Ref: UPenn Coursera courses on Business.
Link to UPenn Coursera page: Link.
ROUGH NOTES (!)
Updated: 13/2/26
Link to UPenn MBA curriculum: Link.
Course-1: Microeconomics
Link to Coursera courses: Link, Link.
Course-1a. Microeconomics: The power of markets
Instructor: Prof. Rebecca Stein.
Sections for 1a: Opportunity cost; Scarcity; Trade; Supply and Demand; Markets; Government Intervention.
Sections for 1b: Costs and Profits; Perfect Competition; Monopoly; Externalities; Public goods; Asymmetric Information; Inequality.
[Opportunity cost]
Q) What is opportunity cost?
A) Opportunity cost is the value of the ‘best foregone alternative’ to any decision.
Opportunity cost is the true economic cost to any decision.
Note that usually
\[{ \text{O.C.} = (\$ \text{ Cost}) + (\text{O.C. of time}) . }\]Eg: Consider a hotel. Suppose the hotel was profitable on paper, that is money coming in (revenue) is greater than money going out (costs). The owner of the hotel realised that instead of a relatively small hotel he can build a big high rise building and rent out the space as office space.
Hence the hotel was demolished, considering the opportunity cost.
Eg: Consider the cost of studying at a University. Suppose the tuition is ${ $ 50 }$k per year. This is not the true cost of attending University. We need to estimate the cost of the time spent.
Suppose by studying at a University a student is forgoing wage of ${ $ 40 }$k per year.
Then the opportunity cost / true economic cost is ${ $ 50 }$k + ${ $ 40 }$k ${ = $ 90 }$k per year.
Eg: Steve bought a fully refundable plane ticket to Florida for Spring Break, which cost him ${ $ 150 . }$
A week before Spring Break, Steve’s roommate Harry invites Steve to come stay with him in New York over break (assume this is his only other alternative).
Train tickets to New York cost ${ $ 50 }$ (the only expense), and Steve knows that he will get ${ $ 250 }$ worth of benefit if he goes to New York.
What is Steve’s opportunity cost of going to Florida?
A) Note that the ${ ($ \text{ cost}) }$ of going to Florida is ${ $ 150 . }$
Note that the ${ (\text{O.C. of time}) }$ of going to Florida is, the net benefit of the best forgone alternative, which is ${ $ 250 - $ 50 }$ ${ = $ 200 . }$
Hence Steve’s O.C. / true cost of going to Florida is ${ $ 150 + $ 200 }$ ${ = $ 350 . }$
Eg: Steve bought a non-refundable plane ticket to Florida for Spring Break, which cost him ${ $ 150 . }$
A week before Spring Break, Steve’s roommate Harry invites Steve to come stay with him in New York over break (assume this is his only other alternative).
Train tickets to New York cost ${ $ 50 }$ (the only expense), and Steve knows that he will get ${ $ 250 }$ worth of benefit if he goes to New York.
What is Steve’s opportunity cost of going to Florida?
A) Note that the ${ $ 150 }$ is sunk cost.
Note that the ${ ($ \text{ cost}) }$ of going to Florida is ${ $ 0 . }$
Note that the ${ (\text{O.C. of time}) }$ of going to Florida is, the net benefit of the best forgone alternative, which is ${ $ 250 - $ 50 }$ ${ = $ 200 . }$
Hence Steve’s O.C. / true cost of going to Florida is ${ $ 200 . }$
Q) Ellie’s Tuesday morning class was cancelled! She now must decide how to spend her extra-time. She has three, mutually exclusive, options for activities:
1) Go to the library and study for her Econ midterm, which costs her nothing and which she values at ${ $ 10 . }$
2) Go to a movie, which costs her ${ $ 5 }$ and which she values at ${ $ 30 . }$
3) Have lunch with a friend, which costs her ${ $ 10 }$ and which she values at ${ $ 55. }$
What is Ellie’s O.C. of having lunch with her friend?
