to the economy. The government uses fiscal and monetary policy to accomplish this task. Unemployment (U) is inversely related to growth in Y, so as national income grows, unemployment shrinks. Conversely, as the national economy shrinks, unemployment rises. Inflaction (P) is directly related to growth in Y, so as the national income grows, the general price index (aka inflation, aka P) will increase.
Just REMEMEBER THIS:
National income (Y) is the primary target of attempts to manipulate the economy
Unemployment (U) and Inflation (P) are secondary
Interest Rates (i) and Exchange Rates (e) are tertiary
So, in other words, every macroeconomic variable we deal with in this course is affected by national income.
-------------------------------
THE CIRCULAR FLOW DIAGRAM
The red arrow flowing from households to producers represents flow of factors (workers provide factors to producers so that consumers may produce products)
The black arrow flowing from producers to households represents flow of income (producers give workers wages in return for providing labour as a factor of production)
The red arrow flowing from producers to households represents flow of output or goods (households buy products from producers)
The black arrow flowing from households to producers represents flow of expenditures (households pay producers money in order to purchase goods)
The red arrows here show real flows (flows of real goods, services, and factors), while the black arrows should money flows. There are two systems represented here: the output-expenditure flow (also known as the products market) and the factor income flow (also known as the factor market)
IMPORTANT*** GDP(Y) = GDP(E) (income = expenditures)
Also, OUTPUT GENERATES INCOME (so the higher our output, the higher out income)
This basic circular flow structure is called a spendthrift economy.
If we add a bank to the system, we can call it a frugal economy. Here, actors can put money into the bank (this is called savings) and the bank can lend money out to different actors (this is called investment). If the level of savings is equal to the level of investment, then the flow of money doesn't change, and the national income remains at equilibrium (so it is constant over time)
If we add government to the system in addition to a bank, we can call it a governed economy. There difference between a government and a bank is that with a bank, withdrawal and injections of money are voluntary, where as with the government, they are imposed. Taxation is like an imposed version of savings- it takes money out of the economy, while government spending is equivalent to investment, it injects money back into the economy.
If we also add the rest of the world to our economic system, we have an open economy. Here, we can have imports, where domestic consumers purchase foreign goods, and effectively move money out of the economy, and exports where foreign consumers purchase domestic goods and effectively inject money into the economy.
JUST REMEMEBER: for any of these added institutions, as long as all money withdrawals are equal to money injections the GDP is in equilibrium!
----------------------------
GDP - Income
W, R, i, & P all refer to different flows of income- they are the returns for factors of production
W = wages- a return on labour (N)
R = economic rent - a return on land (L)
i = interest - a return on capital (K)
P = economic profits - a return on technology and entrepreneurship (T & E)
GDP - Expenditures
C, I, G, & netX all refer to different flows of expenditure- they are returns for output products (ie: payments for goods and services)
There are four plays in an economy, all of whom must accumulate expenditures
C = Consumption, or expenditures by households
I = Investment, or expenditures by firms
G = Government Expenditure, which is obviously expenditure accumulated by the government
netX = Net exports: in other words, the total number of exports minus the total number of inputs. This is foreign expenditure on domestic goods minus domestic expenditure on foreign goods (X-M).
Y has many many different synonyms. It can refer to:
-national income
-national expenditure
-output
-production
-GDP
-the real thing
-it is a measure of material wealth (the standard of living is the per-capita GDP): this is basically a measure of the material wealth of a nation)
It is NOT, however, a measure of quality of life (money can't necessarily buy happiness).
------------------------
REAL VS. NOMINAL VALUES
Nominal: Actual, current, money, refers to changeable prices and quantities
Real: Constant dollar- here, there are only changes in quantity, while holding the price constant to base year values.
REAL = NOMINAL/PRICE (so real could be the number of cars produced, nominal would be the value of cars produced in 2009, and price would be the price of each car in 2009)
***IN OUR COURSE, WE WILL ALWAYS ASSUME THAT Y IS REAL UNLESS OTHERWISE STATED.
------------------------
OUTPUT GAPS
Potential National Income (Y*) is the maximum achievable output level if all inputs are used at their NORMAL UTILIZATION RATE
Output gap = Y - Y* (actual output level minus potential output level)
If the output gap is negative, then it is a recessionary gap, and the economy is producing at less than its potential
If the output gap is positive, the it is an inflationary gap, and the economy is producing at more than its potential.
-------------------------
THE BUSINESS CYCLE: Changes in Y over real time
4 Stages:
1- Trough (recession/depression)
2- Expansion (boom/recovery)
3- Peak
4- Contraction (slump)
Recessions are downturns in economic growth: two quarters (6 months) of negative growth
Depressions are periods of persistent low growth, high unemployment, and excess capacity
HISTORICALLY, potential output has tripled since 1970, and the output gap is very cyclical (hence business cycles)
Growth varies, but average growth over the last 40 years had been 3.5% per year. Sometimes growth is negative (hence a recession)
WHY DOES NATIONAL INCOME MATTER?
Output gaps concern politicians, because inflation causes high prices which voters do not like, and unemployment also makes voters unhappy. As a result, politicians try to focus on eliminating output gaps.
Economists are more concerned by the potential output. Economic growth is a long term trend we are witnessing: per capita GDP or the standard of living is increasing over time (although this may be deceptive, as standard of living applies only to the average person. In reality, the standard of living may seen reasonable for a country when in reality, there is an enormous wealth gap between the poor and the wealthy).
That's all for today
MACROECONOMIC MODELING: There are two different ways to model the economy.
-Bottom up modeling uses all of the principles of microeconomics (such as profit and utility maximization) and analyzes the choices made by workers, firms, consumers, and others to create a model of the economy. A bottom-up model assumes that the economy works, and thus wages and prices are flexible within a bottom-up model.
-Top down modeling is a macroeconomic aggregation (summation) which analyzes the collective behavior of larger groups (as opposed to individual actors). Thus, top down modeling focuses on total demand and supply within an economy, and also assumes wage and price rigidity.
OUR course follows the Top Down approach to macroeconomic modeling. We do not explicitly rely on microeconomic foundations here, and we are initially assuming wage and price rigidity.
