1: THINKING AS AN ECONOMIST

The scarcity principle (no-free lunch principle)

Although we have boundless needs and wants, the resources available to us are limited. Consequently, having more of
one good thing usually means having less of another. Choices have to be made because of Scarcity:
Cost-benefit Principle:
An individual (or a firm or a society) should take an action if, and only if, the extra benefits from taking the action are at
least as great as the extra costs. Cost-benefit principle is one of the core principles of economics. It assumes:
Rationality
Ceteris paribus all other things equal
Therefore we must consider if the benefit of the action are greater than the economic cost?
Opportunity cost: Opportunity cost is the value of the next-best alternative to taking a particular action
Economic surplus: the difference between the benefit and cost of the action.
Reservation price: The highest price one would be willing to pay for any good or service. This may be different from the
price of that commodity on the market.
Eg. Water after a marathon, eraser in a MC exam
Four important decision pitfalls:
Number One: Measure costs and benefits as absolute dollar amounts rather than as proportions
Number Two: Account for all opportunity costs.
The key to using the concept of opportunity cost correctly lies in recognizing precisely what taking a given action
prevents us from doing.
Number Three: Ignore sunk costs
People are influenced by costs they ought to ignore
Eg: the cost of a non-transferable, non-refundable airline ticket is a sunk cost
Sunk cost:
o A cost that cannot be recovered at the moment a decision is made.
o Costs already incurred or sunk are not relevant to your decisions
o The only costs that should influence a decision about whether or not to take an action are those that we
can avoid by not taking that action.
How much should you eat at an all-you-can-eat restaurant?
o Since the marginal cost is zero, we should eat up to the point where the marginal benefit of eating is
zero.
Number Four: Know when to use average costs and benefits and when to use marginal costs and benefits
Marginal cost: The increase in costs associated with a small increase in the level of some activity
Marginal benefit: The increase in benefits associated with a small increase in the level of some activity
Average benefit: The total benefit of undertaking n units of an activity divided by n
Average cost: The total cost of undertaking n units of an activity divided by n
Not all costs and benefits matter equally.
o Some costs and benefits (e.g. opportunity costs, marginal costs and benefits) matter in making
decisions, where as others (e.g. sunk costs and average costs and benefits) dont.
2: PRINCIPLES OF ABSOLUTE AND COMPARATIVE ADVANTAGE
ABSOLUTE AND COMPARATIVE ADVANTAGE
The principle of absolute advantage was developed by Adam Smith in The Wealth of Nations (1776)
a situation where country with a given level of resources can produce more output than another country with
the same level of resources
it was refined by David Ricardo in Principles of Economics and Taxation to the principle of comparative

advantage a country could still engage in trade if it did not have an absolute advantage in production if a
country was comparatively more efficient in the production of a G than another
based on concept of opportunity cost in production
Theory: Even if one country can produce all goods more efficiently than another country, trade will still benefit both
countries if each specialises in the production of the good in which it is comparatively more efficient (measured through
opportunity cost of producing each G in that country).
Sources of comparative advantage:
Individual: Inborn talent, education & training, experience
National Level: natural resources, eg. Australia primary goods, infrastructure, cultural institutions
Comparative advantage can change over time it is dynamic
The process of specialisation itself helps build comparative advantage
CA can also be developed as countries adopt strategic trade policies (eg. Protecting domestic market from
foreign competition)
You can have too much specialisation cost-benefit principle must always be applied to determine whether the
specialisation is still economically sound. Costs of specialisation include education, infrastructure, job mobility,
and the costs of services increasing as level of expertise increases.
Specialisation an alternative to a system in which everyone is a jack-of-all-trades. Specialisation and exchange produce
higher productivity. Everyone can do better when one person (or each country) concentrates on the activities for which
their opportunity cost is lowest. Trade allows people to eventually obtain an output outside the limits of their own
resources by exchanging goods with people who have different opportunity costs. The gains from specialisation grow
larger as the difference in opportunity cost increases.
THE PPC
Production possibilities curve a graph that describes the maximum amount of one good that can be produced for
every possible level of production of the other good. A point on or below the curve is attainable, those above the curve
are unattainable due to insufficient resources. Trade allows people to consume at levels outside the curve.

Opportunity Cost of A/B:

OCA=
(This is the slope of the graph
at a point)

Attainable
Point
Unattainable
Point
Inefficient
Point

Any combination of goods that can be produced using currently available resources. All points
either on or below and to the left of the PPC are attainable.
Any combination of goods that cannot be produced using currently available resources. All
points lying above and to the right of the PPC are unattainable.
Any combination of goods for which currently available resources enable an increase in the
production of one good without a reduction in the production of the other. Any point that lies
below and to the left of the PPC is inefficient.
Efficient Point Any combination of goods for which currently available resources do not allow an increase in
the production of one good without a reduction in the production of the other. Any point on
the PPC is an efficient point.
The low-hanging-fruit principle and increasing opportunity cost:
In expanding the production of any good, first employ those resources with the lowest opportunity costs, and only
afterward turn to resources with higher opportunity costs.
Factors that affect the PPC
Increasing productive resources
Improvements in knowledge and technology (most important)
Why some countries are slow to specialise

Population density and geographical isolation

o Less people = less ability to specialise, smaller and less developed markets
Laws and customs that limit the freedom to exchange goods and services

Specialisation combined with trade between producers of different goods and services, allows a society achieve a
higher level of productivity. The principle of comparative advantage tells us that we can all enjoy more goods and
services when each country produces according to its comparative advantage, and then trades with other countries.
How would we identify comparative advantage of a country?
o Revealed comparative advantage methods identify and measure changes in comparative advantage by
looking at countrys actual patterns of trade
o See: Balassa Index
PPC: The more of a good that is already being produced, the greater the opportunity cost of increasing production
further
Consumption possibilities: The combination of goods and services that a countrys citizens might feasibly consume
In a closed economy: A societys consumption possibilities are identical to its production possibilities, since they can
only consume the G&S produced within their own country
In an open economy: A societys consumption possibilities are typically greater (and never less than) than its production
possibilities since trade accommodates more consumption
Graphically:
consumption possibilities for an open economy are described by a
downward line that just touches the PPC
The slope of this line equals the amount of the good on the
vertical axis that must be traded on the international market to
obtain 1 unit of good on the horizontal axis
A country maximises its consumption possibilities by producing at
the point where the consumption possibilities line just touches
the PPC and trade
DEMAND, SUPPLY & ELASTICITY
DEMAND
Demand: the quantity of a particular good/service that consumers are willing and able to purchase at various prices at a
given point in time
Market Demand: demand by all consumers for a particular good or service, obtained by summing the quantities
demanded by all individual consumers at the various price levels.
Ceteris Paribus: the assumption that only ONE factor changes and all other factors remain constant.
Needs vs wants: needs are the amount of food, clothing and shelter required to maintain health, whilst wants are all
other consumption beyond subsistence levels of consumption
Factors affecting market demand:
Substitution effect the change in the quantity demanded of a good or service caused by a change in price, that
results because the good or service becomes more or less expensive in relation to other goods and services that
can be viewed as substitutes for the product.
Income effect the change in quantity demanded of a good or service caused by a change in price, that results
because of the change in the purchasing power of a buyers income.
o Changes in purchasing power due to changes in price can cause consumers to buy less/more/none
o Necessities are bought regardless of price changes, however, demand is likely to be lower for other
goods such as luxuries when prices increase
o Normal good a good whose D shifts rightward when the Y of buyers increase and leftward when the Y
of buyers decrease
o Inferior G a G whose D curve shifts leftward when the Y of buyers increase and rightward when the Y
of buyers decrease

Law of demand states that as price rises, ceteris paribus, the quantity demanded
falls or as price falls quantity demanded rises. There is an inverse or indirect
relationship between price and quantity demanded.