A) Note that the ${ ($ \text{ cost}) }$ of having lunch with her friend is ${ $ 10 . }$
Note that the ${ (\text{O.C. of time}) }$ of having lunch with her friend is, the net benefit of the best foregone alternative, which is ${ $ 30 - $ 5 }$ ${ = $ 25 . }$
Hence Ellie’s O.C. of going to lunch with her friend is ${ $ 10 + $ 25 }$ ${ = $ 35 . }$
[Scarcity]
Q) What is Economics?
A) Economics is the study of allocation of scarce resources to satisfy unlimited wants.
Note that the definition involves some assumptions:
-
Assumption 1. We have scarce resources.
For example, for some of us, it may be land, water, money, time, etc. -
Assumption 2. We have unlimited wants.
There is often something we want more of in the world. For example, maybe it is more shoes, or to help more poor.
Hence we need to allocate these scarce resources to satisfy unlimited wants.
The need to satisfy these unlimited wants has caused the development of markets and trade. We will see how markets and trade help to improve the situation.
The idea of scarcity is represented by the production possibilities frontier (PPF).
Q) What is the production possibilities frontier (PPF)?
A) PPF is a graph showing the maximal different combinations of output for a given amount of input.
Note that if we are producing along the PPF, we cannot produce more of one good without decreasing production of another good.
We can use PPF as a tool to study economic growth.
Q) What is economic growth?
A) Economic growth is the increase in the production of goods and services.
We can think of economic growth as a shift of PPF outward.
PPF can shift out because of:
- Technological improvement.
- Investment in capital goods, that allows us to have more inputs for production.
Consider efficiency.
Q) What is productive efficiency?
A) Productive efficiency means all available resources are utilized. Production efficiency means we are producing on the PPF.
Q) Suppose we are producing on the PPF. Are we producing at the right point along the PPF? Are we producing the right combination of goods and services?
If we are thinking about producing the right combination of goods and services, we would like to compare the cost of producing a good to the benefit we get from producing this good.
Hence we consider marginal cost and marginal benefit.
Q) What is marginal cost?
A) Marginal cost is the opportunity cost of producing one more unit of a good or service.
Q) What is marginal benefit?
A) Marginal benefit is the benefit recieved from consuming one more unit of a good or service.
We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a good or service.
Note that intuitively as we consume more the marginal benefit decreases. For example, consider chocolate. The first bite gives a lot of marginal benefit and a lot of joy, but the joy decreases with subsequent bites.
Q) What is allocative efficiency?
A) Allocative efficiency is when we cannot produce more of any one good without giving up some other good that we value more highly.
Allocative efficiency is when we are producing at the point on the PPF that we prefer above all other points.
Obs: At the point of allocative efficiency,
\[{ \text{Marginal benefit} = \text{Marginal cost} . }\]We will see the above observation graphically.
Eg: Consider goods “education” and “healthcare”. Note that there is a tradeoff in allocation of resources to education and healthcare.
Note that intuitively the PPF looks like
Eg: Suppose we have ${ 10 }$ identical fields. In each of these fields, we can either grow 10 tons pumpkins or 5 tons strawberries.
Note that the PPF is
Note that the magnitude of slope of the PPF is 2, which tells us we need to give up 2 P for 1 S. We say there is an opportunity cost of 2 P for 1 S (in Tons).
Eg: Consider the above example. Suppose for the moment the 10 fields each have different growing capacities for S and P.
Note that the PPF may look like
Note that as we move down the PPF, the O.C. of growing S in terms of P is increasing.
Eg: Consider the above example of 10 identical fields. Suppose there is a technological progress in growing strawberries (new compost, new breed, etc.) Hence suppose in each field we are now able to either grow 10 tons pumpkins or 10 tons strawberries.
Note that the new PPF is
Note that the technological improvement moves the PPF outward.
Eg: [Allocative efficiency]
Consider the above example of 10 fields. Consider the PPF to be curved outward.