REMEMEBER:
-Macroeconomics is concerned with the 'big picture'
-Macroeconomics studies aggregates and how government policy affects them (ie: the government can manipulate the economy)
-The concepts of price and quantity which we learned in Microeconomics now become the general price level (P) and the national income or production or Gross Domestic Product (Y)
-Two issues of major importance are BUSINESS CYCLES and GROWTH of Y
BUSINESS CYCLES: The cycles of the national income in the medium term
GROWTH of Y: The long term trend of national income
Macroeconomics studies FISCAL and MONETARY policy
FISCAL POLICY: Government policies regarding taxation and spending
MONETARY POLICY: Government policies regarding interest rates and the money supply
There are 5 different variables which we have to learn for macroeconomics. Y, U, P, i, & e (we call these the YUPie varaibles in Gateman's class). For each of these different variables, we will be learning what exactly the variable refers to, what historical trends have we observed regarding the variable, and why the variable is important.
-----------------------------------------------
Y: OUTPUT AND INCOME
****REMEMBER: Output generates income!
DEFINITION OF Y: Final market value of all goods and services produced in the economy during a defined period of time (usually a fiscal year).
Final- refers to the fact that intermediate goods do not count towards GPD (so you cannot count both a car and the steel needed to produce that car both as contributors to national income)
Market Value- This refers to the value of products as determined by supply and demand
Good and Services- Both concrete goods (like tomatoes) and immaterial goods (like economics classes) contribute to GDP
Produced in the economy- this refers to the fact that 'flipping' products does not add to the GDP, so a stock broker who makes a small fortune from buying and selling stocks is not technically contributing to the GDP. On the other hand, if this broker were were to create a financial brokerage service for others, this WOULD contribute to the GDP (because the broker could be seen as offering a service to others for money)
A fiscal year in Canada is usually from April of one year until April of the next year, because that is when the government unveils the budget (their plan regarding spending and taxation)
Nation Income (Y) is the 'target' at which we aim the economy- in other words, it is the variable which we seek to manipulate directly in order to make changes to the economy. The government uses fiscal and monetary policy to accomplish this task. Unemployment (U) is inversely related to growth in Y, so as national income grows, unemployment shrinks. Conversely, as the national economy shrinks, unemployment rises. Inflaction (P) is directly related to growth in Y, so as the national income grows, the general price index (aka inflation, aka P) will increase.
Just REMEMEBER THIS:
National income (Y) is the primary target of attempts to manipulate the economy
Unemployment (U) and Inflation (P) are secondary
Interest Rates (i) and Exchange Rates (e) are tertiary
So, in other words, every macroeconomic variable we deal with in this course is affected by national income.
-------------------------------
THE CIRCULAR FLOW DIAGRAM
The red arrow flowing from households to producers represents flow of factors (workers provide factors to producers so that consumers may produce products)
The black arrow flowing from producers to households represents flow of income (producers give workers wages in return for providing labour as a factor of production)
The red arrow flowing from producers to households represents flow of output or goods (households buy products from producers)
The black arrow flowing from households to producers represents flow of expenditures (households pay producers money in order to purchase goods)
The red arrows here show real flows (flows of real goods, services, and factors), while the black arrows should money flows. There are two systems represented here: the output-expenditure flow (also known as the products market) and the factor income flow (also known as the factor market)
IMPORTANT*** GDP(Y) = GDP(E) (income = expenditures)
Also, OUTPUT GENERATES INCOME (so the higher our output, the higher out income)
This basic circular flow structure is called a spendthrift economy.
If we add a bank to the system, we can call it a frugal economy. Here, actors can put money into the bank (this is called savings) and the bank can lend money out to different actors (this is called investment). If the level of savings is equal to the level of investment, then the flow of money doesn't change, and the national income remains at equilibrium (so it is constant over time)
If we add government to the system in addition to a bank, we can call it a governed economy. There difference between a government and a bank is that with a bank, withdrawal and injections of money are voluntary, where as with the government, they are imposed. Taxation is like an imposed version of savings- it takes money out of the economy, while government spending is equivalent to investment, it injects money back into the economy.
If we also add the rest of the world to our economic system, we have an open economy. Here, we can have imports, where domestic consumers purchase foreign goods, and effectively move money out of the economy, and exports where foreign consumers purchase domestic goods and effectively inject money into the economy.
JUST REMEMEBER: for any of these added institutions, as long as all money withdrawals are equal to money injections the GDP is in equilibrium!
----------------------------
GDP - Income
W, R, i, & P all refer to different flows of income- they are the returns for factors of production
W = wages- a return on labour (N)
R = economic rent - a return on land (L)
i = interest - a return on capital (K)
P = economic profits - a return on technology and entrepreneurship (T & E)
GDP - Expenditures
C, I, G, & netX all refer to different flows of expenditure- they are returns for output products (ie: payments for goods and services)
There are four plays in an economy, all of whom must accumulate expenditures
C = Consumption, or expenditures by households
I = Investment, or expenditures by firms
G = Government Expenditure, which is obviously expenditure accumulated by the government
netX = Net exports: in other words, the total number of exports minus the total number of inputs. This is foreign expenditure on domestic goods minus domestic expenditure on foreign goods (X-M).
Y has many many different synonyms. It can refer to:
-national income
-national expenditure
-output
-production
-GDP
-the real thing
-it is a measure of material wealth (the standard of living is the per-capita GDP): this is basically a measure of the material wealth of a nation)
It is NOT, however, a measure of quality of life (money can't necessarily buy happiness).
------------------------
REAL VS. NOMINAL VALUES
Nominal: Actual, current, money, refers to changeable prices and quantities
Real: Constant dollar- here, there are only changes in quantity, while holding the price constant to base year values.
REAL = NOMINAL/PRICE (so real could be the number of cars produced, nominal would be the value of cars produced in 2009, and price would be the price of each car in 2009)
***IN OUR COURSE, WE WILL ALWAYS ASSUME THAT Y IS REAL UNLESS OTHERWISE STATED.
------------------------
OUTPUT GAPS
Potential National Income (Y*) is the maximum achievable output level if all inputs are used at their NORMAL UTILIZATION RATE
Output gap = Y - Y* (actual output level minus potential output level)
If the output gap is negative, then it is a recessionary gap, and the economy is producing at less than its potential
If the output gap is positive, the it is an inflationary gap, and the economy is producing at more than its potential.
-------------------------
THE BUSINESS CYCLE: Changes in Y over real time
4 Stages:
1- Trough (recession/depression)
2- Expansion (boom/recovery)
3- Peak
4- Contraction (slump)
Recessions are downturns in economic growth: two quarters (6 months) of negative growth
Depressions are periods of persistent low growth, high unemployment, and excess capacity
HISTORICALLY, potential output has tripled since 1970, and the output gap is very cyclical (hence business cycles)
Growth varies, but average growth over the last 40 years had been 3.5% per year. Sometimes growth is negative (hence a recession)
WHY DOES NATIONAL INCOME MATTER?