Increase in demand refers to when the whole curve shifts to the right, and is when consumers are willing and able to
buy more at each possible price.
Decrease in demand refers to when the whole curve shifts to the left and is when consumers want to buy less of the
product at each price.
Utility - the satisfaction people derive from their consumption activities. The utility maximization assumption is the
assumption that people try to allocation their Y so as to maximize their satisfaction.
Marginal utility the additional utility gained from consuming an additional unit of G in a given period of time
Optimal combo of G the affordable combo of G/S that yields the highest total utility
The rational spending rule - spending should be allocated across G/S so that the marginal utility per dollar as the same
for each G
Applies to G that are perfectly divisible (ie. Milk or petrol)
If not perfectly divisible (tv sets, bus rides they must be consumed in whole), allocation each addition $ to the
G for which your MU per $ is highest

=

Consumer surplus:
A quantitative measure of the amount by
which buyers benefit as a result of their
ability to purchase G/S
On a S/D graph, it is shown as the area
b/w D and the market price
CS can be used to measure the effect of
changes in markets on consumer welfare
When the price of a G falls, consumer
surplus increases

PRICE ELASTICITY OF DEMAND

Price elasticity of demand measures the responsiveness or sensitivity of the quantity demanded of a particular product
to a small change in the price of a G/S. It is the % change in the quantity demanded that results from a 1% change in its
$P.
%
=
%$
Price Elasticity (abs values)
>1
Elastic
=1
Unit elastic
<1
Inelastic
Perfectly Elastic Demand
Consumers will demand an infinite quantity at a
certain price, but nothing at all at a price above or
below this.
$P

Perfectly Inelastic Demand

Consumers are willing to pay any given price to obtain
a given quantity of a good. Quantity does not change.

$P
P3

P1
P2

P1
Q1

Q2

Q3

Factors affecting elasticity of demand:

Substitution possibilities
o G&S with no close subs will have inelastic D, eg. Water + electricity
Budget share (whether the item constitutes a large or small % of personal Y)
o The larger the share of ones budget an item accounts for, the greater the incentive to look for
substitutes when the price of the item rises
Time
o Substitution of one G/S takes time
o Some occur right after the price change, but others take place years or even decades later
If the good is addictive or habit forming
Q = original quantity, P = original price
If two demand curves have a pt in common, the steeper
curve must be less elastic wrt $P at that point
PE of D at the midpoint of any straight line D curve always
takes the value of 1
Subsequently, D is elastic in top half, unit elastic at midpoint
and inelastic at bottom half
When price elasticity is greater than 1, changes in $P and
changes in total exp always move in opposite directions
=

%
%

1
= ( ) (
)

2
( + )
=
2
( + )
=
Maximised total revenue will occur at the midpoint of the demand curve, where the demand is unit elastic.
Constructing a total exp curve for movie tickets:
1. Calculate total exp for a sample of pts on D
2. Plot total exp at each of the $P on a graph
3. Sketch the curve by joining these pts
Cross price elasticity of demand percentage by which
the Q demanded of a G changes in response to a 1%
change in the $P of the second good
When the CPE of D is positive, the two goods
are substitutes
When the CPE of D is negative, the two goods
are compliments
Y elasticity of demand percentage by which the Q
demanded of a G changes in response to a 1% change in Y
Measures the sensitivity of the quantity supplied of a product to changes in price. It is the percentage change in the
quantity supplied caused by a 1% change in price.
1. If the rise in quantity supplied is proportionately greater than the increase in price, then supply is very responsive
and therefore relatively elastic.
2. The opposite situation a less than proportionate change in quantity supplied would indicate relatively inelastic
supply.

SUPPLY
Supply: Is the quantity or service that firms in a particular industry are willing and able to offer for the sale at different
price levels at a given point in time.
Market Supply: is the quantity of G&S all firms in an industry are willing and able to offer for sale at different price
levels at a given point in time. The graph is:
Horizontal summation of individual S curves
Upward sloping
o Costs tend to rise with expanded production
o Each individual exploits his most attractive opportunities first (OC)
o Diff. potential sellers face diff. OC

Law of Supply states that as price rises quantity supplied rises or as price falls,
quantity supplied will fall. There is a direct relationship between price and quantity
supplied.
Profit the total revenue a firm receives from the sale of its product minus all costs (explicit and implicit)
A profit maximising firms goal is to maximise the difference between total revenue and total costs.
Summation of supply curves: hold price fixed and add the quantity.
Perfectly competitive markets
A market in which no individual supplier has any influence on the market price of the product
B/c they are unable to influence MP, perfectly competitive firms described as price takers
Characteristics:
1. Market has many buyers and sellers each contribute a small fraction of the total quantity exchanged
2. All firms sell homogenous (identical) products
3. No barriers to entry sellers able to enter and leave market as they like
4. Sellers can sell all the can at MP
5. Advertising is pointless, since buyers and sellers are well informed
Eg. Fruit and vege markets, corner grocery stores
Since a perfectly competitive firm has no control over the MP of its product, it neednt worry about choosing the level at
which to set the price. The challenging is to choose its output level so that it makes maximum profit. Demand curve for a
firm in perfect competition:
Factors of production are inputs used in the production of a G/S. (LLCE) The
short run refers to a period of time sufficiently short that at least one of the
firms factors of production are fixed. The long run is a period of time of
sufficient length such that all the firms factors of production are variable
The law of diminishing returns in the short run, when at least one factor of
production is fixed, successive increases in the input of a variable factor
eventually yield smaller and smaller increments in output.
Fixed factor production an input whose Q does not change as the output,
produced in a given period of time, changes
Variable factor production an input whose quantity varies as the output,
produced in a given period of time, changes
Costs in the SR
Fixed
The sum of all payments made to the firms fixed factors of production.
Variable
The sum of all payments made to the firms variable factors of production.
Total
The sum of all payments made to the firms fixed and variable factors of production.
Marginal
The change in total cost divided by the corresponding change in output.
Shutdown condition
When producing at a loss, a firm must cover its variable cost to minimise losses

The firms SR shut down rule:

<

Average costs:
A firm should shut down and produce nothing in the SR when
PQ<VC for all levels of Q, or P<minimum value of AVC

() =

() =

=
AVC and ATC both decline, reach a minimum and rise again. AFC just
declines. This is because at first, fixed costs are being spread, and then after a while the law of diminishing returns kicks
in. The firm is using more resources but output is not increasing at the same rate.
The upward sloping portion of the MC curve corresponds to the region of diminishing returns. Note that the MC curve
cuts both the AVC and ATC curves at their minimum points, and that the vertical distance between AVC and ATC gets
smaller as output rises.
The profit maximising rule, P=MC choose level of output based on relation of P to MC
P=MC, P>AVC Optimum level, if P>MC, the firm can increase its profit by expanding production and sales.
If P<MC, the firm can increase its profit by produce and selling less output.
P<AVC
If at all levels of output, shut down and produce nothing
SR S curve is the portion of its MC that lies above its AVC curve
P<ATC
In the LR, a firm will leave the market if true at all levels of output
Profit graphically: P=Q(P-ATC)

The firm making a loss in the SR: when P<ATC, but above minimum AVC, at the profit-maximising Q, the firm
experiences a loss, which is equal to the area of the shaded rectangle.
When the $P is less than the min AVC, the firm will shut down in the SR. Therefore, variable costs are ignored.

