c Pareto efficiency requires production of the right things at the lowest cost. B D Q**

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1 1 INTRODUCTION A Normative Approach, the role of government is to promote the public interest 1 Improve economic efficiency a Production (technical, management) efficiency b Allocative efficiency c Dynamic efficiency 2 Macroeconomic stabilization and growth 3 Fairness (equity) 4 Other objectives (many non-economic but with economic repercussions) a Sovereignty b Bilingualism c Unity B Positive Approach, government responds to "interests". Government may act in order to implement policies prescribed by normative analysis. In addition, government may act in ways that do not promote public interests due to special interest groups or self-interest of bureaucrats or politicians.

2 2 FOUR CORE CONCEPTS: A Opportunity Cost: the opportunity cost of any action is the "value of the best foregone alternative". 1 "Value" may or may not be in dollar terms (work versus leisure) 2 "Best" foregone alternative B Marginalism: emphasis on the impacts of incremental changes. 1 "Maximization" implies that any policy or activity should be carried out as long as the marginal benefit exceeds the marginal opportunity cost. C Economic Incentives: we assume that individuals will pursue their self interest. 1 Policy makers should carefully consider the likely impacts of policies on economic incentives. 2 Unforeseen effects of policy changes often involve failure to account for economic incentives. D Economic Efficiency 1 Management (also called production or technical) efficiency: using the fewest resources to produce a given output. 2 Pareto (also called allocational or allocative) efficiency: limited resources are allocated to produce the most valued output. As a result it is impossible to make anyone better off without making someone worse off. a Allocative or Pareto inefficiency involves a deadweight loss (a loss of welfare to society as a whole). b A potential Pareto improvement takes place if the gainers gain enough to fully compensate the losers and still be better off.

3 3 Brander Fig. 2.1 $ pa A MC F M C A B D QA Q* Quantity c Pareto efficiency requires production of the right things at the lowest cost. $ pa A M C (in e ffic ie n t) M C (e ffic ie n t) F MCA B D QA Q* Q** Quantity By moving to the lower MC curve, the surplus can be increased at no cost to anyone (i.e., someone can be made better off without making anyone worse off). E Dynamic Efficiency: the optimal introduction of new products and processes over time. 1 Productive and Pareto efficiency are "static" in nature.

4 2 Dynamic efficiency is very difficult to measure as it involves what could be as opposed to what is. 4

5 5 REVIEW OF MICROECONOMICS A Microeconomics focuses on the determination of equilibrium price and quantity in individual markets. B Equilibrium price and quantity are driven by supply and demand factors. 1 Consumers are the decision makers on the demand side of the market. 2 "Firms" are the decision makers on the supply side of the market. C The "Firm" 1 What is a firm? A collection of transactions that are done more efficiently through "command" than through market transactions. Using markets involves transactions costs (search, negotiation, policing, and enforcement). 2 Firms are assumed to seek maximum profits. Separation of ownership from control in large corporations leads to problems (primarily Principalagent problems). D Demand 1 The concept of marginal utility. Unit Consumed (one taco) Total Utility (utils) 0 0 1st 10 2nd 18 3rd 24 4th 28 5th 30 6th 30 7th 28 Marginal Utility (utils)

6 6 2 Construction of the demand curve. 10 Marginal Utility Quantity The area under the demand curve represents the "value" of that quantity of product consumed. It is the sum of the marginal value of each unit. 3 Own Price elasticity of demand F Costs Q Q P P = ε a Determinants of Elasticity: (1) Substitutes (2) Necessity versus discretionary (3) Share of budget 1 Accounting versus economic costs 2 Short run costs a Fixed and sunk b Variable c Marginal d Diminishing returns to the fixed factor (the explanation for the convex short run ATC curve)

7 7 $ MC ATC c AVC b a 0 z y x Q 3 Long run cost a The long run average total cost curve is an "envelope" of short run ATC curves. b Economies and diseconomies of scale (explanation for the convex long run ATC curve) Brander 6.3a U shaped long run average cost curve $ Long run average total cost E conom ies of Scale C ons tant R etu rns to Scale Diseconom ies of Scale M inim um E ffic ient S cale (M E S ) Q ua ntity

8 8 Brander 6.3b L shaped long run average cost curve $ E conom ies of Scale C ons tant R etu rns to Scale Long run average total cost M inim um E ffic ient S cale (M E S ) Q ua ntity G Supply Under Perfect Competition 1 Assumptions: a Many sellers b Many buyers c Homogeneous product d No barriers to entry or exit e Symmetrical information between buyers and sellers f Low transactions costs 2 Price and quantity determination a Perfect competition faces constant marginal revenue curve b Maximizes profit by equating MR = MC c Supply curve for firm is its MC curve, for industry is the sum of firms' MC curves d After entry and exit, produces at where MC=ATC=MR=Price

9 9 P MC ATC P S D Individual Supplier Q Market Q 3 Efficiency consequences of perfect competition (Pareto efficiency achieved) a Production efficiency achieved (production at minimum ATC) b Allocative efficiency achieved (P=MC) c Pareto efficiency achieved P Supply P > MC P < MC each additional unit is worth more than its resource cost Q c Demand Q each additonal unit is worth less than its resource cost H Supply under Monopoly 1 Assumptions: a One seller, many buyers b No good substitutes for the product or service c Blockaded entry 2 Monopolist faces downward sloped demand curve, and therefore declining marginal revenues

10 10 3 Profit maximizes by equating MR=MC. There is NO supply curve. 4 Efficiency consequences of Monopoly (Pareto efficiency not achieved) a Production efficiency may or may not be achieved. (1) X inefficiency (2) Rent seeking expenditures b Allocative efficiency is not achieved (MR=MC<P). Too little is produced. c Outcome is Pareto inefficient. Assume MC is constant (i.e., doesn't change) over the relevant range of output. U n i t C o s ts ( $ ) A Pm C Pc D B ATC=MC MR Demand Q m Q c Q u a n tity Under perfect competition consumer surplus is PcAB. What happens to this surplus under monopoly? The consumers still get a consumer surplus of PmAC. The monopolist gets profits of PcPmCD. Who gets DCB? NOBODY! This is the deadweight loss of monopoly.

