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Economics
Session #1:
Getting started
Prof. Dr. Hanno Beck
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Getting started
About this lecture
How to study and why
What is Economics?
Catwalk: Germanys next Top-Model
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• 14 chapters • every chapter has
– one topic: basic ideas, examples, case studies, political implications, discussion
– reading assingments: see syllabus for details
• you are supposed to – do the reading assigments before the lecture – repeat what you have learned in the lecture;
answer questions and discuss them with your fellow students
• Questions, comments: Office-Hours; E-Mail; after (or during) the lecture
About this lecture
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• How many days do you need to finish your term paper / thesis? (Bühler, Griffin Ross 1994)
– Expectations: on average 34 days; optimistic students: 27 days
– real time needed to finish paper: 55 days
• Huh, you are not supposed to do such mistakes? A simple question: – how do you pronounce the capital of Kentucky:
Loo-ee-ville or Loo-iss-ville?
– how many Euros are you willing to bet that you know the right answer?
• Empirical findings: We suffer from overcon-fidence, illusion of control, and self serving bias
How to study
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• Neuroeconomics: your brain has two different areas – limbic system: affective system; basic survival; immediate satisfaction
– cognitive system (präfrontal Cortex): self-control; willpower
• As long as the limbic systems rules our behavior (as it in fact does), we
– smoke, drink, eat to much
– Don‘t learn enough, start learning to late
• Solution: self-committment – tight schedule; learning routinely, regulary
– learning with fellow students
– learning with good students improvesyour own grades (Sacerdote 2002)
– compare your learning goals with your real learning efforts by means of a diary
– promise yourself a reward (after you finished)
How to study
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• more money, prestige…
• The economics of education: – going to university is like an investment
– a economics student costs 40.000 Euro
– this is how an investment works: sacrifying consumption today for more consumption tomorrow
• Tuitition fees: – an investor has to pay for his investment (class rooms, teaching staff,
etc.).
– investments are usually financed by credit (bonds) or equity. This does not work for an investment in human capital because there is no collateral
– Tuitition fees: if your investment (your visit of the university) pays off, you are able to pay back your fees. As long as the return of teh investment is > than the costs of your investment it makes you better off
– A matter of fairness: who really pays if your studies are for free?
Why should you study?
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Homework: reading assignments
Reading assignments:
A letter from London
At LSE, we don‘t have one single book for one course.
The amount of literature is huge: 900 pages for three courses, that is 120 pages
per day. For example, the capital markets session requires the reading of nine
research Papers, seven articles from newspapers, selected readings from seven
books plus the slides from the lecture. Source: F.A.Z.
Please get all the slides and the literature you are supposed to read for this
lecture. From now on, you ought to read all the reading assigments before the
lecture. You have to read them anyway, so why not before the lecture?
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What is economics?
• „Economics is making best out of life“
The problem with life: so many wishes, but so little
means to fulfill these wishes. Economics means to
organize an economy in order to reduce scarcity in the
most efficient way
• „People respond to incentives“
Economists think of people as selfish beings – rewards
make them work; punishment makes them behave
properly
• „Economists as policy advisers“
Economics is not an selfish art: reducing scarcity is one
common political goal.
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What is economics?
• Why do we need models? They are like a map to solve economic problems
• Methods: – ceteris paribus-analysis (holding other things constant )
– make your assumptions transparent (people maximize utility)
– make explanations (how do people maximize utility)
– make predictions (if you increase prices, consumption will decrease)
• Three ways to craft a model: – verbal description
– graphical representation
– mathematical representation (exact)
• Statistics: testing theories and models with empirical observation
• Positive vs. normative theory
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Catwalk: Germanys next Top-Model
Brazilian top-model Gisele Bündchen is – according to the Forbes-
list – the best-paid model of the world. She earns 33 million Dollar
(23,9 million euro) per year. Born in 1980, she is paid up to 40 000
Euro per show.