Producer surplus the difference b/w the amount actually received by the seller of a G and the sellers reservation
price
MARKET EQUILIBRIUM
Market Equilibrium- is the situation where, at a certain price level, the quantity supplied and the quantity demanded of
a particular commodity are equal. It occurs when:
All buyers and sellers are satisfied with their respective quantities at the market price
The market clears
There is no tendency to change
Not necessarily socially optimum
o Socially optimum Q = the Q of a G/S that results in the max possible difference between the total
benefits and total costs from producing and consuming the G/S.
o Efficiency (or economic efficiency) occurs when all G/S are produced and consumed at their respective
socially optimum levels
Any consumer wiling to pay MP is satisfied, any producer offering to sell at MP is able to sell all they produce
Assumptions are:
that we have pure competition in the market place
there is no government intervention
Price Mechanism- is the interplay of forces of supply and demand in determining the prices at which commodities will
be bought and sold in the market.
$P
Buyers surplus the difference between the buyers reservation
price and the price that is paid.
Sellers surplus the difference between the price received by the
seller and their reservation price.
Total surplus the sum of the buyers surplus and the sellers surplus,
OR, the difference between the buyers reservation price and the sellers
reservation price.

Excess Supply

Equilibrium

A regulated market: price intervention

Excess D/Shortage
Q
Price Ceiling: The maximum allowable price (specified by law) that can be
charged for a particular commodity.
Price ceilings will redistribute money from sellers to buyers.
Price Floor: The minimum allowable price (specified by law) that can be charged for a particular commodity.
Price floors will redistribute money from buyers to sellers.

$P

Price floor

$P

Price ceiling

Pmin
Pe

Pe
Pmax

However, there are a number of problems associated with price intervention in the market by the government. By
creating a price floor there is excess demand and not enough supply, leading to disequilibrium. When a price ceiling is
created then there is excess supply and not enough demand, also resulting in disequilibrium.
Price ceiling:
consumer and producer surplus both decline after a PC is imposed
producer cannot sell at the price they could otherwise get value of production goes down

producer will try to find alternate ways of creating value other than participating in the regulated
market will reduce the amnt of production on the item
o to supply D at legal price, most producers will lower costs generally means lower quality
with less supply, consumers will try to find other ways to get the product
o w/ the lower price, will want to consume more of the G, but w/ less available, they will be unable to
less utility out of the product
o O/C wasted in non-price competition, eg. Waiting in lines
Quantity intervention occurs when there is too much or too little of a good in the market.
Problem
Market price too high
Market price too low
Market quantity too high
(-ve externalities)
Market quantity too low
(+ve externalities)
Market does not provide G/S
(public goods)

GovtAction
Price ceiling
Price floor
Taxes

Outcome
Reduces price, quantity shortage [disequilibrium]
Increases price, quantity excess [Disequilibrium]
Increases equilibrium price, reduces equilibrium quantity

Subsidies

Reduces equilibrium price, increases equilibrium quantity

Gov provides
G/S

Gov must collect taxation revenue to finance its supply of

public goods

PRICE ELASTICITY OF SUPPLY

Flexibility of inputs
o the extent that production of a G requires inputs that are also useful for the production of other goods
determines how relatively easy it is to lure additional inputs away from their current uses
Mobility of inputs
o if inputs can be easily transported from one site to another, an increase in the $P of a product in one
market will enable a producer in that market to summon inputs from other markets
Ability to produce substitute inputs
o eg. Real diamonds and fake diamonds
Time lags after a price change
o it takes time for producers to switch from one activity to another
o following a $P increase, a producer has a ST limit of production increase, but no restrictions in the LT
o in the time immediately after the P change, the S of most producers would be virtually perfectly
inelastic, because producers cannot increase any other inputs In the long run, however, the producers
would be able to increase any of the inputs, including the size of the production plant or capital to
therefore increase production, in response to a price change, therefore making supply elastic
Excess capacity exists when a firm is not using its existing resources to their full capacity (part time/casuals)
o S is elastic when firms have excess capacity b/c they can respond by using their existing resources more
intensively
7: EFFICIENCY AND EXCHANGE

MARKET EQUILIBRIUM AND EFFICIENCY

Efficient (Pareto efficient) a situation is efficient if there is no opportunity for exchange or trade that will make at least
one person better of without harming others.
A transaction that leaves one person better off without harming others is known as a Pareto-improving transaction.
Pareto efficiency occurs when no further Pareto-improving transactions can be made.
Economists emphasise efficiency, since the market forces of D & S will result in equilibrium maximises
economic surplus, or benefit in economy
o Achieve goals w/ ltd waste most productive use of ltd resources to satisfy unltd wants, since those
who want it most get the G/S
o Market clears no opportunity unexploited
A surplus-enhancing transaction when
the price is below equilibrium:

A surplus-enhancing transaction when the

price is above equilibrium:

Efficiency:
When the price is above or below the equilibrium, the Q exchanged will be below the equilibrium
The vertical value on D curve (marginal benefit) is greater than the vertical value on the supply curve (MC)
Only the equilibrium will maximise economic surplus (leaves no cash on the table)
Efficiency is not the same as desirable efficient markets may yield undesirable results, as there is inequality in
the distribution of Y
Markets are efficient when:
Buyers and sellers are well informed
Markets are perfectly competitive
Supply measures all relevant costs
Demand measures all relevant benefits
THE COST OF PREVENTING PRICES FROM ADJUSTING FREELY
Price ceilings
Unregulated, consumer surplus = blue area and producer surplus = green area. Regulated, the price controls loss in
economic surplus, since it wastes producer surplus without creating any additional consumer surplus.
Unregulated
Regulated

The reduction in economic surplus from a price ceiling will be underestimated when:
Consumers who receive the product are not the consumers who value it the most
Consumers take costly actions to enhance their chances of being served, eg. Arriving early
There are more efficient ways to ensure that low-income households are able to purchase necessities, eg. Price
subsidies, income transfers

Price ceilings reduce total economic surplus. As price is lowered, quantity demanded rises, but quantity supplied
diminishes. There is a shortage in the market. Both producer surplus and consumer surplus are reduced, and the result
is the triangle of dead weight loss in the middle of the diagram. A price floor has a similar effect when the price rises,
quantity demanded reduces and quantity supplied increases so that there is a surplus in the market. Buyers switch to
substitute products. Overall economic surplus is reduced and there is a dead weight loss.
PRICE SUBSIDIES
Government involve themselves in some markets to subsidies the buyers or sellers of a good.
They subsidise the prices of essential G&S to assist low Y earners
With no subsidy, the consumer surplus = green area, and the domestic price is the same as the world price. Since the
country can import as much milk as it wishes at the WP, supply is perfectly elastic MC of each extra L is the same as
the price buyers pay producer surplus = 0. If the government chooses to subsidise the sale of milk by purchasing at
world price and selling at $1, consumer surplus increases to $9000/day. However, the cost of the subsidy must be borne
by taxpayers, which is a $6000/day cost. Although consumer surplus is larger than before, the net effect of the subsidy
reduces total economic surplus by $1000/day (5000-6000).
No Subsidy

Subsidy

Any policy that reduces total economic surplus is a missed opportunity to make everyone better off.
Governments sometimes subsidise either the
sellers or the buyers of the good. The
approach of subsidising the prices of essential
goods and services assists low-income
consumers. This increases consumer surplus,
as consumers are able to buy more at the
lower price. However, the burden of the
subsidy falls on the government, and they are
required to pay the subsidy for every unit that
is purchased. Ultimately, total economic
surplus is reduced by the area of the blue
triangle.
MARGINAL COST PRICING OF PUBLIC SERVICES
The largest possible total economic surplus is achieved when
goods are exchanged at equilibrium prices where the value of the
last unit to the buyer is exactly equal to the sellers marginal cost
of producing it. Eg. The govt should charge 1.5c per L.
Total economic surplus is maximised when the govt charges
each customer exactly the marginal cost of providing the G/S.

