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Stop Consuming

Credit: Mantis - stop consuming: London graffiti by mermaid is licensed under CCBY-NC-ND 2.0

Before you begin this course, make sure you have completed the Course Orientation in Canvas.

An Overview of Lesson 1

Did you ever wonder why engineers typically earn more money than short-order cooks, or how the price of gasoline gets established? Why is it that so many Americans drive to work, but lots of people in Britain take the train, and many Dutch ride their bicycles? Speaking of cars, why do we have so many choices when we want to buy a car, but so few choices if we want to buy cable TV or home Internet service? And why is it that if I want to buy a car, I have to go to a dealership, but I can buy a computer directly from Dell (although I don't have to)? On a more personal note, do you ever stop and think about what you choose to spend your money on? Do you choose to spend more of your income on entertainment than, say, a nicer car? Why don't you do both?

These are all questions that can be answered (or, at least, better understood) by using economic analysis. In this lesson, we will talk about some of the basic underlying principles that guide economics as a way of looking at the world.

What will we learn?

By the end of this lesson, you should be able to:

• list and describe the axioms that underlie the "economic way of thinking";
• describe the economic definition of scarcity;
• define what an "opportunity cost" is;
• tell the difference between a positive and normative question;
• list and describe what is contained in a property right.
• explain what economists mean by the terms "utility" and "monetization".
• What are Gregory Mankiw’s ten fundamental principles of economics?

What is due for Lesson 1?

This lesson will take us one week to complete. Please refer to Canvas for specific timeframes and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.

Questions?

If you have any questions, please post them to the online discussion forum in Canvas.

I am tempted to start the course by trying to say "what economics is" and so on, but it is perhaps easiest to start with a simple illustration.

Imagine you are on a desert island. There are two things you can eat on this island: coconuts and fish. If you wish to survive, you spend all of the available daylight trying to catch fish or harvest coconuts from the palm trees. We can assume, for the time being, that all of your day is taken up doing one of these two things. You need to divide your day between gathering coconuts and catching fish since a diet of just one or the other is not healthy. Suppose you have 10 hours a day to work. It takes you one hour to catch a fish and climbing a tree to get a coconut takes half an hour. So, in 10 hours you can catch 10 fish, or you can gather 20 coconuts. You could also do a bit of both: maybe spend 8 hours fishing and 2 hours getting coconuts, which would give you 8 fish and 4 coconuts. After a few weeks on the island, you settle on a balance whereby you spend 7 hours a day catching fish and 3 hours harvesting coconuts. This gives you 7 fish and 6 coconuts per day. If you want more fish, you have to give up some coconuts, and if you want more coconuts, you have to give up some fish, because there are only a certain number of hours in a day, and you can't make more daylight!

Now, what if it turns out that you are not alone on this island. Suppose there is a person who happens to go by the name "Friday." He's been on the island a long time and has gotten good at fishing. It turns out that he can catch a fish in 20 minutes, but it also takes him half an hour to climb a tree and harvest a coconut. Friday has gotten into a routine where he fishes for 4 hours a day, catching 12 fish, and he harvests coconuts for 6 hours, getting 12 coconuts per day.

This is getting a little complicated, so we'll summarize:

• You: 7 fish, 6 coconuts per day.
• Friday: 12 fish, 12 coconuts per day.
• Total: 19 fish, 18 coconuts.

Image Provided by Classroom Clipart

Now, let's suppose that one day, you and Friday meet up for the first time. After a bit of discussion, you start talking about food, and how much food you get each day. You both work 10 hours per day and get a total of 19 fish and 18 coconuts.

What if I said that it was possible for both of you to get more fish and more coconuts, and neither of you had to work longer hours? Is this magic? Well, not quite.

Let's say you decided to spend all of your day harvesting coconuts, meaning that you were able to get 20 in a day.

At the same time, Friday spends 8 hours fishing. He is able to catch 24 fish and gets 4 coconuts in the other two hours.

Now, between the two of you, you have 24 fish and 24 coconuts. You have more fish AND more coconuts

So, collectively, you are better off. However, neither of you likes the proportion of things you have yourself. You have too many coconuts and not enough fish. Friday does not have enough coconuts. What you can do then is make a trade. Let's say you trade away 10 coconuts in exchange for 10 fish. Now you have 10 coconuts and 10 fish. Friday has 14 coconuts and 14 fish.

Image Provided by Classroom Clipart

Let's summarize:

• Before you meet, 7 fish and 6 coconuts.
• After you meet, 10 fish and 10 coconuts.

Friday:

• Before you meet, 12 fish and 12 coconuts
• After you meet, 14 fish and 14 coconuts.

So, after meeting, you both have more fish and more coconuts. How has this happened? Is this some kind of magic? As I said before, not quite.

The above story may seem a little simplistic - it is - but it powerfully illustrates some important topics that we talk about in the field of economics. What has happened? Well, the first thing that happened after the meeting of you and Friday is that you decided to specialize. You decided to do what you are good at - gathering coconuts. Friday concentrated most of his time on what he is good at - catching fish. By focusing on what you are each good at, you became more efficient. You then decided to trade. Specialization and trade made you both better off and made the sum of the two of you better off.

Complicated? Of course! So, let’s do some more examples.

The same idea holds for more complicated scenarios involving more than two people and more than two goods. If people in a society decide to specialize and make a lot of what they are good at making, and then trade some of the things that they make for other things they want, then both they and the society they are part of will be better off. Or, as I will say a little later on, specialization and trade generate wealth for society.

This is perhaps not hard to understand. We all specialize in something and sell it and use the proceeds of that sale to buy other things. A university professor specializes in teaching students and generating research. The university pays the professor for this, and with his wages, he buys food, housing, transportation, clothing, leisure, and many other things. He is better off doing this than trying to make his own food, build his own house and manufacture his own car. A construction company might build a hundred houses a year, which is more than the owners of the company need. So, they sell some of those houses to buy the other things they need to live. This is how our society is organized.

As a society, we have much more wealth because we arrange our societies this way. Without trade (that is, buying and selling things), we would each have to be a fully self-sufficient unit, and each of us would have much less in such a world. We do not trade because we like each other or even care about each other - we usually don't even know the people we are trading with - but we do so because it is in our own best interest. This curious fact - a society of people, each acting in their own best interest (or out of selfish motives), leads to an increase in the wealth of society as a whole - was first written down and expounded upon by Adam Smith, the author of a book called The Wealth of Nations, which was written in 1776 and was the founding text of modern economic thought. We'll talk a bit more about Smith later.

Now, given this simple example as an introduction, we can move on to start talking about economics in a bit more of a formal and structured manner.

Economics is a social science. What exactly does that term mean? "Social" means that is about examining the way the people organize their interactions with each other in societies. "Science" means that the "scientific method" is used as a way of thinking about and studying social organization. We have some other social sciences, such as sociology, anthropology, education, history, and law. These disciplines all look at different aspects of societies or examine them from a certain perspective. Economics is the social science that concerns itself with how people make consumption and production choices in a world of endless wants and limited means.

Economics is not an ideology or a set of political beliefs; it is merely one of the ways in which people try to understand the society we live in, and how it works. It is a way of looking at the world, what we call the "economic way of thinking." This has proven to be a useful tool for understanding and explaining a great deal of human behavior. It explains how people do many of the things they do, and why, and it allows us to predict, with a reasonable degree of confidence, what the effects of some action taken by a government or a group of individuals will be.

Note that I said, "reasonable degree of confidence." That could be taken as a set of meaningless weasel words, with terms like "reasonable" and "confidence" not being clearly defined. However, what I am trying to do when I make this statement is to avoid being too sure about our knowledge of the outcomes. While it is true that people behave in a way that is "generally" predictable, you must always remember that when we study societies, we are talking about people, and people do not uniformly behave in a predictable manner. In mathematical terms, there are too many variables, and we cannot isolate and correct them all. So, what I am saying here is the "soft-sell" on economics: it is a helpful and pretty reliable way of understanding the world, just not a perfect or strictly deterministic way. Note that the "economic way of thinking" has been applied to many other social science disciplines, most famously law and sociology, and it has done a great deal to explain behavior in these areas. If you are interested, you may want to read more about the works of people like Richard Posner in law and economics, and Gary Becker in sociology. Economics also has strong ties to the field of psychology. Several of the recent Nobel Prizes in economics have been awarded to scholars or teams studying economic behavior from a psychological perspective. This should be unsurprising: both disciplines have the goal of trying to figure out how and why people make the decisions and choices that they make.

A great many economics textbooks have been written, and they all strive to start at the same place, laying out what the "fundamental principles" are. One of the best attempts is by Gregory Mankiw, a professor at Harvard University and former chair of the President's Council of Economic Advisors. He has laid out a list of ten "principles of economics" that is broadly accepted as a good summary of the main points that I will try to make here.

Actually, it's more like "7 Principles," because the last three pertain to macroeconomic issues, which is an area of study that will not be addressed in this course. Instead, we will examine microeconomics, which is the study of individual economic actors: people, and firms, and their interactions in markets. Included as an agent in this study will be governments, which play a large role in the economic lives of every individual and every firm.

A good understanding of these seven points will provide you with a very solid grounding for how to think about economic problems throughout this course and throughout the rest of your lives. I will list them below, with some explication. Before I list them, I want to add three "axiomatic" statements that have to be considered before we move on. An axiom is an assumed statement, sort of a "first principle" that is not, or need not be proved. It is a basic understanding of how things happen.

Axiom 1: Things that we want to consume more of are called economic goods or, usually, just "goods". The opposite of a good is a "bad," which is something that we want less of. However, there are very few things that are universally bad - almost every economic bad is somebody else's good. For example, we might think of pollution from burning coal as bad, and it certainly has a detrimental effect on many people, especially those who live near power plants. But the more pollution a plant operator can put into the air, the more electricity he sells, and the more money he makes.

Axiom 2: All goods are scarce. It is important to understand what "scarce" means in this context. There are quite a few words that have one meaning when used in general conversation, and a narrower, more specific definition when used in economic analysis. In general usage, "scarce" usually refers to something that is in short supply, or is running out, or is hard to find. In economics, scarce simply means that something is not limitless. Another way of thinking about it is this: a good is considered scarce if we have to give something up to consume it. When viewed in this light, the phrase "all goods are scarce" makes a bit more sense. Bottles of orange juice or episodes of TV shows are not scarce in the general sense, but they certainly are in the economic sense.

Axiom 3: Wants are unlimited. This is perhaps a polite way of saying "people are greedy" in the sense that people almost always prefer to consume more goods than less. If they reach a limit to how much of some good they want to consume, it is not hard to find another good they would like to consume more of. It is important to consider that things like leisure, rest, and peace of mind can be seen as goods.

Now, moving on to Mankiw's list:

Principle 1: People face tradeoffs.

This means that we have to make choices in a world of unlimited wants and scarce resources. If you want something, you will have to give something else up. You have to make a choice. Perhaps, in a perfect world, we would not have to make choices – we could have all that we want without having to give up anything else, but this is not the world we live in. From the desert island example, we had a simple trade-off: if you wanted more coconuts, you had to give up fish, and vice versa. If you wanted more leisure time, you had to give up some food to get it.

Principle 2: The cost of something is what you give up to get it.

In everyday life, we think of costs generally in terms of money, or perhaps time or effort. However, whenever you make an economic choice, what you give up are all of the choices that you didn’t make. This is what we call an “opportunity cost.” Ask the average man on the street what the cost of a bag of Doritos is, and he will say “99 cents.” Ask an economist, and he will tell you “every other thing that I could have spent 99 cents on." Or maybe, “the most valuable thing I could have spent 99 cents on, but did not because I spent it on Doritos.” Needless to say, this causes a lot of people to avoid having conversations with economists at parties but, nonetheless, thinking about costs in this way helps us better understand economic decision making. This contains a secondary point: money is only a tool, a store of value or a method of accounting. Money is only basically good for one thing: exchanging for goods that we consume. So, the cost of one consumption choice is the most valuable consumption choice we could have had, but chose not to make. Likewise, the opportunity cost of an investment, of either time or money, is the best other investment we could have made with that time and/or money. For example, the opportunity cost of going to an 8 am class is probably an hour of sleep for most people. Once again, think back to the desert island economy: it took you an hour to catch a fish, or half an hour to get a coconut. So what was the cost of a fish? Well, you can look at it two ways: first, you could say that it cost you an hour. This is true, but, really, an hour was only good for one of two things: catching fish or harvesting coconuts. So, if you spent an hour catching a fish, you were giving up two coconuts. We say that the opportunity cost of the fish is two coconuts - 2 coconuts is what you have to give up to gain an extra fish.

Opportunity cost is all the other things you give up to get something else. For example, let’s say you buy a car for 25 thousand dollars. If you don't spend your money on buying the car, you could invest your money (for example: deposit it into a savings account and receive interest or buy stocks, ...). When you buy the car, you give up all the other things that you could have done with the 25 thousand dollars. In economics, you should consider all of those. For example, if investing the money would give you interest, then, the opportunity cost of buying the car would be 25 thousand dollars plus lost interest of given up investment.

Another example: When you are a full-time student, the opportunity cost would be: the tuition that you pay plus money that you could have made if you were working and not spending your time at school.

Another example: Let's assume you are living in Pittsburgh and you want to buy a TV. There is a store in Pittsburgh that sells the TV for 500 dollars. However, you find a store in New York that has a TV on sale for 300 dollars. But there is no shipping service. So, you need to go there and pick it up there. What would you do? The true cost of buying the TV from the store in New York is \$300 plus all the other costs that you don't need to pay if buy the TV from the Pittsburgh store. If you decide to buy the TV from New York:

• You need to rent a car (if you use your own car, you should consider the wear and tear costs of driving to New York and back).
• You need to pay for gas.
• If you work, you need to take a day off and lose the money that you could have earned.

Next is a short video with more explanation.

Video: What is Opportunity Cost? (2:45)

Principle 3: Rational people think at the margin.

“Thinking at the margin” means that we think about the next decision we need to make, and the incremental effects of that decision. Put another way, people have to be forward-looking, because the past is in the past, and nothing can be done to change it.

Principle 4: People respond to incentives.

I will talk about this in more depth in the next section when we address rationality and utility maximization. This principle is intuitively very obvious: every child understands the notion of the carrot and the stick: positive and negative incentives designed to modify behavior. A further examination of this topic leads us to discover that people usually act in their own best interest, so when governments design policies, they have to be sure that they are incentivizing the “right” behavior. An interesting topic has arisen recently: the Estate Tax, which is applied to inheritances, is set to be reinstated at the beginning of 2011 after having lapsed at the end of 2009. This means that a wealthy person dying a few minutes after the coming New Year will leave his or her heirs with a significantly larger tax bill than if he died a few minutes before midnight. Thus, the heirs perhaps have an incentive to see to it that a terminally ill parent dies a little bit earlier. This is what is called a “perverse incentive,” because our society generally frowns upon people trying to cause others to die earlier than they otherwise might. Whenever you participate in an economic transaction, it always helps to think about what incentives the other person in the transaction faces.

Principle 5: Trade can make everyone better off.

I might be inclined to make a stronger statement: that trade MUST make everybody better off, but we can go with Mankiw’s weaker statement for now. The fundamental notion behind voluntary trade is that each party is giving up something in exchange for something that they place a higher value upon. If this were not the case, the person would choose to not make the trade. For example, when I buy a bag of Doritos, the shopkeeper will voluntarily make the trade because I am paying him more money than he paid for the chips, so he’s better off, and I will voluntarily make the trade because I get more happiness from consuming the chips than anything else I could spend that 99 cents on. We’re both made better off by the transaction. We will look at applications of this notion in much more depth later on.

Principle 6: Markets are usually a good way to organize economic activity.

This is another statement that could be made a little more forcefully, but we can let it be. Markets refer to institutions (not just places) that allow people to voluntarily and willingly participate in trades to improve their lives. People sell their labor and brain power to firms, which use it to help them make profits for the owners of those firms. People use the money they earn to purchase goods and services to help them live their lives in a way that best makes them happy. In a truly free-market system, we have millions of individual, voluntary economic transactions taking place every day. In reality, sometimes (or, perhaps, always) markets do not work in this idealized manner, which leads to the next principle.

Principle 7: Governments can sometimes improve market outcomes.

When markets do not work well, we speak of “market failure” (there will be much more on this later in the course). Sometimes a government can intervene in a market, by setting rules or restrictions that enable a better outcome for society than would be obtained through an unfettered free market. Many people believe, for example, that product safety laws or workplace safety rules are unambiguous improvements upon unregulated outcomes. However, the government cannot fix every problem, and sometimes government intervention in a market can end up making things worse for society. This is what is called “government failure,” and we will also look at this in much more depth later on in the course.

The last three principles, which I will simply list below, pertain to macroeconomic issues that will not be addressed in this course.

Principle 8: A country’s standard of living depends on its ability to produce goods and services.

Principle 9: Prices rise when the government prints too much money.

Principle 10: Society faces a short-run tradeoff between inflation and unemployment.

As outlined in the previous section, we are trying to study why people make the economic decisions that they make. To try to understand this question, we assume that people do things that make them happy. This is not a difficult concept to understand: any time we are faced with a choice, there is an outcome that will make us happier than another outcome. Some choices are not very enjoyable, such as doing our laundry or paying our taxes, but we do so because the alternative will leave us with less happiness: most of us prefer clean clothes to dirty, and most of us prefer to not be hounded into court by the taxman.

Economists don't use the word "happiness," but instead have coined another term: "utility." You might think of a utility as the company that provides your electricity or drinking water, and these have the same root meaning derived from the word "use." In the economic context, think of utility as the use, the value of the use or the happiness derived from the use of some good. Basically, "utility" is the economic catch-all term for whatever benefit we get from the consumption of some economic good, or in a broader sense, the benefit we derive from the outcome of an economic decision.

So, if somebody gets utility from making a decision, and more utility (happiness) is unambiguously better than less, then we make the claim that people are "rational utility maximizers." That is, in every decision that we make, we think rationally about the outcomes and make the choice that gives us the most utility. This is a simple and elegant statement, and it lies at the foundation of modern western economic thought, but it is not completely uncontroversial or even all that uncomplicated. For example, many decisions are not simple yes/no or A/B choices. Sometimes there are many possible choices - indeed, there are usually many possible choices, and we don't always know which of those choices will make us happier for the simple reason that we cannot see the future with perfect foresight. People make uninformed decisions, hurried decisions, unlucky decisions, and just plain wrong decisions every day. We are not perfectly rational, and we usually do not have either the time or knowledge, or foresight to always make the correct decision. This is an area of intense study at the boundaries of contemporary economic thought - several of the recent Nobel prizes in economics have gone to people researching what is called "behavioralism," a field of study that spans economics, psychology, and neurology. In other words, it gets really complicated. So, we make the assumption that people are rational utility maximizers. It may not be perfectly true, but it is reasonably defensible (most of us try to make the best decisions most of the time, and we don't deliberately do things that will hurt ourselves). Most importantly, it gives us a firm foundation to build upon. It is what we call a "simplifying assumption": we can assume it to be true, and doing so will allow us to answer a broad swath of questions about economic decision-making and outcomes. And after we have reasonably answered all of those questions, we can start relaxing our assumptions one at a time to see how the outcome changes. It turns out that, even if you relax the assumption of perfect rationality, most of the answers to the questions do not change in a meaningful or substantive manner.

Money and Utility

It is important to state at this point that money and utility are not the same things. People are not money-maximizers; for example, most of us would rather have the weekends off instead of working a second job. I could take a second job working in a restaurant at night, but I get more happiness spending my evenings at home or out with my family.

However, in this course, and in almost any other study of economics, you will find utility defined in terms of money. This action is defined as "monetization." This is not because we believe that money is everything. It is because we are lazy and want to explain things in simple terms. So, what we are using is using money as a common unit of measure and accounting. For example, for my winter vacation choice, I could go skiing or go to a beach resort in Mexico. In order to measure the happiness obtained from these two choices, we need a common unit of measure, and since money is a universally accepted proxy as a measure of value, that is what we use. So, economists talk about everything in terms of money because doing so makes our lives (and those of students) easier.

Economists like to describe their discipline as a science. This seems odd to some people, who think of science as involving laboratories and experiments. However, any area of study that employs "the scientific method" as a mode of inquiry can be thought of as a science.

So, what is the scientific method? Well, there is no single broadly accepted definition, but there is a generally accepted framework. The scientific method is a structured method of attempting to answer questions about the world about us. In the case of economics, the "world" refers to the multitude of consumption and production decisions made by every person and firm every day.

The scientific method, as described here, has four basic steps:

1. Observe
2. Hypothesize
3. Test
4. Repeat step 1

We start by observing something in our environment that leads us to ask a question. Questions such as: Will a ball float in water? Will price controls lead to shortages? Will smoking cause you to die earlier? To attempt to come to an answer, we first need to ask the question in the form of a "testable hypothesis." Put another way, try to frame the question in such a way as to be able to test it and get a yes/no answer. Actually, we generally frame the questions so that the answer will be "no" or "not no." Note that "not no" is not the same thing as yes. "Not no" can be either yes, or maybe, or we don't know, or the answer is not clear. But we do want a question that can have a clear answer of "no."

This question is called a "hypothesis." We need to test the hypothesis with an experiment: some set of actions that will allow us to answer the hypothesis. In science-speak, we write the question as a "null hypothesis," so looking at our first question from above, I will state the null hypothesis as "this ball will float in water." We then perform some set of actions to test the hypothesis. In this case, there is a simple test: place the ball in water. If it sinks, we can answer "no" to the null hypothesis, or put another way, we can reject the null hypothesis. If the object does not sink, we do not answer yes, but instead we "fail to reject" the null hypothesis.

Notice that we are not trying to prove something to be true, but we are, in fact, trying to prove it to be false. This is the key aspect of the scientific method: we need to have a hypothesis that is testable and falsifiable. If something is not falsifiable, it cannot be tested scientifically. In science, nothing is proven, but many things are disproven. Some hypotheses, such as Newton's theory of gravity, have survived the test of falsifiability for centuries, and as such, we generally accept them to be "true," but, in reality, they are just yet to be disproven, after several hundreds of years of many smart people trying.

The above was a rather long-winded attempt by me to explain why economics is a science - a science that studies an aspect of a human society, which is why it is called a "social science." It is a science because economists, when they ask questions, strive to employ the concept of a testable, falsifiable null hypothesis. Unfortunately, it is much more difficult to do experiments. For example, we cannot impose a price control in one town and not in another, and observe the difference. What we can do is gather data from the world around us, and try to define "natural experiments" to help us test our hypothesis. So, for instance, we can look at different minimum wages in different states and try to ask questions about the effect of raising the minimum wage on youth unemployment. Unfortunately for us, we can not do " controlled experiments," that is, hold everything else constant and change only one variable. When dealing with society and natural experiments, there are many uncontrolled, indeed, uncontrollable variables, which can make hypothesis testing difficult and controversial.

So, what kinds of questions do economists ask? Well, for the most part, they try to ask "positive" questions. A positive question is one that can be falsifiable, or put more simply, has a yes/no answer. Think of a positive question as a "how is the world" question. A different kind of question does not ask how the world is, but how it "should be." These are referred to as "normative" questions.

For example, speaking again about minimum wage laws, a positive question would be "Do higher minimum wages cause higher rates of youth unemployment?", whereas a normative question might be "Are higher minimum wages better for young workers?" The first of those two questions should have a testable answer: yes or no. The answer to the second question hinges upon the definition of "better." We often hear the phrase "There oughtta be a law," or maybe, "We should have higher minimum wages." These are political questions, based upon values-based questions that are not falsifiable. I am not saying that asking these types of questions is wrong or incorrect; clearly, this is what the entire field of politics is about. However, these are not the kinds of questions that we like to ask in economics. Economists are people who see themselves as dispassionate scientists, attempting to rationally undercover the nature of the universe. At least, that's the goal most of us strive to, and in this course, it is the method of explanation I will attempt to employ.

Stated simply, I'm here to try to help you see how things are, and not how they should be.

A positive question is a "scientific" question that you can test it, you can look at the data, build and economic model, ... and eventually conclude if it is correct or not. However, a normative question/sentence is more like an opinion, that you can agree or disagree. You can't really scientifically test it.

The following video (3:59) explains the difference between positive and normative economics.

Property Rights

When we start talking about market systems and trade, we will make an assumption that people have the legal right to trade something for something else, and to do as they wish with the goods they have traded for. That is, if you have money you can trade it for goods that you use in some way that you derive utility from, or if you have a good, you may sell it in exchange for either money or other goods. Of course, the good that most of us sell most frequently is our time and set of skills, sold to an employer in exchange for a salary.

This introduces the concept of "property," the stuff that you sell and/or use. A property right has two separate and specific parts. For something to be a person's property, it is necessary that both parts of the property right are present.

For somebody to hold a property right, they have to have both Use Rights and Disposal Rights. That is, for something to be considered a person's property, you have to have the right to use it as you please, and the right to exchange it for something else, or to dispose of it some other way, which can include destroying the good in question.

One confusing use of the term "property" is in the case of "public property," for which a specific individual may or may not have use rights, and definitely does not have disposal rights. There is a longer write-up on the topic of property rights on pages 32-36 of the text, which I recommend you read. Gwartney adds a third consideration, one concerning legal protection against unauthorized use, but I see this as simply an extension of the "use right" part of the definition.

Before moving on to try to understand and analyze the workings of market systems, we need to have a broad understanding of just what we are trying to study in this class, and why. This was covered in this lesson.

At this point, you should be able to answer the following questions:

• What are the three axioms of the economic way of thinking?
• What are Mankiw's seven "principles of microeconomics"?
• Can you explain what economists mean by the terms "utility" and "monetization"?
• What is a normative question?
• What is a positive question?
• What are the constituent parts of a property right?

If you log in to Canvas, you will find the tasks to be completed for this lesson: a timed online quiz, an untimed homework assignment, and the weekly discussion forum.

Have you completed everything?

You have reached the end of Lesson 1! Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there.

In Lesson 1, we spoke of markets and their role as both a process and arena for making production, consumption, and allocation decisions. In this lesson, we will introduce the fundamental tool for analyzing how markets work: the supply and demand diagram. After this introduction, we will take a deeper dive into one side of the market, the demand side. We will examine why people make the consumption choices they make, and how we can map these choices into a functional relationship between price and quantity consumed.

What will we learn?

By the end of this lesson, you should be able to:

• define and explain the concept of declining marginal utility;
• read a demand schedule and convert it into an individual demand curve;
• aggregate individual demand curves into a market demand curve;
• define and calculate price elasticities of demand.

What is due for Lesson 2?

This lesson will take us one week to complete. Please refer to Canvas for specific time frames and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.

In Lesson 1, we spoke of some of the axioms of economics and the fundamental questions that we are trying to address: who makes and sells what, and for how much?

