Microeconomics 2 Janka

Definition of Externalities

An externality occurs when one person's actions affect the well-being of a bystander without compensation.

Types of Externalities

Negative externalities (e.g., pollution, smoking) cause harm, while positive externalities (e.g., immunizations, technological advancements) provide benefits.

Negative Effects of Externalities lead markets to

produce more than is socially optimal.

Positive Effects of Externalities result in

underproduction.

Socially Optimal Output is where

the social cost curve (which includes externalities) intersects with the demand curve, below the market equilibrium.

Goods with positive externalities have a

social value higher than the private value, leading to underproduction in the market.

Socially Optimal Production quantity is

where the social benefit curve intersects with the supply curve, above the market equilibrium.

Government Subsidies for Positive Externalities can encourage

production of goods with positive externalities, promoting societal benefits.

How can externalities sometimes be resolved privately?

Using moral codes, charities, business integration, or contracts.

The Coase Theorem

If private parties can bargain without costs, they can efficiently solve externality problems on their own.

What can prevent private solutions from being effective>

Transaction costs, bargaining problems, and coordination.

Command-and-Control Policies

Government regulations that directly mandate specific actions or behaviors to correct market inefficiencies, particularly those caused by externalities.

Pigovian taxes definition

Discourage harmful activities by making them more expensive.

Subsidies definition

Encourage beneficial activities by making them cheaper

Tradable Pollution Permits

Permits that allow firms to trade the right to pollute, creating a market where firms with lower reduction costs sell to those with higher costs.

Role of Government in Externalities

When private solutions fail, governments must step in, either through regulations or market-based policies.

Difference between Command-and-Control Policies and Market-Based Solutions

Command-and-Control policies-strict government regulations that must be followed (no flexibility). Market-Based Solutions-give companies freedom using financial incentives (like taxes or subsidies) to encourage them to act in ways that benefit society.

Market Failure in Free Goods

When goods are free, private markets can’t regulate their production or consumption efficiently, often leading to the need for government intervention.

Goods are categorized based on two factors

whether they are excludable (can people be prevented from using them?) and rival (does one person’s use reduce availability for others?)

Four Types of Goods

Private Goods: Excludable and rival (e.g., food). Public Goods: Neither excludable nor rival (e.g., national defense). Common Resources: Rival but not excludable (e.g., fish in the ocean). Natural Monopolies: Excludable but not rival (e.g., cable TV).

Free-Rider Problem

A free rider is someone who benefits from a good without paying for it, which makes it hard for private markets to provide public goods.

Government Solution to Free-Riders

Governments can provide public goods if the total benefit exceeds the cost, funded through taxation.

Optimal Provision of Public Goods

Governments should provide a public good up to the point where the marginal social benefit equals the marginal cost.

Common Resources

Not excludable but they are rival, meaning one person’s use reduces availability for others.

Tragedy of the Commons

A situation where individuals overuse common resources because they aren’t charged for them, leading to depletion (e.g., overfishing, pollution).

Examples of Common Resources

Clean air, water, congested roads, and wildlife

Merit Goods

Under-consumed goods (e.g., education) because individuals don’t always recognize their full benefits. Governments often step in to promote their consumption through subsidies or regulations.

Government Role in Merit Goods

Governments provide subsidies for health, education, and pensions because people often underestimate future risks and benefits.

De-merit Goods

Goods like alcohol that are over-consumed because people fail to consider the full social costs (e.g., healthcare, anti-social behavior).

Market Failure and Property Rights

Market failures occur when property rights aren’t well-defined, meaning no one has legal authority over certain resources (e.g., clean air).

Government and Market Failure

Governments can step in to solve market failures caused by poorly defined property rights by implementing regulations or establishing ownership.

Private Solutions to Common Resource Overuse

Private parties can come together to manage common resources effectively. Examples include community agreements and cooperatives that manage local resources like fisheries or forests.

Information Asymmetry

Occurs when one party in a transaction has more or better information than the other party.

Government Inefficiencies

Situations where government intervention or policies fail to allocate resources effectively, often due to factors like poor information, bureaucratic delays, political pressures, or the influence of special interest groups.

Behavioral Economics

Field that combines insights from psychology and economics to understand how individuals actually behave, as opposed to how traditional economic models predict they should behave.

Moral hazard

The risk that individuals or entities will engage in riskier behavior when they do not bear the full consequences.

Adverse selection

When the uninformed party ends up dealing with unfavorable selections due to hidden information, such as buyers avoiding used cars or insurance companies being disproportionately chosen by those with hidden health issues.

Market Responses to Asymmetric Information

Signaling: Informed parties reveal their private information to reduce information gaps (e.g., educational degrees). Screening: Uninformed parties induce the informed party to reveal information (e.g., insurance companies requiring medical check-ups).

Public choice theory

How government decisions are influenced by self-interest, lobbying, and political pressures, often leading to inefficiencies or outcomes that do not align with the public interest.

The Condorcet Paradox

When majority rule fails to produce consistent societal preferences.

Arrow’s Impossibility Theorem

Demonstrates that no voting system can perfectly reflect collective preferences while satisfying all fairness criteria.

The Median-Voter Theorem

Majority rule will reflect the preferences of the median voter, potentially sidelining minority preferences.

Logrolling

The practice of trading votes among legislators to secure the passage of each other’s proposals or policies, often benefiting special interest groups.

Rent-Seeking

The act of individuals or groups attempting to gain financial benefits or advantages through government intervention, such as subsidies or favorable regulations, without contributing to productivity.

a person’s earnings depend on factors like

supply and demand for labor, natural ability, human capital, and compensating differentials.

Income inequality is measured by

dividing the population into quintiles and analyzing the share of income each group receives.

The Lorenz curve

visually represents income inequality by plotting cumulative income earned by each percentile of the population.

Factors Behind Increased U.S. Income Inequality

Changes in technology and increased international trade with low-wage countries

The poverty rate

the percentage of people whose income falls below a government-determined threshold.

in-kind transfers

non-cash benefits such as healthcare and food stamps

income life cycle

income fluctuations over time

transitory income

temporary income changes

Economic mobility

The ability of people to move between income classes. Factors like luck, effort, and inheritance play roles in determining mobility.

The role of government in redistributing income is a normative question, explored through three main political philosophies:

Utilitarianism-Maximize happiness by redistributing income to help the poorest. Liberalism-Use the veil of ignorance to create fair policies for the least advantaged. Libertarianism-Limit government to protecting individual rights.

Policies to Reduce Poverty

Minimum-wage laws, Welfare programs, Negative income tax, In-kind transfers

The effect of minimum-wage laws depends on

the elasticity of demand for labor.

Workfare

Recipients work in exchange for benefits.

the earnings gap between skilled and unskilled workers has increased significantly due to two primary reasons:

International trade: Increasing trade with low-wage countries has decreased demand for unskilled labor in developed countries. Technological change: New technologies favor skilled workers, raising their wages.

The Superstar Phenomenon

In certain industries, the best performers (e.g., athletes, entertainers) can serve a large audience at low cost, leading to much higher earnings than average workers

Wages can be set above equilibrium due to:

Minimum-wage laws, Unions, Efficiency wages

Discrimination occurs when

People with similar qualifications receive different opportunities based on race, gender, or other characteristics.

John Rawls' theory

The "veil of ignorance"- To create fair policies, we should imagine making decisions without knowing our own social position, wealth, or abilities. This ensures decisions benefit the least advantaged and promote fairness and equality.