When there are multiple marginal costs, the govt should charge the highest marginal cost, since charging any less would
encourage households to use G/S whose marginal benefit is less than its marginal cost.
TAXES AND EFFICIENCY
Taxes levied on sellers usually end up being paid entirely by buyers, as producers view tax as an increase in the marginal
cost. For goods with perfectly elastic supply curves, the entire burden of any tax is borne by the buyer, ie. The increase
in equilibrium price is exactly equal to the tax.
Deadweight loss: The reduction in total economic surplus that arises
when a market operates at some price and output combination other
than the one at which marginal benefit equals marginal cost. Taxes
will cause a smaller deadweight loss if they are imposed on G for
which the equilibrium Q is not highly sensitive to changes in
production cost (eg. habit forming or addictive).
Generally, the smaller the price elasticity of a D for a G, the smaller
the deadweight loss.
However, taxes do not always constitute an obstacle to efficiency.
Taxes on activities that harm others can generate revenue and
increase economic surplus by discouraging people from pursuing too
much of these activities. They also help to take into account externalities.
The introduction of a sales tax on a particular commodity distorts the natural equilibrium of the market. By imposing an
extra cost, the government raises the marginal cost of production by the amount of the tax. The tax forces suppliers to
raise their reservation price, causing a shift of the supply curve to the left. Equilibrium price rises, and equilibrium
quantity reduces. Buyers switch to substitutes which are not being taxed, and producer and consumer surplus are both
reduced. Once you take away the government revenue generated by the tax, the remaining dead weight loss is the
triangle created by the old supply curve, the demand curve and the new equilibrium quantity. Although there is a dead
weight loss, taxes may be justified if the value of the public services financed by the tax outweighs the dead weight loss,
or if the tax reduces consumption of an unhealthy good.
The burden of tax falls on both consumer and producers. However, it is not always shared equally. The relative
incidence of the tax is determined by the price elasticity of demand and supply. If supply is very elastic and demand very
inelastic, then the price will change dramatically, but the quantity demanded will not. The burden of the extra cost
therefore falls mostly on the consumer. If supply is perfectly elastic, the burden of the tax falls entirely on buyers. If
supply is very inelastic and demand very elastic, the reverse is true, and the producers bear most of the burden.
8: INTERNATIONAL TRADE AND TRADE POLICY
COMPARATIVE ADVANTAGE AND GAINS FROM TRADE
The basis for free trade
Free trade occurs when there is an absence of protective barriers such as tariffs, quotas, subsidies and voluntary export
restraints. It is based on the principles of absolute and comparative advantage. The rationale for world trade is based on
two main factors:
1. global distribution of eco resources or factor endowments (land, labour, capital, enterprise) is uneven
2. efficient production of various G&S requires diff. resource combos and technologies
Advantages of Free Trade
1. Increased specialisation leading to economies of scale through lower unit costs (technical efficiency) greater
levels of output and employment
2. Greater range of output increasing quality and quantity of G available to consumers
3. Increased productivity of resources more optimal and efficient allocation of resources
4. Increased competition between firms in tradeable G sector can lead to real Ys and $Ps, equalisation of
resource prices in trading countries
5. Greater incentive for innovation to increase competitiveness due to larger market

6. Countries will profit by exporting G&S for which they have a CA - The revenue from the X are used import G
and S for which they do not have a comparative advantage.
Disadvantages of Free Trade
1. New firms in infant industries difficult to compete against more efficient and established foreign firms.
2. Job displacement / short term unemployment
3. Negative externalities if firms do not pay for the unintended consequences of their activities, ie. higher levels
of pollution, degradation of environment or exploitation of labour in LDCs
4. Unable to diversify export base as they specialise according to comparative advantage. Eg. some countries
specialising in agriculture may not have a high level of industrialisation, and therefore be increasingly
dependent on manufactured/capital G imports
5. Dumping of surplus output / unfair price cutting - countries which are efficient producers of arbitrary G who
sell their exports at below domestic $P in foreign markets
6. Current account deficit country unable to finance its import expenditure with export income
Types of Protection
1. Tariffs

World Price +
Tariff

Revenue

World Price

2. Subsidies
$P

S
S1

P
P1

S1

Q
Q

Q1

3. Quotas
quantitative restriction on certain categories of imported goods
the larger/smaller the import quota the greater/lesser the quantity of goods that may be imported

importers apply for import licence to receive quota

Tariff quotas combine the effects of a quota and a tariff quotas are imposed on imports up to a certain
quantity and then a tariff is also levied, further raising the price
S2

$P

S1

D
P2
P
P1
D
Q2

Q1

Alternatively,

The effects of protection

Macroeconomic:
1. Misallocated resources
2. Inflation distorted effect of tariffs on import prices are passed into domestic cost and $P structure
industries using outputs of protected industries as inputs in their production process (imported capital +
intermediate G) will pay a $P
efficient export industries, ie. mining + agriculture are penalised by paying higher prices for capital
3. Slowed economic growth resources are not used efficiently
4. Lower export earnings protected industries tend not to seek overseas markets because they may be inward
looking and abnormally risk averse
5. Trade barriers are inefficient and reduce the size of the economic pie
6. Certain groups benefit, eg. Domestic suppliers are winners, whilst consumers and importers are losers
7. Gains from trade could be used to assist groups that have been hurt by trade
Microeconomic:
1. Low levels of productivity
2. No incentive to innovate

9: THE QUEST FOR PROFIT AND THE INVISIBLE HAND

THE THREE TYPES OF PROFIT

Economic profit the difference between the firms total revenue and the sum of its explicit and implicit costs
Economic profit = total revenue total costs
o If this is positive, the firm is earning economic profit.
o If it is zero, the firm is earning normal profit.
o If it is negative, the firm is running at an economic loss.
Explicit costs - The opportunity costs of resources that the firm uses that are supplied from outside the firm
Implicit costs - The value of best opportunity forgone by the firm when it uses resources supplied by the firms owners
Accounting profit the difference between the revenue a firm takes in and its explicit costs only
Normal profit the level of accounting profit that a firm earns when economic profit is zero, ie. When revenue fully
takes into account implicit costs. It is equal to the opportunity cost of the resources supplied to a business by its owners.
When a firm earns a normal profit (or zero economic profit), its total revenue is just enough to offset the
opportunity cost of all the resources that it uses, including those that are supplied by the firms owners
resources that are owned by the firms owners are earning a return exactly equal to their OC
If AP>NP the firm is earning a return on resources that exceeds their OC (positive)
If AP<NP resources that belong to the firms owners are yielding a return that is below their OC (negative)
o Should move their resources out of the industry in the LT
A negative economic profit is also called an economic loss, which indicates below-normal profit

THE INVISIBLE HAND THEORY

Two functions of price:
1. Rationing function
To distribute the scarce good to those consumers who value them the most highly (like an auction)
2. Allocative function
To direct resources into the most efficient markets and sectors of the economy
The invisible hand theory: Adam Smiths theory that the actions of self-interested buyers and sellers, all acting
independently, will often result in the socially optimal allocation of resources.
HOW FIRMS RESPOND TO PROFITS AND LOSSES
Economic profit in the SR in the apple market. NB: no entry barriers, everyone
employs the same production method

Due to the positive economic profit, producers are earning more than their OC of
growing apples. Since P>OC, others want to enter the market. Subsequently, there
are more suppliers, and a lower economic profit.