How do we decide which point on the PPF to prefer?
We will consider the marginal cost and marginal benefit curves for the production.
Note that M.C. of S in terms of P increases as we increase S.
Note that intuitively the M.B. of S decreases as we increaase S.
Hence the M.C. and M.B. curves can be modelled as
The point on the PPF where M.C. = M.B., call it M.
Note that heuristically M has allocative efficiency.
For points to the right of M on the PPF: The M.C. exceeds M.B., and it is unfavourable to move in that direction.
For points to the left of M and on the PPF: The M.B. exceeds M.C., and it is favourable to move further right.
[Trade]
Eg: Consider two members of a family, Sarah and Abe. Each of them has 12 hours in a day and in each hour they can spend either making market goods (eg working in a job) or home goods (eg cooking).
Suppose every hour, they can produce market goods or home goods as per the table below.
| Market Goods | Home Goods | |
|---|---|---|
| Sarah | 10 | 5 |
| Abe | 8 | 2 |
Note that the PPFs for Sarah and Abe are
Note that if Sarah and Abe combine the goods produced, the net feasible region is the Minkowski sum of the individual feasible regions.
Hence the feasible region for the combined production is
What is comparative advantage?
A person or a nation has a comparative advantage in an activity if they can perform that activity at a lower opportunity cost than others.
Note that Sarah has a comparative advantage in producing H (Sarah has O.C. of 2 M for 1 H), and Abe has a comparative advantage in producing M (Abe has O.C. of 1/4 H for 1 M).
Note that the extreme point in the joint PPF (60, 96) is realised by individual specialisation according to comparative advantage, that is Sarah producing only H and Abe producing only M.
Note that Sarah can produce more home goods per hour, and more market goods per hour. We can say Sarah has the absolute advantage in producing both goods. But as we saw, it turns out the comparative advantage is more important for the collective production.
Eg: Consider the above example, but in terms of trade.
What is the trade price of 1 H (in terms of M), that both Sarah and Abe will agree upon?
Note the O.C. of 1 H is 2 M for Sarah and 4 M for Abe.
Hence the trade price of 1 H satisfies ${ 2 M < 1 H < 4 M. }$
If ${ 1 H < 2 M, }$ Sarah will not be willing to sell Hs. If ${ 1 H > 4 M, }$ Abe will not be willing to buy Hs.
Suppose they trade at price 1 H = 3 M.
Note that the resouces Sarah and Abe can accumulate via specialized production and trade now have the frontiers
[Supply and Demand]
Q) What is a demand curve?
A) Demand curve is a graph which shows us the quantity demanded at each price.
Note that intuitively as price decreases we are willing to buy more of the product and more people are willing to buy the product. Hence intuitively when price drops quantity demanded increases and vice versa.
Hence intuitively a demand curve looks like
Note that a point ${ (p, q) }$ being on the demand curve means there are ${ q }$ buyers who value the good at price ${ \geq p }$ (and hence buy the good when the price is set at ${ p }$).
Can we think of the demand curve as the marginal benefit curve?
Yes. Consider a demand curve for a good.
Note that a point ${ (p, q) }$ being on the demand curve means there are ${ q }$ buyers who value the good at price ${ \geq p }$ (and hence buy the good when the price is set at ${ p }$).
Hence here ${ p }$ can be thought of as the marginal benefit at the quantity ${ q . }$
Eg: Consider for example the market for eggs, in a city, for 24 hours. An increase in income shifts the demand curve to the right. (For normal goods, as income goes up demand goes up. For example, shoes. For inferior goods, as income goes up demand goes down. For example, public transport). Prices of other goods which are a substitute for eggs will also affect the demand curve for eggs.
Q) What is a supply curve?
A) Supply curve is a graph which shows us the quantity supplied at each price.
Note that intuitively as price increases, firms are willing to sell more of the good. Hence when price rises quantity willing to be supplied increases and vice versa.