Output gaps concern politicians, because inflation causes high prices which voters do not like, and unemployment also makes voters unhappy. As a result, politicians try to focus on eliminating output gaps.
Economists are more concerned by the potential output. Economic growth is a long term trend we are witnessing: per capita GDP or the standard of living is increasing over time (although this may be deceptive, as standard of living applies only to the average person. In reality, the standard of living may seen reasonable for a country when in reality, there is an enormous wealth gap between the poor and the wealthy).
That's all for today
And So It Begins
I have no notes for macroeconomics as of yet. I'm not making a new blog for macro- just keep reading this one and pretend that the title says 102, and not 101. =)
Good luck to all of us...
Good luck to all of us...
Thursday, December 10, 2009
Free ECON 101 Tutoring
I blog this, I can help you out if you need.
Just come down to vanier commonsblock thursday or friday afternoon, or if that doesn't work for you, just send me an email- jsussman@telus.net
Friday, December 4, 2009
Cases Against Government Intervention!
Not every case where the government intervenes in the economy is optimal. There are many cases where intervention is probably not the best idea: for an example, should the government go crazy with spending on new infrastructure and facilities just because vancouver won the bid for the olympics?
So, what determines whether governments should intervene or provide public goods? Well, it depends on whether the social costs outweigh the social benefits (the total social costs and total social benefits- this is includes both private costs and benefits, and externalities). The social costs are the total opportunity costs of a government intervention (eg: should there be marginal cost pricing for vancouver translink? Well, the social costs are the taxpayer dollars which could have been spent in other ways: ie, to lower UBC tuition). The social benefit of an intervention is the cost of the market failure which the intervention prevents. Sometimes, by intervening and attempting to correct a market failure, a government incurs an even larger social cost than the market failure would have caused.
So is there a social benefit to a new skating oval in richmond? Absolutely not! There was no social demand for this skating oval prior to the olympics, and the money could have been spent on much more important things (eg: social housing)
PROBLEMS WITH COST-BENEFIT ANALYSIS?
-How do you quantify subjective costs and benefits to society (eg: the happiness something will bring, the future problems pollution could cause, etc)?
-It can be difficult to forecast the future, and many economic predictions rely on predictable futures (case example: many provincial governments went WAY over budget in 2009, because they did not anticipate the economic meltdown).
-Governments often discount future costs in order to benefit the present (the olympics is a perfect example: vancouver and the BC government are spending billions of dollars on a small party, which we will have to pay off, with interest, for years and years in the future)
METHODS OF GOVERNMENT INTERVENTION:
-Public provision versus user-pay: is it better for the government to own and provide a particular service, or is it better for the government to contract that service out to the private sector, and then just pay the private sector for their work? **Note: check out the handi-dart strike in Vancouver if you want a really cool look at some of the problems that can result from contracting out public work to the private sector. This goes against the right-wing principles of Gatemanism, but its definitely worth a look.
-Regulation (some problems are that there are costs to enforcing regulations, and most firms can find some kind of legal loophole to get around enforcement)
-Redistribution of income (Taking money from the rich and giving some to the poor through different social programs. socialism! Yay!)
COSTS OF INTERVENTION:
-Direct costs: The government uses real resources (ie: steel to make military vehicles)
-Indirect costs/externalities: ie, extra costs of production due to safety standards and environmental control (eg: safety goggles and pollution filters cost money), costs of compliance (eg: Red tape and pay equity), and the cost of Rent seeking (where companies pay for lobby groups to lobby the government for economic advantage).
WHY DOES THE GOVERNMENT OFTEN FAIL WHEN INTERVENING IN MARKETS? Most of the causes of government failure are systemic- they occur naturally within the system of government intervention.
Public Choice Theory:
-There are three different stakeholders for government policy
Politicians: They want to maximize their political power
Bureaucrats: Want to maximize authority and salary
Electorate: Want to maximize utility
The electorate want to maximize their total utility, and often, this is achieved when private citizens choose to IGNORE political-economic policy issues. This is called RATIONAL IGNORANCE: There is no incentive for the electorate to become informed when they only have one vote each. As a result, government can get policies which hurt the electorate passed because we don't have the information to stop them.
Rent Seeking: Special Interest Groups have an inordinate ability to lobby the government and get policies created which benefit them at the expense of everybody else.
Democratic Inefficiency and public Choice:
-One vote fails to account for preferences (so people have, in reality, very little control over the decisions the government makes)
-There is a TRADEOFF between democratic processes and efficiency (so the more democratic something is, the longer it takes to get anything done. Key examples of this include governments like Weimar Germany, which were socially democratic, but incredibly inefficient. In Weimar germany, the merits of everything had to be weighed and voted on, so it took them ages to actually get anything accomplished. Fascism, although often terrible, is much more efficient than democracy).
Government Monopolies: In industries in which there are government monopolies, there are no market forces to create innovation and further efficiencies, which can lead to stagnation. This is not good! Think of Canada Post, and how inefficient it is!
OKAY, so what is the optimum level of government intervention? Well, to decided that, you have to compare the market with government performance. Usually, this involves making value judgements, which is why so many different countries have different levels of government intervention in their economies: they have made different value judgements!
THAT'S THE END OF ECON 101!
HERE IS THE TAKE HOME MESSAGE:
1: Assume nothing. Why? Well, economics is all about putting together arguments. In order to make a good argument, you need to get rid of your assumptions, don't jump to conclusions, and evaluate the evidence clearly for yourself. Make sure your arguments are based on observable, provable facts, and not sound-bites which you've picked up from different sources.
2: Rational Wisdom: Using your smarts with a broader perspective!
-You're at least as smart as the next person. There's even the chance that you might be smarter.
-There are benefits to this: we probably get to become important people.
-On the other hand, you must use your smarts with humility and responsibility. Don't be arrogant- instead use your powers for good.
Congratulations on finishing Econ. It's study time. If you read these notes at all, share them with your friends. I'm probably going to be organizing some small scale, not-for-profit review sessions for anyone who's interested over the next couple of weeks. I'll be making a post here as soon as I've got times and dates figured out for that.
So, what determines whether governments should intervene or provide public goods? Well, it depends on whether the social costs outweigh the social benefits (the total social costs and total social benefits- this is includes both private costs and benefits, and externalities). The social costs are the total opportunity costs of a government intervention (eg: should there be marginal cost pricing for vancouver translink? Well, the social costs are the taxpayer dollars which could have been spent in other ways: ie, to lower UBC tuition). The social benefit of an intervention is the cost of the market failure which the intervention prevents. Sometimes, by intervening and attempting to correct a market failure, a government incurs an even larger social cost than the market failure would have caused.