Eventually, entry will continue until price falls to the minimum value of ATC. At this
point, all orchards earn an economic profit of zero, or a normal profit.

When the market is facing losses, the opposite will occur: suppliers will leave, the equilibrium price increases and the
price rises to the minimum value of ATC.
The fact that firms in a competitive market are free to enter or leave an industry at any time ensures that in the LR all
firms in the industry will tend to earn zero economic profit.
Long run supply in a competitive market
SR supply curve for a PM firm in a competitive market is its MC curve
The long run market supply curve is perfectly elastic (horizontal) at the price corresponding to the minimum
point on the SR ATC curve.
The industry is able to supply as much or as little output as buyers wish to buy production can be changed

Implications:
Efficiency
Goods are produced at the lowest cost possible given the technology existing at the time
o All firms produce the level of output corresponding to minima of ATC
o Buyers pay at price that is no higher than the cost incurred by suppliers
More generally, LR market supply curves can be upward or downward sloping, or horizontal

THE INVISIBLE HAND

a) The decline in D for film processing $P per film to fall in the SR. b) The increase in D for PF causes the $P to rise.

a) The assumed D shifts result in an economic loss for the representative film processor and b) an economic profit

Invisible hand theory does not consider time. In some markets (esp labour), these movements may take months/years,
but if D & S remain stable, markets will eventually reach equilibrium.
The importance of free entry and exit
Barriers to entry and exit reduce firm mobility between markets
Barriers include: copyright laws, product compatibility in software market, infrastructure (telecom)

ECONOMIC RENT VS. ECONOMIC PROFIT

Economic rent the part of payment for a factor of production that exceeds the owners reservation price.
Unlike economic profit, which is driven towards zero by competition, economic rent may persist for extended periods,
esp if its for inputs that cannot be replicated easily (skilled workers, etc).

INVISIBLE HAND AND T HE STOCK MARKET

See finance notes regarding shares, present value and efficient markets hypothesis.

MONOPOLY AND OTHER FORMS OF IMPERFECT COMPETITION

Imperfectly competitive market
Pure monopoly
Oligopoly
Monopolistic competition

A market in which firms have at least some ability to set their own price
A market in which a single firm is the only supplier of a product for which there
are no close substitutes
A market in which only a few rival firms produce G that are close substitutes
A market in which a large no of firms produce slightly differentiated products
that are reasonably close substitutes for each other

NATURAL MONOPOLIES
Constant returns to scale a production process is said to have constant returns to scale if, when all inputs are changed
by a given proportion, output changes by the same proportion.
Increasing returns to scale (or economies of scale) a production process is said to have increasing returns to scale if,
when all inputs are changed by a given proportion, output changes by more than that proportion.
Natural monopoly a monopoly that results from economies of scale.
Often economies of scale are due to an immense start-up or development cost at the outset of production. This cost can
occur because of massive research, design, engineering and infrastructure costs. This cost is spread out over subsequent
production, so that price is always set above marginal cost in order to make back the upfront investment. Average cost
per unit declines sharply and gradually approaches marginal cost, which is often constant in this situation. Total cost
rises at a constant rate. This cost pattern explains why many industries are monopolies or oligopolies.
high startup costs but low marginal costs benefits from economies of scale
eg. Computer software, drugs

Barriers to entry
Exclusive control over important inputs
Govt created monopolies
Network economies

PROFIT-MAXIMISING MONOPOLIST
To a firm that has the ability to influence the price at which it sells its output, and who must sell all output at a single
price, the marginal benefit of selling an additional unit is strictly less than the market price. While a price-taker can sell
as many units as it likes at the market price, in order to sell an additional unit, the price-setter must cut its price. The
marginal revenue curve of the price-setter intersects the price-axis at the same point as the demand curve. However, on
the quantity axis the intercept of the marginal revenue curve is exactly half of the intercept of the demand curve.
Like the price-taker, the price-setting monopolist should continue to expand production as long as marginal revenue
exceeds marginal cost. Profit is maximised at the level of output for which marginal revenue equals marginal cost. A
monopolist will earn an economic profit only if price exceeds average total cost at the profit-maximising level of output.
In the short run, a firm in monopolistic competition can make economic profit, because the market price at the profit
maximising level of output is above the average cost of production. However, in the long run, and at equilibrium,
average cost is the same as price at the profit maximising level of output. The firm therefore makes a normal profit.

The downward-facing demand curve means that when firms set quantity at profit-maximising, they are producing less
than the socially optimal quantity, which occurs at the point where MC and D intersect. There is therefore a dead weight
loss, shown by the area between MC (S), D and quantity produced. Monopoly is socially inefficient.
The invisible hand does not work in the same way as in perfect competition due to barriers entry. The invisible depends
on firms being able to easily enter and exit a market when it is operating at a profit or loss in order to impact on demand
and supply to force price to return to equilibrium. These barriers to entry stop this from happening. However,

sometimes these barriers are natural, or are necessary to cultivate new markets and innovation, or are necessary to
control a dangerous industry such as gaming. Therefore it would be inefficient to attempt to remove them. People will
find ways of manoeuvring around barriers to entry, however, in order to gain the cash left on the table, so the invisible
hand does play a role, just not in the same definitive way.
Profit maximization for price setters : MR = MC
B/c single-$P monopolist must cut price to sell an extra unit, not only or the extra unit sold but also for all existing units,
MR from the sale of the extra unit is less than its selling price.

Monopolists should continue to expand output as long as the gain from

doing so exceeds the cost
At the current level of output, the benefit from expanding output is the
marginal revenue value that corresponds to that output level
Profit is maximised at the level of output for which marginal revenue
precisely equals marginal cost.
o Both monopolists and perfectly competitive firms maximise profit
by choosing output at MR = MC
The fact that the profit maximising price for a monopolist will always be
greater than marginal cost provides no assurance that the monopolist will earn an economic profit
o Monopolist will earn economic profit only if P>ATC at the profit maximising level
Since MR < $P always, output level for an industry served by a monopolist is smaller than the socially optimal
level
o Govts worldwide try to limit the extent of monopoly through competition and anti-monopoly laws and
regulations
Adam Smiths invisible hand does not
operate in a monopoly market in the same
way as in a perfectly competitive market
Without the protection of barriers to entry
and exit, market power alone does not
guarantee an economic profit in the LT
When a monopolist earns an economic
profit, more firms will not enter the market
and expand supply, since the firms market
power acts as a barrier, MP: economies of scale, patent, etc

USING DISCOUNTS TO EXPAND THE MARKET: PRICE DISCRIMINATION

Price discrimination the practice of charging different buyers different prices for essentially the same G/S, where
differences do not simply reflect differences in costs of supplying different buyers.
Make sure buyers w/ high willingness to pay do not purchase at the DP
Must also avoid alienating buyers by giving the impression of unfair discrimination or price gouging
Can increase economic surplus and the number of buyers served in the market
A firm that can charge each buyer their reservation price is called a perfectly discriminating firm.
No loss of efficiency all buyers willing to pay a $P high enough to cover MC will be served
Monopolists MR same as the DC
Consumer surplus = 0 all economic surplus is producer surplus
Group pricing a form of $P discrimination where different discounts are offered in different sub-markets, while
members of a particular sub-market all receive the same discount
Obstacles: sellers dont know exactly how much each buyer is willing to pay + need some means of excluding
those who are willing to pay a high $P from buying at a low $P
Offer discounts to groups that have RP tied w/ easily observable characteristics age, employment status
Hurdle Method of PD (Versioning)
Hurdle method of PD - The practice by which a seller offers a discount to all buyers who overcome some obstacle.