Historically, there have been two basic schools of thought, which can be roughly categorized as "markets" (or "capitalism") and "central planning." In centrally planned economies, government agents are responsible for making decisions about production, distribution, and pricing of goods. In markets, these decisions are decentralized, placed in the hands of millions of individuals, who invest their time, money and ideas into the manufacture or sale of some product, with the hope of making a profit and enhancing their own lives.

Throughout much of the 20th century, there was tension between advocates of market economies and those of centrally planned ones, but over the past 30 years, there appears to have been a clear shift in thinking across the globe towards market systems. Centrally planned economies were largely shown to be less successful at meeting the needs and wants of their consumers, and less able to efficiently allocate money and resources in production. Even countries that are still nominally referred to as "communist," such as China, have adopted market-based reforms that have led to great increases in the welfare and quality of life of their citizens.

The Knowledge Problem

The great problem of attempting to centrally plan an economy is that of information. While it may be possible to understand technology, inputs, and production and distribution costs, and it may be possible to establish what the basic human needs of a society are (e.g., necessary quantities of housing, food, transportation, etc.), it is impossible to assess the entirety of human wants. We all want more than we need, and we all have a different idea of what it is that we want. Indeed, for each of us, what we want is a constantly changing thing, as our tastes, desires and abilities change over the course of our lives. The greatest benefit of a market-based economy is that it is the only place where all of this widespread information about diverse and dynamic human wants is exposed. This information guides producers to alter their production and investment choices to ensure that human needs and wants are addressed. In a market context, this is what Adam Smith referred to as "the invisible hand," the assembly of unseen consumer forces continually changing the production landscape.

Markets and Mixed Economies

When we speak of central planning versus market economies, it is very easy to assume these to be two discrete states of social organization. The reality, of course, is that we exist at some place "in the middle." For this reason, I am reluctant to use the term "free markets," as this implies that under a market system, people are free to do whatever they want. This is not true - there are many constraints on human behavior. Some of these are social and cultural, but a great many are regulatory in nature: governments telling people what they can and cannot do. In the context of an economic system, this is manifested by things like labor laws, product safety rules, hazardous materials rules, consumer protection from fraud at the retail level, and so on. We have a great deal of government involvement in our economic lives, even in the United States, which is frequently held up as the standard-bearer for free-market economics in today's world. Indeed, every year, several thousand pages of new regulations are added at the federal level, and countless thousands more at the state and local levels. Almost no aspect of our economic lives is free of some restriction or regulation.

An economy without any form of government intervention is referred to as "laissez-faire." This is a French term that translates to "let it happen," and the United States is certainly not a laissez-faire economy. The peak of laissez-faire probably occurred in the second half of the 19th century, and gave rise to industrial titans such as Andrew Carnegie and John Rockefeller, who became known as "robber-barons" because of the allegedly predatory way in which they ran their businesses. This gave rise to the first great wave of business regulation, and we have not stopped since. Thus, when speaking of market economies, it is best to refer to them as "competitive markets," and not as free markets, because they certainly are not free in the sense that market participants are not unrestricted agents.

A Model for a Market Economy

The market is a system where producers and consumers interact for the benefit of all involved. It is helpful to look at these two sides of the market separately at first.

On one side of the market is the Demand Side. People on this side of the market can be referred to as consumers, demanders, or buyers - these terms will all be used interchangeably for the rest of this course. Consumers can be thought of as "Utility Maximizers," where the definition of utility is that referred to in Lesson 1. When we speak of consumers, we are generally referring to the end-users of products or services, and not firms that make intermediate purchases of materials or labor.

The other side of the market is known as the Supply Side. On this side, market participants can be called suppliers, producers, or sellers. Once again, all three of these terms can and will be used interchangeably. Producers are typically thought of as profit-maximizers, not utility maximizers, and this is a crucial distinction and affects the way we analyze the behavior of these two sides of the market.

The title of this section uses the term model. A model is a way of representing something else, a kind of "stand-in." A model is necessarily simpler than the thing it is trying to represent and, because of this, there is some detail that is lost in the process. The trade-off that is made when using a model is that a model can make things easier to understand. When we speak of a market, we are talking about something that involves the individual, private decisions of billions of consumers and producers. There is no way in which we can represent all of these decisions and interactions, but we can come up with a tool that illuminates some of the big-picture, general concepts in a way that is easy to grasp and comprehend, and has stood the test of usefulness over time. This is what the supply and demand concept consists of - it is elegant in its simplicity, and extremely powerful at describing the behavior of markets in a generalized way at a high level.

If you choose to study economics in more depth after this course, you will find that the supply and demand diagram will still be the key tool that is used. But at higher levels, we look in more detail at either aberrations from the simplified behavior described in the supply and demand diagram, or we look in more detail at specific parts of the market. However, my point here is that the supply and demand concept is the main underlying model of a market economy, and a good and thorough understanding of it will allow you to make a solid analysis of any situation involving market interactions, even without deeper knowledge of the situation at hand.

The main goal of analyzing markets is to try to figure out:

• “How much of what stuff is made, and by what methods?”
• “At what price is it sold?”

To figure these things out, we study supply and demand. The basic analytical tool is the supply and demand diagram, which is a MODEL of a market, as shown below:

Figure 2.1 Supply and Demand diagram

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

Parts of the Supply and Demand Diagram:

• x-axis: measurement of quantity
• y-axis: measurement of price
• Demand curve: relationship between price and quantity people are willing to buy
• Supply curve: relationship between price and quantity that firms are willing to sell
• Intersection point of supply and demand curves: “market equilibrium”

Markets are dynamic—always changing—so a supply-demand diagram is always just a “snapshot” of a market at a moment in time. Another dimension is “time,” which we do not consider at this point.

Figure 2.1 has two lines, which represent the two sides of the market, or the two parties in any economic transaction. The demand curve describes the behavior of the demanders in the economy. These people can also be called buyers or consumers. Restating: "demanders," "buyers," and "consumers" all mean essentially the same thing.

The other side of the market is described by the supply curve - the red upward-sloping line in the diagram above. The people *(or, typically, firms) on this side of the market can be called suppliers, or sellers, or producers. These three terms all mean basically the same thing.

In the first lesson, we spoke of the concept of marginal analysis. That is, we look at how something changes if we change some other thing a little bit. For example, what will be the effect on sales of raising price a little bit? Or what will be the effect on price of adding some new regulations to a market? We also spoke in Lesson One about the concept of "utility," which is the economist's catch-all term to describe happiness, wealth, value-from-use, and so on. Utility is basically the benefits that derive to a person from using or consuming a product or service, or, more generally, the amount of extra happiness a person gets from making a certain decision and executing that choice. One of the axioms we spoke of is that people are utility maximizers, and every choice that is made is made with the goal of increasing utility.

When we speak of demand in a market, we have to consider just how much utility does a person get from consuming a certain good, at the margin. So, we are considering a process of gradual change: how much utility does a person get from consuming one more unit of a good, and how does this change with further consumption? A great deal of research has been performed on this issue, and it generally backs up what we all know intuitively: the more we have consumed of something, the less value the next unit of consumption holds for us. This is defined as the concept of Declining Marginal Utility. This sounds like a complicated piece of jargon, but it helps to think of what each word means, and the concept becomes easy to grasp.

• "Declining" means "decreasing," or "getting smaller."
• "Marginal," as described above, refers to the effect of enacting some small change, i.e., "at the margin."
• "Utility" refers to the happiness we get from doing something.

String these three definitions together, and what we are saying is that the amount of happiness we get from consuming some good goes down as we consume more of it.

So, what does this mean in the context of a market? Well, to consume a good, we have to give up something to get it. Put simply, we have to buy it. So we give away some money, which can be thought of as a measure of potential utility, for a good that gives us actual utility. Since we want to maximize utility, we will willingly trade money for a good as long as we get more utility from consuming a good than we are giving away to get it. I will restate this, as it is perhaps the key underlying principle of a market economy: if someone gets $5 of happiness from consuming something, they will be happy to pay up to $5 for that good. If the price of the good is $6, then a rational utility maximizer will not buy the good: he is giving away $6 worth of utility to get $5 worth of utility. Nobody will do this willingly - if he has full knowledge of the values of the good and the money.

The concept of declining marginal utility is the foundation of demand-curve modeling, which is one side of our market model. This will be described in more depth in the next section.

We will look at the supply and demand curves separately before we look at the way that they work together. We will start by looking at the demand curve. This is a Functional Relationship between the price of something and the amount of that thing that buyers (consumers, demanders) will buy at a given price. Looking at it another way, it is the maximum amount that a person is willing to pay for some amount of a good.

Pepperoni Pizza!

Credit: Pepperoni Pizza by denithy from Pixabay is licensed under the Simplified Pixabay License

Where does the demand curve come from? It comes from individual preference and utility. An “individual demand curve” is how much a person will pay for a certain amount. This is calculated based upon the idea of “declining marginal utility,” which is another way of saying that the more we have of a certain thing, the less we value getting an additional unit of that good. For example, when you are hungry, you may place a lot of value on the first slice of pizza because you get a lot of utility (happiness) out of that first slice. The second slice gives you more happiness, but not as much as the first, and so on.

When you have had 3 slices, you place very little value on the 4th slice.

A person is willing to pay up to his marginal utility, but not more (because you will not give away more money than the amount of utility you get from using something).

Individual Demand Schedule

Individual Demand Curve

Figure 2.2 Marginal Utility derived from eating pizza

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

Figure 2.2 tells us that after eating five slices of pizza, a person derives no marginal utility from consuming the sixth slice. It is entirely possible that the demand curve can go negative, although economists never really examine this. However, just think about it: let's say you have eaten six slices, and are very full. Eating another slice may cause you to get an upset stomach, or may make you throw up your food. Both of these are things that people do not want to happen under normal circumstances. In this case, the seventh slice of pizza is no longer a "good," but it is a "bad": consuming it will actually decrease the total amount of happiness of the individual. A rational person would certainly not eat a seventh slice.

Figure 2.2 is the demand curve for an individual. Usually, a market consists of more than one individual, so if we want to find out what the demand curve looks like for a market in its entirety, we simply add together all individual demand curves.

What do we mean by "add together"? Well, we can construct a demand schedule for everybody in the market added together. Looking at the demand schedule, we have it written in the form "How much utility do I get from each slice?" We can reverse this, however, and say "At a certain price, how many slices would I buy? If the price of a slice is $2.50, the person described by the demand schedule would buy three slices. They would not buy the fourth slice, because this slice only gives the $2 of utility, but they would pay $2.50 for it. That means that this person would be voluntarily making himself poorer by buying a fourth slice of pizza, and this would violate our assumption about rational utility maximization. As I have said before, in real life there are cases where people do not make the proper decision, but we have to assume that people usually intend to make a utility-maximizing decision. If we don't make that assumption, there are basically no rules for examining human behavior. We are left with chaos; I would not be able to teach this course. So, the assumption of rational utility maximization gives us a sense of peace and order that allows us to study economics. We can look at the messier stuff about bad market decisions later on.

So, getting back on topic, how do we create a market demand curve? Well, let's do a demand schedule, but instead of having the number of slices in the first column, instead, we have the price in the first column. In the second column, we have the total amount of slices sold at that price. By "total amount," we want to think about the total in the market area for one pizza store, or in one town, or on one university campus. It also makes this problem easier to analyze if we assume that the pizza from every shop in town or on campus is identical. Obviously, in the real world, this is not true, but we make this assumption, called "product homogeneity," because it makes life easier for us. Don't worry, we will relax it a little later in the course and see what happens. (Hint: more chaos! I prefer to avoid chaos.)

So, let's assume that I have collected a demand schedule from every person in town and that every person knew just how much utility they got from eating each extra slice of pizza. (Maybe they are all economics students and think about every aspect of their lives in terms of declining marginal utility and rational utility maximization.) (Hey, I do. It makes me a real hit at parties.)

So, now I put together a schedule of how much pizza will be sold at each price point. Let's say it looks like this:

If we were to plot this, like the individual demand curve, we get the following:

Figure 2.3 Quantity of slices sold

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

So, Figure 2.3 is what a "market demand curve" looks like. If you were the owner of the only pizza joint in town, this would let you know how many slices you will sell at each price. Of course, real life is a little more complicated for several reasons. Firstly, it is very unlikely that you have "perfect knowledge" of the demand curve. After all, how can you get everybody in town to tell you how much utility they get from each additional slice? And then, of course, we have another dimension: time. The demand for pizza on Friday night during the school year is a lot different than the demand on a Wednesday morning in the summer. And if you aren't the only guy in town, but one of several pizzerias, how much of that market will you capture? But, of course, we are making simplifications for the purpose of explaining simple principles here. As I keep promising, we can relax some of these assumptions and make things more complicated later. But, for now, let's keep things simple.

There is one thing you should note about the demand curves in both of the above graphs: they slope downwards as we go to the right. This means that as the price of a good decreases, more of it will be sold. Or you can say that as the price rises, fewer will be sold. Why? Because of declining marginal utility. After a person has consumed one unit of a good, they usually get a little bit less happiness from consuming the second unit of a good. Sometimes the difference in utility is very small, which means the curve will be very flat (more on this in the next section), sometimes it will be very steep, but in any case, it will be downward sloping. We cannot believe that somebody gets more marginal utility from consuming an additional unit. This is what we call the "First Law of Demand": demand curves are downward sloping. This means that if a seller raises the price, fewer of an item will sell.

You are looking to buy pizza. Your “pizza happiness” in $ is described in the table below. Pizzas cost $2 each. How many should you buy?

Method 1: Brute Force

Simply figure out your happiness for each number. Happiness=Pizza Happiness-Total Cost (remember pizzas cost $2 each). Inelegant, low score on exam, but it will work. Fill in the table below and choose the spot that maximizes your happiness (what we will soon call consumer surplus).

Method 2: The Elegant Economic Way of Thinking (This gets you all the credit!)

Let Marginal Happiness(X)=Pizza Happiness(X)-Pizza Happiness(X-1). Keep buying pizza as long as marginal happiness>cost of pizza (here $2).

Remember, decisions are made on the margin!

Fill in the blanks, and pick your bliss point!

Practice Exercise

Delicious cuy (a delicacy in Peru) costs $10 a serving. Your cuy happiness is given in the table below. How many cuy will you buy, and what will be your total happiness?

Cuy

Credit: Cuy by Phil Whitehouse from Flickr is licensed under CC BY 2.0

Table 2.7 Cuy Happiness ($)

# of Cuy	1	2	3	4	5
Cuy Happiness ($)	20	36	47	52	54

Some people talk about something called a Giffen Good. This is a mythical good with an upward sloping demand curve, meaning that more sell if the price is higher. Sir Robert Giffen hypothesized that an inferior staple good, such as bread, might actually see an increase in demand as its price rises. The idea being that as the price of bread increases, poor consumers would have less money to spend on other goods (meat, for example), and would actually need to purchase more bread. You can probably see, however, that there would have to be a lot of constraints on this hypothetical world- no other types of inferior staple goods available as substitutes, and no corresponding wage inflation to provide additional income to buy bread, to name a few. In order to come up with a scenario where we have an actual, upward-sloping demand curve, we need to do a lot of semantical gymnastics and make a lot of special-case assumptions. Life is much simpler if we just believe that the First Law of demand holds. Which it does, of course, because it is the law, and not merely just a good idea. I like to think of it as the economic law of gravity. In a few special, rare and carefully constructed circumstances, you can appear to circumvent it, but for almost all of us almost every day, it holds true. (Or, I should say, is not falsified.)

Assume you are hungry and you are willing to pay 5 dollars for one slice of pizza. However, you find that you can buy that slice for only 2 dollars. In that case, your total gain from buying that slice of pizza is 3 dollars because you were able to buy it for less than the value you put on it. This gain is called Consumer Surplus.

“Consumer Surplus is the difference between the maximum price consumers are willing to pay and the price they actually pay.”
                              -- Gwartney, et al., Microeconomics: Private and Public Choice, 14th Edition

Now consider the pizza market: individuals who are hungry and want to buy pizza, people who have different willingnesses to pay for one slice of pizza, some people who put more and some who put less value on that. Consequently, some have more and some have less gain (consumer surplus) by buying a slice of pizza. The summation of all these individual gains is called total consumer surplus in the entire market. In the following figure, the size of the triangular area shows the total consumer surplus gained by all the consumers in the market.

Figure 2.4 consumer surplus equals the area between the demand curve (blue, diagonal line) and market price. So we're looking at the yellow (shaded) triangle, here. 

Credit: F. Tayari © Penn State is licensed under CC BY-NC-SA 4.0

Assume P1 = $2 is the price of one slice of pizza. All the slices of pizza sold in the market (Q1) are purchased by the consumer who value the slice more than and equal to $2. Some consumers value it very highly ($span>8) and some value it less ($5). For each consumer, the gain is the difference between the value and the $2. Therefore, the area of the triangle between demand curve and price (P1) equals the summation of all gains. Clearly, if the value that a consumer puts on the slice pizza is $2 and he pays $2 for it, then the gain will be zero.

Note that we should distinguish between marginal value and total value of a good. At each point (at each quantity of good sold), the marginal value for the consumers is the height of the demand curve and the total value equals the summation of all those marginal values. Marginal gain equals the difference between marginal value and price. Therefore, total gain, which we call consumer surplus, equals the summation of all marginal gains.

In order to calculate the consumer surplus, we need to find the area between demand curve and market price, the area under the demand curve and above the price (horizontal line). As we can see in the graph, consumer surplus is affected by the price. The higher price makes the area smaller and causes lower consumer surplus. The lower price makes the area larger and causes higher consumer surplus.

So, in this example, consumer surplus can be calculated as:

$\text{Area of the triangle}=\frac{\left(9-2\right)\left(14-0\right)}{2}=49$

We often want to perform calculations concerning total utility in a market, or total costs, or some such thing, and to do this, it is helpful to define the functional relationships on a supply and demand diagram with a mathematical equation.

So, an example of a demand curve may be specified as follows (Please note that P stands for "Price," and Q stands for "Quantity") : $P=100-2Q$

This describes a downward sloping line, which intersects the y-axis (which represents price in a supply-demand diagram) at a value of 100, and declines in value by 2 for each extra unit we travel along the x-axis (which represents quantity of goods sold in a supply-demand diagram).

So, if the Quantity is 20, we would say $Q=20$ , $P=100-2\left(20\right)=100-40=60$ , and so on.

If you look at the market demand curve for pizza, on the previous page, we might want to describe it as P = 9 - 0.5Q, which describes a straight line with a y-intercept of 9 and a slope of -0.5. In that case, for example, market price for pizza when the quantity is 10 will be: $P=9-\left(0.5\times 10\right)=\$4$ .

Example:

Assume the market demand curve for pizza is $P=9-0.5Q$ . Calculate the consumer surplus if the price of pizza equals $3. Try to use two methods to calculate the consumers surplus:

• Mathematical equation
• Geometry: and calculating the area of the triangle

Then compare your answers. You should have the same answer.

Answer:

We need to calculate the area of the triangle. First, we need to find the coordinates of three corners of the triangle between demand curve and price. Then we have to find the length of the sides.

The coordinate of the three corners are:
Top corner: (0,9)
Bottom left: (0,3)
Bottom right: to find this point, we need to plug the price = 3 into the demand equation and find the Q. $3=9-0.5Q$ . And Q will be 12. So, the coordinate of the bottom right corner will be (12,3)

Knowing these three points, we should be able to calculate the area of the triangle as: $\frac{12\times 6}{2}=36$

Geometry:

We need to draw the graph and calculate the area of the triangle ($\frac{12\times 6}{2}=36$ ):

Figure 2.5 Demand Curve

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

The market demand curve could be a more complicated function. This illustrates what I have mentioned before: real life is a very complicated thing to model, but in economics, we can use simple models to describe and explain human behavior and market outcomes. So assuming a linear demand curve may be a simplification of reality, but it aids our understanding of markets, and if we can perform numerical examples, it makes the illustration of concepts easier for a lot of us.

Economics is a dynamic process. Given the millions of human interactions that make up an economy, it is not surprising that things do not stay the same for very long, if at all. Things change: this is the nature of a dynamic economy. We now ask, how much do they change?

At this point, this question relates to the shapes and slopes of the demand curves, which we will examine here. We will look at the supply curve in the next lesson.

In physics, the term “elasticity” refers to how much something stretches when force is applied to it. In economics, when we think about "elasticity," we are interested in how much a quantity demanded or supplied will change when some “force” is applied to the market. Both the demand and supply curves have elasticities. Let us talk first about the elasticity of demand. The phrase “elasticity of demand” is incomplete: we are talking about the response of demand to something. So, for the title to be complete, we have to talk about the price elasticity of demand. That is, how much does the quantity demanded change when price is changed? We could also talk about the income elasticity of demand, which asks “how much does the quantity demanded change with income?”

The price elasticity of demand is defined as the percentage change in quantity divided by the percentage change in price. Or, mathematically, we get:

$$\eta =\frac{\%\Delta Q}{\%\Delta P}=\frac{\frac{Q_2-Q_1}{Q_1}}{\frac{P_2-P_1}{P_1}}$$

The Greek letter eta, \eta, is used to denote elasticity.

The notation $\%\Delta P$ is shorthand for "percent change in price", where the Greek letter delta denotes the change in something. This equation is also called “endpoint” elasticity.

A percent change in some variable is: $\frac{\text{value 2}-\text{value 1}}{\text{value 1}}\times 100\%$ .

For example, if the price of a bag of Doritos rises from 99 cents to $1.29, then the percent price change will be:

$$\frac{1.29-0.99}{0.99}\times 100\%=\frac{0.3}{0.99}\times 100\%=0.303\times 100\%=30.3\%$$

We use this format (a percentage change divided by a percentage change) because it conveniently lets us work in a dimensionless world. If we instead looked at absolute changes in quantity and absolute changes in price, our results would have to have dimensions, such as “pounds of oranges per thousand dollars” or “cars per million Euros.” Instead, when comparing a percentage change in one thing to a percentage change in another, we avoid the confusion of what units we should be using.

This formula uses the endpoints of the interval, which means that if we calculate the elasticity from point 1 to point 2, it will be different than the elasticity from point 2 to point 1. This is seen to give inconsistent answers; so instead, we often calculate the “midpoint” elasticity. That is, instead of defining the elasticity using Q₁ and P₁ in the denominators, we use the midpoint between P₁ and P₂, and Q₁ and Q₂. So, the formula for the midpoint elasticity is:

$$\eta =\frac{\frac{Q_2-Q_1}{Q_1+Q_2}}{\frac{P_2-P_1}{P_1+P_2}}$$

We can also define a “point” elasticity. If we shrink the interval between Q₁ and Q₂, we end up not using the distance between two points, but instead we have the reciprocal of the slope of the line multiplied by the ratio of the values of P and Q at the point in question. The slope of a line on a supply and demand diagram will be $\frac{\Delta P}{\Delta Q}$ , but because we are interested in the change in quantity that comes from the change in price, we examine the reciprocal (1 divided by the value), of $\frac{\Delta Q}{\Delta P}$ . Because we want to cancel out any units, we have to multiply this slope by the actual values. So, if we look at the point elasticity at a point (Q₁, P₁) then we would calculate it as:

$$\eta =\left(\frac{\Delta Q}{\Delta P}\right)\left(\frac{P_1}{Q_1}\right)$$

Example

Suppose that at a price of $10 per box, a store will sell 1000 boxes of bananas a week. If the store raises its prices to $12 per box, it will sell 750 boxes. What is the elasticity?

This particular demand curve is illustrated in the following diagram:

Figure 2.6 Quantity of Bananas Sold

Credit: Barry Posner © Penn State is licensed under CC BY-NC-SA 4.0

1) Using the original formula, we get:

$\eta =\frac{\frac{750-1000}{1000}}{\frac{12-10}{10}}=\frac{-0.25}{0.20}=-1.25$

2) Using the midpoint formula, we get:

$\eta =\frac{\frac{750-1000}{1000+750}}{\frac{12-10}{10+12}}=\frac{\frac{250}{1750}}{\frac{2}{22}}=\frac{-0.1428}{0.0909}=-1.57$

So, these numbers are quite different.

What about the point elasticity? Well, to answer this, we need the slope of a line. If we assume that the demand curve is a straight line, then what is the slope? Given that we have the points (Q,P ) = (1000, 10) and (750, 12), then the slope is $\frac{\Delta P}{\Delta Q}=\frac{\left(12-10\right)}{750-1000}=-0.008$ . But in the elasticity, we need $\frac{\Delta Q}{\Delta P}$ , which is $\frac{-250}{2}=-125$ . (Remember, the Greek letter delta, \mathrm{\Delta }, is shorthand for "change in").

So, at point 1, the point elasticity will be $\left(\frac{P}{Q}\right)\left(\frac{\Delta Q}{\Delta P}\right)=\left(\frac{10}{1000}\right)\left(-125\right)=-1.25$ . At point 2, it would be $\left(\frac{12}{750}\right)\left(-125\right)=-2$ .

Steepness of Elasticity

If something only stretches a small amount under pressure, then we say it is inelastic. In economics, we say that a good is inelastic if its quantity demanded does not change very much with a change in price. On a supply and demand diagram, an inelastic good is one that has a very steep slope. This is shown in the following diagram:

Figure 2.7 Elasticities of various demand curves

Credit: Barry Posner © Penn State is licensed under CC BY-NC-SA 4.0

Typically, goods that are thought of as necessities will be very inelastic. That is, no matter how expensive they get, we will still buy them. Health care, staple foods and gasoline are goods with low elasticities. If a demand curve is perfectly vertical (up and down) then we say it is perfectly inelastic. If the curve is not steep, but instead is shallow, then the good is said to be “elastic” or “highly elastic.” This means that a small change in the price of the good will have a large change in the quantity demanded. If the curve is perfectly flat (horizontal), then we say that it is perfectly elastic. Luxury goods are often very elastic – if the price increases a little, then people will move over to something else.

Remember that the elasticity is a ratio of percent changes in quantity and price.

Also, remember that all elasticities of demand will be negative, since the demand curve slopes downwards.

Summary

• A Perfectly Inelastic Demand Curve is vertical (η = 0). This is very rare in reality. You could claim that the elasticity of life-saving medical treatment is perfectly inelastic, since most of us would give anything and everything to stay alive.
• A highly inelastic demand curve is very steep (η close to zero, e.g., -0.1). Many goods that are necessities or have very few substitutes behave this way.
• A demand curve with an elasticity near -1 is said to be “uniformly elastic.”
• A highly elastic demand curve is very flat (η between -2 and -5). Luxury goods, or goods with lots of substitutes behave like this.
  Perfectly elastic goods have a horizontal demand curve (η = -∞). This is rare in the world.
• In the following diagram, the supposed value of the price elasticity of demand is shown beside each line.