Top-model Kate Moss is ranked as the second-best paid model.
Aged 33, she earns 9 million Dollar (6,5 millionen euro) per year.
After leaving her friend, babyshambles-singer Pete Doherty, and
loosing her contracts with Burberry and Agent Provocateur she
made a comeback: she is the new Chanel-girl.
Heidi Klum earns 8 million Dollar (5,8 million euro) per year.
Born in Bergisch-Gladbach, she still is on the catwalk, doing
promotion for several compamies and is hosting TV-shows
(„Germany´s Next Topmodel“, „Runway“).
source: Gala
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• Ein paar Fragen:
- warum wollen so viele Frauen Model werden?
- warum werden Models so hoch bezahlt?
- sollte man die Gehälter für Models nach oben
begrenzen?
Ökonomisches Denken: Germanys next Top-Model
A few questions
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Economics
Session #2:
Economic thinking
Prof. Dr. Hanno Beck
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Economic thinking
Scarcity, Incentives, property rights
Opportunity costs
Specialisation
Economics, freedom and Markets
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Economic thinking: Scarcity
• Scarcity: the cookie-experiment
- test person is asked to try a cookie and to tell her willingness to
pay for that cookie
- Two groups: cookie-jar #1 ist full; cookie-jar #2 is almost empty
- variation I: show a full jar, replace it with an almost empty jar
- another experiment: the toys-partitionwall-experiment
- Empirical findings: humans are focussed on scarce
ressources
- explanations: - if other people value something as valuable, then it must be
valuable
- scarcity means a loss of options; people don‘t like the idea of
loosing options (i.e. freedom)
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Under discussion: scarcity
• Scarcity: Consequences and political implications – why is coffee at Frankfurt Main station so expensive?
And who earns the money from the expensive coffee?
– in 15. Century, the black death killed almost one-third of the population. Afterwards, wages increased; the system of serfdom and lords of the manor disappeared. Why?
– What justifies huge salaries and profits?
• The power of scarcity: If there is a deal to be done and one of the contractors is in possesion of a scarce, unique ressource, then the profits will go to the owner of the scarce resource. Always ask yourself: who owns the scarce resource?
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Economic thinking: Incentives
• Incentives: the cobra-effect – In the 19th Century, the English government in India tried to fight a
cobra-plague in India by paying money for every cobra caught. What
happened?
– 1965: “Unsafe at Any Speed” by Ralph Nader forced a wide array of
automobile safety legislation – cars became much safer. Consequence:
the number of accidents increased. Two effects: More accidents, fewer
drivers killed (side effect: more pedestrians killed)
• Basic idea of economics: pepole respond to incentives
– selfishness: pepole tend to maximise their own utility
– politics: if you want people to behave in a certain way, watch out
for the incentives they are exposed
– banning certain behavior: costs of controlling and prosecution;
people will always try to evade a ban
– Wrong incetives lead to a desaster: theory of oilspots
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Case study: paying farmers for nothing
• Incentives: oilspot-theory
• E.g. agricultural policy in the E.U.: – goal: a minimum income for farmers
– policy: guaranteed prices
– consequence: excess suply
– next step: destroying excess suplly; paying farmers for not growing agricultural products
– Next step: fraud
– consequence: more and closer monitoring of farmers
– result: you are paying people for not to work and spending a whole lot of money for controlling if they really do not work
• Oilspot-theory (W. Eucken): once you start with a wrong policy, your mistakes start to spread over your economy like oil over water
• Homework: taking a cab
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Homework: Taking a cab
Taking a cab in Prague
Journalists from the daily newspaper
Mlada fronta Dnes claimed to be foreign tourists
while taking a cab in Prague. In six out of ten cases,
they were charged extremely high prices. In one case,
they had to pay a price eight times as high as the price
allowed. The city council of Prague said that it controlled 755
cab-drivers; 1.5 percent of them charged a price too high.