Seller might sell a product at a standard list $P and offer a rebate to any buyer who takes the trouble to mail in a
rebate coupon
b/c the decision to jump the hurdle is subject to the C-B test, such a link seems to exist
high and low reservation prices must be differentially sensitive to the hurdle and that the discount for jumping
must not be too sensitive
Perfect hurdle a hurdle that completely segregates buyers whose reservation prices lie about it from others
whose reservation prices lie below it, imposing no cost on those who jump the hurdle
Many sellers employ not just one hurdle but several by offering deeper discounts to buyers who jump
successively more difficult hurdles
Hurdle method reduces loss of efficiency by giving the monopolist a practical means of cutting prices for pricesensitive buyers only

PUBLIC POLICY TOWARDS COMPETITION

NCP National Competition Policy
attain 'workable' competition to ensure that markets operate efficiently
believed that: competition will produce efficiency in resources, lowered production costs, lead to product
innovation, and lower prices for consumers
however, goals must be balanced against economies of scale
o sometimes necessary to reduce the # of firms in an industry firms can produce on larger scale and
achieve lowest possible long run avg costs of production
also attempts to achieve a situation where markets are contestable entry barriers kept to a minimum by
eliminating business practices that restrict potential competition
Trade Practices Act 1974 sets out a code of behaviour for firms, which outlaws certain practices that would tend
to work against the idea of workable competition
however, goals must be balanced against economies of scale
o est. ACCC which monitors competition policy and upholds consumer protection legislation
The TPA and the ACCC
most of the responsibility lies with the CG
consumers most protected through Trade Practices Act and the ACCC
not able to control prices, but able to influence through ACCC:
o conducting inquires into pricing structures
o recommending changes to industries
o giving a firm or industry negative publicity where it find there is overcharging
progressively removes industries from prices monitoring system unless there is evidence that the industry lacks
an adequate level of competition
In extreme cases of market power, monopoly can cause a lot of inefficiency because of the restricted output and also
becomes problematic because a firm is making profit at a buyers expense, sometimes for an essential good.
Competition acts as a check on a firms ability to exploit its market power. Governments adopt policies aimed at limiting
market power and promoting competitive market structures. The National Competition Policy (NCP) was introduced in
Australia in 1995 to expose certain industries to competitive pressure. The Trade Practices Act of 1974 and its
subsequent amendments form the legislative cornerstone of Australian competition policy.
When regulating natural monopolies, the aim is to permit economies of scale to be realised while protecting consumer
and ensuring adequate output. Sometimes, firms are forced to adopt a P=MC output instead of producing at the profit
maximising output. These include utilities in Australia, which because of large set-up costs, were at one point very
monopolistic and socially inefficient.
CHAPTER 11: GAME THEORY THINKING STRATEGICALLY
CHARACTERISTICS OF OLIGOPOLY
Oligopoly consists of a small number of firms each of which has a large share of the market. Such firms are
interdependent and they face a temptation to cooperate to increase their joint profit. Natural or legal barriers prevent
the entry of new firms. A four-firm concentration ratio where share of total revenue exceeds 60% indicates oligopoly.

The kinked demand curve model of oligopoly is based on the assumption that each firm believes that if it raises its
price, others will not follow, but if it cuts its price, other firms will cut theirs. All firms therefore charge the same price. If
a firm increases its price, buyers will switch to one of the substitutes. Above the market price, demand is elastic, and
below it, demand is very inelastic. If a firm raises its price above the market price, it will not gain market share, and will
not increase revenue. If it lowers its price, other firms will follow suit, and it will not gain market share or increase
revenue.
Collusive oligopoly is where firms collude to set market price at some level, usually above average cost of production in
order to secure economic profit. The firms act as one firm there is no substitute. The oligopoly therefore becomes like
a monopoly, with inelastic demand. The demand curve is very steep, meaning that the point at which profit is
maximised is at a price far higher than marginal cost. Collusion is illegal.

GAME THEORY
Basic elements of a game:
1. Players
2. Strategies available to each player
3. The payoffs each player receives for each possible combination of strategies

How to analyse a payoff matrix:

1. Start with situation where no one is advertising
Payoff = what happens when the play the game differently
2. Since one person doesnt advertise, they are losing customers
3. When they both raise spending, they have a lower payoff than leaving spending the same, since neither are
attracting more customers, and marginal cost exceeds marginal benefit.
4. Equilibrium raise spending is equilibrium, but not socially efficient
Dominant strategy a strategy that yields a player a higher payoff no matter what the other players choose
Dominated strategy any other strategy available to a player who has a dominant strategy
Nash equilibrium a set of strategies, one for each player, in which each players strategy is his or her best choice, given
the other players strategies. (memorise this definition)
The prisoners dilemma game a game in which each player has a dominant strategy, and when each plays their
dominant strategy, the resulting payoffs are smaller than if each had played a dominated strategy.

Equilibrium = both confess

Formally Start from 1 box and ask is there at least 1 player who is willing to deviate from this box if the other
players strategy is fixed
If Jasper chooses to remain silent, Horace can go from 1 year in jail (silent) to 0 years in jail (confess)
At both confess there is no way for them to lessen the sentence
There might be more than 1 nsh equilibrium in a game
Need to check each and every box
The prisoners dilemma in imperfectly competitive firms
Cartel any group of firms that conspires to coordinate production and pricing decisions in an industry for the purpose
of earning an economic profit. They are often unstable b/c it is illegal, and therefore difficult to enforce since it goes
against the TPA.

Cartel agreements symbolise the prisoners dilemma

Involves several firms and retaliation against price cutters becomes extremely difficult
o Eg. OPEC members violating cartel agreement
Price-fixing game usually in a duopoly (a market in which there are only two producers competing). In a duopoly, the
dominant strategy is to lower price. However, the dominated strategy, to increase price (or leave it constant), results in
greater revenue for both players. There is therefore an incentive to collude and price-fix.
Tit for tat and the repeated prisoners dilemma
A repeated prisoners dilemma is a game in which two players are confronted with the same prisoners dilemma
not just once, but many times
Strategy tit for tat: the first time you work with someone, you cooperate
o In each subsequent interaction you simply do what that person did in the previous interaction (if they
defect, you defect)

CHAPTER 12: EXTERNALITIES, COMMON RESOURCES AND PROPERTY RIGHTS

Externalities: The positive and negative costs and benefits to society as a result of production. OR: Externalities are the
consequences that occur to those not directly involved with a transaction. They are a form of market failure as they
occur when the price mechanism fails to represent the true costs or benefits of production.
Positive externalities are the benefit of an activity received by people other than those who pursue the activity.
Negative externalities are the cost of an activity that falls on people other than those who pursue the activity.
Externalities and economic surplus