Some sample elasticities (from the real world):

• Gasoline: -0.04
• Sugar: -0.31
• Long distance phone service (1995): 0.35
• Tires: -1.20
• Movies: -3.70

So, let's think for what these numbers mean. The elasticity of gasoline (or, if I want to be complete and formal, the price elasticity of demand of gasoline) is -0.04. Put another way, this means that if the price increases 1%, the quantity that the public wants to purchase only goes down 0.04%. Or if we scale these numbers up, we can say that if the price increases by 100% (that is, it doubles), then the quantity consumed only falls by 4%. So, if gasoline gets a lot more expensive, people will still use almost as much, at least in the short term. This is because most of us don't have a lot of choice about using gasoline (in the short term - more about what "short-term" means a bit later). A lot of us don't have the option of using less gasoline, because we still need to get to the store and to work, and so on. Gasoline was more than twice as expensive in 2012 as it was in 2002, but we used about the same amount.

The number for long-distance phone service was also quite inelastic, because back in 1995 we didn't have a lot of options. Today, this number would be very different. Now we have cell phones that don't charge by how far you are from the caller, and we have Skype and we have VOIP and we have iPhones with video talk and we have webcams, and we have cable companies offering calling plans, and we have people talking about setting up communications networks on power lines, and so on.

Looking at the number for movies, we see that it has a high value (actually, because it is a negative number, it's actually smaller, but it is bigger in absolute terms). This means that if the price goes up 1%, then the quantity demanded goes down by 3.4%. This is because movies are somewhat of a luxury, and there are usually plenty of alternatives.

We'll talk a lot more about the reasons behind these elasticities in Lesson 4 when we talk about market dynamics or what happens to supply and demand when we consider the effects of time and of the costs of other things. The important thing to take from this lesson is just to understand what a demand curve is, and how we measure just how much the quantity of a good demanded changes with the price of the good.

Reiteration

If you remember nothing else from this lesson, I hope you remember and understand the following two points.

1. A demand curve is a functional relationship. I cannot say this enough times. It is a curve that defines the relationship behind how much of a good will be demanded in a market at a certain price. Change the price, and a different quantity will be demanded. Demand is not a constant, but a variable.
2. Demand curves slope downwards because of the notion of declining marginal utility - the more of something that one has consumed, the less benefit (and, therefore, the less they are willing to pay) for the next unit of the good in question. Also, this is why the price elasticity of demand is negative: if price goes up, quantity demanded goes down, and vice versa.

In this lesson, we introduced the concept of a market system, and our core tool for analysis of markets, the supply and demand diagram.

We examined in detail the origins and underpinnings of one half of this market model: the demand curve.

At this point, you should be able to perform the following tasks:

• Explain what a market-based economy is, and what the most common alternative form of economic organization is.
• Define and understand what is meant by the term, "declining marginal utility."
• Identify the parts of a supply and demand diagram.
• Read an individual demand schedule and use it to draw an individual demand curve.
• Understand that a demand curve is a functional relationship between two things: the quantity of goods (Q) that is demanded by consumers at a given price (P). Demand is not a constant, but a line that has changing Q for changing P.
• Amalgamate individual demand curves to obtain a market demand curve.
• Understand what the term "price elasticity of demand" refers to.
• Be able to calculate a price elasticity of demand.

Graded Assessment

If you log in to Canvas, you will find a short written quiz for lesson 2. Complete that by the date noted on the calendar tab in Canvas.

There will also be a new discussion forum topic posted this week.

Have you completed everything?

You have reached the end of Lesson 2! Double check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there.

In the previous lesson, we described and defined the demand curve, which relates prices and quantities on the consumption side of the market. In this lesson, we will learn about supply curves, which define the relationship between price and quantity on the producing side of the market.

What will we learn?

By the end of this lesson, you should be able to:

• describe the differences between fixed, variable, average, and marginal costs;
• understand the difference between "accounting" and "economic" profits;
• describe risk-free returns and risk premiums;
• define what is meant by "long-run" and "short-run," and what the difference between them is;
• draw a supply and demand diagram, and identify the equilibrium point;
• list and describe the assumptions of perfectly competitive markets.

What is due for Lesson 3?

This lesson will take us one week to complete. Please refer to Canvas for specific time frames and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.

In this lesson, we are going to talk about the supply curve and, if you will allow me to jump to the end for a second, the supply curve is based upon costs. So, if we want to try to figure out just what kind of prices producers charge, and how much (or how little) they can accept in exchange for their goods and stay in business, we need to think about what exactly creates the costs of doing business for a supplier (or seller or producer - remember, they are synonymous, the same thing.)

From here on, when talking about suppliers, I will use the term "firm," which is basically a form of shorthand for "an entity that makes things (or provides services) and sells them with the expectation of making a profit." This is what most firms are. As always, we can add a lot of fine print about exceptions and variations, but that does not help us with the illustration of basic concepts. It's better for all of us if we keep things simple. Of course, a firm could consist of an individual person, or an international mega-corporation with a workforce and budget that dwarfs several Eastern European countries, but they have the same basic goal: make things and sell them for enough money to be able to stay in business for another day, and pay the owners of the firm enough to compensate them for their investment.

A firm that does not turn a profit can only stay in business for as long as its owners can pump money into it, which is usually something like "not long." Firms exist to make a profit. More on just what a "profit" is later.

So, what do firms do to make a profit?

A firm takes things and converts them into products. Inputs are converted into outputs.

The inputs that go into making a product can form a list that can be almost endless. To understand this, just refer to the previous page addressing the gasoline value chain, and think about the scope and scale of the entire enterprise required to find oil in the ground and convert it to the fuel in your tank.

Oil, property rights, seismic equipment, drilling rigs, pipelines, tankers, refineries, fuel and electricity to run these machines, people to operate the machines, people to fix the machines, buildings to house the machines, trucks to haul the gasoline to stores, gasoline to power those trucks, people to drive them, lawyers to make sure the company meets all regulations, paper to store records on, computers to process billing records, people to run those computers, furniture for those people to sit on, health care insurance for all those people, telephones to allow them to communicate, creative people to make advertisements for gasoline, waste disposal systems for refineries and offices, and so on. This is not even considering the needs of the firms that are selling gasoline to the end-user, and it is not considering the needs of the firms that make the trucks or machinery, or provide the health care, or host computer records, and so on.

My point here is that analysing the economics of running a business can be very complicated, and, as you may have noticed, economists like to simplify things. It makes the world an easier place to try to figure out, and lets us sleep at night.

So, to simplify things, we take the many and varied inputs into some production process, and divide them into a few simplified classes of inputs, for example:

• Labor (L): simply put, people.
• Materials (M): physical things that get used up to make products.
• Energy (E): electricity, petroleum products, and so on.
• Capital (K): machines and buildings (and may also include land). Does not get “used up” in production.

These four things are abbreviated L, M, E, and K. The things produced, the outputs, are labeled Y. Some people use only K and L. Others use K, L, and M. Since this course is part of a degree program focusing on energy use, it is important for us to view energy as a separate class of inputs, as we are often concerned about how we can maintain or maximize output while consuming less energy. It might be tempting to lump energy in with other "consumables" under the category of "materials" (M). However, in our orange juice example, we have physical materials like oranges and bottles and boxes, and we have "intangible" things we consume that are not an intrinsic, physical part of the final product. Mostly, this describes energy; we require energy to move machine parts or to add heat or to drive chemical reactions, but we do not sell the product based upon how much energy is in it. For this reason, it can be useful for us to break energy out into a separate class of input. This enables the entire field of "energy efficiency."

The relationship between the input and the outputs is called a “Production Function.” Written in math terms, the production function is:

The inputs K, L, E, and M are called “factors of production.” The production function tells us the maximum amount of output (Y) that can be produced from a certain quantity of factors.

As we learnt in the previous page, the production function can be written as:

The marginal product of a factor of production is written as delta Y/ delta F (where F is the factor in question). This tells us, ceteris paribus¹, how much the amount produced changes if we change the amount of one input. There is a general rule: if we hold everything else constant, but increase only factor i, then the increase in Y will get smaller with each additional unit of i employed. This is called the Law of Diminishing Returns. This is a bit like the idea of diminishing marginal utility.

¹The phrase “Ceteris Paribus” means “if nothing else changes,” or “holding everything else constant.”

For example, let us look at the following table, which lists output versus labor for a raspberry farm. The "marginal output" column refers to the extra amount of berries harvested by each additional worker, which can be written as $\Delta Y/\Delta L$ , where Y = pounds of berries and L = number of workers.

We can see that the amount of berries harvested increases with each extra worker, but the increase gets smaller and smaller for every extra worker.

Now, let’s expand the table to include prices for berries and for labor. Let’s say that a pound of berries can be sold in the farmer's market for $5, and a berry picker costs $60 per day to employ. Defining a couple of terms, revenue refers to the amount of money a firm brings in from selling things in the market. If the firm is selling goods that all have the same price, then revenue is simply the price for each good times the number of goods sold, or $P\times Q$ . Remember that "marginal" refers to "the extra amount from doing one more thing," so marginal revenue refers to the extra amount of revenue that is obtained from selling one more thing, or in this case, the amount of extra revenue that comes from adding an extra berry picker. The total cost of labor is how much the firms owner has to pay to the workers. If each worker makes the same amount, it is simply $\left(P\times Q\right)$ , where P = wages = price of a worker, and Q = the quantity of workers employed. The marginal cost of labor is the additional cost of employing an additional worker.

So, we can compare the marginal revenue from labor to the marginal cost of labor. It pays to keep adding labor until we have 4 workers, because the marginal cost of workers 1 through 4 is less than the marginal revenue that each extra worker generates. Each worker more than pays for himself. However, adding the 5^th worker does not make sense, because he costs the farm more in wages ($60) than the farm can get from the fruits of his/her labor. (Sorry...)

So, if the farm has 4 workers and would like to expand production, it should probably spend its next dollar on something other than extra labor. It needs to invest in some other factor of production, such as capital, in the form of more land, or machines that can pick more berries, or give its workers a device that allows each one to pick more berries in a day.

This is the reason why supply curves tend to slope upwards: the productivity from a factor of production decreases as its use increases. As I said before, this is the Law of Diminishing Returns. This happens for two reasons: the amount of output from each additional unit of a factor may get smaller, or the cost of an additional unit of input gets higher. The second effect happens when we have a situation of full-employment in a country: if everybody has a job, and a firm wants to add workers, then it has to lure workers away from other industries, and the only way that this can be done is to offer higher wages. So, returns decline because of lower productivity and higher costs.

Equimarginal Principle

So, what is the perfect mix of capital, labor, materials and energy? Let us define something called the "marginal return to a factor," which is just a fancy way of saying "How much more money do we make from investing in another unit of some factor of production?" We want the marginal revenue (MR) from employing an extra unit of some factor to be greater than the marginal cost (MC), or as a ratio we want $MR/MC$ to be larger than one. The higher that $MR/MC$ is, the better.

Now, consider that there are four different factors of production: K, L, E, and M. Each one has a marginal return, or a ratio of $MR/MC$ . If one of these factors has a higher $MR/MC$ than any of the other factors, it makes sense to invest in that factor: you get more bang for your buck, as it were. However, given the idea of declining marginal returns, the more we spend on a factor, the lower the return, $MR/MC$ . So in the above example, we have invested in labor until $MR/MC$ got as close to 1 as possible. We want to invest, maybe, in machinery. But as you invest in more machinery, the $MR/MC$ for machines gets closer to 1, which means then that investing in some other factor of production makes sense. Maybe you're starting to spot a pattern here: it makes sense for a firm to spend extra money on whatever factor has the best return, but eventually, all factors will have equal returns, because they will all basically be driven towards 1.

This is called the "equimarginal principle," which merely states that in an efficient firm with sufficient information, factors of production will be employed in some optimal mix such that the marginal return to each one is equal, and as close to 1 as possible. If one factor has a higher return, it makes sense to invest more in it, and if the marginal return is above 1, it makes sense to spend more, because each dollar spent returns more than one dollar in extra revenue.

Repeating myself a little bit, the general rule is that the marginal return to all factors will be the same. This is because if one factor gives you a better return, you will use more of it, and its return will drop to the same level as all other factors. This guides a business as to which factor they should employ more (or less) of, and tells them the ideal (most efficient mix) of factors.

Of course, this is a nice theoretical basis for running a business - just invest in more factors of production until they all have a marginal return equal to 1. If any of you have ever run a business, you know how simplistic this sounds. In real life, figuring out the returns to factors can be very difficult - assigning a benefit to every single thing in even a simple business, like our orange juice one, can be very difficult. How many lawyers do you need? How many trucks? How many drivers? How many shifts of workers? Should you generate your own electricity or buy it? Should you use local oranges or imported ones, and so on. I will repeat my often-mentioned caveats about models being (necessarily) simpler than real life.

Economies of Scale

Sometimes we want to make our businesses bigger. When you do this, you do not add just people, or just machinery, you add all factors. But how much should we add? The question is: Do we benefit from getting bigger?:

• If increasing inputs by x% increases output by more than x%, we have what are called “increasing returns to scale.”
• If increasing input factors by x% increases output by exactly x%, we have constant returns to scale.
• If increasing input factors by x% increases output by less than x%, we have decreasing returns to scale.

Firms generally try to be as big as possible without entering the phase of decreasing returns to scale

Long-term versus Short-term

Many people use the terms "short term" and "long term" quite loosely. In the context of economics, we have a more formal definition.

I will start by returning to our example of a refinery. Let's say that the market for gasoline is growing, and you, as the owner of this refinery, would like to make more gasoline and make more money from selling it. So, what do you do? Well, if you want to make more gasoline, you will obviously need more crude oil. If you are currently operating your refinery for a single 8-hour shift, Monday to Friday, you will need to add an extra shift, which means hiring more labor. You will need to run the refinery process units longer, which means using more energy. It is relatively easy for you to do all of these things quite quickly: increasing the amount of crude you want to buy, and hiring some more workers, and using a bit more electricity are all things that you can accomplish in a few days.

However, let's imagine that you have expanded output as much as you possibly can from your refinery. You are now running a 24 hour per day, seven day per week operation; your process units are running every hour at their fullest capacity, and you have all the workers you need to run those machines. What do you need to do if you want to sell more gasoline? Well, you need to expand your refinery, increase the size (or number) of the process units, and build new buildings. This is something that takes a significantly longer period of time. You might be able to hire staff and buy crude easily, but building a new refinery unit and buying industrial equipment all have long lead times.

Think of the above two paragraphs in terms of factors of production. In the first case, where we were ramping up production in the existing refinery, we were adding materials (M), labor (L) and energy (E). These could all be done easily and quickly. In the second case, we had to add buildings and machines, which fall into the category of capital (K). This takes a lot longer.

This is the crucial distinction between "short term" and "long term." In the short term, we can change three of our factors of production: materials, labor and energy, but we are stuck with the capital that we have. In the long term, we can build new factories. So, in the short term, L, E and M are "variable" factors, meaning that they can be changed, but K is fixed, or constant, meaning that it cannot be changed. In the long term, L, E, and M are, of course, variable, but so is K.

Summarizing:

• In the short term, capital is assumed to be constant, all other factors are variable.
• In the long term, all factors are assumed to be variable.
• In other words, the difference between “short-term” and “long-term” is the time required to change a firm’s capital.

The actual length of time that defines short-term versus long-term can be very different in different industries. If I am in the business of selling newspapers on street corners, my only capital is a rack to stand the newspapers on, and if business is very good and I need to expand to another corner, all I need to do is buy another newspaper rack, which can be done by going to a shelf shop. The transition between short- and long-term, in this case, is very short. At the opposite extreme, perhaps, is the nuclear power industry. If you want to build a new nuclear power plant, you are looking at a minimum time-frame of about 7-8 years from the beginning of planning to the start-up, in a best-case scenario. In other areas, we can look at the New York subway system, which is just now building the second Avenue line, which was initially proposed in the 1930s, although that might have something to do with the way governments operate... :-) More on that later in the course.

Try to think of the definition of long-term in a few different businesses. In a small accounting business, the capital consists of computers. Adding more capital takes a couple of days, at most. If you want to sell pizza, it takes maybe 3 months to build or buy a building and install some ovens. In the auto industry, it might take two years to plan and build a new assembly plant, and it takes from 5 - 10 years for a large new power plant. The point being, short-term and long-term are not defined by some certain length of time, but are specified by how long it takes to add capital in the industry in question.

Take Aways

After working through the material on this page and reading the associated textbook content, you should be able to confidently:

1. explain what a production function is;
2. explain what a factor of production is;
3. define the usual factors of production employed in this course;
4. explain the meaning of the phrase “ceteris paribus”;
5. describe what the marginal product of a factor of production is;
6. describe the law of diminishing returns;
7. explain the concept of diminishing returns to a factor;
8. explain what is meant by “increasing returns to scale,” “decreasing returns to scale,” and “constant returns to scale”;
9. explain what companies should do if faced with increasing or decreasing returns to scale;
10. define the difference between long-term and short-term.

In the previous section, we talked of production functions and input factors. When a firm converts factors of production into products (or output), it has to incur costs for those inputs before it can sell the output in the market. In this section, we will examine some of these costs, and how they fit into the concept of a supply curve.

There are several different types of costs that a firm incurs, broken down as follows:

Fixed Costs

This is the amount of money a firm has to spend to produce something that is not related to the amount produced. It is sometimes called the Sunk Cost or Overhead. Remember: in the short run, capital is fixed, so it is capital that forms the fixed cost part of any production process. Put another way, this is money you have to spend before you produce anything. For a pizzeria, it is the cost of the building, the ovens, the meat slicer, and so on. In the oil and gas industry, it is the wells, pipelines, and refineries that have to be built to extract, transport, and transform the crude oil or gas into saleable products. In the electricity industry, it is the power plants and transmission lines.

Variable Costs

These are costs that change with respect to the quantity produced. This basically describes the non-capital factors of production: material, labor and energy. All of these things change with respect to the amount of output a firm creates. An electricity generator has to burn more coal or gas to make more electricity. A pizzeria has to consume more flour, cheese and tomatoes to sell more pizza. A consulting company needs more staff if it is to take on more projects. These factors are all variable costs in the sense that they vary with output. Sometimes, certain types of labor might be seen as "overhead," and thus, basically, a fixed cost, because this labor does not vary with output, but this is a minor detail we need not worry about at this point.

Total Cost

Total Cost = Fixed Cost + Variable Cost

Figure 3.1 Total Cost = Fixed Cost + Variable Cost

Credit: Barry Posner © Penn State is licensed under CC BY-NC-SA 4.0

Using abbreviations, we say that $TC=FC+VC$ .

Average Cost

An average cost is the total cost divided by the quantity:

• $AC=TC/Q$ . (Can also be labeled as ATC: average total cost)

We can also have average fixed cost and average variable cost:

• $AFC=FC/Q$
• $AVC=VC/Q$

Marginal Cost

Marginal Cost is the most important cost of all. Greg Mankiw, whom we mentioned in the first lesson, calls this the “most important concept in economics.” The marginal cost is the cost of producing one more unit (or can be thought of as the cost of producing the last item). So, it is the change in total cost for some change in quantity:

where TC₁ is the total cost of producing Q₁ units, TC₂ is the total cost of producing Q₂ units of output.

We can have the Q₁ = Q  and Q₂ = Q +1 in that case, the Marginal Cost equation will be simplified as:

Example: Assume that the fixed cost for a shoe firm is 500, and it costs 100 to produce each individual pair of shoes. For Q=1 to 10, determine the fixed cost, variable cost, total cost, average variable cost, average fixed cost, and marginal cost.

Take Aways

After working through the material on this page and reading the associated textbook content, you should be able to confidently:

1. define and calculate the following terms:
   • fixed cost, average fixed cost
   • variable cost, average variable cost
   • total cost, average total cost
   • marginal cost
2. derive the fixed cost, variable cost, average costs and marginal cost when given a total cost function.

Everything in the realm of costs that we have talked about - returns to a factor, fixed and variable costs, economic profits - help define the supply curve.

What is the supply curve? Like the demand curve, it is a Functional Relationship. It is a relationship between the amount of money a firm is willing to accept in exchange for a certain amount of some good. It is not a constant. Because of the notion of declining marginal returns, we can assume that as we produce more of a good, the marginal cost of that good increases. This means that supply curves slope upwards. According to the law of supply, there is a positive relationship between the price of a good or service and the amount of it that suppliers are willing to produce. Meaning that if price increase, producers will supply more.

In reality, most marginal costs curves are U-shaped - they start very high at low volumes of production, they decrease as more of a good is made (economies of scale), and then as diminishing returns kicks in, the curve starts to rise again. There are some industries in which the marginal cost - that is, the cost of serving one more customer - continually slope downwards, like the utilities.This is a special case we will talk about later.

So, the supply curve is a relationship that tells us the minimum amount that a firm is willing to accept for selling a unit of a good. What is this minimum amount? Well, if you are a firm and you need to make one more unit of a good, then the cost to you of that good is the marginal cost of that good. To make the good, you need to recover, at a minimum, your marginal cost. Therefore, the supply curve IS the marginal cost curve.

First, we need to find the $Q_1$ and $Q_2$. We can do that using supply function:

We can find the total cost and marginal cost for Q=1 to 10 as:

Individual Supply Curve

Following graph displays the marginal cost (price) on the y-axes versus quantity on the x-axes. This curve is the supply curve (function) for the supplier. As we can see, it is an upward line. So, in order to find the supply curve (function), we need to extract the marginal cost from the total cost function. This graph tells us if price is $15, this producer is willing to produce 7 unites of the good. Or, for example, the minimum amount of money that this producer is willing to exchange for producing 4 units, is $9.

Figure 3.2 Marginal Cost curve

Credit: F. Tayari © Penn State is licensed under CC BY-NC-SA 4.0

Note that market supply curve is the summation of all individual producer supply curves.

Producer surplus

Similar to the concept of consumer surplus that we learnt in Lesson 2, we can define the producer surplus. Let’s start with an example. Assume you own a pizza shop and you are willing to make and sell pizza if price is at least $1.5 per slice. However, the market price is $2 per slice and you can sell each slice at the market price and receive $2. The difference between $2 and $1.5 is your net gain from exchanging the pizza with money. This gain is called your producer surplus. Producer surplus is the difference between minimum price you are willing to make and sell, and the amount you actually receive from selling the pizza. Please note that this gain is different from profit.

Let’s assume market production for a good equals $P=4+2Q$

So, if the market price is $20, market will supply 8 unites of the good $\left(20=4+2Q;Q=8\right)$ . And we know that $P=4+2Q$ is the market supply function, which is the summation of all individual supply functions.

Let’s say the first producer is willing to supply the first unit of the good to the market at the price of 6 dollars (you can plug Q=1 to the supply function). However, the market price is $20. So, his individual gain (individual producer surplus) from producing and selling, will be $14 $\left(20-6\text{=14}\right)$ . And if we do this for all other unites of the good, we can find the individual producer surplus for other suppliers in the market. And if we add them all together, we can calculate the total producer surplus in the market.

You might have already noticed that for finding the total market producer surplus, we just need to find the area of the triangle, which is bounded to supply curve, market price (horizontal line), and the y axis.

For calculating the area, we need to find the length of two sides $\left(A-B\text{and}B-C\right)$ :

A represents the market price and the coordinate will be (0, $20)
B is the supply curve intercept and the coordinate will be (0, $4)
C is the market supply at price = $20, and you can find the coordinate simply by plugging P=20 into the supply function $\left(20=4+2Q;\text{ Q=8}\right)$ . And the coordinate of C will be (8, $20)

Now that we have the coordinates, we should be able to calculate the area of triangle as:

So, producer surplus at market price of P=$20 will be 64.

Figure 3.3 Producer Surplus

Credit: F. Tayari © Penn State is licensed under CC BY-NC-SA 4.0

Note that, in general, when we are talking about the producer surplus, we refer to the market producer surplus, which is the summation of all individual supplier producer surplus. So, to calculate the producer surplus, we need to find the area above the supply curve and below the price. This area represents the total producer surplus in the market.

Price elasticity of supply

Similar to the method that we used to calculate the price elasticity of demand, we can define and calculate price elasticity of supply as:

“Percentage change in quantity supply, divided by percentage change in the price causing the supply response.”

The Greek letter eta $\eta$ is used to denote elasticity.

Price elasticity of supply reflects the sensitivity of suppliers to the price changes. Note that, since supply curve is upward, the price elasticity of supply is a positive number.

Example: Following the previous example find the elasticity of supply when price increase from $20 to $24.

First, we need to find the $Q_1$ and $Q_2$. We can do that using supply function:

We can also calculate the midpoint elasticity as:

We spoke in the last lesson about profits. So, what are profits? They are defined as revenues minus costs, or the money left over after all of the bills have been paid.

Where do they go? Every firm has an owner, and these owners are the people who legally own the profits from the firm. People invest (put in) their money, their time and their effort in a firm with the hope that the firm will make a profit. Therefore, the profit is a payment to the owner of the firm in exchange for the things he has put into the firm. In a small business, the owner puts in time, money and effort. In a large, public share company (called a joint-stock company), owners only put in money when they buy shares. So, the money left over after operations, which is total revenue minus total costs, is what we call the "accounting profit," and this is the payment to the owner in exchange for making an investment in that firm.

How much profit should a firm make? To think about this, it is helpful to think about some choices you have as an investor. Let us imagine that there is an investment that is 100% safe. This means that you know for sure that this investment will pay the profit it promises to pay.

Let’s say this safe investment promises to pay 5% profit after 1 year.

Now, imagine another investment which is not 100% safe. In fact, 10% of the time, this investment vanishes into nothing. How much profit would this investment have to make to want cause you to invest? Phrasing this another way, what kind of earnings would you have to make on the "unsure" investment to make you indifferent to choosing it or the "safe" investment? By indifferent, we mean that you do not care between one or the other, because they are essentially the same thing. This is where we start delving into notions of probability, uncertainty, and expectations about the future.

Well, let us do the math:

For the safe investment, you will get back $105 for a $100 investment today.

For the other one, you will get $0 back 10% of the time, and $100 + X back 90% of the time. X is the profit (interest) on the risky investment. What does X have to be to make these two choices the same?

So, if this other investment pays a profit of $16.67 on $100, then you should be indifferent to the two investment choices. That is, the two investments have the same Expected Profit to the investor.

Yield

When expressed as a percentage gain, this profit is called the Yield from the investment. In the above example, the yield from the second investment has to be at least 16.67% for you to be interested in making that investment. If it is higher (say, 20% yield), then you would prefer it to the safe investment. If it is lower (say, 10% yield), then you would prefer the safe investment.

Risk

Why does the second investment have to pay a higher yield? Because there is a chance that the investment will fail and pay you back nothing. This is what is called Risk. Risk is another word for Uncertainty: the lack of knowledge of what will happen in the future.

The profit from every investment has two parts: the risk-free return, and the risk premium.

