Chapter16

Monopoly

➤In monopolistic competition there are many competing producers, each with a differentiated product,
and free entry and exit in the long run.

➤ Product differentiation can occur in oligopolies that fail to achieve tacit collusion as well as in
monopolistic competition. It takes three main forms: by style or type, by location, or by quality. The
products of competing sellers are considered imperfect substitutes.

➤ Producers compete for the same market, so entry by more producers reduces the quantity each
existing producer sells at any given price. In addition, consumers gain from the increased diversity of
products

➤ Like a monopolist, each firm in a monopolistically competitive industry faces a downward-sloping

demand curve and marginal revenue curve. In the short run, it may earn a profit or incur a loss at its
profit-maximizing quantity.

➤ If the typical firm earns positive profit, new firms will enter the industry in the long run, shifting each
existing firm’s demand curve to the left. If the typical firm incurs a loss, some existing firms will exit the
industry in the long run, shifting the demand curve of each remaining firm to the right.
In the long run, a monopolistically competitive industry ends up in zero-profit equilibrium: each firm
makes zero profit at its profit-maximizing quantity.

➤ In the long-run equilibrium of a monopolistically competitive industry, there are many firms, each
earning zero profit.

➤ Price exceeds marginal cost, so some mutually beneficial trades are unexploited.

➤ Monopolistically competitive firms have excess capacity because they do not minimize average total
cost. But it is not clear that this is actually a source of inefficiency since consumers gain from product
diversity.

➤ In industries with product differentiation, firms advertise in order to increase the demand for their
products.

➤ Advertising is not a waste of resources when it gives consumers useful information about products.

➤ Advertising that simply touts a product is harder to explain. Either consumers are irrational, or
expensive advertising communicates that the firm’s products are of high quality.

➤ Some firms create brand names. As with advertising, the economic value of brand names can be
ambiguous. They convey real information when they assure consumers of the quality of a product.
 17 chapter
 The marginal social cost of pollution is the additional cost imposed on society as a
whole by an additional unit of pollution.
 The marginal social benefit of pollution is the additional gain to society as a whole from
an additional unit of pollution.
 The socially optimal quantity of pollution is the quantity of pollution that society would
choose if all the costs and benefits of pollution were fully accounted for.

 An external cost is an uncompensated cost that an individual or firm imposes on

others.
 An external benefit is a benefit that an individual or firm confers on others without
receiving compensation.

Pollution is an example of an external cost, or negative externality; in contrast, some activities

can give rise to external benefits, or positive externalities. External costs and benefits are known
as externalities.
Left to itself, a market economy will typically generate too much pollution because polluters
have no incentive to take into account the costs they impose on others.
  In an influential 1960 article, the economist Ronald Coase pointed out that, in an ideal
world, the private sector could indeed deal with all externalities.
 According to the Coase theorem, even in the presence of externalities an economy can
always reach an efficient solution provided that the transaction costs—the costs to
individuals of making a deal—are sufficiently low.
 The costs of making a deal are known as transaction costs.

 The implication of Coase’s analysis is that externalities need not lead to inefficiency
because individuals have an incentive to find a way to make mutually beneficial deals
that lead them to take externalities into account when making decisions.
 When individuals do take externalities into account, economists say that they
internalize the externality.
 Transaction costs prevent individuals from making efficient deals.

Examples of transaction costs include the following:

 The costs of communication among the interested parties—costs that may be very high
if many people are involved.
 The costs of making legally binding agreements that may be high if doing so requires the
employment of expensive legal services.
 Costly delays involved in bargaining—even if there is a potentially beneficial deal, both
sides may hold out in an effort to extract more favorable terms, leading to increased
effort and forgone utility.