Market failure tends to follow a divergence b/w the exchange or market price and the price required for optimal
allocation. Hence the market fails to ensure that enviro resources are allocated efficiently.
Effects which fall outside the parties to an exchange, are called external effects or spillover effects
As the market only takes into account the private costs and benefits the existence of externalities means that
the total cost/gain accruing to society from a particular activity may not be registered
Individuals and firms utilise the environment in an anthropocentric way (how humans can use/exploit
resources)
Led to over exploitation of many environmental
resources + pollution of the natural environment,
since it is not protected by a system of private
property rights
There is a distinction between private costs & benefits vs.
social costs & benefits:
Private costs refer to the expenditure incurred by
producers in using resources to produce output, or the
cost incurred by consumers in giving up part of their
money Y in buying G&S.
Private benefits include the profits made by producers in
selling G&S and the utility (satisfaction) gained by consumers from consuming G and S.
Social costs refer to the costs imposed on or borne by society as a result of private actions.
Markets for environmental resources such as clean air/water do not exist, and property rights for the use of enviro G
are not well defined/do not exist.
The price mechanism rarely allocates environmental goods in an optimal manner b/c prices do not always reflect the
true costs of using the resources (ie, pollution, etc).
Market failure occurs b/c the price mechanism takes account of private benefits and costs of production to
consumers and producers, but fails to take into account indirect costs to society, ie. Environmental damage

Costs of additional production, the marginal costs, do not take account of any additional social or
environmental costs b/c they are not borne either by individual producers or consumers

does not take into account of future D for G and S that may not be satisfied or how the economy's ability to
grow in the future may be affected b/c a resource has been used up or destroyed
plays ltd role in protecting the environment by limiting sales of depleted resources which do have a price, ie.
Timber + minerals
PM is unable to allocate environmental resources which can be used for free, such as the use of the atmosphere
to dispose of gases during the production process

Coase Theorem
If at no cost people can negotiate the purchase and sale of the right to perform activities that cause externalities, they
can always arrive at efficient solutions to problems caused by externalities.
The affected parties to an externality will achieve efficient solutions if they can negotiate without cost with one
another
Informal rules and social norms often take care of reciprocal social costs without the need for either Coasian
deals or formal rules
LEGAL REMEDIES FOR EXTERNALITIES
When negotiation is costless, the adjustment generally falls on the party who can accomplish it at the lowest cost
Markets
The most efficient distribution of cleanup effort is the one for which each polluters marginal cost of abatement is
exactly the same.
Government regulators seldom have information on how the cost of abatement differ across firms
Market based instruments (MBIs) offer an alternative: Policies that use a range of approaches to positively
influence the behaviour of people in markets to achieve targeted outcomes

Price based market instruments

Taxes to control externality problems are called Pigouvian taxes
It concentrates pollution reduction in the hands of the firms that can accomplist it at least cost
Requires detailed knowledge about each firms cost of reducing pollution
o Too low tax too much pollution
o Too high tax too little pollution
Tax on production or use
CG imposes a tax of 38c/L forces owners of motor vehicles to contribute to social cost of air pollution +
road maintenance
aim to internalise the externalities
Quantity based market instruments
Issuing tradable permits for activity creating property rights
CPRS/ETS tradable pollution permits
recent change in enviro policy is concept of a system of tradable pollution rights where polluting firms can
buy licences to pollute, but can also trade these rights or permits in a market

employs market mechanism

Tax incentives
for green technology

Baseline and Credit

Cap and Trade

Polluters not under

aggregate cap can
create credits by
reducing their
emissions below a
baseline level of
emissions credits
can be purchased by
polluters that do have
a regulatory limit
QUANTITY
INSTRUMENT (allows
$P to vary)

Market based
aggregate cap on all
sources is est and are
allowed to trade
amongst themselves
to determine which
sources actually emit
the total pollution
load
QUANTITY
INSTRUMENT

Command and Control (Regulation)

Traditional
deals directly w/ problem law
prohibits/limits activity
Govt regulates based on sanctioning and
fines
applies uniform emissions limits on
polluters, even though each firm has
different costs for emissions reductions
direct/indirect tax
PRICE INSTRUMENT fixes the price while
emission level is allowed to vary according
to economic activity
environmental outcome not guaranteed
charges/taxes

The optimal amount of negative externalities

The socially optimal amount of a negative externality is not necessarily zero. For instance, there is a point at which the
marginal benefit of reducing pollution is less than the marginal cost.
optimal amount is not zero
curtail pollution until the cost of further abatement = MB
MC and MB curves often intersect at less that then maximum amount of pollution reduction
Intersection marks the socially optimal level of pollution reduction

CHAPTER 12: COMMON RESOURCES AND PROPERTY RIGHTS

Common resource a resource from which it is difficult to exclude people and for which each unit consumed by one
person means one fewer unit available for other users.
when peoples use of a common resource is not subject to some control, it means that no one has an incentive
to take the OC of using it into account one persons use imposes an external cost on others by making the
property less valuable
Tragedy of the commons the tendency for a common resource that is open access to be used until marginal benefit
falls to zero. (unrestricted access to common resources leads to overexploitation and eventual depletion).

Open access a situation where no one has the ability to restrict access or to regulate use of a resource, meaning that
the resource is exploited on a first-come, first-served basis
One solution to the tragedy of commons is to turn it into private property.
gives its holder incentive to use the resource efficiently
the most economically successful nations have all been ones with well defined private property laws
Common property A type of property rights regime where resources are controlled by an identifiable community of
users, and the ruse governing use are made and enforced locally.
State property a type of property regime where government has sole jurisdiction over the resource and where
regulatory controls are centralised
Managing global commons can be difficult, since it overlaps with many jurisdictions. Each country will have an incentive
to understate the value of the treaty to them in the hope that other countries will shoulder more of the burden. Given
that each country can continue to enjoy the benefits of the agreement whether or not they honour their commitment
to it, cheating is the dominant strategy. Eg. Atmosphere, oceans (extinction), space
CHAPTER 13: PUBLIC GOODS AND THEIR FINANCING
Rivalry The extent to which consumption of a G/S by one person diminishes its availability to others.
Non: consumption of the G by one individual consumer does not reduce the Q of the G available for other
consumers
o an anti-terrorist unit prevents a terrorist attak
riv: a person having a 30 min massage
Excludability the extent to which non-payers can be excluded from consuming a G/S
once provided, the producer cannot exclude consumers from enjoying the benefit of the G, even if they are not
prepared to pay
non: even if your neighbours dont pay their share of cost of maintaining anti-terrorist unit, they cant be
excluded from enjoying the protection provided by the unit
exc: a masseuse can refuse to provide their S to someone who has not paid for it

Non Excludable
Excludability
Excludable

Rivalry
Non-Rivalrous
Public G (national defence,
street signs, free TV)
Collective G (pay TV, uncrowded
toll road)

Rivalrous
Common G (fish in the ocean,
atmosphere)
Private G

some goods become public or private as a result of deliberate policy choices or basic properties
o some govts decided to collectively provide education

Free Riders
The problem of free riding: The incentive that arises to not contribute to the provision of a G/S in situations in which
individuals are able to enjoy the benefits of a G/S w/o contributing to its cost
if the MC of serving additional users is zero once the G has been produce, then charging for the G would be
inefficient
possibility of free rider behaviour private sector lacks incentive to provide public goods, since they would be
unable to make a profit. Therefore public goods usually provided by govt
even though the provision of a public good may create net social benefits for the community as a whole, if
consumers fail to reveal their true preferences in the market, little of the G/S will be supplied
o the benefit of an additional unit of a private G is the highest sum that any individual buyer would be
willing to pay for it, whereas the benefit of an additional unit of a public G is the sum of the reservation
prices of all people who value it
free riding prevents allocative efficiency from being achieved with environmental resources, amenities and
services

Paying for Public Goods

not everyone benefits equally from the provision of a public G
most equitable way to finance the G would be to tax people according to their willingness to pay (WTP), but in
practice, govts lack WTP for specific Gs
joint purchases and sharing facilities are difficult in practice b/c of
o significant communication costs
o FR problems
o Difficulty in reaching an agreement on fair sharing of costs
Type
Head tax
Regressive tax
Proportional Y tax
Progressive tax

description
a tax that collects the same amount from every tax payer
a tax under which the % of Y paid in taxes declines as Y rises. (HT is eg of RT)
a tax under which all taxpayers pay the same % of their Y in taxes (eg. GST)
A tax in which the % of Y paid in taxes rises as Y rises.