Risk-free Return (RFR)

Risk-free return (RFR) is the profit you can make from an investment that has absolutely NO uncertainty. You know, for sure, that you will get paid a promised profit. Is there a risk-free (100% sure) investment? No. But there is one that is very close: lending your money to the US Government. The US Government borrows money by printing up pieces of paper called Treasury Bills (T-Bills). These are promises to pay a certain amount of money at some point in the future. For example, a T-Bill might promise to pay $100 one year from now. If you buy this T-Bill for $95 today, you are making a yield of 5.26%.

This is considered to be the safest investment in the world. The chance that the US Government will not pay the promised amount on its T-Bills is considered to be so close to zero as to be equal to zero. So, for any investment, the risk-free rate is the return a person could get from buying US T-Bills.

Risk Premium (RP)

Risk premium (RP) is the amount of profit that is paid to compensate for the chance that the investment will disappear. In the example shown above, the risk premium is equal to 16.67% - 5% = 11.67%. Because there is a 10% chance that your investment will vanish, the owner of the firm will have to promise to pay you an extra 11.67% IN ADDITION TO the risk-free return in order to get you to take the risk. The riskier the investment (that means, the higher the chance the investment will vanish) the higher the risk premium that has to be paid.

$$\begin{array}{c}\text{Risk Premium = }\frac{\text{Interest on the Investment - Risk-free Interest}}{\text{Initial Investment}}\\ \\ \text{ = }\frac{\text{Interest on the Investment}}{\text{Initial Investment}}\text{ - }\frac{\text{Risk-free Interest}}{\text{Initial Investment}}\\ \\ \text{ = }\text{Return (yield) on Investment - Risk-free Return}\end{array}$$

Risk versus Reward

Risk versus reward is an underlying concept of the capitalist system: that a person who takes a higher risk expects a higher return. Thus, risk-takers are often people who make a large amount of money, but only after they have lost their money several times. The higher the risk in an investment, the higher the risk premium.

Expected Profit and Economic Profit

The expected profit from an investment is the risk-free return (RFR) plus the appropriate risk premium (RP) for the industry in question. So, the accounting profit (TR – TC) should be equal to (RFR + RP). If the profits are greater than (RFR + RP) then we say that an investment is making an Economic Profit. This means the firm is paying a yield that is greater than the yield for other companies with similar risk. We expect economic profits to always be moving towards zero. The reason for this is simple: if an investment is paying an economic profit, it is basically paying out “free money,” more money than a similar investment. So, what happens? Everybody will move into the “good” investment. There will be more demand for this investment. More demand means the price will go up, which means the yield will shrink. (Remember, yield = (future payment – purchase price)/purchase price. As purchase price goes up, yield goes down.)

This is the theory of Efficient Markets. This means that if there is a very good investment, everybody will want to invest in it, making it more expensive, and therefore making it less of a good investment. So, in the long run, we expect every economic profit to be pushed towards zero. The only way a firm or person can make positive economic profits over time is to keep their profits secret or their methods secret, and both of these are very difficult to do.

Think of the idea of opportunity cost. The opportunity cost is the value of the most valuable thing you did not do. So, when you invest your money, you will discover that there are many, many places where you can put your money. Which is the best one?

The profit you expect to make from an investment should be at least as good as the next best possible choice. So, the economic profit from an investment is the difference between the best choice and the next-best choice.

For this reason, we always expect the economic profit to be zero. Or, at least, moving towards zero.

This helps us define how much profit a firm "should" make. In the first lesson, I counseled against "should" statements, because they are normative statements, and as objective and disinterested observers of the real world, we are only interested in "positive" statements. So maybe we can rephrase the question: how much profit does a firm have to make in order to make it an attractive investment? Well, we know that it has to make at least the risk free rate plus the risk premium. If it is making exactly this amount, it is making zero economic profit, and the investor should be indifferent to this investment and all others that make zero economic profit. If it is making more than zero economic profit, it is a very attractive investment, and because a lot of people will want to get at the "free money" that this firm is making, the stock price should go up, driving the economic profit to zero. The opposite will happen to a firm that is making negative economic profits.

The textbook author talks about "explicit" and "implicit" costs - explicit costs refer to things that a firm has to purchase in order to operate - paying wages to staff, purchasing raw materials and energy, paying rent and taxes, and so on. The other type of costs are implicit, and these refer to the use of the owner's resources - the owner's time and effort. This is the "return to the owner" I spoke of above. The return to the owner is equal to the opportunity cost of his/her time - the value of the best alternative use. Any business enterprise should be compensating the owners of the firm at a level that at least matches the opportunity cost of capital, on a risk-adjusted basis. If it does not, it makes more sense for an owner to invest elsewhere.

This informs us about the cost structure of a firm. When a firm is selling its product, it has to be selling at a price that is high enough to ensure accounting profits sufficient to generate enough of a return to cover the risk-free rate plus the risk premium - the payment that the owner must get in return for investing his money in the firm.

Take Aways

After working through the material on this page and reading the associated textbook content, you should be able to confidently:

1. define accounting profit;
2. define economic profit and understand its difference from accounting profit;
3. understand what we expect economic profit to be, and why;
4. understand the concept of risk in an investment;
5. know what the two parts of profit from an investment are;
6. understand what a risk premium is, and where it comes from.

In this lesson, we described the source of the supply curve, which is basically a functional relationship that defines the minimum amount of money a firm can charge for a certain amount of some good it is selling in a market place.

It turns out that the supply curve is defined by the marginal cost of a good, which means that if a firm makes one more unit of a good, they must be willing to sell it for at least the cost of making that unit. Included in the marginal cost is an amount that is equivalent to a necessary return to an owner, sufficient to make a person want to invest in a certain industry. This is the amount that yields "zero economic profit," which simply means that a firm in a specific industry is generating an accounting profit that is sufficient to provide a return on investment that equals the risk-free rate plus the appropriate risk premium for the industry in question.

When the supply curve is plotted on the same diagram as a demand curve, we have a "supply and demand" diagram, and the point at which the supply and demand curves intersect is called the "market equilibrium." It is the price and quantity sold that we expect to see in a perfectly competitive market at a given point in time.

A perfectly competitive market is one in which our four assumptions of perfect competition are met:

1. No market power
2. Perfect information
3. Product homogeneity
4. Free entry and exit

These four conditions are rarely met in real life. Any deviation from this condition is called a "market failure." We will spend much of the rest of the course studying market failures, and the problems that are associated with governments trying to fix market failures, which we call "government failure."

Have you completed everything?

You have reached the end of Lesson 3! Double check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there.

In the previous two lessons, we discussed the basics of the supply and demand curve, and the origins of the curves. In this lesson, we will take a look at how the interaction of the two sides of the market creates wealth for both sides, and then we will talk about how the market changes with time, and what drives those changes. What factors cause prices to go up or down, and what drives the quantities of different goods sold?

What will we learn?

By the end of this lesson, you should be able to:

• explain what consumer surplus, producer surplus and total wealth generated by a market are;
• identify the parts of a supply and demand diagram that represent consumer and producer surplus;
• describe the changes in the equilibrium prices and quantities caused by movements of the supply and demand curves;
• describe and explain the underlying causes of movements of the supply and demand curves.

What is due for Lesson 4?

This lesson will take us one week to complete. Please refer to Canvas for specific time frames and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.

Now we have defined these two relationships: the demand curve, which defines the relationship between the maximum amount that somebody will pay for a certain quantity of goods, which is defined by the marginal utility derived from consuming that good, and the supply curve, which defines the relationship between the minimum amount that a firm is willing to accept for a certain quantity of goods, derived from the notion of marginal cost and declining marginal returns to a factor. For any given quantity of goods, these two curves define the limits of the price we expect to see for a good. The price should not be higher than the marginal utility, because a rational individual would not give away more utility (in the form of money) than the utility he or she would get from consuming the good. The price would not be below the marginal costs, because the firm would be losing money on production of the unit, and thus they would choose to not make the unit of the good in the first place.

So, we have a downward sloping demand curve and an upward sloping supply curve. Unless the supply curve is higher than the demand curve at the zero quantity, then the curves will intersect somewhere. In the case that the supply curve starts above the demand curve, this means that the cost of producing one good is higher than the highest amount of utility anybody gets from consuming that good, which is a trivial outcome: none of the good will be produced, and there will be no market for it. So, we can forget about this case (except and until the government gets involved...)

Below is an example of a supply and demand diagram:

Figure 4.1 Supply and Demand Diagram

Credit: Barry Posner © Penn State is licensed under CC BY-NC-SA 4.0

So, looking at Figure 4.1, the demand curve begins on the left, above the supply curve, and as quantity increases as the curves move to the right, they get closer and closer. Then they intersect. This intersection is the point where the utility of consumption of the marginal good is exactly the same as the cost of making it. If we go further to the right, the cost of production is higher than the utility of consumption. This means that for a quantity to the right of the intersection, nobody is willing to pay the full cost of production of the good, with the result that those goods will not be made.

The point where the supply and demand curves intersect is called the Market Equilibrium. An equilibrium is defined as some condition that is not prone to change from minor perturbances. If you drop a marble down the side of a salad bowl, the marble will settle at the bottom and will not move from the bottom unless there is a major disturbance. It is said to be in equilibrium. When a market is in equilibrium, it is not prone to change - it is at a "stable" amount of output at a "stable" price. Equilibrium is where we expect a market to be. Why? If the quantity of goods being produced is lower than the equilibrium quantity (if we are producing at the left of the equilibrium), then there are some people who are willing to pay more than the marginal cost of the good. This means that somebody can make a profit from making more of the good, so we expect production to increase until we hit the equilibrium point. If production is to the right of the equilibrium point, units are being made that nobody will buy, and firms will lose money on them. This incentivizes firms to make less of a good, once again driving the market towards equilibrium.

The equilibrium is not a number, but an ordered pair of numbers: a price and a quantity. We typically use the notation (Q*, P*) to describe an equilibrium. If I ask a question about a market equilibrium, and the answer is only a single number, it will be considered incomplete. An equilibrium consists of an equilibrium price, P*, and the quantity at which that price is observed, Q*. The equilibrium price is sometimes called the "market-clearing" price, meaning that it is the price where the market "clears" all of the goods in it: If the price is below the market clearing price, people will want to buy more, and more will be made. If the price is above the market-clearing price, more will want to be made by producers.

At any given point in time, we expect the market to be in equilibrium. Of course, a market, being the result of human wants, is always changing, and, in this context, you can think of the equilibrium as something that is always shifting, like a set of moving goalposts in a hockey game, but is something that the market is always striving to move towards. The equilibrium is like a magnet, always pulling the market towards it, but always moving, so the market is always chasing. We will talk more about these market dynamics in the next lesson.

Summarizing the supply and demand diagram:

• x-axis: measurement of quantity
• y-axis: measurement of price
• Demand curve: relationship between price and quantity people are willing to buy, derived from marginal utility of consumption
• Supply curve: relationship between price and quantity that firms are willing to sell, derived from marginal cost of production
• Intersection point of supply and demand curves: “market equilibrium”

Perfect Competition

Given all of the assumptions we have made to date, the market that is described above is what we call “perfect competition.” This does not exist in real life, but is a good starting place to study markets.

Perfect competition is based upon four assumptions:

1. Nobody has market power. This means that nobody has the ability to change the market equilibrium price based on their own behavior. This means that there must be many buyers and many sellers. We also say “everybody is a price-taker,” which means that they must accept the market price, and they are not “price-setters.”
2. Perfect information. This means two things – first, that everybody knows what their own choices are, and also that they know everything about the product.
3. Product homogeneity. This means that in a specific market, all products are identical. In real life, no two things are identical, and people make “differentiation” between products. But, for purposes of modeling, we assume that certain groups of products are close enough to being the same.
4. Free entry and exit. This means that people only make production and consumption decisions based upon their own free will. They are not forced to buy or sell things they do not want. It also means that people are not negatively affected by other people’s market decisions.

The closest we get to perfect competition is a large stock market like those in New York or London.

A perfectly competitive market gives the greatest possible wealth - we will show just how in the next lesson. Any market that fails to get this full amount is not perfect, and we say that we have a “market failure.” By “failure” we simply mean “not perfect.” All markets are in failure, but some more than others.

Many people wish to correct market failure, and to do this, they usually decide that government must act since no individual has enough power to correct the failures.

However, sometimes in their attempt to fix the problem, the government actually makes things worse (that is, they make the consumer and/or producer surplus even smaller). When this happens, we have what we call “government failure.” We have government failure when a government tries to fix a problem but only makes it worse. Even if the government has good intentions, it usually makes things worse.

Much of the rest of the course will look at deviations from this notion of perfectly competitive markets, that is, violations of one or more of our assumptions of perfect competition, and how these violations play out in real life. We will spend a lot of time looking at market failures, and ways in which we can deal with them, with a focus on how these things affect markets in the energy and resources spheres.

Take Aways

After working through the material on this page and reading the associated textbook content, you should be able to confidently:

1. sketch out a supply and demand diagram, and identify the equilibrium;
2. define and understand the four assumptions of “perfect competition”:
   • nobody has market power
   • perfect information
   • product homogeneity
   • free entry and exit
3. understand the concepts of wealth maximization and market failure:
   • when is wealth maximized?
   • when is a market said to be in failure?

We have now defined the demand and supply curves and described where they "come from" and how they fit together, giving us a "market equilibrium," which is a combination of a price and quantity that we expect a market to move towards and stay at if there are no external disturbances. If we assume for a moment that we have a stable market that is at equilibrium, we will be able to take a look at how, and by how much, a market system improves wealth in a society. And remember, when I talk about wealth, I am not talking about money, but about the things that improve the quality of our lives. Money is merely a mechanism for interaction that allows us to exchange our labor and investments for goods that we derive utility from.

There are two reasons why we have trade in markets:

• People trying to maximize their utility
• Firms trying to maximize their profits, which increases what they can pay their owners, who can then convert these profits into utility-bearing goods to help maximize owner utility

A reminder: the demand curve is defined by the maximum amount a person is willing to pay for something, which equals the utility gained from consuming goods, which equals the wealth gained. (Wealth ≠ cash). An individual's maximum willingness to pay is sometimes called the "reservation price."

In a perfectly competitive market, we hold that an individual (a consumer, demander, or buyer) will freely enter into a market to exchange money for goods and that a firm (a producer, supplier, or seller) will take that cash in exchange for the good in question. In order for self-interested, non-coerced individuals and firms to enter into such a transaction, it must be in the self-interest of both, and by “in the self-interest,” we mean that each side will gain from the trade. The individual will exchange money for a good that gives him/her more utility than he/she gets from the money, and the firm will gain more money from the sale than it cost to make the good. Remember, people are utility maximizers (happiness maximizers), and firms are profit maximizers.

So, in a (theoretical, perfectly competitive) market, everybody gains something from participating in the market. In the real world, this still holds generally, although not universally, true: most people do not buy things they do not value, and most firms cannot continue to operate while losing money for very long.

The question we wish to ask now is, how much wealth (happiness + profits) is generated by a market? Well, before talking about wealth, let's quickly review the concepts of Consumer Surplus (CS) and Producer Surplus (PS).

A consumer’s net gain of wealth in a trade = maximum amount willing to pay – the purchase price.

(Remember, the maximum willingness to pay is the marginal utility obtained from consuming the good. A rational person will not pay more than the value he gets from the good.) Because we assume the law of one price, all consumers pay the same price, which happens to be the equilibrium price, P*.

Add this up for all buyers, and we have the total wealth created by the market for consumers. This is called Consumer Surplus.

The consumer surplus is the sum of the net wealth gain for each buyer in the market. If a buyer has a willingness to pay (henceforth referred to as WTP) \$10 and the price is \$7, then he has gained \$3 in wealth (\$10 - \$7). If a buyer has a WTP of \$7, he has just broken even (we might say that he is “indifferent” to making this purchase, as he has the same amount of utility whether he makes the trade or not.) If a buyer has a WTP of \$6.50, he would not willingly make the trade, because he is would be exchanging \$7 of money for \$6.50 worth of happiness, and nobody would rationally decrease their amount of happiness (given our assumptions of rational behavior and perfect information).

Note that WTP is the function defined as the demand curve.

So, the consumer surplus (we’ll call this CS to save typing time for me) for the entire market (all buyers added together) is the area between the demand curve and the equilibrium price, to the left of the equilibrium quantity, or the yellow shaded area in the following diagram:

Figure 4.2 Consumer Surplus

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

We do not have to worry about what happens to the right of the equilibrium quantity, Q*, because at this point, trades are not made, because the equilibrium price (a constant, and hence, a horizontal line) is above the willingness to pay (above the demand curve) to the right of the equilibrium point.

Now, let’s look at the supply side of the market. Remember our definition of the supply curve:

Supply curve = minimum amount a seller is willing to accept = marginal cost of producing a good.

A producer will not want to sell at below the marginal cost, because this will result in negative net revenue ($P<MC$, so $P-MC<0$, which equates to a LOSS!). So, any producer in the market will want to sell goods up to the point where price equals marginal cost.

Why? Because this is a profit-maximizing strategy.

Let’s spend a couple of minutes examining why this is. We can assume that we have an UPWARD SLOPING supply curve. In real life, supply curves are usually U-shaped, meaning that the marginal cost of the first few items is very high, then goes down to some minimum point, and then starts to slope upwards (that is, marginal cost will increase with the quantity produced.) Why would MC slope upwards? Because, as you start to add more resources to your production function (remember the previous lesson?), you will have to pay more to attract them away from some other use. There are some special cases where marginal cost is always sloping down – this is something called a natural monopoly that we will talk about later, and is quite common in some parts of the energy industry – but, for the time being, we can assume that near the equilibrium point, the supply curve will be upward sloping, which means that the marginal cost is increasing with increases in Q.

So, if $MC<P$, you are earning an accounting profit of $P-MC$, which is larger than 0. This means you will want to produce more of a good. As you produce more, it gets more expensive, because of the upward slope of the supply curve.

Let’s say we are producing at $Q=Q_1$, with a marginal cost of $M{C}_1$. Given an equilibrium price P*, then Profit at $Q=Q_1=P*-M{C}_1$. Now, we produce at $Q=Q_2\left(>Q_1\right)$, which means $M{C}_2>M{C}_1$. Profit at $Q=Q_2=P*-M{C}_2$, which is smaller than the profit at $Q_1$. The firm will want to keep producing more, and earning a positive but declining profit on each unit, up until we reach the point (call it unit “n”, or $Q_{\mathrm{n}}$ ) where $M{C}_n=P*$. At this point, the accounting profit from marginal unit Q_n is exactly zero. Every unit you have produced up to Q_n has earned you a positive accounting profit, but now you have hit the point where $P*=MC$, so $P*-MC=0$.

As a producer, this is where you want to stop. If you make another unit, the marginal cost will be above the market equilibrium price, and you will make a negative profit (sometimes called a “loss” ) on the next unit. A rational actor will not want to make a loss, so he will prefer to stop at the point where $P=MC$.

This is what we call the “profit-maximizing condition”: profit is maximized when the quantity produced is sufficient to make $MC=P*$. Make less than this quantity, and you are leaving money (and profit) on the table. Make more than this quantity, and you will be losing money on some items. In either case, making the $MC=P*$ quantity will give you the most amount of profit. Hence, the use of the term “profit-maximizing” condition.

I will point out here, again, that we are assuming a “Perfectly Competitive Market,” which is one in which there is perfect information, so every producer will know what his marginal costs are and what the market-clearing price, P*, will be. In real life, this is not true, and producers have to use their best judgment, intelligence, and experience to try to get as close to $MC=P*$. But, for the time being, we can assume we have perfect information, just to make understanding of the basic concept a little simpler than real life.

A producer’s net gain of wealth in a trade for a single good = purchase price – minimum willingness to accept. This is the same as “equilibrium price minus marginal cost.”

To get the total profit generated from all goods sold in the market, add the “net gain” up for all goods from sellers, and we have the total wealth created by the market for producers. This is called Producer Surplus (PS).

The minimum willingness to accept (WTA) is defined as the marginal cost curve, which is also called the supply curve.

So, PS is the area between the equilibrium price and the supply curve:

Figure 4.3 Total Wealth

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

“The sum of consumer surplus and producer surplus is social surplus, also referred to as economic surplus or total surplus.” We also call it the total wealth created by a market.

The qualification about trade only taking place to the left of the equilibrium also applies here. No producer would want to sell to the right of the equilibrium, because the price received will be less than the marginal cost. And, also, the supply curve is above the demand curve, so the price demanded will be above the willingness to pay

The sum of the consumer surplus and the producer surplus is the total wealth created by a market.

Example: In a hypothetical market

Demand is given by: $P=100-2Q_d$
Supply is given by: $P=10+Q_s$

1. What is the competitive market equilibrium, the consumer surplus and the producer surplus?
2. Given the data from Question 1, how much wealth will a consumer make if his willingness to pay is 70? 40? 30?
3. Given the data from Question 1, how much wealth will a producer make if his willingness to accept is 70? 40? 30?

Part 1)

At equilibrium, supply equals demand (both quantity and price). So, first, we need to equate the supply and demand functions and find the equilibrium price and quantity $(Q*,P*)$ .

$P=100-2Q_d$
$P=10+Q_s$

Then,

At equilibrium

$Q_d=Q_s$

$90=3Q$

Then, equilibrium quantity will be $Q*=\frac{90}{3}=30$

By plugging equilibrium quantity ($Q*$ ) in one of the supply or demand equations (doesn’t matter which one, we should get the same answer), we will find the equilibrium price ($P*$ ):

$P_d=100-2Q_d$

$P*=100-2\left(30\right)=40$

The next step will be calculating the CS and PS at market equilibrium $(Q*,P*)$ :

$CS=\frac{\left(100-40\right)\left(30-0\right)}{2}=900$

$PS=\frac{\left(40-10\right)\left(30-0\right)}{2}=450$

And total wealth created by the market

Figure 4.4 Consumer Surplus

Credit: Farid Tayari © Penn State is licensed under CC BY-NC-SA 4.0

Note for review: Here are the steps in calculating the equlibrium, consumer surplus, and producer surplus:

• P* and Q* can be calculated by solving the supply and demand system of equations for P and Q, which give P* = 40 and Q* = 30
• Consumer surplus is the area of triangle above the P* and below the demand curve (yellow triangle): area = base times height/2
  • base of this triangle = Q* = 30
  • height = P₁ - P*
    P₁ is the intercept of demand function. So, we can find P₁ by plugging Q = 0 into the demand function.
    P₁ = 100 - 2*0 = 100
    Then, height = 100 - 40 = 60
  • Consumer Surplus = area of yellow triangle = base * height/2 = (30 * 60)/2 = 900
• Producer surplus, is the area of triangle below the P* and above the supply curve (red triangle): area = base times height/2
  • base of the red triangle = Q* = 30
  • height of the red triangle = P* - P₂
  • P₂ is the intercept of the supply curve. So, we just need to plug Q = 0 into the supply function to find the P₂.
    P₂ = 10 + 1*0 = 10
    So, height of the red triangle = P* - P2 = 40 - 10 = 30
  • Producer Surplus = area of red triangle = base * height/2 = (30*30)/2 = 450

Part 2)

$\text{Maximum willingness to pay}=70$ : the consumer will make $70-40=30$

$\text{Maximum willingness to pay}=40$ : the consumer will make $40-40=0$

$\text{Maximum willingness to pay}=30$ : the consumer will not buy the good because willingness to pay > price

Part 3)

$\text{Minimum willingness to accept}=70$ : the producer will not sell the good because willingness to accept < price

$\text{Minimum willingness to accept}=40$ : the producer will make $40-40=0$

$\text{Minimum willingness to accept}=30$ : the producer will make $40-30=10$

Take Aways

After working through the material on this page and reading the associated textbook content, you should be able to confidently:

1. calculate the consumer surplus created by a single trade and by a market;
2. calculate the producer surplus created by a single trade and by a market;
3. calculate the total wealth created by a single trade and by a market;
4. understand why a buyer decides to enter the market (or not);
5. understand why a seller decides to enter the market (or not);
6. understand why there are no trades to the right of the equilibrium.

When we use the world “dynamics,” we simply mean that things change with time, that they do not stay the same. We defined the equilibrium in a market as the point where the supply and demand curves intersect, which is also called the “market clearing” point, where the amount and price of goods that sellers want to sell matches the price and quantity that buyers want to pay. An equilibrium is a “steady state” that things tend towards, and where they will tend to stay unless there is some upsetting force. If you think of a marble in a salad bowl: if you drop the marble from the rim of the bowl, it will move around for a while, but it will settle in the bottom of the bowl, and will not move unless some external force is applied to it – unless it is disturbed.

A market tends towards an equilibrium, but the equilibrium does not stay still. Think about this: the price of a good, and the quantity sold, does not tend to stay the same over time for many goods. For example, in 1998, the average price of gasoline was $1.03/gallon, and about 350 million gallons per day were consumed in the US. By 2007, the price had risen to $2.80, and the consumption had risen to 390 million gallons/day. But in 2009, the average price was $2.35 and consumption had dropped to 378 million gallons/day. Each of these three points represents an equilibrium, and each is quite different.

Figure 4.5 is a plot of the annual average equilibria for gasoline in the United States from 1992 to 2015. The point at the start of the line, near the lower left corner, is the equilibrium for 1992, and the line then travels through the next 24 years.

Figure 4.5 Annual Gasoline Equilibria, 1992-2015

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

In this chart, I have population-weighted sales by simply dividing sales by annual average population. You might notice that the path that is followed is pretty predictable for much of the period – the price is fairly stable for several years, from about 1992 to 2002, after which it climbs pretty steadily through 2008. We also see the quantity of sales per person growing quite steadily from 1992 to 2005. Over this period, the average person was consuming more gasoline, but the price was pretty stable. In 2005, volumes were 16% higher than 1992. Then something strange happens – for the years 2006-2012, the path of the equilibrium has “doubled back” on itself, with quantity falling as price tended to rise (if we take out the anomalous bom-bust of 2008 and 2009, prices rose quite steadily from 2005 through 2012. Then, starting in 2013, this trend reversed, and now we are starting to see some modest growth in consumption. We saw a big jump in 2015 as the price dropped a great deal after the oil price crash of Fall 2014. We will talk a little more about “why" in the next section, but I am showing you this path here to illustrate the idea of economic dynamics: how things change with time. Each point on Figure 4.5 represents an equilibrium, an intersection of (not shown) supply and demand curves. But the equilibrium moves with time, with both the equilibrium price and quantity shifting. If each point is an intersection of two lines, clearly one or both of the lines are moving with time. When you look at a standard supply and demand diagram, you are looking at something that is in two dimensions: it has length and width, or price and quantity, and these are both variable, but there is a third variable that we cannot see on the S-D diagram: time. If we had some sort of 3-D paper, there would be not two but three axes intersecting at the origin: price, quantity, and time, and the supply and demand curves would not be lines, but planes that have three dimensions, planes that are wavy and twisty, not flat.

This is a rather long-winded way of saying: things change with time. All things change with time, and markets are no exception.

Results of Changes in the Market

Please read Section 3.3 in the text

In the previous two lessons, we talked about what causes the movements of the supply and demand curves, here we will model the results of these changes. That is, what happens to the equilibrium as market dynamics occur?