How would you like to pay a cab-driver assuring that he will not
cheat you? How do you think a physician should be paid?
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Economic thinking: property rights
• Property rights: pay the piper, call the tune – why are there so many expensive restaurants in
Frankfurt City and who is willing to pay for the expensive food?
• Who pays the bill? – you: maybe you’ll choose McDonalds instead – your company: you may order champagne instead of table water
• If you have to pay your bill by yourself, you will take care of your expenses and your property
• Property rights ensure an efficient allocation of ressources; if your boss pays the restaurant, you make a decision about hispropoerty, not yours
• Private property is neccesary for a market-economy • For a world without property rights see former eastern-
european socialist economies
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Case study: Tokio Hotel serving for the army?
Tokio Hotel:
You‘re in the army now?
Instead of staging concerts, Tom and Bill Kaulitz from Germany‘s most sucessfull pop group Tokio Hotel may soon be serving for the german army. They got their call-up-order recently, as „Bild“, a tabloid newspaper, wrote. „We do not make any exeptions for prominent people, actors or musicians“ says Uwe Ullrich from the draft comission Stendal. „If they don‘t show up at the recruiting station they may be forced by the police to do so.“ (Source: Bild-Zeitung)
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Opportunity costs
• Opportunity costs: should the german army draft Tokio
Hotel? (from an economic point of view)
– should Tiger Woods mow his own lawn?
– should you bake your own bread?
– the costs of some action might not be as obvious as it
seems – what about your time?
– opportunity costs of an item is what you give up to get
that item. There is no free lunch – whatever you choose
to do, you do it at expense of the next best alternative
• So what is more expensive: compulsory military services or
volunteers?
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Homework: Too busy for university?
Too busy for university?
What do Bill Gates, David Beckham an Kylie
Minougue have in common? None of them has a
university degree. In fact many extremely sucessfull
people – especially those in careers like acting or athletics,
where starting early in life is especially crucial – do not attend
university. On the other hand, Queen-guitarist Brain May just
recently finished his Ph.D. in astrophysics – more than 30 years
after he left university to rock the world.
Do you think Mr Beckham or Mrs. Minougue should have finisehd
their studies before making a fortune? Should you leave university
for a career as singer/manager? And do you think that it was
clever from Mr. May to finish his Ph.D.?
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• Specialisation: should Tiger Woods mow his own
lawn?
– the principle of specialisation: everybody should
specialise in the activities he is best at
– the division of labor (i.e. specialisation) constitutes
modern market economies: journalists, lawyers, car
makers, baker etc.
– idea: everybody does what he is best at and trades the
fruits of his work on the market
– division of labor is ALWAYS welfare-increasing
– division of labor on an international level: globalisation
– Ricardo: the principle of comparative advantage
Specialisation
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Economics, freedom and markets
• freedom – as a value; people want to enjoy the benefits of liberty – efficiency needs freedom: voluntary contracts between
rational, equally entiteled parties are welfare-maximising
• Problems – equally entiteled partners? One needs to protect wekaer
parties and minorities – rational parties: unintended, unforeseen consequences of
our actions – contracts bothering third parties: enviromental policy;
speed limit to protect other drivers – here, policy has to step in and restrict personal freedom in
order to protect consumers, weak parties, third parties. Markets need additional policy.
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• Policy
– to protect weaker parties (labor market, information
asymmetries, subsistence level)
– to protect consumers from their selves (obligation to
save for retirement, compulsory health insurance, drug
policy, education)
– to protect third parties (enviromental policy, speed limit)
• What should this policy be designed?
– marginal utility should equal marginal costs
– efficient and effective
– use the power of incentives instead of coercion
Economics, freedom and markets
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Economics, freedom and markets
• markets are
– specialisation: you can only specialise in what you are good at if
you can exchange your production on an market
– therefore you need the right to exchange with whom you want
and the right to choose the job you want to do
– the distribution of the gains from specialisation is done by the
market according to the scarcity of the goods exchanged
– incentives: I will only exchange goods if it makes me better off
and if I am sure that I can reap the benefits form this exchange.