11 11 5 The case of the Natural Monopoly U n it C o s ts ($ ) D em and ATC Q uantity MC Costs decline over the relevant range of demand - the market will "support" just one firm. I Supply under Monopolistic Competition 1 Assumptions: a Many sellers, but they do recognize some interdependence b Heterogeneous products or services c Moderate barriers to entry and exit. 2 Price and quantity - efficiency outcomes. a Price a little above MC b Output a little less than at minimum ATC c Not terribly inefficient

12 12 $ ATC P MC MR Demand Q Q u a n tity J Supply under Oligopoly 1 Assumptions a So few sellers that interdependence is strongly recognized. (core assumption) b Products can be homogeneous or heterogeneous. c There are substantial barriers to entry and exit. 2 There is no single model of oligopoly! 3 The Cournot model Note, Figure 6-5 is wrong (it is a duplicate of the monopolistic competition diagram).. The essence of the Cournot model is that each firm bases its output decision assuming an output level for the other firm(s) in the market. The model captures the notion of interdependence (one firm's output depends upon the other's) in a non-cooperative setting (the firms do not agree on output). Each firm has what is called a reaction function. Firm 1's reaction function shows how much Firm 1 will produce given each possible output of Firm 2. Figure 6-5 should look like the following. The analysis goes like this. Firm 1 thinks Firm 2 will produce nothing so chooses to produce quantity A. Firm 2 observes this and chooses to supply B. Firm 1 sees that Firm 2 is producing B and reacts by producing C. And so forth. Ultimately they will end up at Z which is a stable position as neither has any motivation to change output.

13 F i r m 1 s o u t p u t 13 F irm 2 s reac tio n func tio n A C Z F irm 1 s reac tio n func tio n B Firm 2 s output A more rigorous formulation is set out at the end of this note. I do not expect you to be able to do the derivation but I do expect you to have the general idea. 4 Nash equilibrium: this type of equilibrium exists when each player is doing the best that he/she can give the other player's strategy. The Cournot equilibrium is a Nash equilibrium. 5 Game Theory. a Game theory is one way of modeling oligopoly markets. A simple game is the prisoner's dilemma FIRM 1 FIRM 2 Cooperate Defect Cooperate 40, 40 0, 70 Defect 70, 0 20, 20 6 Equilibrium price and quantity and efficiency outcome: because there is no single model of oligopoly it is not possible to produce a unique equilibrium price and quantity without considerable information on how firms behave (do they cooperate, collude, cheat each other, compete, predate, etc.).

14 14 K Structure, Conduct and Performance STRUCTURE CONDUCT PERFORMANCE Number of Sellers Pricing Behaviour Technical Efficiency Number of Buyers Product Strategy Allocative Efficiency Condition of Entry & Exit Product Differentiation Dynamic Efficiency (Progressiveness) Equity 1 A critical element in structure is the number of sellers. We will use these measures again so they should be learned. a Concentration ratio. This is the market share of the largest 4 or 8 firms. It is abbreviated as CR4 or CR8 which refers to the four or eight firm concentration ratio. A CR4 of 78% means the top four firms account for 78% of the market. b The Herfindahl index. H index = (%S 1 ) 2 + (%S 2 ) 2 + (%S 3 ) 2 + (%S 4 ) 2 + (%S 5 ) (%S n ) 2 Where S 1 is the market share of the first firm, S 2 is the market share of the second firm, and so forth. In the case of a monopoly, H index = (100) 2 = 10,000. This is the maximum value the H index can take. If there were two firms in the industry, with market shares of 75% and 25% respectively, the H index would be: (75) 2 + (25) 2 = 5, = 6,250 If there were 100 firms with 1% of the market each, the H index would be: (1) 2 + (1) 2 + (1) 2 + (1) 2 + (1) 2 + (1) 2 + (1) (1) 2 = 100 The larger the number of firms and the more equal their market share, the smaller the H Index.

15 15 APPENDIX COURNOT EQUILIBRIUM Assume two producers of spring water, Vichy and Perrier. Assume industry demand is P = 2,000 Q, where Q = Qv + Qp Qv = Vichy's sales Qp = Perrier's sales MC = ATC = 0 for both (the water just bubbles out of the ground) Both want to maximize profits given the other's quantity. Vichy: TRv = P * Qv = (2,000 Qv Qp) (Qv) = 2,000Qv Qv 2 QvQp dr/dqv = marginal revenue = 2,000 2Qv Qp MC = 0; profit maximization implies MC = MR = 0 = 2,000 2Qv Qp, solving for Qv, 2Qv = 2,000 Qp; Qv = 1,000 Qp/2 This is Vichy's Reaction Function Same logic holds for Perrier: result, Qp = 1,000 Qv/2 This is Perrier's Reaction Function Plot these.

16 Perrier's Reaction Function Vichy's Reaction Function Quantity Perrier Quantity Vichy Now, solve for Qv to obtain the Cournot equilibrium Vichy: Qv = 1,000 Qp/2 Perrier: Qp = 1,000 Qv/2; rearranging, Qv/2 = 1,000 Qp; rearranging, Qv = 2,000 2Qp Simultaneous equations: Qv = 1,000 Qp/2 -Qv = -2, Qp 0 = -1, Qp 1.5Qp = 1,000 Qp = , and solving for Qv =