Our model of a market consists of two things: a demand curve, and a supply curve. So, when we look at market dynamics, we are looking at a movement of either the demand curve or the supply curve, or, more likely, a movement of both. Let’s take a look at these one at a time first, and then together.

Movements of the Demand Curve

Below, we have a basic, properly-labeled supply and demand diagram. The axes are labeled as price, P (the y-axis), and quantity, Q (the x-axis), the upward-sloping supply curve in red, labeled “S”, the downward-sloping demand curve in blue, labeled “D”, and the equilibrium, at the intersection of the supply and demand curves, labeled “e”, and the equilibrium price and quantity, shown as P* and Q*.

Figure 4.6 Supply and Demand diagram

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

It is important for me to state here: an equilibrium is ALWAYS an ordered pair: (Q*, P*). If I ask a question in a quiz or exam where I ask for an equilibrium, and you give me only a price or a quantity, you will be giving me only half of the answer. Price and quantity.

So, focusing on the demand curve, for the sake of simplicity, we will leave the slope unchanged, and simply look at side-to-side movements. The demand curve can be shifted to the right. This is the same as shifting it upwards, or the same as shifting it diagonally away from the origin. This is called an “outward” shift of the demand curve, as it moves out from the origin. Such a movement is shown in Figure 4.7.

Figure 4.7 "Outward" shift of the demand curve

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

Figure 4.7 shows a movement of the demand curve, from D1 (in light blue) to D2 (in dark blue). Look at what has happened to the equilibrium: it has shifted from (Q*1, P*1) to (Q*2, P*2). Note that P*2 > P*1, and Q*2 > Q*1. In other words, an outward shift of the demand curve results in a larger quantity of goods being sold, and at a higher price. Why? Well, remember that the demand curve is a functional relationship that defines how much people are willing to pay for any given quantity of goods, and this willingness to pay is based on how much happiness people get from consuming one more unit of the goods in question (the marginal utility). When the demand curve shifts outward like this, it means that people are willing to pay more for any given amount of goods. So, given the same upward-sloping supply curve, we can expect more goods to be sold, and at a higher price, because people are willing to pay more, and because they are willing to pay more, producers make more to match their marginal cost with the higher price.

Notice that the equilibrium has moved from e1 to e2. It has moved “along” the supply curve. The demand curve moved outwards, and the equilibrium “slid” along the static supply curve. If you read the popular press, you’ll often see writers talking about “demand for a good increasing.” What they really should say is, “The demand curve has moved outwards, and the equilibrium quantity has increased.”

I will leave it as an exercise for you to figure out what happens when the demand curve moves to the left (which is the same as the demand curve moving downwards, or towards the origin), known as an “inward” movement of the demand curve.

Movements of the Supply Curve

A movement of the demand curve is pretty unambiguous: if the curve moves outwards, equilibrium price and quantity both increase. If the demand curve moves inwards, then equilibrium price and quantity both decrease. Things are a little bit more complicated for movements of the supply curve.

First, let us look at a downward (or rightward) shift of the supply curve while holding the demand curve steady. This is shown in Figure 4.8, with the supply curve shifting from its original position, S1 (in red), to a second position, S2 (in green).

Figure 4.8 Downward shift of the supply curve

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

See how the equilibrium has “slid” along the demand curve, from e1 to e2. Now, notice that at e2, quantity has increased (Q*2 > Q*1), but equilibrium price has moved down (P*2 < P*1). This tells us that a movement of the supply curve downwards means that more goods will be sold, and at a lower price. This sounds like a good thing, at least from the consumer’s point of view, but the phrase “supply shifting downwards” might lead a person to think that fewer goods will be made. What is happening? Well, the supply curve is a functional relationship (there’s that phrase again) which describes the marginal cost of producing a given quantity of goods. If the curve shifts down, it means that the cost of producing the n^th instance of the good has decreased. Repeating myself: costs have come down. Producers are willing to accept a lower payment for each unit of the good in question because it does not cost as much to produce. A lot of technology goods follow a path like this: when I bought my first personal computer in 1989 it cost me over $3,000, and there were far fewer sold than today. The same goes for my first CD player and first cell phone. As these technologies improved, prices dropped and the volumes sold increased, sometimes dramatically.

So, what happens in the opposite case, an upwards shift of the supply curve? I will leave the diagram to you, but it is not too hard to understand that equilibrium price will increase, and the quantity sold will decrease.

Movements of Both Curves

It is typically true that both supply and demand curves observe shifts over time. Let’s take a look at what happens when both move at the same time. First case, what about an outward shift of the demand curve and downwards shift of the supply curve? This is shown in Figure 4.9.

Figure 4.9 Movements of both curves

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

I have put some arrows on Figure 4.9 to show the downward movement of the supply curve, from S1 to S2, and the upward movement of the demand curve, from D1 to D2. The equilibrium has shifted from point e1 to point e2.

What has happened to equilibrium quantity? It has increased – Q*2 > Q*1. Both movements have led to an increase in Q*. What about equilibrium price? Well, the demand curve movement caused P* to increase, but the supply curve movement caused P* to decrease. One step up, one step down. Which one is bigger? Well, on the diagram, it looks like P*2 is a little bit lower than P*1, but I should make it very clear that this diagram is an illustration, and not to scale. There are no numbers on it. In a real life situation, we will be measuring things and will be able to determine the answer, but here, in the theoretical abstract, we do not know which one is bigger.

We know that Q* increases because the supply curve movement makes the equilibrium move to the right, and then the demand curve movement also makes the equilibrium move to the right. Both changes push quantity in the same direction, so we know that Q* must increase. But P*, we don’t know.

So, to summarize, if D shifts up and S shifts down, then Q* increases and the change in P* is undetermined.

I will leave it up to you to draw diagrams of the other three combinations, but I will give you a shorthand summary of the four results:

• $\text{If D}\uparrow \text{and S}\uparrow \text{, then Q*<mo>↑</mo> and P*?}$
• $\text{If D}\uparrow \text{and S}\downarrow \text{, then Q*?}\text{and P*<mo>↑</mo>}$
• $\text{If D}\downarrow \text{and S}\uparrow \text{, then Q*?}\text{and P*<mo>↓</mo>}$
• $\text{If D}\downarrow \text{and S}\downarrow \text{, then Q*<mo>↓</mo> and P*?}$

Take Aways

After working through the material on this page and reading the associated textbook content, you should be able to confidently:

• understand and describe the changes in market equilibrium caused by an outward movement of the demand curve;
• understand and describe the changes in market equilibrium caused by an inward movement of the demand curve;
• understand and describe the changes in market equilibrium caused by an upward movement of the supply curve;
• understand and describe the changes in market equilibrium caused by an downward movement of the supply curve;
• understand and describe the results of combinations of movements of the supply and demand curves;
• understand the difference between the movement of a curve and the change in equilibrium - that is, the movementOF a curve versus the movement of an equilibrium ALONG a curve.

Suppose orange demand function in a small town is given by $P=5-0.002Q_D$ . Also, supply function is given by $P=2+0.001Q_S$ . Where P is the price of one pound of orange ($/lb) and Q is the total pounds of orange demanded/supplied in the market (lb). Find the equilibrium price and quantity.

$$5-0.002Q_D=2+0.001Q_S$$

$$\text{At equilibrium }{Q}_D=Q_S=Q*$$

$$5-0.002Q*=2+0.001Q*$$
$$0.003Q*=3$$
$$Q*=1000lbs$$
$$P*=5-0.002Q*=5-0.002(1000)=\$3/lb$$

Assume hurricane damages some orange farms this year. Consequently, supply curve is shifted upward. The new supply curve will be $P=2.75+0.001Q_S$ . Find the equilibrium price and quantity.

$$P=5-0.002Q_D$$
$$P=2.75+0.001Q_S$$

$$5-0.002Q_D=2.75+0.001Q_S$$

$$\text{At equilibrium, }{Q}_D=Q_S=Q*$$

$$5-0.002Q*=2.75+0.001Q*$$
$$0.003Q*=2.25$$
$$Q*=\frac{2.25}{0.003}=750$$
$$P*=5-0.002Q*=5-0.002\left(750\right)=\$3.5/lb$$

As we can see from the result upward movement of supply shifts the new equilibrium to ($P*=\$3.5/lb,Q*=750lb$ ). The new equilibrium has higher price and lower quantity.

Following the previous example, we found that if demand and supply functions for a local orange market are $P=5-0.002Q_D$ and $P=2+0.001Q_S$ , then market equilibrium will be ($Q*=1000lb,P*=\$3/lb$ )

Now assume, results of a recently published study shows that eating an orange a day will have significant health benefit. And this causes the demand curve to shift outward (to the right). Assume new demand function will be $PD=9.5-0.002Q_D$

Find the equilibrium price and quantity

$$P=9.5-0.002Q_D$$
$$P=2+0.001Q_S$$
$$9.5-0.002Q_D=2+0.001Q_S$$

$$\text{At equilibrium, }{Q}_D=Q_S=Q*$$

$$9.5-0.002Q*=2+0.001Q*$$
$$0.003Q*=7.5$$
$$Q*=2500lbs\text{ of oranges}$$
$$P*=9.5-0.002Q*=9.5-0.002\left(2500\right)=\$4.5lbs$$

Then, new equilibrium is $\left(P*=\$4.5/lb,Q*=2500lbs\right)$ , which indicates that outward (to the right) shift of demand curve increase equilibrium price and quantity.

And let’s find the equilibrium considering both supply and demands shifts. Assume hurricane damages some orange farms causing the supply curve to shift upward with new supply curve of $P=2.75+0.001Q_S$ . Also, the recently published study causes the demand curve to shift outward (to the right) with new demand function of $PD=9.5-0.002Q_D$ . Find the new equilibrium in the market. What are your expectations on the new equilibrium price and quantity? Higher or lower compared to initial case?

$$P=9.5-0.002Q_D$$
$$P=2.75+0.001Q_S$$

$$9.5-0.002Q_D=2.75+0.001Q_S$$

$$\text{At equilibrium }{Q}_D=Q_S=Q*$$

$$9.5-0.002Q*=2.75+0.001Q*$$
$$0.003Q*=6.75$$
$$Q*=2250lbs\text{ of orange}$$
$P*=9.5-0.002Q*=9.5-0.002\left(2250\right)=\$5/lb$

$$\text{The new equilibrium will be }\left(Q*=2250lbs,P*=\$5/lb\right)$$

In the previous section, we examined what happens to the market equilibrium when the supply and/or demand curves move. Because markets are dynamic things, that is, they are always changing with time, the market equilibrium is always moving. From the previous section, you should understand what happens to a market when the demand and supply curves move up or down (or in or out.) Now we want to consider why these curves move.

It is important to remember that the supply and demand diagram is a static object, but the economy is not static, and things are changing all the time. A supply and demand diagram is only a snapshot of a market at some fixed point in time. We need to understand what causes changes, and what results from these changes.

Causes of Demand Curve Movements

When thinking of things like this, I always like to go back to “first principles.” Or what are sometimes called “fundamentals.” That is, when trying to understand why something happens, try to go back to the underlying root causes. To do that in this instance, we first have to understand what a demand curve is. You should be able to tell me at this point: it is a functional relationship that describes the quantity of goods that consumers in a market will want to purchase at any given price. Digging a bit deeper into the fundamentals, we understand where the demand curve comes from: marginal utility, or how much happiness the consumers obtain from consuming the good.

So, if the demand curve comes from the amount of utility a consumer will get from consuming the good, then the demand curve can only change if the consumers get a different amount of utility from the good in question.

That’s a bit of a mouthful. I’ll try to make it simpler: demand curves change because people change their willingness to pay. They want to buy more or less of the good. The next question then arises: what causes this change in utility?

There are several factors that can cause the demand curve to shift. If the curve shifts upwards (or outwards, away from the origin), then more of a good is demanded by the consumers at a given price. Or, looked at another way, for a fixed quantity, the price will be higher. This means that people derive more utility from a unit of the good. If the reverse happens, and the curve shifts down (or inwards, toward the origin) then less is demanded at a given price, or a lower price will be offered for a certain quantity, and this happens because something has caused the consumer to derive less utility from consumption of the good.

Some Causes of Demand Shifts

Cause #1 – Population

This one is pretty trivial. As we know, a market demand curve is simply an aggregation of every consumer’s individual demand curve. So, it is a matter of arithmetic to understand that if there are more consumers, then there are more individual demand curves to add together, and therefore, the demand curve will be further to the right. There are many examples of this. For example, when Penn State was a much smaller school, in the 1960s and 1970s, there were far fewer apartment complexes in State College. We now have many more apartments than we had in 1970 because there are far more students, and not because students today want to consume more apartments than they did 40 years ago.

Cause #2 – Income

As a person makes more money, their ability to consume more goods increases. The “willingness to pay” increases because the consumer has more money to spend. For this reason, for a lot of goods, as a person makes more money, the individual demand curve shifts to the right. In a community, the wealthier the community, the more the aggregate demand curve moves outwards. This explains why stores that sell luxury goods are usually in well-to-do suburbs, and not poor, inner-city neighborhoods.

To describe this situation, we define something called the “income elasticity of demand.” This is written as follows:

where “I” is the symbol for income

Spelled out, this means “the percent change in the quantity demanded for a given percent change in income.” If your consumption of sushi goes from 2 times a month to 3 when your salary goes up 10%, then your income elasticity of demand for sushi is $\frac{50\%}{10\%}=5$.

Example, assume demand for economy car falls from 4000 to 3000 units per year if the average real income of the customers decreases from $60,000 to $50,000. Find the income elasticity of demand for the economy car in this town.

$$Q_1=4,000$$
$$Q_2=3,000$$
$$I_1=60,000$$
$$I_2=50,000$$

Using the income elasticity of demand formula,

$${\eta }_{(I)}=\frac{\%\Delta Q}{\%\Delta I}=\frac{\frac{Q_2-Q_1}{Q_1}}{\frac{I_2-I_1}{I_1}}$$

$${\eta }_{(I)}=\frac{\frac{3,000-4,000}{4,000}}{\frac{50,000-60,000}{60,000}}=1.25$$

The income elasticity can either be positive or negative. If it is positive, then the quantity demanded increases as income increases (a positive number divided by a positive number). Goods that have positive income elasticities are usually referred to as “normal” goods by economists. Luxury cars have positive income elasticities.

It is also possible for a good to have a negative income elasticity. This means that as I increases, Q decreases (a negative number divided by a positive number = a negative number). What does this mean? It means that as a person makes more money, their marginal utility from consuming a certain good declines. I mentioned above that while luxury cars have positive income elasticities, we might say that used cars, or economy cars, have negative elasticities: as people in a society make more money, they are less likely to consume a good. I know that as I have gone through life, my willingness to buy new cars has increased, and my desire to purchase used cars has declined.

Another example might be ramen noodles: students typically do not have a lot of money, so they buy a lot of cheap food, and ramen noodles are about as cheap as it comes. However, when students graduate and get jobs, they can afford to eat better, more satisfying meals, and given that most of us eat a fixed amount of food, this means that the quantity of ramen noodles decreases as income rises. (For the record, I still like a brick of noodles every once in a while, but I do not eat them nearly as much as when I was a student.)

Goods that have negative income elasticities are referred to by economists as “inferior” goods. An inferior good is one that we consume less of as we become wealthier. As we have more money, we can substitute for the inferior good with something that is more expensive, but more enjoyable. We will talk more about substitutes in a minute.

Cause #3 – The Price of Other Goods

The willingness to pay for a good is always relative to the willingness to pay for any and all other goods. The price of some other good can have an effect on our consumption choices.

When we think of how the price of one good can affect the demand curve for another good, we have to define two categories of goods: substitutes and complements.

A substitute is a good that you would consume instead of the good in question. As mentioned above, ramen noodles and steaks can be thought of as substitutes: if you are eating a lot of one, you are likely not eating a lot of the other. Life is full of substitution options: working instead of going to school, taking the bus instead of driving, renting a house instead of buying, taking an expensive vacation versus buying football tickets, going to a movie instead of going to a nightclub, and so on.

A complement is a good that you consume in addition to the good in question, with the condition that without one, you would not consume the other. For example, cars and gasoline (and tires) are all complements. On their own, each of these goods is fairly useless. But use them together, and they suddenly have more value. And, as you consume more of one, you are likely to consume more of another. Think of DVDs and DVD players, or iPods and earbuds, or shoes and shoelaces.

Now, we have to think about how the price of one good can affect the price of another. For this, we define the term “cross-elasticity of demand”. This is defined as follows:

where X and Y are subscripts denoting the two goods in question.

Spelled out, this statement reads: the cross-elasticity of goods X and Y is the percent change in the quantity of good X demanded that corresponds to a percent change in the price of good Y.

Assume demand for chicken is 2000 lbs per day and beef price $3/lb. Holding everything else constant, demand for chicken increases to 3000 lbs per day when beef price increase to $4/lb. Calculate cross-elasticity of demand for chicken.

$$Q_{X1}=2000\text{lbs/day}$$
$$Q_{X2}=3000\text{lbs/day}$$
$$P_{Y1}=\$3\text{/lb}$$
$$P_{Y2}=\$4\text{/lb}$$

$${\eta }_{(XY)}=\frac{\frac{Q_{X2}-Q_{X1}}{Q{X}_1}}{\frac{P_{Y2}-P_{Y1}}{P_{Y1}}}=\frac{\frac{3000-2000}{2000}}{\frac{4-3}{3}}=1.5$$

The cross-elasticity can be either positive or negative, and the sign will tell us if goods are substitutes or complements. In the previous example cross-elasticity of chicken and beef is positive. So, we can say they are substitutes.

Let’s think of two common substitutes: chicken and beef. It is not hard to understand that if the price of beef goes up while the price of chicken stays the same, then people will tend to substitute chicken for beef. So, as the price of beef increases, the quantity of chicken demanded increases. The cross-elasticity in this case is a positive number divided by a positive number (or a negative divided by a negative), which gives us a positive number. Therefore, substitute goods have a positive cross-elasticity.

Now, let us think about complements. In the 1980s, CD players came on to the market. At first, CD players were very expensive, and very few people had them. Correspondingly, there were fewer music CDs sold. Over time, the price of CD players came down, and as a result, the quantity of CDs sold increased dramatically (even though the price did not change much for many years). It is easy to see that CD players and CDs are complements: one of the two is of little use without the other. So, when we look at our formula for the cross-elasticity, a decrease in the price of CD players led to an increase in the quantity of CDs demanded. A positive number ($\Delta Q_X$ ) is divided by a negative number ($\Delta P_Y$ ). Thus, the cross-elasticity is negative.

This leads to the definition of a handy rule: if the cross-elasticity of two goods can be shown to have a consistently positive value, then the goods are substitutes. If the cross-elasticity is shown to be consistently negative, the goods are complements. If the cross elasticity is either zero, or inconsistent, then it is likely that the goods are neither complements nor substitutes, but unrelated. Obviously, in our complicated economy, everything is related to everything else - the price of jet planes in Europe probably has some effect on the price of corn in Illinois, but the effect of one on the other is so dispersed as to be unobservable in any meaningful manner.

Cause #4 – Expectations

This is similar to income, but instead refers to future changes that a buyer expects to happen in the near future. For example, if you expect gasoline to be more expensive next week, you are more likely to fill up this week. This will cause the equilibrium for gasoline to shift today.

Cause #5 – Taste (or Fashion)

Some things, such as music styles, car models, clothing or house furnishings change in style over time. As such, desires for certain styles can change. What is fashionable, and popular one day may be out-of-date and unwanted the next. For example, why is it that skinny ties or Britney Spears CDs sell millions in one year, but are not popular a couple of years later? This is a point where economics starts to approach psychology, which is an area where I have little expertise. At this point, we need simply be content with the fact that at different points in time, people will want to buy different quantities of things for reasons that do not have any direct economic causes.

Cause #6 – Information

Going back to fundamentals, the demand for a good is based upon the utility, or happiness, one gets from consuming it. Sometimes, new information comes onto the market that leads to a change in the happiness that someone derives from consuming a good. The most obvious example of this has to do with health information. We often learn that consumption of a good may have beneficial or detrimental effects on one’s health. A few years ago, the “Atkins” diet was popular, in which it was believed that people could lose weight by eating a diet that was high in proteins and low in carbohydrates. A lot of people adopted this diet, so much so that many bakeries went out of business because bread sales declined a great deal. A little while later, some detrimental health effects of the Atkins diet were publicized, and this caused some people to abandon this diet. Fewer people smoke today than in the past, because we have better information about the long-term effects of smoking on health.

Health information is not the only form of information that can move demand curves. For example, when some people publicized what they felt were poor working conditions in clothing factories in Asia, a number of people in the US decided against purchasing goods made in those factories. In other cases, people fall out of favor. There are probably not too many Brett Favre football jerseys being sold in Green Bay these days, even though he was a hero in that city for many years. Deciding to play for a rival team in Minnesota greatly reduced the demand for clothing with his name and picture on it in Green Bay.

Causes of Movements of the Supply Curve

Unlike changes in demand, changes in supply are usually simpler to explain. A downward shift of the supply curve, which means that more goods are supplied at the same price, usually results from a lowering of the cost of production. This cost reduction could be because of a new, more efficient technology, or could be because of lowered taxes, or cheaper labor costs.

An upward shift of the supply curve (less being offered at the same price) is usually the result of some disturbance in the market. The most common example is when crops are damaged by weather conditions: hurricanes, unexpected cold, not enough rain, and so on. If prices for materials or labor of energy, any of the things that go into making a good, have increased in price, then the supply curve shifts upwards. If a tax on a good is increased, then the supply curve will shift upwards, as a tax is a cost that has to be paid on the good, not to the seller of the good or to the sellers of the factors of production, but to government. We will talk more about the incidence and effects of taxes later in the course.

Sample Question

Let us suppose that the following two events happen simultaneously:

1. The Food and Drug Administration releases a report showing that drinking orange juice causes bald men to grow hair.
2. A giant freeze destroys the orange crop in Florida, meaning that we have to import all of our oranges from Brazil for a year.

What do you expect to happen to the equilibrium price and quantity of orange juice?

Answer

The first statement will likely cause many bald men to start drinking more orange juice. This will cause an outward shift of the demand curve.

The second statement means that oranges will likely be more expensive to produce, which corresponding to an upward shift of the supply curve.

The demand curve movement will increase the equilibrium price and quantity. The supply curve movement will increase the equilibrium price, but reduce the equilibrium quantity.

Therefore, the net result will be an increase in the price of orange juice (both curve movements cause price to increase), but the change in quantity sold is unknown from the information at hand. One movement increases quantity sold, the other decreases it. Without measurement, we do not know which effect will dominate the other.

Conclusion

When prices change, they change because either the supply curve or demand curve (or both) has moved. Whenever a price changes, to understand why we want to figure out which of the underlying curves has moved, and why. After working through this lesson, you should be able to explain what happens when supply and demand curves move, and what some of the common causes of such movements are.

Take Aways

After working through the material on this page and reading the associated textbook content, you should be able to confidently:

• explain the basic causes of the movements of the demand curve;
  • changes in tastes
  • the prices of other goods
  • changes in income
  • new information
  • expectations
  • population changes
• understand the concepts of complementary and substitute goods;
  • explain how cross-elasticity is linked to the definition of substitutes and complements
  • understand what the sign of the cross-elasticity implies
• understand the concepts of normal and inferior goods;
  • explain how income-elasticity is linked to the definition of substitutes and complements
  • understand what the sign of the income elasticity implies
• explain the basic causes of upwards and downwards shifts of the supply curve;
• understand that the supply curve is strongly related to the cost of producing goods.

In this lesson, we studied the notions of wealth creation in markets - how both buyers and sellers can be made "better off" (increase their utility or profits) by participating in markets. We then addressed the concept that a market is a dynamic thing - it is constantly changing with time. Since we model a market by using two things: a demand curve and a supply curve - we are able to examine all changes in a market by movements of the supply and demand curves.

We looked at what happens to markets when supply and demand curves move. We then examined the root causes of movements of the supply and demand curves.

Have you completed everything?

You have reached the end of Lesson 4! Double check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there.

In the previous three lessons, we learned the fundamentals of supply and demand in the framework of perfect competition. In this lesson, we will begin to relax some of the assumptions of perfect competition, and see what happens in markets when some participants have what we call "market power." This will help explain what happens in some energy markets.

What will we learn?

By the end of this lesson, you should be able to:

• list and describe the assumptions that define "perfect competition;"
• understand and explain what is meant by the phrase "market power;"
• define "monopoly" and understand monopolistic behavior;
• show the differences between competitive and monopolistic equilibria;
• explain the effects of other types of market power;
• describe how we can measure market power;
• describe what a cartel is, and how it manages prices.

What is due for Lesson 5?

This lesson will take us one week to complete. Please refer to Canvas for specific time frames and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.

As mentioned earlier in the course, the kind of market we have been examining in the past few lessons, the simplified supply-and-demand diagram, and the underlying assumptions about rational utility maximization, supply being defined by marginal cost, and the law of one price, are all part of what we call "perfect competition.” As I have said, this is an idealization. It does not exist in real life, but is a good starting place to study markets.

When we talk about "perfect," we mean that this form of market gives the best possible outcome with respect to "aggregate wealth," which is just consumer surplus and producer surplus added together. There are many ways in which markets can generate less than optimal quantities of wealth - cost can be too high, people might not know certain information, costs can be borne by others, people can manipulate markets to charge a price that is either higher or lower than the market equilibrium, and so on. In real life, it is safe to say that there is no such thing as a perfect market; that, in every case, there is a distortion of some sort that adversely affects prices, quantities, or wealth. At this point, we will go over, once again, the four things that we assume for perfectly competitive markets to exist, and over the next few weeks we will look at what happens if one or more of these assumptions is violated.

If a market produces less than the optimal (maximum) amount of wealth, then we say we have "market failure." This sounds a bit extreme - anything less than perfection is called "failure." It's a good thing college isn't like this - anything less than 100% is a fail. So, we have to consider that there are "degrees" of market failure, just like there are degrees of success in a course. Getting 90% in a class is better than getting 40%. My car having a broken clock is a lot better than having a broken transmission, even though both represent some degree of "failure." So, when we think about market failure, we have to understand when it is serious, and thus needs some fixing, or when it is not, and trying to fix it will only make things worse.

So, let's go through the four assumptions of perfect competition, and their meanings.

Nobody Has Market Power

This means that nobody has the ability to change the market equilibrium price based on their own behavior. This means that there must be many buyers and many sellers. We also say “everybody is a price-taker,” which means that they must accept the market price, and they are not “price-setters.” When we say that "nobody has the ability to affect price based upon their own decisions," then each market entrant must be small compared to the size of the market in general, such that one consumer choosing to consume or not does not "meaningfully" change the market price based upon his/her decisions. As we have seen, a market is an aggregation of individual desires and actions, and, in theory, a change in the consumption habits of some part of the market will be reflected in the form of the market as a whole. In theory, me choosing to buy peaches instead of oranges at the grocery store will affect the markets for both peaches and oranges. However, since I am only one of several hundred people that buy fruit daily in that store, my consumption choices will have a very small, almost imperceptible, effect on the price of either good.

