BBA Principles of Economic Notes

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THE ECONOMICS OF THE PUBLIC SECTOR

Maximized total benefit

Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market.

Externalities and Market Inefficiency Notes

An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.
Externalities cause markets to be inefficient, and thus fail to maximize total surplus.
- An externality arises…
. . . when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.
When the impact on the bystander is adverse, the externality is called a negative externality.
When the impact on the bystander is beneficial, the externality is called a positive externality.
Negative Externalities
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building

Positive Externalities
Immunizations
Restored historic buildings
Research into new technologies

Negative externalities lead markets to produce a larger quantity than is socially desirable.
Positive externalities lead markets to produce a smaller quantity than is socially desirable.

Welfare Economics A Recap

The Market for Aluminum
The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.
If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.
The Market for Aluminum
For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

Negative Externalities Notes

The intersection of the demand curve and the social-cost curve determines the optimal output level.
The socially optimal output level is less than the market equilibrium quantity.
Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.
Achieving the Socially Optimal Output
The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

Positive Externalities Principles of Economic Notes

When an externality benefits the bystanders, a positive externality exists.
The social value of the good exceeds the private value.
A technology spillover is a type of positive externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.
The intersection of the supply curve and the social-value curve determines the optimal output level.
The optimal output level is more than the equilibrium quantity.
The market produces a smaller quantity than is socially desirable.
The social value of the good exceeds the private value of the good.
Internalizing Externalities: Subsidies
Used as the primary method for attempting to internalize positive externalities.
Industrial Policy
Government intervention in the economy that aims to promote technology-enhancing industries
Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention.
The patent is then said to internalize the externality.

PRIVATE SOLUTIONS TO EXTERNALITIES Notes

Government action is not always needed to solve the problem of externalities.
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses
Contracting between parties

The Coase Theorem Principles of Economic Notes

The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
Transactions Costs
Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.

Why Private Solutions Do Not Always Work

Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

PUBLIC POLICY TOWARD EXTERNALITIES

When externalities are significant and private solutions are not found, government may attempt to solve the problem through .
command-and-control policies.
market-based policies.
Command-and-Control Policies
Usually take the form of regulations:
Forbid certain behaviors.
Require certain behaviors.
Examples:
Requirements that all students be immunized.
Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).
Market-Based Policies
Government uses taxes and subsidies to align private incentives with social efficiency.
Pigovian taxes are taxes enacted to correct the effects of a negative externality.
Examples of Regulation versus Pigovian Tax
If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could…
tell the firm to reduce its pollution by a specific amount (i.e. regulation).
levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).
Market-Based Policies
Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another.
A market for these permits will eventually develop.
A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

Public Goods and Common Resource

“The best things in life are free. . .”

Free goods provide a special challenge for economic analysis.
Most goods in our economy are allocated in markets…
When goods are available free of charge, the market forces that normally allocate resources in our economy are absent.
When a good does not have a price attached to it, private markets cannot ensure that the good is produced and consumed in the proper amounts.
In such cases, government policy can potentially remedy the market failure that results, and raise economic well-being.

THE DIFFERENT KINDS OF GOODS

When thinking about the various goods in the economy, it is useful to group them according to two characteristics:
Is the good excludable?
Is the good rival?
Excludability
Excludability refers to the property of a good whereby a person can be prevented from using it.
Rivalry
Rivalry refers to the property of a good whereby one person’s use diminishes other people’s use.
Four Types of Goods
Private Goods
Public Goods
Common Resources
Natural Monopolies
Private Goods
Are both excludable and rival.
Public Goods
Are neither excludable nor rival.
Common Resources
Are rival but not excludable.
Natural Monopolies
Are excludable but not rival.

Public Goods Notes

A free-rider is a person who receives the benefit of a good but avoids paying for it.

The Free-Rider Problem

Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it.
The free-rider problem prevents private markets from supplying public goods.
Solving the Free-Rider Problem
The government can decide to provide the public good if the total benefits exceed the costs.
The government can make everyone better off by providing the public good and paying for it with tax revenue.

Some Important Public Goods Notes

National Defense
Basic Research
Fighting Poverty

The Difficult Job of Cost-Benefit Analysis

Cost benefit analysis refers to a study that compares the costs and benefits to society of providing a public good.
In order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good.
A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a whole.
It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs.
The value of life, the consumer’s time, and aesthetics are difficult to assess.