Hence intuitively a supply curve looks like
Note that a point ${ (p, q) }$ being on the supply curve means there are ${ q }$ sellers who value the good at price ${ \leq p }$ (and hence sell the good when the price is set at ${ p }$).
Note that a supply curve can be thought of as a marginal cost curve.
Note that factors like number of firms, price of inputs, technological change affect the supply curve for a good.
Q) What is market equilibrium?
A) Market equilibrium is a price quantity pair ${ (P, Q) }$ such that at that price, quantity demanded = quantity supplied.
Note that graphically
How do we reach the market equilibrium?
Consider the “Invisible Hand” proposed by Adam Smith.
If the price is greater that equilibrium price, ${ Q _S > Q _D . }$ Hence we have excess supply. Hence the sellers will start to lower the price. The price gets attracted downwards.
If the price is lower that equilibrium price, ${ Q _S < Q _D . }$ Hence we have excess demand. Hence the sellers will start to heighten the price. The price gets attracted upwards.
[Markets]
Eg: Suppose you are a mango farmer trying to sell mangoes. At what price do you sell them?
Consider the demand curve.
Note that revenue = ${ P \cdot Q _D . }$
As price P increases, quantity demanded ${ Q _D }$ decreases, and vice versa. Hence the increase or decrease in revenue depends on the relative changes in P and ${ Q _D . }$
Note that the change in revenue per change in price is
\[{ {\begin{aligned} &\, \frac{\Delta (P Q _D)}{\Delta P} \\ = &\, \frac{(P + \Delta P)(Q + \Delta Q) - P Q}{\Delta P} \\ = &\, P \frac{\Delta Q}{\Delta P} + Q \\ = &\, Q ( -E _D + 1 ). \end{aligned}} }\]We define elasticity of demand as
\[{ E _D = \left \vert \frac{\% \Delta Q _D}{\% \Delta P} \right \vert = \left \vert \frac{\Delta Q _D / Q _D}{\Delta P / P} \right \vert . }\]A good is inelastic if ${ 0 < E _D < 1 . }$ Note that it is favourable to the seller to increase price in the inelastic zone.
A good is elastic if ${ 1 < E _D < \infty . }$ Note that it is favourable to the seller to decrease the price in the elastic zone.
Note that the revenue vs ${ Q }$ graph has a maximum at the point where the good is unit elastic.
Eg: Consider a good having substitutes, for eg frozen peas. Consumers are price sensitive. Demand is relatively elastic.
Consider a good having no substitutes, for eg chemotherapy drugs. Consumers are less price sensitive. Demand is relatively inelastic.
Eg: Consider a straight line demand curve. Note that elasticity
\[{ E _D = \left \vert \frac{\Delta Q}{\Delta P} \right \vert \frac{P}{Q} . }\]Hence elasticity changes along the line. Near the top of the line, elasticity is ${ > 1 , }$ and near the bottom of the line, elasticity is ${ < 1 . }$
We will now think about efficiency we get on reaching market equilibrium.
Q) What is consumer surplus?
A) Consumer surplus is the value of a good (marginal benefit) minus the price paid, summed over the quantity bought.
Note that consumer surplus is measured by the area under the demand curve and above the price, up to the quantity bought.
Note that we can read “# people willing to pay ${ \geq 10 }$” as “# people valuing the good at ${ \geq 10 }$”, etc.
Note that a similar observation holds for producer surplus.
Eg: Consider the supply and demand curves for bread. Suppose the equilibrium price is ${ p ^{\ast} . }$ Suppose the government sets a price ceiling at ${ \overline{p} , }$ where ${ \overline{p} < p ^{\ast} . }$
Note that there is a loss in total surplus due to the price ceiling, which is shown below.
Eg: Consider the labor market. Suppose the government sets a price floor, that is a minimum wage, which is above the equilibrium price.
Note that there is a loss in total surplus due to the price floor.