So is there a social benefit to a new skating oval in richmond? Absolutely not! There was no social demand for this skating oval prior to the olympics, and the money could have been spent on much more important things (eg: social housing)
PROBLEMS WITH COST-BENEFIT ANALYSIS?
-How do you quantify subjective costs and benefits to society (eg: the happiness something will bring, the future problems pollution could cause, etc)?
-It can be difficult to forecast the future, and many economic predictions rely on predictable futures (case example: many provincial governments went WAY over budget in 2009, because they did not anticipate the economic meltdown).
-Governments often discount future costs in order to benefit the present (the olympics is a perfect example: vancouver and the BC government are spending billions of dollars on a small party, which we will have to pay off, with interest, for years and years in the future)
METHODS OF GOVERNMENT INTERVENTION:
-Public provision versus user-pay: is it better for the government to own and provide a particular service, or is it better for the government to contract that service out to the private sector, and then just pay the private sector for their work? **Note: check out the handi-dart strike in Vancouver if you want a really cool look at some of the problems that can result from contracting out public work to the private sector. This goes against the right-wing principles of Gatemanism, but its definitely worth a look.
-Regulation (some problems are that there are costs to enforcing regulations, and most firms can find some kind of legal loophole to get around enforcement)
-Redistribution of income (Taking money from the rich and giving some to the poor through different social programs. socialism! Yay!)
COSTS OF INTERVENTION:
-Direct costs: The government uses real resources (ie: steel to make military vehicles)
-Indirect costs/externalities: ie, extra costs of production due to safety standards and environmental control (eg: safety goggles and pollution filters cost money), costs of compliance (eg: Red tape and pay equity), and the cost of Rent seeking (where companies pay for lobby groups to lobby the government for economic advantage).
WHY DOES THE GOVERNMENT OFTEN FAIL WHEN INTERVENING IN MARKETS? Most of the causes of government failure are systemic- they occur naturally within the system of government intervention.
Public Choice Theory:
-There are three different stakeholders for government policy
Politicians: They want to maximize their political power
Bureaucrats: Want to maximize authority and salary
Electorate: Want to maximize utility
The electorate want to maximize their total utility, and often, this is achieved when private citizens choose to IGNORE political-economic policy issues. This is called RATIONAL IGNORANCE: There is no incentive for the electorate to become informed when they only have one vote each. As a result, government can get policies which hurt the electorate passed because we don't have the information to stop them.
Rent Seeking: Special Interest Groups have an inordinate ability to lobby the government and get policies created which benefit them at the expense of everybody else.
Democratic Inefficiency and public Choice:
-One vote fails to account for preferences (so people have, in reality, very little control over the decisions the government makes)
-There is a TRADEOFF between democratic processes and efficiency (so the more democratic something is, the longer it takes to get anything done. Key examples of this include governments like Weimar Germany, which were socially democratic, but incredibly inefficient. In Weimar germany, the merits of everything had to be weighed and voted on, so it took them ages to actually get anything accomplished. Fascism, although often terrible, is much more efficient than democracy).
Government Monopolies: In industries in which there are government monopolies, there are no market forces to create innovation and further efficiencies, which can lead to stagnation. This is not good! Think of Canada Post, and how inefficient it is!
OKAY, so what is the optimum level of government intervention? Well, to decided that, you have to compare the market with government performance. Usually, this involves making value judgements, which is why so many different countries have different levels of government intervention in their economies: they have made different value judgements!
THAT'S THE END OF ECON 101!
HERE IS THE TAKE HOME MESSAGE:
1: Assume nothing. Why? Well, economics is all about putting together arguments. In order to make a good argument, you need to get rid of your assumptions, don't jump to conclusions, and evaluate the evidence clearly for yourself. Make sure your arguments are based on observable, provable facts, and not sound-bites which you've picked up from different sources.
2: Rational Wisdom: Using your smarts with a broader perspective!
-You're at least as smart as the next person. There's even the chance that you might be smarter.
-There are benefits to this: we probably get to become important people.
-On the other hand, you must use your smarts with humility and responsibility. Don't be arrogant- instead use your powers for good.
Congratulations on finishing Econ. It's study time. If you read these notes at all, share them with your friends. I'm probably going to be organizing some small scale, not-for-profit review sessions for anyone who's interested over the next couple of weeks. I'll be making a post here as soon as I've got times and dates figured out for that.
Wednesday, December 2, 2009
Government Intervention: When Markets Fail
WHAT IS THE BASIC FUNCTION OF THE GOVERNMENT?
-The government has a monopoly on violence, in order to keep society from dissolving into violent anarchy (in countries where the government does not have a monopoly on violence, anarchy and civil unrest make like very difficult- just think of Somalia, or Afghanistan)
-Because the government has this monopoly on violence, they can enforce property rights laws, and prevent people for stealing other people's property
-The government's main job from an economist's perspective, then, is to enforce property rights
-By enforcing property rights and maintaining stability, governments allow for economic activity and prosperity.
OKAY!
So, for most of this course, we have been focusing on how the market works. In most of the cases we have explored, an economy regulated by the invisible hand of the market leads to the best possible outcome for society. This chapter will examine certain situations where markets fail to provide the best possible outcome for society, and how the government can intervene to correct this. We're also going to look at some inherent problems with government intervention.
Basically, when looking at any economic situation, we should ask ourselves:
-"Is the market working or failing"
-"If the market is failing, what is the optimal level of government
Markets are working best when they are allocatively efficient. Competitive markets are allocatively efficient:
-Competitive Markets use marginal cost pricing, so the price is set at the marginal cost of producing the last unit
-Competitive Markets minimize price and maximize the quantity produced
-Competitive Markets maximize economic surplus
If all markets were perfectly competitive, then the economy would be allocatively efficient. This is a pareto optimum, and neither producers not consumers would be able to add to their own surplus without causing the other to lose surplus.
PROBLEM: Most markets aren't perfectly competitive!
Here is an informal defense of natural market forces- why governments should usually just let the economy run itself.
-Free markets are automatic, flexible, and decentralized
-The price system acts like an invisible hand, regulating the market: demand affects price, which in turn, affects supply.
-There is no need for inefficient, centralized planning
-The pursuit of profits stimulates innovation and economic growth
-Power is naturally challenged through competition and innovation, so it is ultimately difficult for monopolies to exist indefinitely.
-Milton Friedman argued that economic freedom is essential to political freedom (which makes sense: if you don't have enough money to afford a house or fixed address, then you can't vote).
--------------------------------
INSTANCES OF MARKET FAILURES: Sometimes we do need the government to intervene. Sometimes, intervention is a waste of public funds. Many of the services which the government provides are, according to our prof, unnecessary and wasteful.