This is sometimes called "atomistic" competition, referencing the idea of elementary particles from physics. We, and everything around us, are composed of atomic particles, but the adding or changing of a few particles does not change us in a "meaningful" manner. So, to reiterate: "nobody has market power" means that everybody is a price-taker, not a price setter, and it means that there are so many individual buyers and sellers that the actions of one or a few will not meaningfully change the market equilibrium.

Perfect Information

This means two things – first, that everybody knows what their own choices are, and also that they know everything about the product. When we say "know your own choices," we mean that you are capable of knowing what amount of marginal utility you will receive from consuming a product, and you will also know the amount of marginal utility you will obtain from consuming every possible other consumption choice. This means that when you consume something, you will definitely be spending money on the thing that maximizes your utility.

Clearly, this is an unreasonable assumption. We do not spend every waking minute calculating the marginal utility of consumption. We can't, for several reasons. Firstly, the universe of choices is too large to consider every option. Secondly, some of your consumption choices take place in the future (that is, should I spend now or save my money and spend later?) We do not know the future. We do not know how much money we will have in the future; we do not know how our tastes and needs will change in the future. The final point is, it can be difficult to measure "happiness" from a consumption choice. Smoking a cigarette might make somebody happy today but very unhappy in a few years if he gets lung cancer. How can we calculate and assign values to such things? We can't.

A great deal of work on the frontiers of economics (the part that intersects with psychology) is about trying to figure out how and why we make choices. This is not something we can address here. That is fine - we are interested in studying what kind of market outcomes we have from the results of those choices, and trying to come up with some general observations, with a bit of predictive power, about how people behave in markets. If you are interested in this area of study, you might want to take a look at a field called "behavioral economics," which concerns itself with examining why people make choices that seem, on the surface, to be against their own best interests. Many people who study in this area claim that their findings undermine the axiomatic assumption about rational utility maximization, but I prefer to think that most "irrational" behavior can be tied back to imperfect information.

A second component of information is a bit simpler to understand: information about a product. That is, when we buy something, do we understand what we are getting? If I buy a Rolex watch, I expect something made in the Rolex factory in Switzerland, not something made in China. If I buy the Chinese Rolex, thinking that it is a Swiss one, I do not have perfect information. On a more mundane level, with reference to the law of one price, am I able to get the best price? For example, I recently moved to a new city. I like to send my shirts out to be laundered, mostly because I am very bad at ironing shirts. There are several dry cleaners near where I live, so how do I know that I am getting the best price? Well, I have to invest some time and effort into discovering the prices at each of these places. What if there is a place that I missed? What if a place does not have an informative website, or will not tell me their prices over the phone? These are all types of information market failure, some more serious than others.

Speaking of the supply side of the market, the most important type of information is cost information. This may seem like a simple idea - a firm can figure out what it's spending money on - but sometimes it can be very difficult figuring out the marginal cost - the cost of producing one more item. It can also be very difficult to make production function and investment choices: should a firm expand, or buy more machinery, or hire more staff? This can be difficult to assess because the alternate states of the world that they entail in the future are unknown.

Product Homogeneity

This means that in a specific market, all products are identical. In real life, no two things are identical, and people make “differentiation” between products. But, for purposes of modeling, we assume that certain groups of products are close enough to being the same.

In many industries, firms go to great efforts to differentiate their products from others. Some of the best examples are soft drinks, hair care products, and cars. The primary tool for product differentiation is advertising. The reason that firms do this is to be able to charge higher prices. For example, a four door car with a four cylinder engine may be an undifferentiated product, but if it is a four-door, four-cylinder car with a badge on the front that says "Toyota" or "Ford," then it is a differentiated product, and each of those manufacturers will try to charge more by convincing you that the name on the front has some extra value. This is another case where modeling consumer choice becomes a bit more difficult.

Free Entry and Exit

This means that people only make production and consumption decision based upon their own free will. They are not forced to buy or sell things they do not want. It also means that people are not negatively affected by other people’s market decisions. In situations where a private economic transaction negatively affects a person who is not a willing participant in that economic transaction, we have something called an "externality." This is a very important type of market failure, and one we will study at length in the next few weeks. The most important externality we will study is pollution, which is a major issue in energy markets and is the basis for the field of environmental economics.

Another aspect of free entry is that competitors can not put up "barriers to entry". 

As mentioned above, there is no such thing as a perfectly competitive market. Probably the closest we get to perfect competition is a large stock market like those in New York or London. Think about why: there are usually many buyers and sellers, there is a lot of information about the value of a company behind the stock, a share of a company is identical to any other share of that company, and there are no externalities.

Reiteration

A perfectly competitive market gives the greatest possible wealth – the sum of consumer and producer surplus. Any market that fails to get this full amount is not perfect, and we say that we have a “market failure.” By “failure” we simply mean “not perfect.” All markets are in failure, but some more than others.

Many people wish to correct market failure, and to do this, they usually decide that government must act, since no individual has enough power to correct the failures.

However, sometimes, in their attempt to fix the problem, government actually makes things worse (that is, they make the consumer and/or producer surplus even smaller). When this happens we have what we call “government failure.” We have government failure when a government tries to fix a problem, but only makes it worse. Even if government has good intentions, it usually makes things worse.

In the next few sessions, we will talk about market failure and then move on to studying government failure.

Our first assumption is that of market power, which states that everybody is a price taker, or that there are many buyers and sellers in a market. In this case, the equilibrium price in a market is defined by so many different transactions that anybody who wishes to buy or sell in this market has to do so at the market equilibrium price, and they are not able to move the equilibrium price with their own actions. Hence, you have to "take" whatever the price is. If you are able to move the equilibrium price with your own choices, then you can be referred to as a "price-setter." In reality, in many situations, somebody in the market has some power to change prices through their individual actions. These include:

• Monopoly: only 1 seller.
• Duopoly: 2 sellers.
• Oligopoly: a few sellers.
• Monopsony: only 1 buyer.

Monopoly

This is the most extreme, but not the most common, example of market power. A monopoly is a market with only one seller. A monopolist is free to set prices or production quantities, but not both because he faces a downward-sloping demand curve. He cannot have a high price and a high quantity of sales – if he has a high price, people will buy less.

There are three ways that a monopoly can exist and/or persist:

1. All of some resource is owned by some firm (e.g., deBeers and diamonds).
2. The government allows a monopoly to exist (not common in the US, but in many countries things like airlines or railways are government-designated monopolies).
3. A Natural Monopoly exists (e.g., your local power company). We will talk more about natural monopolies a bit later in the course.

At this point, you might think about some markets that have a dominant market share held by a single firm, such as Microsoft in the market for spreadsheet software. These are not monopolies, in that firms in these markets do have competitors, and consumers do have choices. If a firm obtains an inordinate market share due to offering a product that many people want to buy, we do not have a monopoly. Firms in a case such as this may have a lot of market power, and may face a lot of scrutiny from the government, but they are not technically monopolies.

Why is a monopoly bad?

Monopolies are typically assumed to be undesirable market structures. They are undesirable, or "bad," because in this case "bad” means less than the most possible total wealth – the sum of the producer and consumer surpluses. A market in which there is a monopoly will generate less wealth for a society than a competitive market would.

A monopoly leads to the following:

• A lower quantity of goods produced and consumed than in a competitive market.
• A higher price than the equilibrium price in a competitive market.
• A higher profit for the firm. In a monopoly, a firm will typically make greater than zero economic profit (remember that term?).

In a competitive market, it is the act of competition that drives prices towards the equilibrium price and quantity at which the marginal firm makes zero economic profits - they are earning just enough money to cover their costs of production and to pay their owners a return that is sufficient to cover their risks. If firms in an industry are making positive economic profits, then other firms have an incentive to enter the market to try and deliver these positive profits to their owners. Generally, this extra market entry is enough to increase production and decrease equilibrium price to the point where zero economic profits are seen. In a monopoly, these competitive pressures are absent. A firm is able to earn positive economic profits, and because they are a monopoly, other firms are unable to enter their market and drive down price.

This leads to an increase in the size of the producer surplus and a decrease in the size of the consumer surplus. As a disinterested economist, we might say "who cares?" especially if we are generating wealth. That is, should we care who gets the wealth, as long as wealth is being generated? That would be a "normative" statement. However, since we are concerned with maximizing the aggregate wealth of a society, we can ask the positive question "does a monopoly decrease total wealth generated?" If it does, then we have the definition of a market failure.

It is quite easy to answer this question with a supply and demand diagram. But first, consider how a monopoly works. We may have a single seller, and this seller may be able to choose his price, but he cannot control the demand curve. Remember, the demand curve is defined by the marginal utility of consumption, a measure of how much happiness the consumers get from consuming. So, the monopolist faces a demand curve he or she cannot change. So what a monopolist can do is choose just where the supply curve intersects the demand curve. He can choose any combination of price or quantity that exists along the demand curve. If he picks a high quantity, then he chooses a low price, or vice-versa. He cannot have a high price and high quantity. When I say "high" here, I am speaking in relationship to the competitive market equilibrium.

So, a monopoly producer will typically restrict output to some quantity below the market equilibrium. This is illustrated on the following supply and demand diagram, where $Q_{\mathrm{m}}$ refers to the quantity produced by the monopolist. To find out what price we see in this market, draw the line up from $Q_{\mathrm{m}}$ until it intersects the demand curve. This gives us the monopoly price, $P_{\mathrm{m}}$ . These contrast to the "free-market" equilibrium, which I label as $\mathrm{Q*}$ and $\mathrm{P*}$ in this diagram.

As you can see, since $Q_{\mathrm{m}}$ < $\mathrm{Q*}$ , then $P_{\mathrm{m}}$ has to be greater than $\mathrm{P*}$ , because the demand curve is downward-sloping.

Figure 5.1 Supply and Demand diagram showing DWL

Credit: F. Tayari © Penn State is licensed under CC BY-NC-SA 4.0

In a competitive market, wealth is the sum of the red, yellow, and blue areas. In the monopoly market, it is just the sum of the yellow and red areas. The blue area is wealth that is lost to society. This area is the Deadweight Loss. This labeled as "DWL" in Figure 5.1. This is the cost to a society of allowing a monopoly to operate. So, in a monopoly, the producer makes more, the consumer makes less, and the society, added together, is poorer as a result.

This is called a Social Cost: a cost to the total society.

The goal of a firm is to maximize profits. So, if a firm is free to set whatever price (or quantity) they want, which level will maximize profits?

Profit (producer surplus) is the area below the equilibrium price and above the supply curve. The supply curve is the same thing as the Marginal Cost curve for the firm.

Figure 5.2 Supply and Demand diagram showing profit (producer surplus)

Credit: F. Tayari © Penn State is licensed under CC BY-NC-SA 4.0

(Note: in Figure 5.2, I use $Q_{\mathrm{m}}$ and $P_{\mathrm{m}}$ to represent “monopoly equilibrium quantity” and “monopoly equilibrium price.")

At which value of $Q_{\mathrm{m}}$ is the producer surplus (the profit, the red area) the largest?

Answer: it is maximized when supply = MC = MR (Marginal Revenue).

What is marginal revenue? Well, it is the amount of money a firm takes in from selling one more unit of the good. If the price is constant, then MR = price - selling one more unit means we collect one more times the price. But, in this case, since the monopolist faces a downward sloping demand curve, each additional unit he sells will have a lower price, and he will sell every unit at that lower price. As an example, using the demand curve in the previous numerical example, if the monopolist sets $Q_{\mathrm{m}}=50$ , then he sells 50 units at a price of 500, and has total revenue of 500 x 50 = 25,000. If he makes one more unit, he sells 51 units at a price of 492 (price is derived from the demand curve, 900-8*51=492), for a revenue of 25,095. His marginal revenue from making one more unit is 95, even though the price is 492.

So, we need to plot the marginal revenue curve.

It turns out that the marginal revenue curve is a line that has the same y-intercept as the demand curve, but has a slope that is twice as steep. So, for example, if our demand curve is given as $P=100-Q$ , then 100 is the intercept and -1 is the slope (remember the equation of a line; $y=mx+n$ . In our case, y=-1\ast x+100 , which is another way of writing $P=100-Q$ .

So, the marginal revenue curve has the same intercept, 100, but is twice as steep, with a slope of -2.

This is written as: $MR=100-2Q$

Generally, if a Demand curve is given as $P=a-bQ$ , then $MR=a-2bQ$ .

Figure 5.3 Supply and Demand diagram showing MR

Credit: F. Tayari © Penn State is licensed under CC BY-NC-SA 4.0

In Figure 5.3, the MR curve is shown in blue. To find the profit maximizing point, set $Q$ to the amount where the MR and MC curves intersect. These will be sold at price $P_{\mathrm{m}}$ . Any other quantity will give a smaller profit (the red area on the graph).

So, it is important to remember two things:

1. The marginal revenue (MR) is a line with the same intercept as the demand curve, but with a slope twice as steep; and
2. When $MR=MC$ , profit is maximized.

We say that in a monopoly, profit is maximized when $MR=MC$, just like in a competitive market, when MR = Price = MC. You will remember that in a competitive market, the demand curve is flat. Its slope is zero. So, the derivative of this curve, which is the MR curve, also has a slope of zero (two times zero = zero). So the result that P(max) occurs when MR = MC is true not just in a monopoly, but all markets.

Your turn!

Calculate the dead-weight loss using this method and compare your answer with what we calculated. You should have similar results.

Try and work it through and see if you can get these answers.

Take Aways

After this lesson and the associated readings, you should be able to:

1. define and understand the meaning of “market power;”
2. know the names of markets with:
   • one seller,
   • two sellers,
   • a few sellers,
   • one buyer;
3. understand why a monopolist can set price or quantity, but not both;
4. describe the three ways a monopoly can come into existence;
5. explain the effects of a monopoly on price and quantity compared to a free market;
6. understand what happens to consumer and producer surplus in a monopoly;
7. understand the concept of a “dead-weight loss” and a “social cost;”
8. understand and apply the rule for profit maximization in a monopoly;
9. find the marginal revenue curve:
   • the intercept of the marginal revenue curve,
   • the slope of the marginal revenue curve;
10. find the monopoly equilibrium and compare it to the competitive equilibrium.

Single buyer = Monopsony

In this case, a buyer has market power and tries to maximize the consumer surplus, not the producer surplus. We essentially have a monopoly in reverse, and consumer surplus is maximized by the consumer's choice of quantity purchased. Instead of looking at the producer's marginal revenue function to define the monopoly quantity and price, we instead look at the consumer's "marginal expenditure," the amount of money he has to spend to obtain one more unit of a good, which changes with his purchase decision. Once again, we have a quantity that is less than the free-market equilibrium, but in this case a price that is lower than the free market equilibrium. This is described in the following diagram:

Figure 5.4 Marginal Expenditure

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

As you can see in Figure 5.4, the “Marginal Expenditure” line has the same intercept as the marginal cost line, but double the slope.

Monopoly-Monopsony

It is possible to have a situation where there is only one buyer and one seller. In this case, the quantity sold and the price will be a function of the negotiation between the trading partners.

Duopoly

This is the case where we have two sellers. Without getting into the mathematical details, we discover that the price is lower than the monopoly price, but higher than the competitive price. The quantity is also between the two. The best outcome for the two firms would be to share the monopoly profits between them; but each side has an incentive to cheat, which results in a different equilibrium. Incentives to cheat in a collusive environment are described in Chapter 11 of the text.

Oligopoly

In this case, we are adding a few more sellers. As we add more sellers, the equilibrium moves along the demand curve towards the competitive equilibrium, as in the following diagram:

Figure 5.5 Competitive Equilibrium

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

The obvious conclusion is that the more firms in a market, the closer we get to the competitive (wealth-maximizing) solution. This is why governments generally try to stop monopolies and break market power.

Take Aways

After this lesson and the associated readings, you should be able to:

1. define an equilibrium in a monopsony;
2. compare a duopoly equilibrium to monopoly and competitive equilibria;
3. understand how an oligopoly equilibrium compares to monopoly and competitive equilibria;
4. understand what happens to the equilibrium as we add more firms.

Because we have a deadweight loss in a monopoly, some social wealth is not collected. This means that a society is poorer, in total, because of the existence of a monopoly. But it is possible for a producer to capture some of this lost wealth. This can be done by using price discrimination. Price discrimination refers to charging different prices to different customers. In a perfectly competitive market, this is not possible, because there are many firms competing for the price; but it is possible in a monopoly, because people have no other place to buy.

If the seller is able to discover just what price the buyer is willing to pay (what the buyer’s Reservation Price is), and offer a price incrementally below the reservation price, then the seller is capturing basically all of the total surplus.

There are three general ways in which price discrimination can occur:

• First degree (or perfect) price discrimination refers to charging a different price to every consumer. This is not very possible in real life.
• Second degree price discrimination refers to charging different amounts for different sized purchases. If a car rental company buys 300 cars from a dealer, they will get a better price than if I go and try to buy 1 car. This is known as bulk pricing.
• Third degree price discrimination refers to breaking up the market into different groups who have different demand curves and maximizing profit in each different market sub-group. For example, a restaurant might have a special children’s menu, with small portions at lower prices. Adults would not want to buy these small portions, but forcing adults to buy adult portions for children might make the customers decide to stay home.

Take Aways

After this lesson and the associated readings, you should be able to:

• explain what first-degree price discrimination is;
• explain what second-degree price discrimination is;
• explain what third-degree price discrimination is.

Herfindahl - Hirschman Index (HHI)

Governments are interested in controlling market power, and to do this they need a way of measuring it. The most common tool is called the Herfindahl - Hirschman Index (HHI)

This is the sum of the squares of each firm’s market share, expressed in percentage terms:

$$HHI={\displaystyle \sum }_{i=1}^N{S_i}^2$$

where S_i is the market share of firm i in percentage. Market share can be calculated as firm's sale divided by total market sale.

So, if we have one firm in an industry, the HHI will be 10,000, and if we have an infinite number of tiny firms, it will approach zero.

• If the HHI is less than 1000, a market is generally considered to be not concentrated.
• If the HHI is between 1000 and 1800, a market is thought to be “moderately concentrated.”
• If the HHI is above 1,800, the industry is considered to be highly concentrated.

In the third case, governments will often act to reduce concentration. This is called an “anti-trust” action.

A cartel is a form of market power in which suppliers collude with each other to manipulate supply. The most famous cartel in the world is OPEC, the Organization of Petroleum Exporting Countries. It turns out that crude oil is found in many countries in the world. In fact, there are probably oil wells in pretty much every country in the world. But there are a few countries that have large supplies of oil that is relatively cheap to produce.

The history of the international oil industry is convoluted and full of lots of stories about power, colonialism, and nationalism. The oil in many parts of the world was controlled for about half a century by a group of American and European companies called the "Seven Sisters." The countries in which the oil was found resented this control, as they believed that the price was being kept artificially low to benefit the consuming, and not producing countries. Several of these countries banded together to take control of their own resources and formed the organization we know as OPEC.

As I mentioned, there is a lot of fascinating history in the oil industry and OPEC. If you have more interest, I suggest you look at the Wikipedia page for OPEC for a quick overview, and if you are interested in investing a little more time, I recommend reading the book "The Prize" by Daniel Yergin. However, this is an economics course, and I want to focus on the economics of cartels.

OPEC is able to act somewhat like a monopolist, even though the oil industry is not a monopoly. OPEC countries produce about 30% of the world's oil. However, they produce a lot of low cost oil, so they are able to effectively control the supply curve and where it intersects the demand curve by restricting their output. This is shown in Figure 5.6 below.

Figure 5.6 OPEC, Supply and Demand

Credit: Barry Posner © Penn State is licensed under CC BY-NC-SA 4.0

As mentioned in Figure 5.6, OPEC controls the "low cost" part of the supply curve. By exercising control and reducing output from where it would be in an uncontrolled, competitive market, they are able to shift the equilibrium from the competitive point (P*, Q*) to what I call the "OPEC" point: (P(O), Q(O)), which gives us a price that is higher than the competitive market price.

I should make it clear that OPEC is not trying to maximize the price in the short run. Since the elasticity of demand for oil is quite steep in the short run, OPEC could raise the price quite a bit more with slightly lower production. However, such actions are likely to be damaging to the OPEC nations in the longer run: it will cause recession, which hurts long-term demand, but, more importantly, having a very high oil price will incentivize the development of alternative energy sources, which means that oil would then have substitutes, and its demand elasticity would not be as steep. OPEC would not, then, be able to control the price as much.

Instead, OPEC is playing a bit of a game, whereby they are trying to find the price that is as high as possible without spurring the development of alternatives. OPEC tries to "stage-manage" the price of oil to provide the long-term maximum profit.

It should be said that cartels are difficult to hold together. The principal reasons are as follows:

1. As the number of member firms (or nations) increases, it is increasingly difficult for collusion to be effective - members all have an incentive to "cheat" on the cartel by producing "a little bit" more and earning a little bit more money. But if everybody cheats a little bit, the supply increases and prices get lowered, and we move closer towards a competitive market. This has happened a lot in OPEC, and it is periodically controlled by having Saudi Arabia open up the taps for a while to lower the price in order to get the message to other OPEC nations that they can punish cheating. This brings us to the second point:
2. When it is difficult to detect cheating, it is hard for collusion in a cartel to hold. OPEC nations do not allow other nations, even other OPEC nations to independently verify what their production levels are. This is very different from western nations like the US, Canada, and Britain, where the volume of petroleum production is reported by private and public firms to the government, and these figures are collected and reported by the government. Because nobody is able to independently measure and police production quotas, there is a lot of cheating.
3. The third point is that low barriers to entry - we will talk more about barriers to entry in the next lesson - make it difficult to control price. In the oil business, the barrier to entry is the presence of oil in a country. If there is oil in a country, that country can produce and sell the oil relatively easily, and it turns out that many, many countries have at least some oil. The OPEC nations have a big slice, but when OPEC drives up prices by successfully restraining production, every other country has an incentive to look for oil, and frequently find it. This increases production globally and tends to lower prices. High oil prices also provide incentives for the development of other forms of energy - the substitution effect - and the last thing that OPEC wants is for oil to become obsolete because somebody figures out a better, cheaper way to power our cars and planes. We used to burn a lot of oil to generate electricity and heat homes, but we do very little of that now because there are cheaper alternatives, and we are getting closer to the point where we have alternatives for powering our vehicles. We will talk a lot more about this topic in the last lesson or two of this course.

These are the main reasons why cartels like OPEC are difficult to maintain. Please read the full list on pages 248-249 in Chapter 11.

In this lesson, we took a closer look at the assumptions we make in our model of perfectly competitive markets. However, in real life, no markets are perfectly competitive - at least one of our assumptions will be violated. This results in "market failure," a situation where the market fails to generate the maximum theoretical amount of wealth.

We took a close look at the failure of the first assumption, that concerning market power. We looked at how firms that have market power can behave in ways that increase their profits, and how this behavior affects market equilibria. We looked at outcomes for various types and degrees of market power, and we looked at a couple of tools that government has to try and measure just how concentrated a market is.

Have you completed everything?

You have reached the end of Lesson 5! Double check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there.

In the previous lesson, we talked about the first and most common violation of perfectly competitive markets, that being market power. As you are aware, there are three other assumptions of perfect competition that can be violated, leading to market failure of some degree. In this lesson, we will examine a couple of other types of market failure, those being violations of the assumption of free entry and exit as manifested in the form of barriers to entry into a market, and how market players can use imperfect market information to distort market outcomes. We will also look at a special case of monopoly, where having only one supplier actually makes sense from an economic efficiency standpoint, and how society deals with such monopolies.

What will we learn?

By the end of this lesson, you should be able to:

• list and explain the several types of barrier to entry as outlined in the next section of this lesson;
• describe just how it is that natural monopolies can exist;
• describe the negative outcomes that derive from a natural monopoly;
• explain the methods that societies use to deal with natural monopolies;
• list and describe the aspects of information market failure described in this lesson;
• understand and explain when and why firms will use information market failure to their advantage.

What is due for Lesson 6?

This lesson will take us one week to complete. Please refer to Canvas for specific time frames and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.

In the previous lesson, we spoke about monopolies and oligopolies. These are markets where there is only one or are only a few sellers, and therefore, suppliers in these industries are able to earn greater than zero economic profits by charging at prices above the point where $P=MC$ .

In a competitive market, this would be a signal to other suppliers to enter the market and compete for business with other suppliers by driving price down to marginal cost, and economic profits down to zero. In a monopoly, this does not happen. This is one of the violations of the assumption of "free entry and exit." Here we will talk about "free entry," or the ability of firms to enter a market. Another manifestation of this assumption is the notion of "free exit," meaning that an individual is free to choose to not participate in an economic transaction. When people are negatively and involuntarily affected by some economic transaction they do not willingly participate in, we have the issue of "externalities." This will be addressed in the following lesson.

As I said in the previous lesson, there is a very limited set of reasons why monopolies can persist. These are:

1. A monopoly has government protection.
2. A monopoly involves having total control over a limited-supply good.
3. A natural monopoly exists, where it is economically efficient to have only one seller.

The third of these types of market, a natural monopoly, will be talked about in the next section of this lesson. In this section, we will talk about the first two types of monopoly.

Economists generally believe that market forces are always powerful enough to break a monopoly. For a monopoly to be able to stay in existence over time, it must need some protection from market forces, and such protection can only typically come from government. In most cases, government generally acts to try to reduce monopoly power, since we demonstrated in the past lesson that monopolies are detrimental to economic efficiency, as well as hurting equity. Put in simpler words, we don't like monopolies for a couple of reasons: they tend to concentrate wealth into the hands of already wealthy individuals, and they hurt the total wealth of a society by causing unsatisfied demand to exist - there are people who are willing to purchase a good at a price higher than the marginal cost, but are unable to because monopolists refuse to produce the goods, instead restricting output to the point where $MC=MR$ .

So, governments generally discourage monopolies. At the Federal level in the US, this is typically performed by the Federal Trade Commission, or FTC, which is a branch of the Department of Justice responsible for maintaining fair and open markets. Another group that polices markets, specifically in the energy arena, is the Federal Energy Regulatory Commission (FERC). I strongly suggest that you take a look at the FERC website if you are interested in how the energy industries are regulated at the Federal level. There is a wealth of information available at that website. If firms act in ways that are deemed to be detrimental to competitive markets, they can be sued, fined, or punished in other ways. One famous case involved the Department of Justice suing Microsoft for being an illegal monopoly, and seeking to break Microsoft up into three companies, two operating system developers, and one applications developer. Microsoft was able to defeat that lawsuit. Another famous case was the breakup of Standard Oil in the first decade of the last century. I suggest you read about the Standard Oil case.