Therefore you need property rights (Art. 14 GG)
• A exchange of goods via markets makes both parties
better of is is always welfare-increasing
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Economics, freedom and markets
• what makes markets work
– competition; no power resulting from scarcity or
monopolies
– protection from sweating
– rational consumers and voters
– no externalities
• Policy to make markets work
– competition policy (GWB)
– Social protection against hardships of life (Art. 20 GG)
– consumer protection; (alcohol, drugs etc.)
– protection of third parties from externalities (enviromental
policies)
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Economics
Session #3:
How markets work
Prof. Dr. Hanno Beck
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Homework: Taking a cab
• passenger: wants to get to his destination fast and cheap
• cab driver: wants to maximise his income
– pay per hour: driving lot of roundabout ways or traveling at speed
of light
– pay per kilometer: no good idea
– fixed price: fear for your life
– bonus for reaching destination as fast as poassible: see fixed
price
– Fixed price plus bonus if the passenger reaches destination
without suffering from the roman disease
• Other examples: profit sharing schemes in companies;
payment of physicains; managers salaries
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Homework: Too busy for university?
• Opportunity costs: opportunity costs of an item is what you give up to get that item
• What about Bill,Kylie and David? – the costs of their studies are the foregone profits from their career – David and Kylie: they are making their fortune in young years –
maybe they should go to university after they finished their active career
• Brian: – leaving university for Queen was a good decision – now, the Brians opportunity costs are decreasing due to the
decreasing marignal utility of money (why?)
• Should you leave university? – it depends on your opportunity costs – it depends on the changes of making it to the charts / Bayern
München; the higher the risk of failing, the closer you should stick to your studies
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How markets work
The hog-cycle
The path to equilibrium
Supply and demand
Markets in action
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The hog cycle
The year of the golden pig
„Economists are remebered of the so-called hog-cycle taught in economics-courses in the first year at university. It explains why prices are volatile – because productions responds not immideately to changes in demand. In 2004, the price for pigs was not higher than today. Then, high prices made farmers to raise more pigs. In consequence, prices dropped dramatically, what in turn made farmers stop raising pigs. As an inevitable result, the price for pork increased to todays high level – this may lead to lower prices in the next years. (Economist, June 9th 2007; p. 59)
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The hog cycle
• More examples: teachers, doctors
• How does this work, anyway?
– scarcity as a sign of demand for a product / service
– scarcity leads to higher prices
– higher prices as an incentive for producers to increase production – as long as he can reaps the profits from his increased production (property rights!)
– as prices rise, supply rises, which helps to reduce scarcity
– this happens only as long as prices are allowed to change and producers are allowed to profit from their increased efforts
• Result of free markets: equilibrium
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The path to equilibrium
• You are in a supermarket: which cash desk to choose?