Policies Toward Pollution:

 Environmental standards are rules that protect the environment by specifying actions
by producers and consumers. Generally such standards are inefficient because they are
inflexible.
 An emissions tax is a tax that depends on the amount of pollution a firm produces.
 Tradable emissions permits are licenses to emit limited quantities of pollutants that can
be bought and sold by polluters.
 Taxes designed to reduce external costs are known as Pigouvian taxes.
  When the quantity of pollution emitted can be directly observed and controlled,
environmental goals can be achieved efficiently in two ways: emissions taxes and
tradable emissions permits.
 These methods are efficient because they are flexible, allocating more pollution
reduction to those who can do it more cheaply.
 An emissions tax is a form of Pigouvian tax, a tax designed to reduce external costs.
 The optimal Pigouvian tax is equal to the marginal social cost of pollution at the socially
optimal quantity of pollution.

 When there are external costs, the marginal social cost of a good or activity exceeds the
industry’s marginal cost of producing the good.
 In the absence of government intervention, the industry typically produces too much of
the good.
 The socially optimal quantity can be achieved by an optimal Pigouvian tax, equal to the
marginal external cost, or by a system of tradable production permits.

The marginal social benefit of a good or activity is equal to the marginal benefit that accrues to
consumers plus its marginal external benefit.
 A Pigouvian subsidy is a payment designed to encourage activities that yield external
benefits.
 A technology spillover is an external benefit that results when knowledge spreads
among individuals and firms. The socially optimal quantity can be achieved by an
optimal Pigouvian subsidy equal to the marginal external benefit.
 An industrial policy is a policy that supports industries believed to yield positive
externalities.
 The marginal social cost of a good or activity is equal to the marginal cost of production
plus its marginal external cost.
 A good is subject to a network externality when the value of the good to an individual is
greater when a large number of other people also use the good.
 Any way in which other people’s consumption of a good increases your own marginal
benefit from consumption of that good can give rise to network effects.
 A good is subject to positive feedback when success breeds greater success and failure
breeds failure.

Chapter 18

Public Goods and Common Resources

Characteristics of Goods

A good is excludable if the supplier of that good can prevent people who do not pay from
consuming it.

A good is a rival in consumption if the same unit of the good cannot be con- sumed by
more than one person at the same time.

A good that is both excludable and rival in consumption is a private good.

When a good is non excludable, the supplier cannot prevent consumption by people who
do not pay for it.

A good is nonrival in consumption if more than one person can consume the same unit of
the good at the same time.

Because goods can be either excludable or nonexcludable, rival or nonrival in con-

sumption, there are four types of goods, illustrated by the matrix in Figure:
Why Markets Can Supply Only Private Goods Efficiently

Goods that are nonexcludable suffer from the free-rider problem: individuals have no
incentive to pay for their own consumption and instead will take a “free ride” on anyone
who does pay.

Public Goods

A public good is both nonexcludable and nonrival in consumption.

Here are some other examples of public goods:

■ Disease prevention. When doctors act to stamp out the beginnings of an epidemic before
it can spread, they protect people around the world.
■ National defense. A strong military protects all citizens.
■ Scientific research. More knowledge benefits everyone.

Figure 18-2 illustrates the efficient provision of a public good, showing three marginal
benefit curves.
Cost-Benefit Analysis

Governments engage in cost-benefit analysis when they estimate the social costs and social
benefits of providing a public good.

Common Resources

A common resource is nonexcludable and rival in consumption: you can’t stop me from
consuming the good, and more consumption by me means less of the good available for
you.

The Problem of Overuse

Common resources left to the market suffer from overuse: individuals ignore the fact that
their use depletes the amount of the resource remaining for others.

The Efficient Use and Maintenance of a Common Resource

There are three fundamental ways to induce people who use common resources to
internalize the costs they impose on others.

■ Tax or otherwise regulate the use of the common resource

■ Create a system of tradable licenses for the right to use the common resource
■ Make the common resource excludable and assign property rights to some individuals

Artificially Scarce Goods

An artificially scarce good is exclud- able but nonrival in consumption.