However, despite the fact that government generally fights monopoly, there are some instances where governments either allow, encourage, or even protect monopolies. These, and some other barriers to free entry in a market, are described below.

Types of Barrier to Entry

Legal Restrictions

Governments sometimes restrict competition, either from domestic or international competitors. This is sometimes done to help develop a native industry where none existed, sometimes for nationalistic reasons, and sometimes because a firm has lots of influence with the government. For example, the United States restricts the importation of sugar into the country, protecting from global competition the 800 or so firms in the US that make sugar. This harms American citizens who consume sugar by making it about twice as expensive as in neighboring countries. It also drives candy manufacturing to Canada, because the cost of making candy is cheaper there, and there are few barriers to the entry of candy into the country.

Licensing Requirements

In many cases, in order to enter a profession, a government either sets licensing requirements, or empowers some other body to set such conditions. In many cases, this is generally approved of by the public: we like knowing that our doctors know what they are doing, and that our accountants are certified as competent. However, such rules apply to many other professions. In many states, if you wish to buy a casket to bury a deceased relative, you have to buy one from a funeral director, and to become a funeral director you have to get a license. The awarding of licenses is typically controlled by commissions that are dominated by members of the funeral profession. Therefore, an industry is able to restrict free entry by competitors, enabling the incumbent members to set prices higher than in a free market. The same is true of flower arrangers, or hair cutters, or tour guides in many states. The industry in question will have licensing commissions, whose role is nominally to protect the public from fraud or incompetence, but which, in reality, merely serve to restrict entry and stifle competition.

Another example of this is taxi commissions. In most cities, if you wish to operate a taxi cab, you need a license, often referred to as a "medallion." In most cities, the number of medallions available is limited. For example, in New York City, there are 13,000 taxi medallions available. Many people believe that this is far too few for a city the size of New York, and one of the effects is that a lot of unlicensed "gypsy" cabs operate, completely out of the view of the authorities, in violation of regulations.

Patents

A patent is a government license to have a monopoly for a certain length of time in a certain good. Patents raise the price of a good, but are felt necessary to promote invention and technological progress.

The above paragraphs refer to methods by which government erects barriers to entry. Below are some other methods that can be employed by firms, that are of various levels of legality. In many cases, these behaviors will be challenged by governments, but it is not always easy to observe and verify that such actions are taking place, and, if they are, whether they cross the line from "aggressive business behavior" to "illegality."

High Fixed Cost versus Small Margins

In many industries, you have to spend a lot of time and money before you are able to sell anything. The longer into the future the potential profits are, the more uncertain the return, and the more uncertainty, the greater profit required. Many such industries fall into the category of "natural monopoly," which will be addressed in the next section.

Predatory Pricing

This is connected to the above point: a firm that is established has often recovered its capital costs (its buildings and machines are paid for). This means that it can lower its price, and it will not be harmed as much as a competitor with high capital costs. So a predatory pricer will lower his price to drive his competitors out of business. In reality, this does not happen often, and economists believe that it generally does not work. But sometimes the threat of predatory pricing is enough to stop a competitor from entering a market.

Excess Production Capacity

This is also related to the above point: an existing monopolist will usually keep some spare production capacity. If a new firm enters, the old firm will increase production, thus driving down the price and making it less profitable for both firms. This is tied in with the idea of economies of scale.

Bundling

Also called “tying,” this means selling several items as a package. Perhaps the best example was Microsoft adding an Internet browser for free to their operating system. This destroyed the previous market leader, Netscape, who used to sell their browser software.

Brand Loyalty

As mentioned in the monopolistic competition section, every firm would like to have a monopoly, and the legal way to get this is through product differentiation from advertising. If you develop a valuable brand, it is difficult for people to compete – imagine launching a new drink to compete against Coca-Cola.

In a competitive market, we expect firms to compete with each other until the point where marginal cost increases to match the demand curve at the equilibrium point. For this situation to be able to occur, we make the assumption of upward-sloping supply (marginal cost) curves. This is a reasonable assumption to make, because as production of some good increases, the cost will increase because we have to compete with other goods for consumption of the inputs. That is, if we want to open a factory to make more detergent, we will have to hire workers, and assuming that we have something close to full employment, to get those workers, you will have to offer them higher wages than what they are receiving from their existing jobs. Simply put, we can reasonably expect supply curves to be upward sloping.

But sometimes, they are not. There are cases where the marginal cost, that is, the cost of satisfying one more customer, is lower than the cost of servicing the previous customer. In such a case, the marginal cost curve, and thus, the supply curve, will be downward sloping or flat over the relevant range of production.

This is called a “natural monopoly” because it is economically efficient for there to only be one supplier. The following diagram can help to illustrate just why.

Figure 6.1 Natural Monopoly

Credit: B. Posner © Penn State is licensed under CC BY-NC-SA 4.0

I should comment here that the textbook lumps natural monopoly in with other barriers to entry, and while it can potentially be thought of as a barrier, it is not one that is created by a market-power-seeking firm. Instead, it is a characteristic of a certain type of market - one with high capital costs and low marginal costs.

Given the downward sloping supply curve, and ignoring the demand curve for a minute, let’s say we have an equilibrium at point E₁, which corresponds to quantity Q₁, and gives us price P₁. Let’s assume this is a monopoly equilibrium, where Q₁ represents the entire size of the market – it represents everybody who wants to buy the good.

Now, let’s imagine that this was a duopoly market, where there are two suppliers. We can assume, for simplicity, that each seller in the market has exactly half of the market. This corresponds to the equilibrium E₂ on the above diagram, which gives us quantity Q₂ and price P₂. We can assume the $Q_2=0.5Q_1$ , and that each of the two firms supplies Q₂ of the good in question.

Do you see the problem? If we have one firm only, the marginal cost of supply is P₁, which is lower than the duopoly price, P₂. This means that having two firms in a market ends up with the firms having to charge a higher price than if only one firm existed. In this case, it is efficient, or “natural,” for there to only be one firm in the market. This is why declining-marginal-cost industries are called natural monopolies.

What types of industries have this type of structure? Well, generally, industries that have very high capital costs, and comparatively low variable costs. This means that to be the first entrant, you have to spend a large amount on fixed costs, but the cost of servicing an extra customer is very low. Some typical industries would be the delivery of telephone services, or natural gas, or electricity, or cable television. These industries are typically referred to as “utilities,” and they require the development of large infrastructures to serve the customer base. For example, if you have a natural gas distributorship, you have to build a large network of distribution pipes and valves covering an entire city. This represents a pretty massive capital (or fixed) cost component, but the cost of servicing a new customer is very small compared to that.

Now, imagine that this was a competitive market. If there was to be competition between different natural gas suppliers, then there would have to be two sets of distribution pipes. Each firm would have to spend a lot of money, but then compete for the same size of customer base. Each firm would have to spend the same amount of money, but have half of the size of market to try to recover their costs from. Therefore, it makes sense for there to only be one firm in each city – it would be economically inefficient to have two competing natural gas distribution grids, just as it would be inefficient to have two redundant electricity grids, or two telephone grids, or sets of water distribution pipes, and so on.

The Problem of Natural Monopoly

Because natural monopolies tend to be utilities, which are services like gas, electricity, water, and telephones, which the public generally holds to be necessities of life, we are not comfortable allowing these firms to charge monopoly prices (i.e., the pricing where $MR=MC$ ). Because these are staples or necessities, the demand curve for these goods is very inelastic – it is very steep. This means that the monopolist price would be much higher than the free-market price, and a large volume of people would be denied basic necessities of life. Instead, we use the power of government to regulate prices in these markets.

The normal avenue for regulation of natural monopolies is the public utilities commission. These exist at the state-level in the United States, and at the national level in many other countries. Utilities commissions are given the task of making sure that utility companies make enough money to stay in business, but not enough to enjoy monopoly profits. They make sure that everybody is served, and served well, in theory. Since utilities are monopolies that are not subject to market forces and competition, they have little pressure to be responsive to market forces, which means that they do not have to treat their customers well, because their customers do not have the ability to switch to a different supplier.

In an ideal, perfectly competitive market, we expect price = MC. So, if we were the government power, we might want to regulate the utility to this point. Unfortunately, in a natural monopoly, this would lead to failure of the firm, because of the notion of declining marginal cost. If the firm was paid the marginal cost of the last unit sold for all units (that is, if the law of one price were to apply), then they would lose money on every unit sold, and, inevitably, fail. Another way to say this is that the marginal cost is always lower than the average cost, because the cost of the next unit is lower than all of the previous units made. For a firm to be able to survive in a natural monopoly, it must be able to charge at least the average cost.

Therefore, the goal of the utility commission is to make sure that a utility is able to charge no higher than average cost. However, most utilities are private companies (although some are owned by local governments in many parts of the world), and as private companies they strive to maximize profits. Typically, a private utility will file what is called a “rate case” to a utility commission, which is basically a statement of what the utility needs to earn in order to stay in business and ensure reliable service. It is the role of the utility commission to examine the rate case and see if it believes that the utility is exaggerating its costs. One of the problems of regulating a utility is that they usually are allowed to earn a certain percent accounting profit on their capital base. That is, the larger the capital base (the more buildings and pipes and power plants, and so on) that a utility owns, the more money it is able to earn. For this reason, utilities tend to be “over-capitalized”- they build more capital than would exist in a competitive market.

Another of the benefits of competition is that it drives innovation and efficiency: firms are always trying to come up with smarter and cheaper ways of doing things. While such actions lead to private gains in the near-term, they tend to be beneficial to society over time, as firms make profits and reinvest these into other productive uses. In a monopoly, these pressures also exist to some extent – if a firm can be smarter, it can make more money at the same market prices - but it is totally absent in a rate-regulated natural monopoly, since firms are allowed to earn a certain amount of money by the Public Utility Commission and any extra money they earn must be returned to the public. While such a result is good for the public, it is not for the utility, and therefore, the utility is unlikely to be particularly innovative or efficiency-driven.

The biggest issue in utility regulation today is the question of how to incentivize innovation in utilities, especially when public watchdog groups keep a close eye on what happens at utility commission meetings and protest loudly if they think the commission is allowing the firms to earn too much money, or include too much into the rate base. If a utility wants to spend any money on research and development, they must get approval from the commission, which will then allow the firm to recover the costs of that research. This means that electric or gas or water rates will be higher than they would be without the R&D spending, and members of the public complain if their rates go up. In many places, utility commissioners are elected by the general public, and they usually wish to be re-elected. This means that they want to keep the public happy, and they best do this by keeping rates low. So, we are stuck in a circle of bad incentives that leads to technical stagnation and a lack of innovation.

We will spend quite a bit of time talking about this when we look deeper at the issue of government failure in a few weeks.

Former Natural Monopolies

The above statements about lack of innovation and competitive pressure do not mean that natural monopolies are immune to technological innovation that weakens their market power. Instead of having multiple firms compete to provide a single service, instead, we now have competing technologies attempting to provide the same service. The most obvious example is that of telephones. It used to be that the telephone system, or at least the part of it from the end user to the phone company’s switching and transmission points, was fully hard-wired. The local phone company had to build a network of cables connected to every house, usually at very high cost, a cost that could only be recovered by either charging monopoly prices or having regulated profits. It was a classic natural monopoly, and one that is government regulated or government-owned in many parts of the world. However, new technology was developed that allowed that last piece of wire between the customer and the phone company to be replaced by radio signals. Thus, we have the cellular phone, and competition with the land-line telephone. People no longer have to rely upon the old-fashioned phone company for their voice communications needs. The same is true of cable television and satellite TV, and now we can get Internet services delivered by the cable company or the phone company or the cell-phone company. Thus, the list of markets that can be classified as natural monopolies has shrunk in recent years. We have yet to find competitive alternatives for electricity, natural gas, and water, and markets for these products remain tightly regulated.

Perfect information is one of our assumptions of perfectly competitive markets, and it is easy to see that this assumption is perhaps the toughest one to make, simply because perfection is something that does not exist. Information can have many aspects in a market setting. The foundation for our analysis of demand in markets is the idea that people are able to place value on the consumption of goods, on understanding the amount of happiness they will obtain from the economic decisions they make. Since the realization of many of our economic decisions takes place in the future, and because the future has an unknown component, it is basically impossible for us to have perfect knowledge without perfect foresight – and that is something we do not have, and cannot have.

However, as a market failure, this is not something we can correct. We can, as individuals, educate ourselves about the world and what sort of outcomes we can come to expect. We can gain wisdom and insight, but we can never tell the future with certainty. Thus, we will consider this issue further. It is merely a manifestation of the nature of our existence and the linear nature of time.

Instead, we need to concern ourselves with information that is knowable, but the lack of knowledge by one or another party in an economic transaction causes a loss of wealth to society.

Some markets have close to perfect knowledge of present information. Perhaps the best example is the market for shares of widely traded public companies at places like the New York or London stock exchanges. The shares are all homogeneous – one share is exactly the same as another, the prices are readily available, in real-time, to anybody who is interested, and there are many, many people studying the activity of the companies that are being traded. Because they are publicly traded on stock exchanges, these companies are required to release a lot of information to the public about their business activities, their profitability, their debt levels, and so on. Generally, a person buying a share in a large public company like IBM or General Electric or Exxon knows or, at least, has the ability to know, about as much as anybody else in the market for the share in question.

There is one situation where somebody might know something about a company that the general, investing public does not: when a person is an “insider,” and has some non-public knowledge about the future of the company. A manager or director of the company may know that they are in the process of planning a takeover of another company, or are being taken over, or are about to suffer a large loss due to some non-public event. The announcement of such pieces of information can have significant effects on the price of shares of these companies. Thus, insiders can profit greatly by buying or selling stock using information that is not available to the general public. This is what is referred to as an “information asymmetry.” For this reason, insider trading of stocks is highly regulated in many countries. Insiders – managers and directors – have to make public record of their stock trades, and if a material event happens that they can reasonably be expected to have had inside information on, the securities authorities will examine the history of their trades to make sure that they did not profit from that knowledge unfairly. If they are found to have done so, they can be severely punished. In other countries, for example, Germany, the securities authorities make sure that all insider trades are publicized immediately, so that the general public can mimic them. The authorities in countries like this assume that this is a better way to disseminate information about what is going on in markets and in industry. If insiders are making big moves, and people can see them, the market will assimilate that information quicker than it otherwise would. At least, that’s the theory. If you go ahead and study finance, this is what is called the strong form of the efficient markets hypothesis, about which there is a great amount of disagreement in academic and professional circles.

The last type of information market failure concerns another type of information asymmetries: that about products or services being sold. It is not hard to realize that, typically, a seller of a product knows a great deal more about that product than the buyer. Sometimes, a seller will use this to his advantage by not telling the buyer something meaningful and important about the product. This is sometimes referred to as getting “ripped off.”

When will a seller take advantage of such a situation and “rip off” a consumer? The short answer is: when it pays to do so. More specifically, there are some conditions:

1. When you can’t find out that you are being cheated until after the purchase is made, and
2. When you can’t punish them once they’ve cheated you:
   • When you only make a single purchase from the seller. For example, most people only purchase a house a few times in a lifetime and very rarely more than once from the same seller.
   • When there is only one seller. If you feel like you’re getting ripped off by the power company or the only gas station for 20 miles, you cannot easily take your business elsewhere.
   • When getting cheated is a small enough loss to not change your preferences.
   • When you will never find out if you have been cheated. One example of this is people undergoing unnecessary surgery. This why they say you should always get a second opinion.

So, summing up, sellers will have an incentive to cheat buyers when buyers cannot adequately punish sellers.

Consumers can also take advantage of suppliers — moral hazard. The best example of this is insurance:

• a) Insurance companies agree to pay your damages after an accident.
• b) However, they do not control your behavior, and you have incentives to be risk-loving, knowing your damages will be paid.

Another example is academic integrity:

• a) Most teachers believe that you hand in your own work and don’t go to great lengths to certify that what you hand in is yours.
• b) However, they cannot control (or costlessly discover) whether you have done the work yourself, or copied from a friend.

Of course, when insurance companies (or teachers) catch you, consequences are usually significant.

Correcting Information Market Failure

In this case, there are private as well as public (governmental) solutions:

1. Trade Organizations: If a company misbehaves, their reputation will be hurt and the trade organization will cease to support them.
2. Consumer Organizations: Publications like Consumer Reports independently monitor companies’ performance and keep consumers informed.
3. Anti-Fraud Legislation: If you can prove a company cheated you, they will have to pay restitution to you and prohibitive damages to the government.

In this lesson, we looked at some of the other types of market failure that can exist. Firstly, we talked about one of the manifestations of the violation of the assumption of free entry and exit, that being the way in which some incumbent sellers in a marketplace try to erect barriers to entry into a market, which helps reduce the amount of competition a firm faces, whether it is a monopoly or not. There are various barriers to entry, some supported by government, some illegal, and some perfectly legal. We then talked about natural monopolies, which are typically utilities, in which it makes sense from a standpoint of economic efficiency to have only one supplier in each market. The last section was about the violation of the assumption of perfect information. We spoke of some ways that asymmetric information can be used to gain an unfair advantage in a marketplace, and when and why this information can and will be used.

Have you completed everything?

You have reached the end of Lesson 6! Double check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there.

In this lesson, we reach the end of the topic of market failures. The last market failure mechanism for us to address, which is perhaps the most important to the topics of energy and sustainability, is the market failure known as an "externality," which is a violation of the assumption of free entry and exit into a market. The most important type of externality is the existence of air and water pollution. In this lesson, we will take a look at how we can use economics methods to "internalize" externalities. We will also speak of goods that are under-provided or over-exploited in an uncontrolled marketplace due to the absence of well-defined property rights.

What will we learn?

By the end of this lesson, you should be able to:

• define what an externality is;
• list and describe some examples of externalities;
• explain the difference between private and social costs;
• draw a diagram showing the private and socially optimal equilibria, and the private and social cost functions;
• show how we can define and get to the socially optimal equilibrium given a schedule of utilities/costs for each party;
• explain the fundamentals of the Coase Theorem;
• describe situations where the Coase Theorem does not work well;
• describe different approaches to pollution control;
• describe and explain the merits of different approaches to pollution abatement.

What is due for Lesson 7?

This lesson will take us one week to complete. Please refer to Canvas for specific time frames and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.

“Externalities” are the last type of market failure we will talk about. They are a form of free entry/exit market failure. When a trade is made, there are normally two people affected by the trade: the buyer and the seller. But, sometimes, a trade or some other piece of economic activity has an effect on people who are not directly involved. Because these effects are on a person who is external to (or outside of) the trade, we call them externalities. Externalities can be either positive or negative; that is, the economic activity of one person or group can have either a positive or negative "spill-over" onto other people.

An externality is when the welfare (utility) of a person depends not only on his activities, but also on the activities of an “outside” person. An externality exists whenever an individual or firm undertakes an action that impacts another individual or firm for which the latter is not compensated (a negative externality, e.g., pollution), or for which the latter does not pay (a positive externality, e.g., voluntary vaccination). This occurs when property rights are NOT well-defined. When externality exists, the competitive market does not achieve the efficient allocation of resources in society (i.e. the market fails) because no market exists in which the affected party can express his/her preferences for the externality. The presence of externalities means we are ‘missing a market’ for the externality. Because externalities are often co-produced with other market transacted goods (e.g., emissions and electricity) this distorts the markets of the transacted goods as well as the markets connected to them.  

Examples of externalities:

Pollution

This is the most common type of externality, and the one that will be addressed most frequently in this course and in real life. It can take many guises. For example, think about a case where a village makes its living from catching and selling fish from a river. Now, if a chemical plant opens 25 miles upriver and decides to discharge chemical waste into the river, then the fish all die and the people in the village lose their ability to make a living. In this case, the chemical plant (and, by extension, its customers) is not being forced to cover all of the costs of its operation. If it was required to dispose of hazardous waste in some way that did not involve dumping it into a river, then it would be faced with higher costs, and if it has higher costs, then the price of its products will be higher. If the price is higher, then consumers will purchase less.

Air Pollution

Air pollution is one of the key externalities that has been addressed in the US over the past 40 years. And coal has been the largest source of some of the worst air pollution. In 1998, coal power plants were responsible for:

• 67% of Sulfur Dioxide (SO2)
• 33% or Mercury
• 35% of Nitrous oxides (NOx)
• 40% of GHG emissions (CO2, methane, etc.)
• Particulate Matter (PM)

In the Industrial Heartland of the US - places like Michigan, Ohio, and Pennsylvania - a lot of industrial facilities have burned coal over the past 150 years. The coal that is burned in these power plants, steel mills, and factories contains sulfur. When sulfur burns, it forms a compound called Sulfur Dioxide, SO₂. The SO₂ is carried into the environment by the exhaust stacks connected to the boilers of these plants. When the SO₂ mixes with water vapor in clouds, it forms Sulfuric Acid, H₂SO₄, and eventually, this falls as part of rain. This is what is known as Acid Rain, and was responsible for lowering the pH of many lakes and rivers in the north-eastern part of the United States to the point where these bodies of water were unable to sustain any life. Another form of air pollution comes from the burning of gasoline in motor vehicles, which gives us several undesirable compounds: unburned hydrocarbons and partially reacted oxygen, in a form called ozone, which, in the presence of sunlight, creates photochemical smog, which can be severely damaging to the lungs. We also get particulate emissions - another word for soot - which consists of very fine particles of partially burned hydrocarbon that float in the air and get inhaled by people, and we also get Carbon Monoxide, a poisonous gas that can cause nausea at low concentrations and death at not so high concentrations. These emissions have all been the target of environmental legislation over the past 40 years, and we will talk at length later of attempts to regulate them.

Water Pollution

A common form of water pollution is runoff of fertilizer from fields. In the central part of the US, known as the "Bread basket" (think of places like Illinois, Iowa, Kansas, and so on), farmers use a great amount of chemical fertilizer to ensure large crops of corn and soybeans. Since fertilizer is relatively cheap, farmers have an incentive to over-apply, as opposed to under-applying it. Any fertilizer that is not absorbed by the plants runs off with rainfall into rivers, and these rivers all end up flowing into the Mississippi River. As you go downstream, the concentration of the Mississippi river increases. The result is that in the Gulf of Mexico, just off the coat of Louisiana, there is a large "dead zone' several hundred square miles in size which is caused by the excess fertilizer in the water. This fertilizer accelerates the growth of algae in the water, and the algae consumes all of the oxygen in the water, meaning that nothing else can live in the water. One of the reasons that the damage from the recent oil spill in the Gulf was not larger was that it occurred in this "dead zone," so there was not a lot of marine life to kill to begin with. This situation creates a benefit for everybody who consumes corn or soybeans - which is, basically, all of us, in the form of cheap food, but it has a significantly negative effect on the biodiversity of the Gulf of Mexico, with secondary effects that are scarcely understood by humans.

Bees and Crops

This is an example of a positive externality: bee keepers take part in a market for honey; they raise and keep bees in order to harvest honey and sell it to the public. In the process of creating honey, bees fly around and pollinate plants, which enables them to grow. This is very beneficial to people who grow flowers and vegetables for a living. Without bees, these vegetable or flower growers would have to manually pollinate their plants - a very tedious and labor intensive process, or develop hybrid plants that are self-pollinating. These are both costly propositions. Indeed, these businesses rely upon the presence of bees to enable their business models to work - without them, their products would be more expensive, and thus there would be less consumed. So, the presence of bees to pollinate commercial plants is a positive externality that arises from the presence of honey farmers.

Noise

Pollution does not simply refer to dirty air or water, but it also refers to other bespoilments of the environment, and one of these is noise pollution. Noise pollution can come from a variety of sources: highways, airports, factories, construction sites, nightclubs, railroads. (I live close to a railway level crossing, and the sound of sirens and horns as the trains pass the crossing several times a day can be very annoying. Fortunately, one grows accustomed to this noise, and after a while, you don't really hear it.) It is basically another by-product of economic activity, and if the noise was forced to be reduced in some way, then the firms generating it would have one of two choices: reduce the amount of economic activity (this is common, such as airports being forced to be closed overnight), or install expensive equipment to reduce the amount of noise emitted. Once again, this has the effect of raising costs, and the raising of costs means that the equilibrium price is higher, and there will be less consumed. Sometimes the economic activity gets shut down completely - for example, a lot of bars and clubs in New York City have been forced to close because the buildings they occupy have become residential areas, and the clubs get fined for excessive noise so frequently that they are unable to continue doing business.

There can be positive and negative externalities, but since positive externalities do not present a large economic problem, economists concentrate on negative ones - positive externalities do not really present much of a market failure issue.

The general issue here is one of costs: there are costs that are borne by the participants in the economic transaction, and then there are costs that are borne by non-participants - the external costs. The costs that the participants bear - the costs to the seller that are transferred to the buyer via the price mechanism - are what we call "private" costs. In an ideal world, all economic costs will be private - they will be all borne by the people who derive utility from the transaction. However, in reality, there are many cases where there are some costs that are transferred to non-participants - such as fisheries destroyed by acid rain, or the ill-health that comes from breathing dirty air, or the problems of trying to sleep near noisy factories or railroads. These costs, which are not carried by the manufacturer or purchaser of the goods in question, are what we call "social costs," because they are borne by society. They are illustrated in the following supply and demand diagram:

Figure 7.1 Social Cost

Credit: F.Tayari © Penn State is licensed under CC BY-NC-SA 4.0

In the above diagram, we have the "private" equilibrium (Q1, P1), which is the intersection of marginal private costs (MC) or supply curve (for example marginal cost of producing each kWh of electricity) and market demand. We also have the "social" equilibrium (Q2, P2), which is the intersection between Social Marginal Cost and demand curve. Social Marginal Cost is the sum of marginal private plus Marginal External Cost (Social Cost). We can define the Marginal External Cost (MEC) as for example the additional external cost from each additional kWh of electricity that is produced. We can assume the Social Marginal Cost a line parallel to the marginal private costs but above that, because it bears the social cost (for example cost of harm to the people).

The difference between these two equilibria comes from the upward shift of the supply curve when we include the social costs, which are costs that are paid by society in general, or by people "external" to the transaction, versus the private supply curve, which is the one that contains all the private costs. Therefore, "social" equilibrium would be at higher price and lower quantity. It should be clear that the true social optimum is not (Q1, P1), but instead (Q2, P2) once we account for the costs of the negative externality on society. Note that the competitive equilibrium leads to too much pollution being produced and less total wealth. If we ignored external costs from producing electricity from coal and consumed at (Q1, P1), we would obtain gains in consumer and producer surplus equal to the green trapezoid, however we also incur marginal external costs equal to the purple parallelogram. So, society experiences a wealth loss equal to the blue triangle.

Figure 7.2 Society wealth loss due to externality

Credit: F.Tayari © Penn State is licensed under CC BY-NC-SA 4.0

I may be over-simplifying things here, but, basically, the entire field of environmental economics is concerned with trying to shift the equilibrium from the private one, (Q1, P1), to what we call the "socially optimal" equilibrium, (Q2, P2). This is often referred to as "internalizing" an externality.

