Supplement lecture notes final exam Microeconomics

This summary was written in the year 2012-2013.

Micro-economics lecture 6

General equilbrium and economic efficiency, externalities and public goods

General equilibrium and economic efficiency

In partial equilibrium (this was before the ‘normal’ equilibrium) we presumed that the activities of one market were independent of the other markets. Now we’ll look at the general equilibrium, where all markets simultaneously are determined with feedback. A feedback effect is a price/quantity change in one market which is caused by a price/quantity change in another related market.

Assume you have two products; movie tickets and dvd’s. Say that the supply curve for movie tickets goes up, because for example the tax on movie tickets increases. In the partial equilibrium, the equilibrium price would increase as well. However in the general equilibruimà the demand for dvd rental increases, so the price of dvd’s will also increase.

Thus this equilibrium also increases. This results in the fact that going to the movie will become more attractive again. This is called the feedback mechanism and it will continue until a new equilibrium price is reached. In a complete analysis, the prices and quantities of both the goods would be determined simultaneously. Without the feedback analysis, the effects of tax etc on prices would be underestimated.

An outcome (allocation of resources) is Pareto efficient when there is no other outcome that would make everyone better off. Thus an efficient outcome maximizes the surplus.

Adam Smith’s (1776) invisible hand theory explains that if everybody follows/maximizes its own self interest, this would lead to an efficient allocation of the resources in a country.

To set the efficient use of the inputs in production, assume that: - there are fixed total supplies of two inputs; L and K; - you produce two products: X and Y; - income (L) is divided over X and Y (consumption), so there is a connection between income and consumption because income is spent on the products which the people themselves produce; - change in input prices, leads to changes in income and demand and thus there is a feedback effect; - there is technical efficiency

The Production Possibility Frontier shows the different combinations of two products that can be produced with a fixed quantity number of inputs. It describes efficiently the produced level of the two products. It also assumes that technology is fixed and every point that is not on this curve is inefficient (so all the point on the curve are efficient). The PPF slopes downward because producing more of good X means producing less of good Y.

The Marginal Rate of Transformation (MRT) measures how many units of good Y the economy should give up in order to produce another unit of good X. It is the negative of the slope, because we want to have a positive number. The MRT is increasing, thus PPF is concave. MRTx,y = MCx/MCy.

The output of overall efficiency means that the goods are produced at the minimum costs and they are in combinations with what people want to pay for the goods. The efficient production/Pareto allocation occurs when MRS=MRT. The intersection point between the PPF and the indifference curve is the efficiency point (MRS=MRT).

With perfect competition; MRSx,y = Px/Py and MCx=Px and MCy=Py à MRT = MCx/MCy=PCx/PCy à so Px/Py = MRT = MRS and perfect competition leads to overall efficiency. When there is an excess demand of product X and an excess supply of product Y (and the point is no longer on the PPF), the price of good X will increase and the price of good Y decrease until the point is on the PPF again. 

Perfect competition leads to 1) exchange efficiency à MRS = Px/Py 2) efficiency in production à w/r 3) efficiency in output à MRS = MRT.

When market circumstances are not perfect, there might be ineffective outcomes and there is market failure and the government might intervent:

• Market power; (MR=MC is not P) not enough production and inefficiency
• Incomplete or assymetric information; moral hazard and adverse information
• Externalities; effects are not reflected in the price
• Public goods; market leads to undersupply

Markets with asymmetric information

In this situation the buyers and sellers have different information about a product or a quality (for example with second hand goods). You start with a two different markets (one for higher and one for lower quality) with two different equilibria. Buyers then don’t see the quality and get on mediocre cars and they are willing to pay less for higher quality and more for lower quality. Thus the demand for high quality cars decreases and the demand for low quality increases and the average will be an ever lower quality car. This continues until only low quality cars are sold. Market signaling is when a seller sends signals to a buyer to persuade the consumer to buy its product. For example showing that you studied at a good university. If you have had a better education, you’ll probably have a better salary and the costs for the firm will be lower.

Moral hazard is when the probability an event that happens is affected by the behaviour of someone, but other people cannot monitor its behaviour (because of lack of information for example). An example is when people are insured for accidents, they’ll be more likely to drive less safely.

Externalities and public goods

An externality occurs when action by economic agent (consumer or producer) affects other economic agents but is not reflected in the price, those externalities can be positive (when it has a positive effect) or negative (when it has a negative effect). Marginal Economic Costs, MEC, (also Marginal Demand) is extra costs of externality caused by every extra unit of production by the company.

Marginal Social Costs (MSC) is MC + MEC. The difference between MSC, P and MC are the social costs of a single company. The difference between MSC, Demand and MC are the aggregate social costs of negative externality.

Within a company there is a trade-off between lower emissions and higher costs of production. The lower the emissions, the higher the costs of reducing them even further. When the marginal abatement costs are higher than the marginal social costs, it would cost more than what the people would gain when there is less abatement. The profit is maximized when the level of abatement is zero. The optimal efficient level of emissions, E*, is where MSC = MCA (marginal costs of abatement).

A company can be induced to reduce emissions to E* by: - emission standards (set a limit); -emission fees (charge levied on every unit of emission); -transferable emission permits (create a market for externalities). Total abatement is above E* and total fees are under E*. Total costs of a company (total fee + total abatement costs) at E* < fee if emissions are not reduced to E*.

Standards are used when the actual fee is lower than the most efficient fee, however fees are more useful for the government most of the time because the government gets money in this way.

There can be economic efficiency without intervention of the government when the externality affects few companies and the property rights are well specified. A specific kind of externality is ‘common property resource’ which means that everyone has free access and no one has to pay. So it is likely that this product will be overutilized, for example air and water.

Public goods: the government becomes the producer of goods and services. There are two characteristics: 1) the good is nonrival; the MC of providing the product to one extra consumer is zero 2) the good is nonexclusive; people cannot be excluded from consuming the product (or maybe at very high costs). Defense is for example a public good, whereas ice cream is a private product.

In case of a private good every consumer has the same price, but has a different level of units used à horizontal summation of individual demand curves: there is efficiency if MB1=MB2=MB3=MC.

In case of public good every consumer uses the same amount, but every one has a different valuation of the good (price = willingness to pay = marginal benefit) àvertical summation of the individual demand curves: there is efficiency if MB1+MB2+MB3=MC.

• It is impossible to provide public goods and services without free benefit for everyone.
• Households don’t have the incentive to pay what it is worth to them.
• Free riders understate the value of the good so that they can make use of it without paying for it.
• Once the good is supplied, the MC per consumer is zero. A private company will not supply the good efficiently (P = MC = 0), therefore there is undersupply.
• The government production of a public good may have advantages for the government, because it can raise taxes/fees to make use of the product.