---------------------------------
MONOPOLIES:
-Monopolies and monopolistic competition have downward-sloping demand, so they are allocatively inefficient.
-This is due to barriers to entry
-The government usually does not obliquely try to eliminate monopolies. Instead, they either punish monopolies with regulation, or they try to create a level playing field with competition policy
-Governments can intervene in monopolies to make things more allocatively efficient
EXTERNALITIES: Non-priced costs or benefits which affect third parties
-This refers to the results of economic functioning which effect people other than the buyer and the seller (for an example, if you buy a coat of paint for your house, and then paint the ugly front of your house to make it look nicer, this creates an external benefit for your neighbor, whose property values probably will increase as a result).
-EXTERNAL ECONOMIES are external benefits, such as the added benefit your neighbor receives when you paint your house
-EXTERNAL DISECONOMIES are external costs, such as pollution or second-hand smoke.
-PRIVATE COSTS are the costs to the buyer or seller (this includes opportunity cost)
-SOCIAL COSTS are the combined external costs and private costs of any economic decision. This is the opportunity cost to society.
Externalities create unrecorded discrepancies between private costs and social costs, and result in allocative inefficiencies on a societal level
Negative externalities can be treated like an extra cost, and thus shift supply to the left!
This means that when there are negative externalities which are not taken into account, usually an economy is overproducing at too low a price. By raising prices and scaling back production, these economies can become allocatively efficient
Positive externalities can be treated like an addition to demand, and this they shift demand to the right!
This means that when there are positive externalities which are not taken into account, usually an economy is underproducing at too low a price. By increasing production and raising prices, these economies can become allocatively efficient.
Governments can correct externalities by forcing corporations to pay for negative externalities as an added cost.
APPLICATIONS OF EXTERNALITIES:
Here are some negative externalities which are fairly well known
-Nuisance externalities (pollution is considered a nuisance in legal terms)
-Open access resources (eg: fish in the Fraser river. There is a negative externality, in that catching the fish depletes fish stocks and reduces the availability of fish in the future).
-Congestion of highways (The fact that cars take up space on the highway is not taken into account, so even though it doesn't cost to use the highway, a negative externality is created from the frustration and irritation of having to deal with too many extra drivers)
-A famous example is the tragedy of the commons. In olden days when peasants still had commons land where they could let their animals graze, many peasants failed to take into account the cost of maintaining the grass and animal food supply of the commons. As a result, they overused the commons, and eventually all of the natural animal food become depleted, so the livestock died of starvation. This is an example of overproduction (overuse of the commons) due to a failure to factor external diseconomies into social costs.
PUBLIC GOODS: Sometimes, governments must intervene in order to provide society with a specific kind of good which markets cannot provide. Here are the characteristic of a pure public good:
1: It must be non rivalrous- in other words, consuming this good will not reduce the ability of others to consume this good (a good example of this is information-- gathering information from a sources does not hinder anyone else from gathering that information (unless you are stealing library books or something stupid like that)
2: Non excludability- If this good is produced, it must be a product which can be consumed equally by all- there are no restrictions in who is allowed and not allowed to use the good (so within the context of Gateman's class, the lecture itself is non-excludable. Everyone in the class is equally able to listen to the lecture and learn about economics from it). Example here include a lighthouse, or national defence.
Normal Goods: Rivalrous and Excludable-- This includes most goods which are sold on a market, such as chocolate bars, legal advice, plane tickets, etc. Governments can let markets take care of the distribution of normal goods. The market works here!
Common Property Goods: Rivalrous and Non Excludable-- This includes goods which anybody can access, despite their being a limited supply of the good. Examples include camping sites, or fish stocks. Often, common property goods suffer from the tragedy of the commons, and are overused because negative externalities are not factored into private costs. The market fails due to external diseconomies here!
Psuedo Public Goods: Non-Rivalrous and Excludable-- This includes goods which do not deppreciate when consumed, but which are distributed in such a way that some people are excluded from using them. Examples include art galleries, day care, roads, public parks, education, and others. The fact that these are non-rivalrous implies that supply is always greater than demand, so this excess supply will often push the price of a quasi public good down to zero. Often, the government provides these as merit goods. The market fails due to $0 price demanded, here!
Pure Public Goods: Non-Rivalrous and Non Excludable-- These are goods which do not deppreciate with use, and which are accessible to everyone. This includes things like national defence, a ligthouse signal, public information, and public protection. The free rider problem means than consumers usually will not reveal their price preferences, because they would rather someone else pay for the pure public good (everyone wants a free ride). As such, the government must use taxation to force everybody to pay for this good, or else, the good will not be produced. As such, we need the government to intervene. The market fails due to the free rider effect here!
So we need the government to intervene!
ASYMMETRY OF INFORMATION: This is where the buyer and the seller have different levels of knowledge about a particular good
a MORAL HAZARD, is an example of assymetry of information where one party has the ability and incentive to shift costs onto the other party due to some special knowledge which they posess (for example, a car mechanic could trick you into getting expensive work done on your car which you don't need). Another example is a used car salesman inflating the price of a used car.
ADVERSE SELECTION is an example of assymetry of information where "self selection" adverse affects the group. Because people who are poor drivers are more likely to purchase insurance, and isurance companies often have no way of evaluating each customer's driving abilities, poor drivers increase the overall cost of insurance at the expense of good drivers. Similarly, people who are unhealthy pay the same medical premiums as everyone else, yet cost the medical system much more money. Here, there are negative externalities created by adverse selection. The private cost to a smoker for using the hospital is less than the social cost of that hospital visit.
THE PRINCIPLE AGENT PROBLEM: Where top employees for a company seek to maximize revenues (and their own salaries) at the expense of net profits. Here, marginal social benefits and marginal social costs are not equated, so the firm is inefficient.
THUS WE HAVE A CASE FOR GOVERNMENT INTERVENTION
OTHER SOCIAL GOALS: Sometimes, governments seek to intervene for reasons other than market failures! Here are some of them
-Income redistribution (many people think this a fairer way of allocating wealth. Professor Gateman thinks its just a throwback to communism)
-Merit Goods: The government provides goods which are not pure public goods based on their Merit to society (eg: Healthcare and education). They cold technically also be provided by private groups.
-Social obligations (eg: jury duty, conscription, voting, etc.)
-Economic Growth (research and developement)
That's all for now!