 Chapter 19

The economics of the welfare state

The term "welfare state" refers to a type of governing in which the national government plays a
key role in the protection and promotion of the economic and social well-being of its citizens. A
welfare state is based on the principles of equality of opportunity, equitable distribution of
wealth, and public responsibility for those unable to avail themselves of the minimal provisions
of a good life. Social Security, federally mandated unemployment insurance programs,
and welfare payments to people unable to work are all examples of the welfare state.
Most modern countries practice some elements of what is considered the welfare state. That said,
the term is frequently used in a derogatory sense to describe a state of affairs where the
government in question creates incentives that are beyond reason, resulting in an unemployed
person on welfare payments earning more than a struggling worker. The welfare state is
sometimes criticized as being a "nanny state" in which adults are coddled and treated like
children.
• The welfare state is a way of governing in which the state or an established group of social
institutions provides basic economic security for its citizens.
• By definition, in a welfare state, the government is responsible for the individual and social
welfare of its citizens.
• Most modern countries have programs that are reflective of a welfare state, such as unemployment
insurance and welfare payments.
• However, the term "welfare state" is a charged one, as critics of such a system say it involves too
much government involvement in the lives and well-being of citizens.

Understanding the Welfare State

The welfare state has become a target of derision. Under this system, the welfare of its citizens is
the responsibility of the state. Some countries take this to mean offering unemployment benefits
and base level welfare payments, while others take it much further with universal healthcare, free
college, and so on. Despite most nations falling on a spectrum of welfare state activity, with few
holdouts among the most developed nations, there is a lot of charged rhetoric when the term
comes up in conversation. A lot of this owes to the history of the welfare state.

The History of the Welfare State

Although fair treatment of citizens and a state-provided standard of living for the poor dates back
further than the Roman Empire, the modern welfare states that best exemplify the historical rise
and fall of this concept are the U.K. and the United States. From the 1940s to the 1970s, the
welfare state in the U.K.—based on the Beveridge Report—took hold, leading to a growth in the
government to replace the services that were once provided by charities, trade unions, and the
church. In the U.S., the groundwork for the welfare state grew out of the Great Depression and
the massive price paid by the poor and the working poor during this period.
The U.K.'s system grew despite some spirited opposition by Margaret Thatcher in the 1980s, and
it continues today although it frequently needs restructuring and adjustments to keep it from
getting too unwieldily. The U.S. never went to the extent of the U.K., let alone somewhere like
Germany or Denmark, and Ronald Reagan had much more success than Thatcher in shrinking
government. Many people look at the differing economic growth rates of the U.S. and the U.K.
throughout periods where the welfare state flourished and floundered to make conclusions on
whether it is good or bad for a nation as a whole.
Special Considerations

While it is true that the government is rarely the most cost-effective agent to deliver a program, it
is also true that the government is the only organization that can potentially care for all its
citizens without being driven to do so as part of another agenda. Running a welfare state is
fraught with difficulties, but it is also difficult to run a nation where large swaths of the
population struggle to get the food, education, and care needed to better their personal situation.

Chapter 20

Physical capital – consist of manufactured productive resources such as equipment,

buildings, tools, and machines.
Human capital is the improvement in labour created by education and knowledge that is
embodied in the workforce.
The factor distribution of income is the division of total income among labor, land, and
capital.
In a perfectly competitive market economy, the price of the good multiplied by the
marginal product labor is equal to the value of the marginal product of labor: VMPL = P ×
MPL. A profit-maximizing producer hires labor up to the point at which the value of the
marginal product of labor is equal to the wage rate: VMPL = W. The value of the marginal
product of labor curve slopes downward due to diminish- ing returns to labor in
production.
The value of the marginal product of a factor is the value of the additional output
generated by employing one more unit of that factor.
The value of the marginal product curve of a factor shows how the value of the marginal
product of that factor depends on the quantity of the factor employed.