In the next lesson, we will discuss methods for performing this shift, how these methods are implemented, and how effective they are.

What is not an externality?

When we talk of one person's actions affecting another person negatively, we sometimes hear about something called a "fiduciary externality." This can be boiled down to the following: if one person buys a good, they are moving the demand curve outwards. This act of moving the demand curve outwards will result in movement of the equilibrium to a point where the price will be higher than it would be without that person buying. Put another way, if I buy a good, you cannot buy it, and if you want to buy it, you may have to pay a higher price. This is most obvious in an auction scenario. Just last night, I was watching an auction for exotic cars, and, in one case, there were two bidders for a certain vehicle. Each person kept increasing their bid, that is, causing the other person to pay more. This is not a market failure. Another example could be travel at Thanksgiving: because more people want to fly, and because the number of airplanes is finite, fares tend to increase over Thanksgiving. Similarly, more people want to drive over this period, and thus roads are more congested (and thus, the opportunity cost of using them increases). These are all situations where increased demand raises prices, so that any one person is adversely affected by everybody else's economic choices, but this is not an externality in the sense that it is not a market failure - it is merely a dynamic realignment of the market equilibrium as a response to a temporary change in demand, much like the fact that roses are more expensive on February 14th than they are on February 21st, gasoline is more expensive around Memorial Day than around Columbus Day (ceteris paribus), and hotel rooms are a lot more expensive at Rehoboth beach, DE in July than in November. I reiterate: these are not market failures, except in cases where market power comes into play, but that is a separate issue.

In this lesson, we will describe a real-world use of Coasian policy to deal with an externality and provide an example of how such systems work in general. We will also talk of other methods and why they are less attractive than Coasian methods.

We will now focus on the topic of attempting to reduce the emissions of Sulfur Dioxide (SO₂) from power plants and steel mills that consume coal. We previously mentioned why SO₂ emissions are "bad" - they create acid rain, which renders lakes incapable of supporting life. Acid rain also damages buildings, as any of you who have been to Pittsburgh can readily see.

There are three general ways in which SO₂ emissions can be reduced. These all involve attempting to move from the private to the socially optimal level of pollution. We should note at this point that the socially optimal level of pollution is not zero, but is the point where the marginal benefit of pollution equals the marginal cost.

You might ask, what is the social benefit of pollution? Well, pollution itself does not have any benefit, except perhaps to companies selling pollution-control equipment and to class-action lawyers. However, we need to remember that it is merely a by-product of an industrial process that creates something we find to be very useful: electricity. Without burning coal, electricity would be much more expensive in the US. Therefore, when we consider the benefits of using electricity, we have to consider this as a benefit that comes from emitting SO₂ into the environment.

As mentioned above, there are three general ways we can proceed:

1) Command and Control. This is exactly what it sounds like: governments issue commands in order to control the amount of pollution. This approach is simply to require that all firms employ some abatement or emissions control technology or equipment (think “scrubbers”—devices that one can attach to the end of a smokestack to pull out bad emissions from the stack). If emitters fail to comply with these rules, they face criminal sanction and the possibility of fines and imprisonment.

Command and Control approach may involve some distortions:

• Instead of forcing all firms to invest in an expensive scrubber, it may be cheaper for some firms to reduce emissions by purchasing cleaner inputs (e.g., low sulfur coal)
• Plants have different ages and design, can impose unequal cost burdens to firms
• May discourage firms from investing in newer pollution abatement technology (e.g., may need to trash investments if new C&C regulation comes along (often a motivation for firms to push for C&C regulation—in order to reduce regulatory uncertainty)
• Current firms can “capture” regulatory board and require technologies that are easy to implement (or already in place). May serve as a barrier-to-entry to new competition (e.g., Cement).
• Political distortions: a US senator, pushed for mandated scrubber technology so high-sulfur WV coal could compete with low-sulfur PRB coal

Thus Command and Control is unlikely to be the most efficient solution.

2) Pigouvian taxes. These are taxes on pollutants, and got their name from the first person to propose them, a British economist called Arthur Pigou. A Pigouvian tax moves the equilibrium from the private to the social one, but it does so by setting a fixed cost (the tax), and then allowing quantity to adjust in the marketplace. The problem with this system is that it requires more information. If the tax is too high, the quantity emitted will move to a quantity below the socially optimal value, which means that some wealth is destroyed. If the tax is too low, then we will not reduce pollution by very much, and we will be producing at a level above the socially optimal amount, which is also not a wealth maximizing situation.

3) Coasian permit trading. This is a system whereby the government delegates to itself the property right to emitting sulfur dioxide and then sells (or gives away) these property rights. A company needs a permit for every ton of SO₂ they wish to emit into the environment, and the quantity of those permits is controlled by the government. This method has the benefit of allowing firms to trade permits so that firms that have a high cost of emitting can buy rights from firms that can reduce pollution at lower costs, which means that as a society we can have the same amount of pollution reduction as in the command and control method, but at a lower cost to society. This will be illustrated a little later. This method is called "cap and trade," because the government will set a cap on the amount of SO₂ that can be emitted each year and then allow emitters to trade amongst themselves to obtain the socially efficient result. Cap and trade contrasts with Pigouvian tax method in this way: with a Coasian system, we are setting the socially optimal quantity, and then allowing the price to find the market equilibrium. In theory, this is equivalent to the "social cost," the difference between the two supply curves in our social versus private equilibrium diagram. The good thing is, we do not have to try to figure out this cost, which can be extremely difficult to discover, but, instead, we can simply let the market find the level. Cap and trade method seeks to creates a market for externalities. This a possible solution to the missing market problem of externalities. Once we create a market for the externality, it is no longer external to the market.  Hence we say we have “internalized the externality.”

So, in theory, all three methods get the same results, but, in reality, the cap-and-trade method can be shown to work better than either alternative.

The first attempt to limit sulfur emissions, the Clean Air Act of 1970, used command and control regulation, and relied upon government to specify and administer all aspects of pollution control (i.e., micro-management). The Environmental Protection Agency (the EPA), the government agency charged with administering environmental policy, would determine performance standards applicable to each pollution source. Typically, standards were set in rates: quantity of pollution emitted per hour, or per unit-of-energy, etc. Sources then would have to find a way to meet these fixed, general standards. Each could choose one of two methods of compliance:

1. Install pollution control equipment
2. Reduce the number of hours of production (in the extreme, shutting down completely)

Both of these methods of compliance are very expensive. Old plants have high emission rates (because they were designed without pollution control in mind) and need to install A LOT of pollution control equipment to come into compliance. According to the law of diminishing returns, each next unit of pollution reduction costs more than the previous unit. This translates into HUGE costs to old sources, and huge costs for middle-aged sources. Another large cost comes from the fact that most industrial facilities are very valuable to society - in the hundreds of millions of dollars each. Completely abandoning a facility, even if it has been paid for, necessitates construction of a replacement facility. As a result of these high costs, industry would choose to endlessly litigate new environmental policy in the courts rather than comply, and the environment was never very adequately protected. The Clean Air Act of 1970 required all coal-fired plants to install pollution-control devices called "scrubbers," but the legal fight back was great - to this day, 40 years later, the majority of power plants built before 1970 still do not have scrubbers.

The result was that by the end of the 80s, the rates of SO₂ emission were still much higher than what was thought to be the socially optimal amount, and acid rain was still a problem. At the urging of economists, the government adopted a different approach, one consistent with the teachings of Coase. In the Clean Air Act Amendments of 1990, Congress adopted a cap and trade program for sulfur dioxide, known as the Title IV program, based on the chapter in the law.

Under Title IV, every year, the EPA would decide how many permits were to be issued. This number shrank every year. The number started at about 17.3 million tons in 1991, and was down to about 9 million tons/year by 2000. The EPA would allot the permits to plants based upon their emissions in some base year, and the firms could either emit SO₂ and surrender permits to the government, or it could sell the permit and then release less SO₂. This aligns the incentives of the firms with the goals of reducing pollution - it would award firms for innovating and reducing pollution by being able to "sell," and hence benefit from, their pollution control efforts.

The accounting behind this system is very complex, so I will use some simple numerical examples to illustrate how such a system works.

Let us say that there are three firms: Awful Industries (Firm A), Bigbaddirty Inc (Firm B) and the Crud Corporation (Firm C). In the beginning of our problem, there are no pollution laws, and each firm is polluting at their maximum level. For each firm, this is 5 tons per hour. The air is getting terribly polluted, and the government hires a group of biologists, who say that there should never be more than 9 tons per hour emitted.

1. Using Command and Control

Firstly, the government decides to limit each firm to 3 tons each. The following are the firm profits at each level of pollution:

From Table 7.1, we can see that each firm makes the maximum profit at 5 units of pollution, so that is what they will do if there are no controls - emit the maximum amount. This is because reducing pollution costs money: firms have to spend to clean up their waste, and they are not able to produce as much stuff. Another way to look at this is to reverse Table 7.1 and look at the TOTAL COSTS of reducing pollution (this is also called “Pollution Abatement”):

Table 7.2 tells us how much it would cost to move from the uncontrolled situation to a certain amount. For example, if Firm A had to move to 1 unit, they would have to give up 300 in profit.

In order to calculate the numbers in table 7.2, we can start from the last column and move to the left. The last column to the right is when firms make no effort in reducing units of pollution. In that case, the total cost of pollution reduction is zero. Then, we move to the next column, where firms reduce only one unit of pollution (producing 4 units of pollution each). Total cost of reducing only one unit of pollution can be calculated as: (total profit at 5 unit of pollution) – (total profit at 4 unit of pollution). The next column (moving to the left) is when each firm produces only 3 unites of pollution (removing 2 units). We can calculate the total cost of producing only 3 unites of pollution as: (total profit at 5 unit of pollution) – (total profit at 3 unit of pollution). And if we continue this method to get to the first column, we will have Total cost of producing zero unit of pollution = (total profit at 5 unit of pollution) – (total profit at 0 unit of pollution).

So, what are the costs to the firms if they are each forced to emit only 3 tons each? Well, we just add up the total costs in the column headed by “3 units.” The total loss is $130+90+30=250$ . Remember this number.

This is the same as the government giving 3 pollution permits to each firm, and telling the firms that they may not trade the permits amongst them.

2. Cap-and-Trade

What if the government gives three permits to each firm, and says that the firms can trade them? Well, Firm A will make 70 more in profits if they can pollute 4 units. Firm C will make 40 less units of profit if they go to two units. So, we have a potential trade. Firm A is willing to pay up to 70 for an additional permit, and Firm C is willing to accept more than 40 for a permit. Since we can find a mutually beneficial amount between 40 and 70, then the trade will happen. This means that Firm A will now emit 4 units (because it has 4 permits) and Firm C will emit 2, as it now only has 2 permits.

The result is that we will have Firm A polluting 4, at a total cost of 60, Firm B will still pollute 3, at a total cost of 90, and Firm C will pollute only 2 units at a cost of 70. So, the total cost for all three firms is now $60+90+70=220$ .

So, now we have the same amount of pollution, but the total cost to the firms is reduced from 250 to 220. This benefits society: either the firms can make more profit, or they can lower their prices. Both of these things are good for the economy.

There is one more benefit to having a permit system: if a person wants to reduce pollution, all they have to do is buy a permit and then not use it. This reduces the total amount of pollution in the world.

In this market, permits will trade for between 40 and 70. If we have a larger market, with more firms, we can expect more trades and we can expect the equilibrium price for permits to converge to a single value. This value will be the value of the Pigouvian tax we need to have the same result, but, as I mentioned above, this would likely require quite a bit more trial-and-error on behalf of the tax-setter. Simply setting a cap and letting the price equilibrate based upon firms trading in their own best interest is a more effective way to reduce pollution.

Here is a story about two guys sharing an apartment. We’ll call them Bert and Ernie. It turns out that Bert is a big fan of Megadeth, and can't get enough of their music. However, Ernie does not like this music so much. Ernie likes quiet. So, we have a bit of a problem: two people sharing the same apartment, one who likes loud, raucous, heavy metal, and one who cherishes peace and quiet. Is there a solution? This being an economics course, we are inclined to ask, is there some application of “economics” that would allow us to define just how much music can be played and keep both people happy? Is there some way we can "optimize the social wealth" in the apartment, some way to maximize happiness in the entire in-apartment community, which consists of Bert and Ernie. (We'll not worry about any externality effects the music might have on the neighbors for now.)

Well, in economics we are fond of stating things, especially utility and happiness, in terms of money, if only for the ease of accounting and measurement it allows us, so we have to define Bert and Ernie’s “happiness” in numbers. These numbers represent happiness in money terms. Let us suppose that the happiness for between zero and 5 songs is given on the following table:

The above table contains the "total" amount of happiness for each number of songs. As you can see, the more songs played, the happier Bert gets and the more unhappy Ernie gets. We can assume, for simplicity, that all of the "happiness" numbers are denominated in dollars.

What is the “best” number of songs? Well, we want to know at which number total social happiness is maximized. Since our society here consists of two people, it's pretty easy to do - we add together everybody’s happiness and find out what the highest total is for everybody added up:

So it appears that 2 is the “best” number of songs played. It is the “socially optimal” amount.

Now, how do we get to this amount?

Let us assume that this apartment belongs to Bert, and Ernie is his guest. So Bert has the “property right” to play music. Since he has the right, and he is happiest when playing 5 songs, then this is how much he will play in the beginning.

This being economics and all, Ernie decides that maybe he can buy a little bit of peace and quiet. So, he offers Bert some money to go from 5 songs to 4. If we go to 4, Ernie's happiness increases from -32 to -20, so he is 12 dollars better off. So, he would be willing to offer up to 12 for one less song. If we go from 5 to 4, Bert's happiness decreases from 30 to 28. He will be giving up 2 dollars of happiness to listen to one less song. So, if he is being offered more than \$2 to not play the 5^th song, he should accept if he is a rational utility maximizer, and, of course, we assume that he is. For this drop in music, he must gain back at least \$2 to be better off. So, we will have a trade. Ernie will pay less than 12, but more than 2, to go from 5 songs to 4. Both guys are happy with between 2 and 12 dollars being exchanged for one less song.

We can repeat the same thing for 4 to 3 songs and 3 to 2 songs.:

From 5 to 4 songs, the payment is between \$2 and \$12

To go from 4 songs to 3 a payment of between \$4 and \$7 will satisfy both Bert and Ernie.

Now, if we have negotiated a total of three songs, and Ernie wants to go down to 2, he will offer up to 7, and Bert will accept anything over 6.

So, to date, we have had three opportunities to make trades where both people are better off - Bert is willing to give up music if he is compensated more than the happiness he is losing from not hearing music, and Ernie is willing to pay if he pays less than the amount of happiness he gains from each less song. These trades are mutually beneficial, and are "wealth generating" - both guys are better off if these "trades" are made.

So, what about going from 2 to 1 song? Well, to do this, Bert needs to get at least \$8, because that's how much value he places on the second song. However, Ernie is only willing to offer 4, since that is how much he values the extra silence. Since there is no number that is above 8 AND below 4, this trade will not be made. We will stop at 2. So, if we add up the trades, we can say that:

“We will go from 5 songs to 2 for an exchange of between \$12 and \$26.”

Note that we stop at 2 songs, which is the “socially optimal” amount.

OK, now what if we assume that the opposite is true: that Ernie owns the flat, and Bert is his guest. In this case, Bert is happiest with 0 songs. So, that is where we start. In this case, Bert is willing to offer Ernie some money in order to be able to play some music. To go from 0 songs to 1 song, he will offer up to 10. Ernie will be happy with anything more than 2.

So, we will go from 0 to 1 songs with a payment between \$2 and \$10. This will be a mutually beneficial trade, so both are willing to make it.

Now, if we want to go from 1 song to 2 songs, Bert is willing to offer up to \$8, and Ernie is willing to accept anything over \$4. Once again, there is an opportunity for a trade to be made, and it will be made.

So, what about going from 2 to 3 songs? Well, Ernie needs to get at least \$7 to want to do this trade. However, Bert is only willing to offer \$6. Since there is no number that is above 7 AND below 6, this trade will not be made. We will stop at 2. So, if we add up the trades, we can say that:

“We will go from 0 songs to 2 for an exchange of between \$6 and \$18.”

Note that we stop at 2 songs, which is the “socially optimal” amount.

You will notice that we started in two different places - in one case we started with 5 songs being played and, with voluntary exchange, we got to 2. In the other case, we started at 0, but with mutual, wealth-generating trades, we also got to 2. No matter where we start, we end up at the same place, and that place happens to be the socially optimal amount of Megadeth tunes.

OK, so this example seems a little silly. But let’s say I changed the table above to “Tons of Hideous Guck Emitted into Stream by Steel Plant Near Your House,” “Payoff to Steel Plant,” “Payoff to People in Your Town.”

Another Example

Paris Hilton and Nicole Ritchie are stuck in a room at the Motel 6 for the next 3 hours. Both are hungry. Paris has a bag of 5 Junior Whoppers, while Nicole has no food. Nicole does have money. Here are their TOTAL value of Junior Whoppers. All values are in \$ million

Assuming that Nicole does not use force, and that neither party acts out of spite (ok, let’s pretend), explain any deal that will take place. Some hints: 1) Calculate marginal values; 2) Remember, don’t have the sum of Junior Whoppers that Paris and Nicole eat exceed 5!

The Coase Theorem:

If transactions costs are not “too high,” the market will find the optimal (best, wealth maximizing) solution.

But what constitutes “transactions costs?”

What could be a transactions cost?

1. Spite. Perhaps not so much in business, but often in divorce (“The War of the Roses” (1989))
2. Government Regulation and taxes; say a tax on trading
3. Public goods problem. Instead of having only Ernie being affected by the toxins in the stream, let us have 100,000 residents in your hometown being affected. Now, fighting pollution becomes a public goods problem. (So, the problem with externalities is that they create public good problems. We will learn more about public goods in following lessons) Here the government could come in and impose a solution. The government could say: Don’t pollute so much; or pay us X dollars every time you pollute. What is the difference?

This theory was first elaborated by a professor by the name of Ronald Coase, who won the Nobel Prize in Economics for his work in 1991. He was the first person to observe that if property rights were well defined, and could be enforced, it was possible for a society to move to the socially optimal equilibrium in cases of pollution, or other externalities. In his honor, this has become known as the "Coase Theorem," and is the foundation of a large part of environmental legislation in the United States.

The most important underlying assumption of using a "Coasian" solution to an externality problem is that property rights need to be well defined and enforceable. That means that we have to know who owns what, and that the people who own those things should be able to enforce their rights, and stop unauthorized users from using resources that they own. After a little bit of thinking, this becomes self-evident. Externalities arise because an economic actor is able to off-load some of his costs onto another person, and if the afflicted person had well-defined and defendable property rights, this would not happen, or at least, it would not persist. Coase was able to home in on the underlying, root problem of externalities, and shows how such problems can be solved.

Summarizing

The Coase Theorem states that assigning property rights for the affected resource will result in the socially optimal quantity being produced.

It DOES NOT MATTER to which party the rights are assigned; to get the socially optimal quantity, all that is required is the clear definition of property rights.

When the producer has the property rights:

• The parties receiving dis-utility from the externality will pay the producer of the externality to reduce production levels.
• The optimal quantity is reached when the cost required by the producer to reduce by one more unit is higher than the benefit of the reduction.

When the affected party has the property rights:

• The producer of the externality will pay the affected party to be permitted to increase production.
• The optimal quantity is reached when the cost required by the affected parties to allow one more unit of production is higher than the benefit of that production.

This can only work with low transaction costs, which is not the case:

• If there are many affected parties, so it is expensive to coordinate the necessary contracts for the sale of property rights.
• If one person can block the sale, regardless of the costs actually imposed on them.
• When enforcement of the contract can be expensive, such as the costs of court proceedings if there is a breach of contract.
• If the costs of monitoring the offending behavior are high. That is, can we tell if someone is polluting a river?

Another issue facing application of the Coase Theorem is that of equity: it assumes that an affected party has the ability to pay a polluter to pollute less, which is not always the case. There is also a social issue here: the notion of paying a person in order to not perform a "bad deed' seems very wrong to many people. Looked at from the other perspective, allowing a company to make a payment to government in order to be able to emit pollution is seen by some people as wrong. This notion is described in the article at the following link, which I would like you to read:

We will talk a little bit more about this issue later. These are issues that can, and have been, addressed. The difficult part then boils down to the notion of defining property rights. Who has a property right to a river, or to the air, or to peace and quiet?

Let's assume 2 firms, and no environmental regulation. Each firm pollutes 4 "units" (say tons) of "guck," an environmental bad. Abatement is costly.

Scenario 1) The Environmental Protection Agency (EPA) announces each firm must reduce pollution 2 units. So, each firm gets a non-tradeable right to pollute 2 units.

Scenario 2) EPA gives each firm tradeable rights to pollute 2 units (in our example, 10 in all).

So how much does it cost firms?

A small detour:

$MC\left(X\right)=TC\left(X\right)-TC\left(X+1\right)$ ;

But…let Z=the “no regulation” state. This implies $TC\left(Z\right)=0$ .

So, $MC\left(Z-1\right)=TC\left(Z-1\right)-TC\left(Z\right)=TC\left(Z-1\right)$ ;

$TC\left(Z-1\right)=MC\left(Z-1\right)$

$MC\left(Z-2\right)=TC\left(Z-2\right)-TC\left(Z-1\right)=TC\left(Z-2\right)-MC\left(Z-1\right)$ ;

$TC\left(Z-2\right)=MC\left(Z-2\right)+MC\left(Z-1\right)$ ;

We can show that:

$TC\left(Z-3\right)=MC\left(Z-3\right)+MC\left(Z-2\right)+MC\left(Z-1\right)$ and so on.

This all implies that we can calculate total costs by simply adding up the marginal costs from right to left.

Back to the problem…

Now, the EPA decides that each firm must reduce its pollution to 2. How much will this cost?

Reading off the total cost tables, we get $18+30=48$ .

Allowing Trading Between Firms

Or: The EPA gives each firm 2 pollution “credits,” which are tradeable. To pollute x units, each firm must own x credits. Since Firm 2 is the “high cost” firm, we’ll ask: Should Firm 2 buy a credit from Firm 1?

Firm 2's marginal cost of abatement (going from 2 to 3 units of pollution) is 12. Firm 1's marginal cost of abatement (going from 2 to 1) is 8. So, if Firm 1 sells a credit to Firm 2, abatement costs will go down by 4.

Check: For Firm 1, if $x=1$ , $\text{total cost}=26$

For Firm 2, if $x=3$ , $\text{total cost}=18$ , $18+26=44$ . Cost went down by 4.

What price should they trade at? It costs Firm 1 8 “units” to abate one more unit, so that is the lowest they should accept. Firm 2 gains 12, so that is the most they should be willing to pay. So, the price of this credit will be in the range [8, 12].

Should Firm 2 buy a second credit from Firm 1? Firm 2's marginal cost of abatement (going from 4 to 3) is 10. Firm 1's marginal cost of abatement (going from 1 to 0) is 9. So, they should trade, reducing total costs by 1 (you’ll want to check this), at a price in the range [9,10].

Market Trading of Permits to Pollute

Let's assume 5 firms, and no environmental regulation. Each firm pollutes 4 "units" (say tons) of "guck," an environmental bad. Abatement is costly.

Scenario 1) EPA announces each firm must reduce pollution 2 units. So, each firm gets a non-tradeable right to pollute 2 units.

Scenario 2) EPA gives each firm tradeable rights to pollute 2 units (in our example, 10 in all).

So, how much does it cost firms? Assume 5 firms, as in the next table.

Marginal Cost of Pollution

From this, we need to calculate a total cost table. To do this, just add up the marginal costs from right to left. Thus, the total cost for firm 1 of 3 units of emission is 1. The total cost of 2 emissions is $1+2=3$ . The total cost of 1 emission is $1+2+6=9$ , and so on.

This results in a total cost table:

So, the total cost of Scenario 1 (no trading, 2 units guck emissions per firm) is the sum of the total costs at 2 units of pollution:

$3+6+3+8.5+9=29.5$

The Benefits of Allowing Trading

Now, let’s go to scenario 2, where trading is allowed:

We need to derive supply and demand curves for permits.

What does our supply curve look like? $Q=10$ . There is always a supply of 10 in the market.

What does the demand curve look like? Simply rank marginal pollution control costs from high to low:

With 10 permits available, the market price will be the average of the 10^th and the 11^th value. Here, that is 4.

The top 10 demanders will get the pollution units—at a market price of 4.

How much will each firm make from the market?

If this firm could not trade, it would have costs = 3.

With a market price of 4, it sells 1 (or 2) pollution rights, has abatement costs $1+2+3=6\text{ or }1+2+3+4=10$ and sells 1 or 2, revenues 4 (8)

$TC=6-4=2\text{ or }TC=10-8=2$ . So, Firm 1 makes 1 off the market.

How much does Firm 2 make?

Before trading cost = 6. After trading cost = 6

In this lesson, we examined the last of our market failures: the externality. We described several different cases where economic costs can be transferred onto people who are not willing participants in an economic transaction.

We then looked at methods of internalizing externalities, or how to move from some private equilibrium to a "socially optimal" equilibrium. As we saw, externalities typically exist because of poorly-defined or non-existent property rights. By instituting a system of property rights, and allowing self-interested exchange between elements of society, we are often able to move to the socially optimal equilibrium at the lowest possible cost to society.

We examined various methods of pollution-abatement schemes, including command-and-control and Coasian Cap-and-Trade schemes. We demonstrated why cap-and-trade systems can be more effective than command and control, and easier to operate and more accurate and effective than Pigouvian tax schemes.

We continued in the theme of poor property rights, looking at public goods and common pools, and we described ways of addressing the problems associated with the undesirable results of these property-rights failures.

Have you completed everything?

You have reached the end of Lesson 7! Double check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there.

In this lesson, we will begin our look at why using government to attempt to correct market failures may not always be a good idea. There are times when using government does not improve aggregate welfare over a market outcome, and there are some cases when using government to do this actually makes things worse. We will talk in this lesson about some of the main underlying causes for this.

What will we learn?

By the end of this lesson, you should be able to:

• understand the concepts of public goods;
• define and explain rivality and excludability;
• know the difference between public, private, club, and common pool goods;
• explain what the concept of "methodological individualism" means;
• understand the general concept of public choice theory;
• define and explain "rational ignorance;"
• describe what a bureaucracy is;
• explain why bureaucracies exist;
• explain how bureaucracies are self-interested, and what this results in;
• describe the relationship between politicians and the agencies they oversee.

What is due for Lesson 8?

This lesson will take us one week to complete. Please refer to Canvas for specific time frames and due dates. There are a number of required activities in this lesson. The chart below provides an overview of those activities that must be submitted for this lesson. For assignment details, refer to the lesson page noted.