-The government has a monopoly on violence, in order to keep society from dissolving into violent anarchy (in countries where the government does not have a monopoly on violence, anarchy and civil unrest make like very difficult- just think of Somalia, or Afghanistan)
-Because the government has this monopoly on violence, they can enforce property rights laws, and prevent people for stealing other people's property
-The government's main job from an economist's perspective, then, is to enforce property rights
-By enforcing property rights and maintaining stability, governments allow for economic activity and prosperity.
OKAY!
So, for most of this course, we have been focusing on how the market works. In most of the cases we have explored, an economy regulated by the invisible hand of the market leads to the best possible outcome for society. This chapter will examine certain situations where markets fail to provide the best possible outcome for society, and how the government can intervene to correct this. We're also going to look at some inherent problems with government intervention.
Basically, when looking at any economic situation, we should ask ourselves:
-"Is the market working or failing"
-"If the market is failing, what is the optimal level of government
Markets are working best when they are allocatively efficient. Competitive markets are allocatively efficient:
-Competitive Markets use marginal cost pricing, so the price is set at the marginal cost of producing the last unit
-Competitive Markets minimize price and maximize the quantity produced
-Competitive Markets maximize economic surplus
If all markets were perfectly competitive, then the economy would be allocatively efficient. This is a pareto optimum, and neither producers not consumers would be able to add to their own surplus without causing the other to lose surplus.
PROBLEM: Most markets aren't perfectly competitive!
Here is an informal defense of natural market forces- why governments should usually just let the economy run itself.
-Free markets are automatic, flexible, and decentralized
-The price system acts like an invisible hand, regulating the market: demand affects price, which in turn, affects supply.
-There is no need for inefficient, centralized planning
-The pursuit of profits stimulates innovation and economic growth
-Power is naturally challenged through competition and innovation, so it is ultimately difficult for monopolies to exist indefinitely.
-Milton Friedman argued that economic freedom is essential to political freedom (which makes sense: if you don't have enough money to afford a house or fixed address, then you can't vote).
--------------------------------
INSTANCES OF MARKET FAILURES: Sometimes we do need the government to intervene. Sometimes, intervention is a waste of public funds. Many of the services which the government provides are, according to our prof, unnecessary and wasteful.
---------------------------------
MONOPOLIES:
-Monopolies and monopolistic competition have downward-sloping demand, so they are allocatively inefficient.
-This is due to barriers to entry
-The government usually does not obliquely try to eliminate monopolies. Instead, they either punish monopolies with regulation, or they try to create a level playing field with competition policy
-Governments can intervene in monopolies to make things more allocatively efficient
EXTERNALITIES: Non-priced costs or benefits which affect third parties
-This refers to the results of economic functioning which effect people other than the buyer and the seller (for an example, if you buy a coat of paint for your house, and then paint the ugly front of your house to make it look nicer, this creates an external benefit for your neighbor, whose property values probably will increase as a result).
-EXTERNAL ECONOMIES are external benefits, such as the added benefit your neighbor receives when you paint your house
-EXTERNAL DISECONOMIES are external costs, such as pollution or second-hand smoke.
-PRIVATE COSTS are the costs to the buyer or seller (this includes opportunity cost)
-SOCIAL COSTS are the combined external costs and private costs of any economic decision. This is the opportunity cost to society.
Externalities create unrecorded discrepancies between private costs and social costs, and result in allocative inefficiencies on a societal level
Negative externalities can be treated like an extra cost, and thus shift supply to the left!
This means that when there are negative externalities which are not taken into account, usually an economy is overproducing at too low a price. By raising prices and scaling back production, these economies can become allocatively efficient
Positive externalities can be treated like an addition to demand, and this they shift demand to the right!
This means that when there are positive externalities which are not taken into account, usually an economy is underproducing at too low a price. By increasing production and raising prices, these economies can become allocatively efficient.
Governments can correct externalities by forcing corporations to pay for negative externalities as an added cost.
APPLICATIONS OF EXTERNALITIES:
Here are some negative externalities which are fairly well known
-Nuisance externalities (pollution is considered a nuisance in legal terms)
-Open access resources (eg: fish in the Fraser river. There is a negative externality, in that catching the fish depletes fish stocks and reduces the availability of fish in the future).
-Congestion of highways (The fact that cars take up space on the highway is not taken into account, so even though it doesn't cost to use the highway, a negative externality is created from the frustration and irritation of having to deal with too many extra drivers)
-A famous example is the tragedy of the commons. In olden days when peasants still had commons land where they could let their animals graze, many peasants failed to take into account the cost of maintaining the grass and animal food supply of the commons. As a result, they overused the commons, and eventually all of the natural animal food become depleted, so the livestock died of starvation. This is an example of overproduction (overuse of the commons) due to a failure to factor external diseconomies into social costs.
PUBLIC GOODS: Sometimes, governments must intervene in order to provide society with a specific kind of good which markets cannot provide. Here are the characteristic of a pure public good:
1: It must be non rivalrous- in other words, consuming this good will not reduce the ability of others to consume this good (a good example of this is information-- gathering information from a sources does not hinder anyone else from gathering that information (unless you are stealing library books or something stupid like that)
2: Non excludability- If this good is produced, it must be a product which can be consumed equally by all- there are no restrictions in who is allowed and not allowed to use the good (so within the context of Gateman's class, the lecture itself is non-excludable. Everyone in the class is equally able to listen to the lecture and learn about economics from it). Example here include a lighthouse, or national defence.
Normal Goods: Rivalrous and Excludable-- This includes most goods which are sold on a market, such as chocolate bars, legal advice, plane tickets, etc. Governments can let markets take care of the distribution of normal goods. The market works here!
Common Property Goods: Rivalrous and Non Excludable-- This includes goods which anybody can access, despite their being a limited supply of the good. Examples include camping sites, or fish stocks. Often, common property goods suffer from the tragedy of the commons, and are overused because negative externalities are not factored into private costs. The market fails due to external diseconomies here!
Psuedo Public Goods: Non-Rivalrous and Excludable-- This includes goods which do not deppreciate when consumed, but which are distributed in such a way that some people are excluded from using them. Examples include art galleries, day care, roads, public parks, education, and others. The fact that these are non-rivalrous implies that supply is always greater than demand, so this excess supply will often push the price of a quasi public good down to zero. Often, the government provides these as merit goods. The market fails due to $0 price demanded, here!
Pure Public Goods: Non-Rivalrous and Non Excludable-- These are goods which do not deppreciate with use, and which are accessible to everyone. This includes things like national defence, a ligthouse signal, public information, and public protection. The free rider problem means than consumers usually will not reveal their price preferences, because they would rather someone else pay for the pure public good (everyone wants a free ride). As such, the government must use taxation to force everybody to pay for this good, or else, the good will not be produced. As such, we need the government to intervene. The market fails due to the free rider effect here!