• That’s how markets work: Incentives (save time) trigger behavior (search for the shortest queue); that will bring markets into equilibrium (all queues do have the same expected time to wait)
• Incetives, property rights and freedom make disequilibria dissapear – supplier: seeks for profit
– consumer: seeks for cheapest contract
• markets channel egoims of supplier and consumer to a social efficient result
• Adam Smith: „invisible Hand“
• In fact, there are two invisible hands: Supply and demand
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• A markets consists of consumers (demand) and
producers (supply)
• the price is the crucial variable that coordinates
supply with demand
• requirements for well-functioning markets:
– free prices; no obstacles to changes in prices
– property rights, incentives
– freedom to choose job, supplier, contract partner
– competitive marktes: no single supplier; no exploitation
• Graphical representation: Supply-demand-
diagramm
Supply and demand
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Supply and demand
5
4
3
2
1
1 5 10 20 30
price
quantity demanded
price quantity
5 1
4 5
3 10
2 20
1 30
• Law of demand: as p decreases, D increases
• substitiution
• Income-effect
• but: ceteris-paribus-assumption
D
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Supply and demand
5
4
3
2
1
1 5 10 20 30
price quantity
1 1
2 5
3 10
4 20
5 30
• Law of supply: as p increases, S increases, too
• Selling more promises more profits
• but: ceteris-paribus-assumption
price
quantity supplied
S
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Supply and demand
5
4
3
2
1
1 5 10 20 30
price D S
1 30 1
2 20 5
3 10 10
4 5 20
5 1 30
• equilibrium: supply = demand
• Excess suplly: S > D
• Excess demand: D > S
price
quantity
S D
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Markets in action
5
4
3
2
1
1 5 10 20 30
p
q
p old new
5 1 0
4 5 1
3 10 5
2 20 10
1 30 20
• Change of a exogenous variable: demand-curve shifts; loosening the ceteris-paribus-assumption
• This is not a movement along the curve (endogenous variable)
D
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Markets in action
• The government decides to increase the tax on income
• The demand for Playstations: a new version enters the market
• The interest rate is rising
• The government introduces a new minimum wage legislation
• The price of your playstation is increasing
• Discuss the demand-curve for
– hard drugs
– silicon
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• with the 1996 BSE-crisis, consumers switched from beef to pork
• farmers switched from rearing cows to pigs
• what happened to the price of beef?
• what happened to the price of pork?
p
q
S
D
D‘
S‘
Case study: the BSE-crisis
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• For the last years, demand for natural ressources was steadily increasing
• Prices for natural ressources were steadily decreasing
p
q
S D
S‘
D‘
Case study: natural ressources
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• What can politics do against drug-consumption?
• More punishment, more prosecution
• more educational work
• What if government decides to give heroin to addicted people for free?
p
q
S D
Case study: drug policy
D S‘
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Case study: cheap food no more
• findings:
– Food-prices are rising
– Inventories are decreasing
– record crops worldwide
• Why are prices rising?
– China and India are getting richer; demand for meat is
increasing; meat needs more grain as input
– Demand for (state-sponsored) biofuels increases
– bad harvest in Australia
• measurements
– politics: price controls; export restruictions
– farmers: producing gen-food; re-activate fallow lands
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• Demand curve shifts due to
- increasing incomes
- increasing demand for biofuels
• Supply curve shifts due to
- bad harvest in australia
- but: supply-curve may shift back due to reactivated fallow land
p
q
S
D S‘ D‘
Case study: cheap food no more
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• Before price controls and export restrictions:
- Domestic suppliers produce S1; exports: S1-D1 sold at price P1
- Price controls; export restrictions
- price decreases to p2
- demand increases
- supply decreases
- consequences: more fallow land; smuggling; black markets
p
q
S D
Case study: cheap food no more
S1 D1
p1
p2
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Homework: Beating the traffic
Beating the traffic
All big cities have traffic problems, and many
ities try to discourage people from driving into
the crowded city centre. If we think of a car journey
into the city as a good that people consume, one can
use the economics of demand and supply as a tool to analyze anti-
traffic policies. Here are a few strategies: One could reduce the
prices of substitutes (making bus or rail-tickets cheaper) or raise
the price of complements (high taxes on commercial car parks;
shorter times on the parking meters). The city of London imposed
a congestion charge on cars entering the city during the business
hours. Some cities restrict the number of cars allowed to enter the
city during the rush-hours.
Show graphically what happens to the market for car journeys to
the city if you implement the policies described above .
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Economics
Session #4:
Elasticities and welfare analysis
Prof. Dr. Hanno Beck
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• Reducing demand by taxes on carparks; higher costs of parking in the city shifts demand curve to the left
• Lower prices for substitutes shift demand curve to the left
• What happens if the government decides to restrict the number of cars allowed to enter the city?
p
q
Homework: Beating the traffic
D‘ D S S‘
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Elasticities and welfare-analysis
Elasticity of demand
Elastic and inelastic demand
Other elasticities
Consumer- and Producer-Surplus
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• Who needs protection in social and economic
life – and why?