[Government Intervention]
We will study about taxes and subsidies.
The govt can for example tax cigarettes to discourage smoking, and subsidize vaccines to encourage vaccinations.
Eg: Note that with a tax ${ t }$ the money ${ p _d - t = p _s . }$
Consider the ${ p _d }$ vs ${ Q _s }$ curve before tax, that is the supply curve. A generic point looks like ${ (p, q) . }$
Note that the ${ p _d }$ vs ${ Q _s }$ curve after tax has the generic point ${ (t + p, q) . }$
Hence the ${ p _d }$ vs ${ Q _s }$ curve after tax is the original supply curve shifted up by ${ t }$ units.
Note that the graph looks like
Note that the govt can use the tax revenue for public infrastructure, etc.
Eg: Note that a subsidy can be viewed as a negative tax.
Note that the graph looks like
Course 1b. Microeconomics: When markets fail
[Costs and Profits]
We will study costs and profits.
Note that
\[{ \text{Profit} = \text{Revenue} - \text{Cost}. }\]Hence for a firm producing a single good
\[{ \Pi = P \cdot Q - \text{Total Costs} . }\]Note that for any firm
\[{ \text{Total Costs} = \text{Fixed Costs} + \text{Variable Costs} . }\]Hence
\[{ \text{TC} = \text{FC} + \text{VC(Q)} . }\]The fixed costs are the costs that are independent of the quantity the firm is producing. The variable costs depend on the quantity the firm is producing.
Eg: Suppose a firm is producing t-shirts. The fixed costs might be the plant and the machinery, and the variable costs may be the cloth and the labour.
Eg: Suppose a firm is producing t-shirts.
Note that the marginal output vs labour curve looks like
Total product means the total product produced in a given period.
Marginal product (of labour) is product that results from a unit increase in the quantity of labour employed, with other inputs remaining the same.
The law of diminishing marginal returns states:
As a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes.
Note that the marginal cost vs quantity curve looks like
Note that the average cost vs quantity curve looks like
Obs: Note that the ${ (\text{min ATC}) }$ point is a point on the marginal cost curve.
Pf: Note that
\[{ ATC = \frac{TC}{q} . }\]Note that
\[{ \frac{d ATC}{dq} = (TC) ^{'} q ^{-1} - (TC) q ^{-2} . }\]Hence
\[{ \frac{d ATC}{dq} = (MC) q ^{-1} - (ATC) q ^{-1} . }\]Hence at the ${ (\text{min } ATC) }$ point, ${ MC = ATC . }$
[Perfect Competition]
Q) What is a perfectly competitive firm?
A perfectly competitive firm has four defining characteristics:
-
It produces a standardized product.
-
It produces in an industry where there are many buyers and sellers.
-
It produces in an industry where there are no barriers to new firms entering the market.
-
It produces in an industry which is characterised by full information. (Full information in terms of product, going price, etc.)
A standardized product means a good which many other firms are producing as well. For example, a fruit or a vegetable. For example, gasoline.
Q) What is a perfectly competitive market?
In a perfectly competitive market, no individual supplier has significant influence on the price of the product. Firms are price takers.
Note that profit
\[{ \Pi = \text{Rev} - \text{Costs} . }\]Taking derivative wrt quantity, we see
\[{ \Pi \text{ is max} \implies MR = MC . }\]Hence in order to maximize profit, a firm should always produce where marginal revenue equals marginal cost. That is, the supply curve should be the marginal cost curve.
Note that in a perfect competition, ${ MR = \text{Price} . }$
Note that the graph for maximum profits at a given price looks like
Why might a firm still want to produce in losses?
Consider a firm in losses. The firm has to pay fixed costs even if the firm is shut down. Hence they lose even more if they decided to shut down.
In the short run, the firm will produce as long as the price covers variable costs.
In the long run, the firm will produce as long as the price covers total costs (i.e. as long as ${ p q _{\text{chosen}} > q _{\text{chosen}} ATC(q _{\text{chosen}}) }$).