So we need the government to intervene!
ASYMMETRY OF INFORMATION: This is where the buyer and the seller have different levels of knowledge about a particular good
a MORAL HAZARD, is an example of assymetry of information where one party has the ability and incentive to shift costs onto the other party due to some special knowledge which they posess (for example, a car mechanic could trick you into getting expensive work done on your car which you don't need). Another example is a used car salesman inflating the price of a used car.
ADVERSE SELECTION is an example of assymetry of information where "self selection" adverse affects the group. Because people who are poor drivers are more likely to purchase insurance, and isurance companies often have no way of evaluating each customer's driving abilities, poor drivers increase the overall cost of insurance at the expense of good drivers. Similarly, people who are unhealthy pay the same medical premiums as everyone else, yet cost the medical system much more money. Here, there are negative externalities created by adverse selection. The private cost to a smoker for using the hospital is less than the social cost of that hospital visit.
THE PRINCIPLE AGENT PROBLEM: Where top employees for a company seek to maximize revenues (and their own salaries) at the expense of net profits. Here, marginal social benefits and marginal social costs are not equated, so the firm is inefficient.
THUS WE HAVE A CASE FOR GOVERNMENT INTERVENTION
OTHER SOCIAL GOALS: Sometimes, governments seek to intervene for reasons other than market failures! Here are some of them
-Income redistribution (many people think this a fairer way of allocating wealth. Professor Gateman thinks its just a throwback to communism)
-Merit Goods: The government provides goods which are not pure public goods based on their Merit to society (eg: Healthcare and education). They cold technically also be provided by private groups.
-Social obligations (eg: jury duty, conscription, voting, etc.)
-Economic Growth (research and developement)
That's all for now!
Wednesday, November 25, 2009
Productive and Allocative Efficiency for different market structure
We know that there are 4 different market structures in economics.
Now we're going to explore the idea of efficiency
PRODUCTIVE EFFICIENCY:
-This is when firms minimize the cost of inputs required to produce a given number of outputs
-This is also when firms maximize the quantity of outputs given a set combination of inputs (or set amount of money to spend on inputs)
-This is maximizing the input/output ratio (the greatest bang for your buck)
-Either hold output constant and minimize inputs (in other words, get on the LRAC curve, because the LRAC shows the combination of inputs which will cost the least in order to produce any quantity of output): This is the condition needed to reach productive efficiency for individual firms
OR
-Hold inputs constant and maximize outputs (get on the Production Possibilities Boundary)
In order for the industry to reach productive efficiency, each individual firm must have the same marginal costs because if one firm has lower marginal costs, then it is more efficient for that industry to switch to favor the lower cost producer.
CONCLUSION: In order to reach the production possibilities boundary for any one industry, both individual firms and entire industries must be productively efficient
ALLOCATIVE EFFICIENCY:
-The Allocative Concept is build around the idea of Pareto Optimality: a scenario where we cannot make someone better off without making someone else worse off. The allocative concept states that it is good to reach Pareto Optimality, because there, the mix of commodities which are produced match the mix of commodities which are desired by consumers. Allocative efficiency refers to a quality of an entire industry- not just an individual firm. While there can be many productively efficient points on a production possibilities boundary, only ONE of these is allocatively efficient.
-Allocative efficiency is one definition for "the best society can do"
CONDITIONS FOR ALLOCATIVE EFFICIENCY:
-We know that consumers will buy any one product up until the marginal benefit equals the marginal cost of that product
-The marginal benefit is the marginal value of any unit of a product minus the price
-THEREFORE, consumers buy units of a product until the price is equal to the marginal cost
-Perfect competition uses MARGINAL COST PRICING
-If the marginal benefit to the consumer outweighs the marginal cost to the producer, too little is being produced from society's viewpoint
-If the marginal benefit to the consumer is smaller than the marginal cost to the producer, then too much is being produced from society's viewpoint
ALL INDUSTRIES MUST EQUATE PRICE TO MARGINAL COSTS in order to that industry to be allocatively efficient
ECONOMIC SURPLUS MAXIMIZATION:
-Economic surplus maximization is allocatively efficient because it maximizes total surplus for all members of society
-This occurs when the price is equal to the point where demand equals supply (as it will in perfect competition). Here, total economic surplus is maximized and there is no dead weight social loss
-With free markets (where demand and supply naturally reach an equilibrium), it is impossible to make either the producers or the consumers better off without hurting the other: THIS IS PARETO OPTIMUM! This is the best scenario for society!
To test for allocative efficiency, we must ensure that:
-Price is equal to marginal cost
-Total economic surplus is maximized- there is no dead weight social loss!
--------------------------
PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH A PPC Curve
ANY POINT ON THE PPC IS PRODUCTIVELY EFFICIENT, because by definition, the PPC is the maximum level of output where all inputs are fully employed and productively efficient
ONLY ONE POINT ON THE PPC IS ALLOCATIVELY EFFICIENT, because only one combination of outputs will exactly match consumer's demands. On any other point, a tradeoff could be made in order to better one group of consumers without making anyone worse off. At the one point of allocative efficiency, no one can be made better off.
It is possible to produce too much or too little of either product.
REMEMBER: If the price is lower than the marginal cost, the producer is getting ripped off. Meanwhile, if the price is higher than the marginal cost, then the consumer is getting ripped off.
-----------------
EFFICIENCY IN PERFECT COMPETITION AND MONOPOLIES
PERFECT COMPETITION
CONDITION ONE: Is each firm producing on the LRAC in the long run? YES, because in the long run, all firms in perfect competition will produce at minimum efficiency scale.
CONDITION TWO: Is the marginal cost equal for all firms? Yes, because all firms in perfect competition face the same prices, and at the MES output level, marginal cost will = the price for all firms!
As a result, no reallocation among firms can lower industry costs: Firms in perfect competition are productive efficient!
In perfect competition, firms maximize their profits by producing where the price is equal to the marginal cost (marginal cost pricing). This will guarantee Pareto Optimality if all firms are in perfect competition: Why? Because here, there is no deadweight social loss, so both consumer and producer surpluses are maximized
Any output greater than or less than QE will reduce the total sum of producer and consumer surplus
IN SUMMARY: For perfect competition,
-Firms will produce at the minimum efficiency scale, so individual firms are productively efficient
-Marginal costs are equal for all firms, so the industry is productively efficient
-Price is equal to the average cost minimum, so in the long run, firms only make normal profits
-Price = marginal cost, so this market structure is allocatively efficient
MONOPOLIES AND EFFICIENCY
Monopolies are productively efficient!