– tenants / lodgers
– employees
• What is the problem with drugs?
• Should we sell life-saving medicine via
markets – and if not, why?
• What is exploitation and what is the root of it?
Elasticitiy of demand
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Elasticitiy of demand
• Basic idea of marktes: supply and demand react to changes in prices
• How can we measure the reaction of supply / demand to changes in prices? („sensity of demand to price changes“)
• We may use
– the absolute decline of demand (supply) per Euro
– decline of demand (supply) in percent per Euro
– elasticities
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• Elasticity: percent change in demand divided by the corresponding percent change in its price
• p decreases by -20 % = -(5 – 4) / 5
• demand increases by 11,11 % = (100 – 90) / 90
• elasticity: 11,11 / (-20) = -0,55
• If the price decreases by one %, demand increases by 0,55 %
• unit-free number enables comparisons between different goods; PE is independent from the price level
p
q
Elasticitiy of demand
D
5
90
4
100
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• What if the price increases?
• p increases by 25 % = (5 – 4) / 4
• q decreases by -10 % = -((100 – 90) / 100)
• elasticity: (-10) / 25 = -0,4
• The value of PE depends on whether the price increases or decreases
• solution: averaging
p
q
Elasticitiy of demand
D
5
90
4
100
19
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elasizität • Price on average:
(5 – 4) / 4,5
• p changes by 22 %
• average quantity: (100 – 90) / 95
• q changes by 10,5 %
• elasticity: 10,5 / 22 = 0,47
• Lets omit the „-“-sign
• bow elasticity
• Elasticity is NOT the slope of a curve (ΔQ/Δp); but it is an important part of it: PE = (ΔQ/Δp) (p/q)
p
q
Elasticitiy of demand
D
5
90
4
100
4,5
95
change in price mean price
change in quantity mean quantity
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Homework: some elasticities
Oscar Angela p demand p demand
2 20 2 19
4 15 4 18
6 12 6 18
8 11 8 12
10 5 10 4
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• elasticity: if the price decreases by one %, demand increases by Є %
• inelastic demand: Є < 1. (0,19)
• elastic demand: Є > 1 (1,6)
• Isoelastic demand: Є = 1. (113 – 90) / 101,5 (5 – 4) / 4,5
p
q
Elastic and inelastic demand
D
5
90
4
130
D
94
20
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• Complete inelastic demand: demand does not react to a change in price; Є = 0. E.g. drugs.
• Totally elastic demand: if p increases only slightly, demand goes to zero;if p decreases only slightly, people every quantity
offered. Є = . Perfect substitutes; demand in the case of polypol
p
q
Elastic and inelastic demand
D
D
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• Hard drugs (heroin): completely inelastic demand
• Soft drugs: elastic demand (pott; alcohol, cigarettes)
• consequence: drug policy has to distingiush between hard and soft drugs
• prosecution: shift of the supply-curve. Helps with soft drugs; not with hard drugs
• education: shift of demand-curve; does not work that well with soft drugs because as p decreases; demand increases again. Helps with hard drugs.
p
q
S D
Case study: hard and soft drugs
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• What determines elasticity of demand?