Note that via entry and exit of firms, in the long run the price approaches ${ \text{min ATC} }$ where the firms profits are ${ 0 . }$
[Monopoly]
A monopolistic market is a market where:
- One firm.
- Product is differentiated.
- Barriers to entry.
For eg, a pharmaceutical firm producing a specific patented drug.
Note that in a monopolistic market the firm is the price setter.
Note that a monopoly sets ${ Q }$ such that ${ MC = MR < p . }$ Then price is determined by the demand curve.
Why do monopolies have ${ MR < p }$?
Eg: Consider a monopoly. Hence the firm supplies for the entire market demand. Consider a demand curve ${ Q _D = 150 - P . }$ Note that the marginal revenue is ${ \frac{d}{dQ} \text{Rev} }$ ${ = \frac{d}{dQ} PQ }$ ${ = (150 - 2 Q ). }$ Note that the marginal revenue is less than the price.
Obs: Consider a monopoly. Then
\[{ MR < p , }\]that is marginal revenue is less than price.
Pf: Note that the monopolistic firm sets the price and supplies for the corresponding market demand.
Consider a linear demand curve
\[{ Q _D = - a P + b . }\]Note that the marginal revenue is
\[{ {\begin{aligned} &\, MR \\ = &\, \frac{d}{dQ _S} (\text{Rev}) \\ = &\, \frac{d}{dQ _S} (P Q _S) \\ = &\, \frac{d}{dQ} \left( \frac{b-Q}{a} \right) Q \\ = &\, \frac{b - 2Q}{a} . \end{aligned}} }\]Hence
\[{ {\begin{aligned} &\, MR = \frac{b - 2 Q}{a} , \\ &\, P = \frac{b - Q}{a} . \end{aligned}} }\]Hence
\[{ MR < p }\]as needed.
Note that price setting by a monopoly is given by
Note that compared to perfect competition, a monopoly introduces dead weight loss.
The graph showing consumer surplus and producer surplus in a monopoly vs perfect competition is given below.
Monopolies produce less and charge more compared to perfect competition. There is a reduction in total surplus, that is a dead weight loss, in a monopoly as well.
Why do we allow monopolies?
There are two major reasons:
-
Encourage product innovation.
For eg, to encourage pharmaceutical research, by giving incentives like patent rights and remove competition. -
Economies of scale.
It is often chaper and more effective to have one firm than to have multiple firms.
A natural monopoly is a case where the ATC is falling for the relevant production range, so one firm producing a large quantity is more efficient than having many firms producing small quantities. An extreme case is where MC is constant.
For example, Water systems.
Government intervenes in monopoly and oligopoly markets in two main ways to alleviate dead weight loss:
-
Regulation: Marginal and average cost pricing by the government. We see this in the case of utilities, like water and electricity.
-
Antitrust laws: For eg, government may take a monopoly and divide it into multiple firms. For eg, firms in airline industry need government permissions before merging.
Note that the cost curves of a typical natural monopoly looks like
Eg: Consider a transportation company which is a natural monopoly.
Note that the deadweight loss due to the natural monopoly is
One solution is to have regulation.
One way to regulate is to set marginal cost pricing, that is MC pricing. The government steps in and says you must set price equal to MC.
One problem is MC pricing is only letting the firm cover marginal costs, and not the cost of putting the firm in place.
So the government has to pair MC pricing with paying for the fixed costs of production.
Another solution is to have average cost pricing, that is ATC pricing.
A disadvantage in ATC pricing is that the government sets price at breakeven point, and the firms have less incentive to cut costs.
Consider price discrimination. Price discrimination is a situation in which a firm is selling different units of a good for different prices.
To be able to price discriminate, a monopoly must:
-
Identify and separate different buyer types.
-
Sell a product that cannot be resold.
For example, theatre tickets with senior discount.