COMMON RESOURCES

Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them.
Common resources are rival goods because one person’s use of the common resource reduces other people’s use.

Tragedy of the Commons Principles of Economic Notes

The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole.
Common resources tend to be used excessively when individuals are not charged for their usage.
This is similar to a negative externality.

Some Important Common Resources Principles of Economic Notes

Clean air and water
Congested roads
Fish, whales, and other wildlife

CONCLUSION THE IMPORTANCE OF PROPERTY RIGHTS

The market fails to allocate resources efficiently when property rights are not well-established (i.e. some item of value does not have an owner with the legal authority to control it).
When the absence of property rights causes a market failure, the government can potentially solve the problem.

Firm Behavior and the organization of Industry

The Costs of Production Notes

The Market Forces of Supply and Demand

Supply and demand are the two words that economists use most often.
Supply and demand are the forces that make market economies work.
Modern microeconomics is about supply, demand, and market equilibrium.

What are Costs

According to the Law of Supply:
Firms are willing to produce and sell a greater quantity of a good when the price of the good is high.
This results in a supply curve that slopes upward.
The Firm’s Objective

Total Revenue, Total Cost, and Profit

Total Revenue
- The amount a firm receives for the sale of its output.
Total Cost
- The market value of the inputs a firm uses in production.

Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue
– Total cost

Costs as Opportunity Costs

A firm’s cost of production includes all the opportunity costs of making its output of goods and services.
Explicit and Implicit Costs
- A firm’s cost of production include explicit costs and implicit costs.
  - Explicit costs are input costs that require a direct outlay of money by the firm.
  - Implicit costs are input costs that do not require an outlay of money by the firm.

Economic Profit versus Accounting Profit

Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.
Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.
When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.

Product and Costs Notes

The Production Function
The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

TFrom the Production Function to the Total-Cost Curvehe Production Function

Marginal Product
The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.
Diminishing Marginal Product
Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.
Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.
Diminishing Marginal Product
The slope of the production function measures the marginal product of an input, such as a worker.
When the marginal product declines, the production function becomes flatter.

From the Production Function to the Total-Cost Curve

The relationship between the quantity a firm can produce and its costs determines pricing decisions.
The total-cost curve shows this relationship graphically.

Fixed and Variable Costs Notes

Fixed costs are those costs that do not vary with the quantity of output produced.
Variable costs are those costs that do vary with the quantity of output produced.
Total Costs
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC
Average Costs
Average costs can be determined by dividing the firm’s costs by the quantity of output it produces.
The average cost is the cost of each typical unit of product.
Average Costs
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC

Average Costs Principles of Economic Notes

Marginal Cost
Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.
Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?

Marginal Cost Notes

Cost Curves and Their Shapes

Marginal cost rises with the amount of output produced.
This reflects the property of diminishing marginal product.
The average total-cost curve is U-shaped.
At very low levels of output average total cost is high because fixed cost is spread over only a few units.
Average total cost declines as output increases.
Average total cost starts rising because average variable cost rises substantially.
The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.
Relationship between Marginal Cost and Average Total Cost
Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is rising.
Relationship Between Marginal Cost and Average Total Cost
The marginal-cost curve crosses the average-total-cost curve at the efficient scale.
Efficient scale is the quantity that minimizes average total cost.

Typical Cost Curves Principles of Economic Notes

It is now time to examine the relationships that exist between the different measures of cost.

Three Important Properties of Cost Curves
Marginal cost eventually rises with the quantity of output.
The average-total-cost curve is U-shaped.
The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

Costs in the Short Run and in the Long Run

For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered.
In the short run, some costs are fixed.
In the long run, fixed costs become variable costs.
Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

Economies and Diseconomies of Scale

Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases.
Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases.
Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases
The goal of firms is to maximize profit, which equals total revenue minus total cost.
When analyzing a firm’s behavior, it is important to include all the opportunity costs of production.
Some opportunity costs are explicit while other opportunity costs are implicit.
A firm’s costs reflect its production process.
A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product.
A firm’s total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.
Average total cost is total cost divided by the quantity of output.
Marginal cost is the amount by which total cost would rise if output were increased by one unit.
The marginal cost always rises with the quantity of output.
Average cost first falls as output increases and then rises.
The average-total-cost curve is U-shaped.
The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC.
A firm’s costs often depend on the time horizon being considered.
In particular, many costs are fixed in the short run but variable in the long run.

BBA Principles of Economic Question Paper 2019-2021

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