• Essentials or luxury goods
– travelling, restaurants
– gasoline, basic foods
• Availability of substitutes – are there good
substitutes? (I-Pod and telecom)
• Supply; i.e. competition prevents consumers from
being exploited (GWB)
• Time
– gasoline: in the long rund demand is more elastic
– Cars (durables): in the long rund demand is more inelastic
Elastic and inelastic demand
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• revenue: price times quantity
• revenue at p = 5: 90 * 5 = 450
• revenue at P = 4: 100 * 4 = 400
• revenue has decreased altthough demand has increased: reason: the decrease of the price. Inelastic demand
p
q
Elastic and inelastic demand
D
5
90
4
100
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• revenue: price times quantity
• revenue at p = 5: 90 * 5 = 450
• revenue at P = 4: 120 * 4 = 480
• if demand is elastic; a decrease of price increases revenues
• Elasticity of demand depends also on the actual price
• as p declines, PE declines, too
p
q
Elastic and inelastic demand
D
5
90
4
120
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Other elasticities
• Elasticity of supply – %-change of quantity supplied divided by %-change of price
– shows how supply reacts on changes of market data (how long does it take to close a gap between demand and supply?)
– ES is determined by availability of inputs, time, profits
• income elasticity – %-change of demand divided by %-change of income
– inferior goods: food (IE<1); superior goods: travelling (IE>1)
• cross-price-elasticity – %-change of demand for good 1 supplied divided by %-change
of price for good 2
– important for competition policy
– close substitutes: CPE is small and < 0; complements: CPE > 0
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PE
tomatoes 4,6
legal gambling 1,9
marijuana 1,5
cigarettes 0,51
cinema 0,87
IE
cars 2,5
restaurant 1,4
clothes 1,0
margarine -0,2
source: Samuelson 1998
Empirical estimates
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Home work: the boll weevil
Boll Weevil Monument, Enterprise, Alabama
From 1910 – 1915, the boll weevil, a bug from
mexico, destroyed almost the entire harvest of
the local cotton farmers, exspecially in Enterprise,
Alabama. In december 1919, a monument was built
in the heart of the city to remind of the bug. It was
manufactured in Italy, the city payed 1800 dollars for it.
It is the only monument worldwide built in honor of a parasite.
Why should the city build a monument in honor of the boll weevil?
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Consumer- and producer surplus
5
4
3
2
1
1 2 3 4 5
p
q
p q
5 1
4 2
3 3
2 4
1 5
• Demand curve represents the willingness to pay of every single consumer; i.e the utility they derive from consuming the product
• What if the price is below the willingness to pay?
D
23
67
• If p = 4 Euro, consumer #1 and 2 buys one unit;
• consumer #1 pays 4 Euro for something he is willing to pay 5 Euro this increases his total welfare by 1 Euro
• Is p = 2 Euro, so the increase in welfare for #1 = 3 Euro #2 = 2 Euro #3 = 1 Euro
Consumer- and producer surplus
5
4
3
2
1
1 2 3 4 5
p
q
D
68
• Consumer surplus: welfare increases if p is below the willingness of the consumer to pay
• If p decreases, total welfare increases
• graphically: area between market price and demand curve
Consumer- and producer surplus
5
4
3
2
1
1 2 3 4 5
p
q
D
69
Consumer- and producer surplus
5
4
3
2
1
1 2 3 4 5
p q
1 1
2 2
3 3
4 4
5 5
p
q
S
• Supply curve represents the willingness to offer a good for a given price; i.e. his total costs
• what if p is above costs?