For example, email coupons for a grocery store. It is strategic to email coupons to price sensitive customers.
Eg: Consider pricing for a monopolistic theatre’s tickets.
Note that the price discrimination for regular customers and students is given by
Consider a monopolistically competitive market.
In a monopolistically competitive market:
-
A large number of firms.
-
Each firm produces a differentiated product.
-
FIrms compete on product quality, price, and marketing.
-
FIrms are free to enter and exit the industry.
For eg, the market for granola bars. Intuitively the ATC falls rapidly like in a natural monopoly, but firms are free to enter and exit.
Monopolistic competitive market, despite its flaws, has differentiated products.
Consider a firm in a monopolistic competitive market. In the short run, it functions like a monopoly (produce at quantity where ${ MC = MR , }$ etc.) but due to new firms sees the demand curve shift in. The shift in of the demand curve for the firm considered happens till the profits become zero, that is ${ p = ATC }$ as well.
[Externalities]
Externality:
A cost or benefit that arises from production and falls on someone other than the producer,
or
A cost or benefit that arises from consumption and falls on someone other than the consumer.
A negative externality imposes a cost for the other party. A positive externality creates a benefit for the other party.
Eg: [Negative externality] Smoking. (Second hand smoke for people surrounding the smoker.)
[Negative externality] CO2 emissions from for example driving a car.
[Positive externality] Vaccines.
[Positive externality] Education.
Why do negative and positive externalities create market failure?
Eg: Consider a negative externality.
For eg, consider making electricity using coal.
Note that to account for the negative externality, we consider a social marginal cost SMC curve which is higher than the private marginal cost curve.
The competitive market overproduces and creates a deadweight loss. The usual market equilibrium is inefficient.
In an unregulated market, MB = MC.
The efficient quantity is where MB = MSC.
Eg: Consider vaccines. Note that we have a positive externality, and hence we have an SMB curve above the MB curve. The competitive market underproduces and produces a deadweight loss. The usual market equilibrium is inefficient.
Note that in externalities we have a party effected by the transaction but is not included in the transaction.
We have the Coase theorem which states:
If
-
property rights exist
-
only a small number of parties are involved
-
transaction costs are low
then, private transactions are efficient.
Eg: If for example everytime I drove my car I have to compensate someone for CO2 emissions I would take that compensation into account when I drive my car. The problem is there isnt someone to pay. Suppose some person X owned the atmosphere. Then I pay X. If we have well defined property rights, we can get efficient outcome.
Eg: We can internalise a negative externality by a tax. Consider the same example of electricity production using coal.
We set a per unit tax such that the shifted supply curve coincides with SMC curve. The tax leads the market to achieve an efficient outcome.
Similarly we can internalise a positive externality by a subsidy.
Three main methods governments use to cope with negative externalities / external costs:
- Regulation (eg restrictions).
- Taxes.
- Marketable permits (ie indirectly assigning property rights).
[Public Goods]
A pure public good is nonexcludable and nonrival.
A good is nonexcludable if it is impossible to prevent a person from enjoying its benefits.
Eg: Sunshine, Rule of Law.
A good is nonrival if its comsumption by one person does not decrease its consumption by other people.
Eg: A Pay-per-view show on TV, an MP3 song.
Here are some examples of goods.
A good which is excludable and non-rival is an extreme case of a natural monopoly.
The value of a public good is the maximum amount that all the people are willing to pay for one more unit of it.
Eg: Suppose the price of a satellite is ${ $ 65 . }$ Suppose we consider only two people Lisa and Max. Suppose their marginal benefit curves for satellites is
Note that privately, Lisa will buy one satellite and Max will not buy any satellite. The result is one satellite up in the sky, and both Lisa and Max enjoying its benefits.
But for the efficient outcome, we need to consider the sum of their marginal benefits.
For the price of ${ $ 65 , }$ for efficiency, the society needs to buy ${ 3 }$ satellites.