-In the long run, the monopolist will be on the long run average cost curve (although not necessarily at MES). Why? Because monopolies want to maximize their profits by minimizing costs.
-This is productively efficient
-NOTE: The long run average cost for monopolies may be abnormally high (due to high fixed costs and excess capacity)
Monopolies are not allocatively efficient in the long run!
-To maximize profits, monopolies produce where marginal revenue equals marginal costs
-BUT, marginal revenue falls much more quickly than average revenue (price) as output increases, and thus, price will be greater than the monopolist's marginal costs at the monopoly's selected output level
-Because MC < P, the consumer is getting ripped off in a monopoly, and as such, monopolies are allocatively ineffienct
P > MC
Price is higher and quantity produced is lower than it would be if that same industry was in perfect competition
There is a deadweight social loss
WHEN INDUSTRIES CARTELIZE, THERE IS A DEADWEIGHT SOCIAL LOSS
See?
Now we're going to explore the idea of efficiency
PRODUCTIVE EFFICIENCY:
-This is when firms minimize the cost of inputs required to produce a given number of outputs
-This is also when firms maximize the quantity of outputs given a set combination of inputs (or set amount of money to spend on inputs)
-This is maximizing the input/output ratio (the greatest bang for your buck)
-Either hold output constant and minimize inputs (in other words, get on the LRAC curve, because the LRAC shows the combination of inputs which will cost the least in order to produce any quantity of output): This is the condition needed to reach productive efficiency for individual firms
OR
-Hold inputs constant and maximize outputs (get on the Production Possibilities Boundary)
In order for the industry to reach productive efficiency, each individual firm must have the same marginal costs because if one firm has lower marginal costs, then it is more efficient for that industry to switch to favor the lower cost producer.
CONCLUSION: In order to reach the production possibilities boundary for any one industry, both individual firms and entire industries must be productively efficient
ALLOCATIVE EFFICIENCY:
-The Allocative Concept is build around the idea of Pareto Optimality: a scenario where we cannot make someone better off without making someone else worse off. The allocative concept states that it is good to reach Pareto Optimality, because there, the mix of commodities which are produced match the mix of commodities which are desired by consumers. Allocative efficiency refers to a quality of an entire industry- not just an individual firm. While there can be many productively efficient points on a production possibilities boundary, only ONE of these is allocatively efficient.
-Allocative efficiency is one definition for "the best society can do"
CONDITIONS FOR ALLOCATIVE EFFICIENCY:
-We know that consumers will buy any one product up until the marginal benefit equals the marginal cost of that product
-The marginal benefit is the marginal value of any unit of a product minus the price
-THEREFORE, consumers buy units of a product until the price is equal to the marginal cost
-Perfect competition uses MARGINAL COST PRICING
-If the marginal benefit to the consumer outweighs the marginal cost to the producer, too little is being produced from society's viewpoint
-If the marginal benefit to the consumer is smaller than the marginal cost to the producer, then too much is being produced from society's viewpoint
ALL INDUSTRIES MUST EQUATE PRICE TO MARGINAL COSTS in order to that industry to be allocatively efficient
ECONOMIC SURPLUS MAXIMIZATION:
-Economic surplus maximization is allocatively efficient because it maximizes total surplus for all members of society
-This occurs when the price is equal to the point where demand equals supply (as it will in perfect competition). Here, total economic surplus is maximized and there is no dead weight social loss
-With free markets (where demand and supply naturally reach an equilibrium), it is impossible to make either the producers or the consumers better off without hurting the other: THIS IS PARETO OPTIMUM! This is the best scenario for society!
To test for allocative efficiency, we must ensure that:
-Price is equal to marginal cost
-Total economic surplus is maximized- there is no dead weight social loss!
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PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH A PPC Curve
ANY POINT ON THE PPC IS PRODUCTIVELY EFFICIENT, because by definition, the PPC is the maximum level of output where all inputs are fully employed and productively efficient
ONLY ONE POINT ON THE PPC IS ALLOCATIVELY EFFICIENT, because only one combination of outputs will exactly match consumer's demands. On any other point, a tradeoff could be made in order to better one group of consumers without making anyone worse off. At the one point of allocative efficiency, no one can be made better off.
It is possible to produce too much or too little of either product.
REMEMBER: If the price is lower than the marginal cost, the producer is getting ripped off. Meanwhile, if the price is higher than the marginal cost, then the consumer is getting ripped off.
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EFFICIENCY IN PERFECT COMPETITION AND MONOPOLIES
PERFECT COMPETITION
CONDITION ONE: Is each firm producing on the LRAC in the long run? YES, because in the long run, all firms in perfect competition will produce at minimum efficiency scale.
CONDITION TWO: Is the marginal cost equal for all firms? Yes, because all firms in perfect competition face the same prices, and at the MES output level, marginal cost will = the price for all firms!
As a result, no reallocation among firms can lower industry costs: Firms in perfect competition are productive efficient!
In perfect competition, firms maximize their profits by producing where the price is equal to the marginal cost (marginal cost pricing). This will guarantee Pareto Optimality if all firms are in perfect competition: Why? Because here, there is no deadweight social loss, so both consumer and producer surpluses are maximized
Any output greater than or less than QE will reduce the total sum of producer and consumer surplus
IN SUMMARY: For perfect competition,
-Firms will produce at the minimum efficiency scale, so individual firms are productively efficient
-Marginal costs are equal for all firms, so the industry is productively efficient
-Price is equal to the average cost minimum, so in the long run, firms only make normal profits
-Price = marginal cost, so this market structure is allocatively efficient
MONOPOLIES AND EFFICIENCY
Monopolies are productively efficient!
-In the long run, the monopolist will be on the long run average cost curve (although not necessarily at MES). Why? Because monopolies want to maximize their profits by minimizing costs.
-This is productively efficient
-NOTE: The long run average cost for monopolies may be abnormally high (due to high fixed costs and excess capacity)
Monopolies are not allocatively efficient in the long run!
-To maximize profits, monopolies produce where marginal revenue equals marginal costs
-BUT, marginal revenue falls much more quickly than average revenue (price) as output increases, and thus, price will be greater than the monopolist's marginal costs at the monopoly's selected output level
-Because MC < P, the consumer is getting ripped off in a monopoly, and as such, monopolies are allocatively ineffienct
P > MC
Price is higher and quantity produced is lower than it would be if that same industry was in perfect competition
There is a deadweight social loss
WHEN INDUSTRIES CARTELIZE, THERE IS A DEADWEIGHT SOCIAL LOSS
See?
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