Econ351 Lecture 2. Review of Main Economic Concepts

Econ351 Lecture 2. Review of Main Economic Concepts

Lecture outline Rationality Consumer surplus Costs (opportunity costs, social vs. private costs, sunk costs) Efficiency (productive and allocative) Compensated Pareto improvement Examples illustrating efficiency concepts Externalities and market failures

Rationality An economic actor is rational if he maximizes something (preferences) and his preferences are stable and satisfy certain assumptions (esp., transitivity) Individuals maximize utility ; firms maximize profit (or perhaps something else) Without maximizing behavior, it is hard to model (predict) behavior

Optimization condition MB=MC Maximization of utility in a continuous case generally involves reaching a point where marginal benefit of having (or doing) something is equal to its marginal cost: max BB xx CC(xx) BB xx = CCC(xx) xx In a discrete case it s a point at which the benefit from having the last unit of a good is > or = the cost of that last unit and the benefit of one additional unit of a good is < or = to the cost of that additional unit (Implicit assumption: declining MB and non-decreasing MC or more generally, that MB-MC is declining; what is this condition called?) Example: Oranges cost $1/unit; I value 1 st orange at $5, 2d orange at $3, 3d orange at $1.50, 4 th orange at $0.5. How many oranges do I purchase to maximize my utility?

Consumer surplus What is the maximum amount I would be willing to pay for three oranges if the alternative is to have none? $9.50 How much I will actually pay in a market? $3 The difference ($6.50) is consumer surplus, which is useful in evaluating the benefits of various public projects, as well as legal arrangements

Opportunity cost Opportunity cost of a resource is the value that this resource has in the next best alternative use What is opportunity cost of a $1 orange? What is opportunity cost of leisure? What is opportunity cost of going to college? What is opportunity cost of buying and consuming $10 worth of goods today? See http://crookedtimber.org/2015/08/18/the-opportunity-cost-of-war/ for opportunity cost of war

Example "You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your nextbest alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50."

Example (cont.) Answer: $10 your alternative net benefit = the difference between the $50 that seeing Dylan s concert would be worth to you and the $40 you would have to pay for a ticket 21.6% of professional economists answered correctly (lower percentage than if they chose randomly) Among students who had taken a course in economics, 7.4% answered correctly, compared with 17.2% of those who had never taken one

Opportunity cost (cont.) In competitive markets, opportunity cost determines what the price of a good is What happens if the market price of oranges exceeds opportunity cost of resources needed to produce oranges? What happens if the market price of oranges is lower than opportunity cost of resources needed to produce oranges?

Social vs. private costs Somebody has stolen $100 from me. What is my private cost? What is the social cost? What is the cost to Nick s of having Upstairs Pub across the road? What is the social cost? The condition for social optimization: SMC=SMB

Sunk cost Sunk costs are costs that have been incurred and are no longer recoverable ( sunk costs are sunk ) Examples of sunk cost fallacy: I might as well keep eating because I already bought the food (Thaler s pizza experiment) I might as well keep going to a bad/useless class that I paid for I shouldn t sell this stock, because I bought it for a higher price

Efficiency Productive efficiency Allocative efficiency Example: person A has 4 apples and no oranges and person B has 5 oranges and no apples. Suppose A hates apples but likes oranges and that B hates oranges and loves apples. Is the initial allocation of apples and oranges efficient? Is it possible to redistribute apples and oranges in such a way as to improve the welfare of both?

Pareto efficiency An allocation of resources among economic actors is called Pareto-efficient if it is not possible to improve welfare of any one party without reducing welfare of somebody else Pareto improvement (example: voluntary transactions between individuals that do not affect third parties) Compensated Pareto improvement

Example Consider a town with three people, A, B, and C They want to decide whether to build a bridge over a nearby river and how to pay for it. Bridge cost: $900 Valuations: A -- $400; B -- $400; C -- $200 Tax & build: tax each person $300 and build the bridge

Example (cont.) Is the tax & build scheme a Pareto-improvement over no bridge state? Why? Is the tax & build scheme compensated Paretoimprovement over no bridge state? Why? The difference between Pareto-improvement and compensated Pareto-improvement is essentially the transaction costs (TC) of negotiating side-payments; TC is high Pareto-improvement is hard to achieve via voluntary negotiations

Example (cont.) Is voting a good mechanism for achieving compensated Pareto-improvements? Given the numbers above, voting works But what if valuations are as follows: A -- $600, B -- $200, C -- $200? Can you think of valuations such that tax & build scheme is not efficient, but voting leads to building the bridge? Moreover, if there are more than two alternatives, voting cycles are possible

Example (cont.) If valuations are known, it is always possible to design such a tax scheme that depends on valuations that would result (via voting) in the bridge being built if and only if it is a compensated Pareto-improvement But valuations are usually not public information. If taxes depend positively on valuations people report, people would have incentives to understate their valuations. This is one problem with compensated concepts.

Externalities Examples of externalities: Pollution, education, network externalities Externalities can cause market failure; other potential reasons for market failure: Monopoly, public goods, asymmetric info However, market failure should not necessarily be a cause for government or legislative fix; we should always compare the potential costs of market failure with the costs of government failure

Is economic approach to law too simplistic?