Hence the private market is underproducing. We need another mechanism to achieve efficient outcome.
Implications of non-excludability:
Note that there is the issue of free riding. If a private firm tried to produce and sell a public good, almost no one would buy it. The free-rider problem is that too little of the good is being created.
Implications of non-rivalness:
Note that the marginal cost of providing a public good is zero. Note that at the efficient outcome the price is zero. Hence there is a pricing problem as well.
How do we solve free riding and pricing issue?
Public provision (Government):
The Government taxes all consumers of the public good. It forces everyone to pay for its provision, thereby overcoming the free rider problem.
A tax policy must satisfy efficiency constraint ${ \sum MB _i (q ^{\ast}) \geq MC(q ^{\ast}) }$.
A tax policy can satisfy the constraints
- Budget constraint ${ \sum t _i \geq TC(q ^{\ast}) . }$
- Participation constraint ${ MB _i (q ^{\ast}) \geq t _i . }$
The second rule need not hold from an efficiency perspective.
Note that free riding can be thought of as a prisoners’ dilemma problem.
[Asymmetric Information]
Adverse selection occurs when one side of the market (i.e. buyers) have better information than the other side (i.e. sellers) and so there is selection of only a high cost or low value being bought or sold.
Eg: Consider the market for life insurance. Life insurance is only going to pay if you die, but the probability of dying is something a consumer is much more knowledgeable about than the firm.
A company selling life insurance will find that people at higher risk of death will be more willing to take out life insurance.
If the insurance company charges an average price, but only high risk consumers buy - they will make a loss.
Consider higher overall price as firms insure themselves against high risk customers taking out life insurance.
Low-risk customers may not want to buy because it is relatively too expensive - leading to a missing market.
There are a few mechanisms firms can employ:
-
Firms may invest considerable time in identifying which groups of consumers are higher risk. For eg, asking for Doctor evaluation.
-
Sell to mixed consumers. For eg, offering health insurance to mixed groups like workplaces, etc.
How to avoid adverse selection?
There is for example:
- Force sale of product or good. Eg, Health Care Reform Act.
We will now consider Moral Hazard.
Moral Hazard is the idea that under certain circumstances, individuals will alter their behaviour and take more risks.
Eg: Taking more risk if you have life insurance.
Eg: Banks which believe they are “too big to fail” and government will bail them out take more risk.
Eg: Taking more risk if you have phone insurance.
In the case of a Moral Hazard, people can take on too much risk and markets can fail. For example, the market for phone insurance.
Avoiding market failure:
-
Build in incentives. For eg, in phone insurance we have deductibles to be paid when using insurance.
-
Penalize bad behaviour. For eg, interrogating people running banks riskily.
[Inequality]
How do we measure economic inequality?
Consider the annual household incomes in the US. Note that the distribution looks like a normal distribution which is cut off.
The income Lorenz curve graphs the cumulative percentage of income earned against the cumulative percentage of households.
Note that in the case of perfect equality the income Lorenz curve would be a straight line.
The real distribution looks like
Consider also the wealth distribution. It turns out the income curve is closer to the line of equality than wealth curve. That is, inequality in wealth is greater than inequality in income.
The Gini ratio (of an income distribution), is the area between the line of equality and the income curve, divided by the area below the line of equality.
Poverty: Household’s income too low to buy food, shelter, and clothing deemed necessary.
Usually countries set a poverty threshold. The thresholds must be adjusted for inflation.
The governments in the United States use three main ways to redistribute income to alleviate some degree of economic inequality:
-
Income taxes.
-
Income maintenance programs. Eg, sending cheques to people who dont have enough. For example, US does this well for the elderly.
-
Subsidized services.
There are types of income taxes.
Progressive income tax: average tax rate rises with income.
Regressive income tax: average tax rates falls with income.
Eg: Sales tax is usually a regressive tax.
Proportional income tax: constant average tax rate.
Progressive taxes increase equality. Regressive taxes decrease equality.