The market demand curve for labor is the horizontal sum of all the individual demand
curves of producers in that market.
There are three main aspects that causes factor demand curves to shift:
1) Changes in prices of goods
2) Changes in supply of other factors
3) Changes in technology
As in the case of labor, producers will employ land or capital until the point at which its
value of the marginal product is equal to its rental rate. According to the marginal
productivity theory of income distribution, in a perfectly competitive economy each factor
of production is paid its equilibrium value of the marginal product.
The equilibrium value of the marginal product of a factor is the additional value produced
by the last unit of that factor employed in the factor market as a whole.
The rental rate of either land or capital is the cost, explicit or implicit, of using a unit of that
asset for a given period of time.

Existing large disparities in wages both among individuals and across groups lead some to
question the marginal productivity theory of income distribution.
Compensating differentials, as well as differences in the values of the marginal products of
workers that arise from differences in talent, job experience, and human capital, account
for some wage disparities.
Market power, in the form of unions or collective action by employers, as well as the
efficiency-wage model, also explain how some wage disparities arise.
Discrimination has historically been a major factor in wage disparities. Market competition
tends to work against discrimination.
The choice of how much labor to supply is a problem of time allocation: a choice between
work and leisure.
A rise in the wage rate causes both an income and a substitution effect on an individual's
labor supply. The substitution effect of a higher wage rate induces longer work hours, other
things equal. This is countered by the income effect: higher income leads to a higher
 demand for leisure, a normal good. If the income effect dominates, a rise in the wage rate
can actually cause the individual labor supply curve to 66 slope the "wrong" way:
downward.

The market labor supply curve is the horizontal sum of the individual labor supply curves of
all workers in that market. It shifts for four main reasons: changes in prefer ences and social
norms, changes in population, changes in opportuni ties, and changes in wealth.

Chapter 21. Uncertainty, Risk, and Private Information

 A random variable is a variable with an uncertain future value.

 The expected value of a random variable is the weighted average of all possible values, where
the weights on each possible value correspond to the probability of that value occurring.

 A state of the world is a possible future event.

 Risk is uncertainty about future outcomes. When the uncertainty is about monetary outcomes,
it becomes financial risk.

Expected value of a random variable

EV = (P1 × S1) + (P2 × S2) + . . . + (PN × SN)

 Expected utility is the expected value of an individual’s total utility given uncertainty about
future outcomes.
  A premium is a payment to an insurance company in return for the insurance company’s
promise to pay a claim in certain states of the world.

 A fair insurance policy is an insurance policy for which the premium is equal to the expected
value of the claim.

 Risk-averse individuals will choose to reduce the risk they face when that reduction leaves the
expected value of their income or wealth unchanged.

Expected utility

(Probability of state H × Total utility in state H) +

(Probability of state S × Total utility in state S)

= (0.5 × UH) + (0.5 × US)

 The funds that an insurer places at risk when providing insurance is called the insurer’s
capital at risk.
 An efficient allocation of risk is an allocation of risk in which those who are most willing
to bear risk are those who end up bearing it

 Two possible events are independent events if each of them is neither more nor less
likely to happen if the other one happens.

 An individual can engage in diversification by investing in several different things, so that

the possible losses are independent events.

 A share in a company is a partial ownership of that company.

 Pooling is a strong form of diversification in which an investor takes a small share of the
risk in many independent events. This produces a payoff with very little total overall risk.

 Two events are positively correlated if each event is more likely to occur if the other
event also occurs.

 Private information is information that some people have that others do not.

 Adverse selection occurs when an individual knows more about the way things are than
other people do. Private information leads buyers to expect hidden problems in items
offered for sale, leading to low prices and the best items being kept off the market.

 Adverse selection can be reduced through screening: using observable information about
people to make inferences about their private information.

 Adverse selection can be diminished by people signaling their private information through
actions that credibly reveal what they know.

 A long-term reputation allows an individual to reassure others that he or she isn’t

concealing adverse private information.

 Moral hazard occurs when an individual knows more about his or her own actions than
other people do. This leads to a distortion of incentives to take care or to exert effort
when someone else bears the costs of the lack of care or effort.

 A deductible in an insurance policy is a sum that the insured individual must pay before
being compensated for a claim