Wealthy individuals to tend assign greater value to public goods than

low-income people do
A head tax would result in high-income persons getting smaller
amounts of public good than they want
A progressive tax system makes possible a better outcome
However, progressive taxation and proportional taxation have been
criticised as being unfair to wealthy

Local, state, federal or global?

Benefits of some public goods are clearly local
o E.g. Street lights, firework displays
Local governments are best placed to govern these public goods as
different communities have different preferences
Economies of scale argue for provision of defence at the national level
Externalities that transcend local boundaries provide additional
rationale for national and international agreements
o E.g. Carbon dioxide emissions
Optimal quantity of a public good
not everyone benefits equally from the provision of a public G
Market demand curve is required to calculate the socially optimal
quantity of any good
Demand curve for a private good is calculated by the horizontal
summation of individual demand curves
The process of constructing a market demand curve for a public good
is different
Constructing the demand curve for a public good: placing the individual D curves side by side and add them
horizontally. For each series of FP, add the resulting Q D on the individual D curves.

Private provision of public goods

The reliance on the government to provide public good has disadvantages
o The one-size-fits-all approach requires many people to pay for public goods they dont want
o Many social institutions have evolved to provide public goods outside the government sector
o The challenge is to devise a scheme for raising the required revenues to provide the public good
Funding by donation
o Private charities, volunteering, Wikipedia
Development of new means to exclude non-payers
o Scrambling TV signals to non-payers, electronic toll charges for urban roads
Private contracting
o Gated private communities
Sale of by-products
o Radio and TV programming costs are paid by the sale of advertising, Not-for-profit groups selling
calendars, books and bumper stickers

Sources of inefficiency in the political process

Pork barrelling: Enacting legislation and regulations whose total costs are more than the total benefit it creates, but
that is favoured by a legislator because his or her constituents benefits from the expenditure by more than their share
of the resulting extra taxes
eg. Bill splitting at a restaurant makes a total bill higher
Logrolling: The practice whereby legislators support one anothers legislative proposals
Rent seeking: The socially unproductive efforts of people or firms to win a prize, eg.Why would anyone pay $50 for a
$20 note?

Many government expenditures are wasteful

o Government employees may not face strong incentives to get the most for what they spend

However, demand for public goods grows

How much of our money do we want to spend on public services and how can we ensure that politicians deliver
the services they have promised?

What should we tax?

The primary purpose of a tax system is to generate the revenue to fund public goods
Taxation also affects the distribution of real purchasing power in the economy
When governments run deficit budgets to fund public goods, they borrow from capital markets
This causes crowding out: The extent to which government borrowing leads to higher interest rates, causing
private firms to cancel planned investment projects
Taxes affect incentives and cause deadweight losses
Arguments that the economy would perform better if taxes were lower
Taxes may help achieving socially optimal output levels in externality situations
o Taxing carbon emissions

CH 14: THE ECONOMICS OF INFORMATION

The invisible hand theory assumes that buyers are fully informed. Consumers must employ strategies for gathering
information. The middleman, such as wholesalers, sales agents and retailers, can provide the necessary information that
improves economic surplus.
Although more information is better than less, information is costly to acquire. As additional information is acquired,
MB will decline and MC will rise. Cost-benefit analysis must be employed to determine optimal amount of information.
Spending additional search time is more likely to be worthwhile for expensive items than for cheap ones. Sellers must
decide how much information to provide to prospective buyers due to free rider problem. Providing information is
costly, as sales people must be paid wages etc.
THE GAMBLE
Expected value of a gamble the average amount you would win (or lose) if you played that gamble an infinite number
of times. It is calculated as the sum of the possible outcomes of the gamble multiplied by their respective probabilities.
Expected value E[X] = [ x P(x) ]
where E[X] is expected value, x is the outcome (eg. Good/bad) and P(x) is the probability of x (ie. probability of each
outcome).
Fair gamble a gamble whose expected value is zero.
Better than fair gamble a gamble whose expected value is positive.
Risk neutral person someone who would accept any gamble that is fair or better.
Risk adverse person someone who would refuse any fair gamble.
The commitment problem as gaining enough information about a commitment is too costly, often people will choose
an option and then discover a better one. To stop people from abandoning their original choice, there are agreements
to be signed to ensure commitment for a specified period of time. These include lease agreements between landlords
and tenants, contracts between employers and employees.
ASYMMETRIC INFORMATION
Asymmetric information situations in which people on different sides of an economic exchange are not equally wellinformed about a particular aspect of the transaction that will affect the outcome for them. Asymmetric information
causes uncertainty, which leads to inefficiency in the market. Warranties can eliminate some issues caused by
asymmetric information, but not all. How do you determine the value of goods under uncertainty? Using the formula
used to calculate the expected value of a gamble above.
The lemons model this is George Akerlofs explanation of how asymmetric information about the characteristics of
good tends to reduce the average quality of used goods offered for sale. People who have below average cars are more
likely to want to sell them. Buyers know that below average cars are likely to be on the market and lower their
reservation prices. Sellers of good cars have a reservation price higher than that of the buyer, and are therefore unable
to sell on the market. Only cars on the market, therefore, are lemons.

Principal-Agent problem - a situation where an agent whose actions are costly to monitor and whose objectives are not
aligned with those of the principal, takes actions that do not result in the best outcome for the principal. Includes
doctors, lawyers, real estate agents, with clients being principal. Concern for reputation eliminates the problem to some
extent, but agents interests must be aligned with those of the principal to attempt to mitigate the problem completely.
For example, tipping waiters to induce good service. Principals must also seek second opinions, quotes from many
sources, in order to ensure that they are not being exploited.
Buyers and sellers interests tend to conflict, so there is an issue with credibility and trust. However, the parties to a
potential exchange can often gain if they can find some means to communicate truthfully:
The costly-to-fake principle the idea that to communicate information credibly to a potential rival, a signal must be
costly or difficult to fake. E.g. warranties.
Conspicuous consumption can be taken as a signal of ability. People with the most abilities tend to receive the highest
salaries, and the more someone earns, the more he or she likely to spend on high-quality goods and services. Therefore
people will tend to trust a lawyer with an expensive suit.
Statistical discrimination the practice of making judgements about the quality of people, goods or services based on
the characteristics of the groups to which they belong.
Adverse selection a pattern which emerges in markets where those on the informed side of the market self-select in a
way that tends to reduce the average quality of the good or service sold. E.g. high risk individuals are more likely to buy
insurance.
Moral hazard the tendency of people to change their behaviour once they become party to a contract. In insurance,
this hazard is mitigated by imposing an excess.
Disappearing political discourse the theory that people who support a position may remain silent, because speaking
out would create a risk of being misclassified on the basis of their membership of a statistical group.
First-dollar insurance coverage insurance that pays all expenses associated with claims generated by the insured
activity. This can cause hundreds of millions of dollars of waste each year, as people have costly and unnecessary
procedures and stay in hospital longer than is necessary. Total economic surplus would be larger if insurance coverage
incorporated high deductibles or co-payments, because such policies provide an incentive to use only those services
whose benefit exceeds their cost. Attempts to encourage private health insurance are often frustrated by adverse
selection. Mounting insurance premiums have caused many people in good health to do without health coverage,
resulting in higher premiums for those who remain insured.