24
70
Consumer- and producer surplus
5
4
3
2
1
1 2 3 4 5
p
q
S • with p = 2 euro, supplier
#1 gains 1 € on top; #2 just breaks even
• with p = 4 Euro, the additional gains are: #1 three Euro #2 two Euro #3 one Euro #4 breaks even
71
Consumer- and producer surplus
5
4
3
2
1
1 2 3 4 5
p
q
S • Producer surplus:
increase in producers welfare, if market price is above total costs of production
• if p is increasing, total welfare increases, too
• graphically: area between supply curve and price
72
Consumer- and producer surplus
5
4
3
2
1
1 5 10 20 30
p
q
S D
• CS and PS represent consumers‘ and producers‘welfare from market transactions
• Overall welfare (OW): CS plus PS
• CS = total utility consumers receive from the good – payments to producer
• PS = consumers‘ payments – costs
• OW = total utility of consumers – costs
25
73
Markets revisited
• markets are efficient: – if p is above equilibrium price, total utility consumers derive from
consuming the good is larger than costs of production
– if p is below equilibrium price, total utility consumers derive from consuming the good is smaller than costs of production
– on markets, goods are allocated to the customers with the highest willingness to pay
– on markets, customers by at the companies with the lowest costs (price)
– remember: markets need freedom of coalition; freedom to buy where ever and what ever you want; freedom to sell what ever you want a which price you want
• on markets, goods are only distributed by ability to pay, not by needs
• markets do not provide equity
74
• Before price controls and export restrictions:
- domestic suppliers produce S1; exports: S1-D1 sold at price P1
- PS: 0p1B
- CS: p1CDE
- Price controls; export restrictions
- PS: 0p2A; producers lose p2p1CBA
- CS: p2ADE; consumers gain p2p1CA
- Net loss of welfare: CBA
p
q
S D
Case study: cheap no more (revisited)
S1 D1
p1
p2 A
0
B C
E D
p
q1
p1
p2
A
B C
E
D S
q2
PS with free trade : ABC CS with free trade: E PS with export restrictions : A CS with export restrictions: EB Loss of welfare: C
Case study: cheap food no more (revisited)
26
76
• Should one pay organ donors?
• Some people would spent even
without pay (S‘)
• Those who receive an organ gain
A, those who do not get one,
loose B
• voluntary donators loose A; those
who would spent their organs for
pay loose C
• but:
- who shall receive organs?
- does a professional market
for organs undermine the
willingness to spent without
pay?
p
q
Case study: organ donations
p
S
D
q1 q0
A
B
C
D
S‘
77
Economics
Session #5:
How markets work:
Price controls and taxes
Prof. Dr. Hanno Beck
78
Homework elasticities: Oscar
q p dq dP Mold +Mnew
2
Pold +Pnew
2
(3) / (5) (4) / (6) PE:
(7) / (8)
5 10 - 2
11 8 6 - 2 8 9 0,75 - 0,22 - 3,3
12 6 1 - 2 11,5 7 0,08 - 0,28 - 0,3
15 4 3 - 2 13,5 5 0,22 - 0,4 - 0,55
20 2 5 - 2 17,5 3 0,28 - 0,66 - 0,4
q = quantity; p=price; dM=change of quantity; dP = change of price; Mold = quantity before change of price;
Mnew = quantity after change of price; Pold = old price; Pnew = new price
27
79
Homework elasticities: Angela
q p dq dP Mold +Mnew
2
Pold +Pnew
2
(3) / (5) (4) / (6) PE:
(7) / (8)
4 10 - 2
12 8 8 - 2 8 9 1 - 0,22 - 4,5
18 6 6 - 2 15 7 0,4 - 0,28 -1,4
18 4 0 - 2 18 5 0 - 0,4 0
19 2 1 - 2 18,5 3 0,05 - 0,66 - 0,08
q = quantity; p=price; dM=change of quantity; dP = change of price; Mold = quantity before change of price;
Mnew = quantity after change of price; Pold = old price; Pnew = new price
80
• why should one built a monument for a parasite?
• the destruction of the harvest shifts the supply curve to the left. consequence: revenues are increasing
• With inelastic demand, revenues are increasing
• Second reason: weevil made farmers switch to other products (peanuts)
p
q
Homework: the boll weevil
D S S
81
Analysis of competitive markets
Price strategy and consumer surplus
Price ceilings
Minimum wages
Taxes
28
82
• Basic idea: capturing consumer surplus by charging customers according to their willingness to pay
• Two prices: expensive pt and cheap Pb
• Old CS: A+B+C
• New CS: A+C
• Old PS: D+E
• New PS: D+E+ B
p
q
N
Price strategy and consumer surplus
pt
qM
A
pb
A
B C
D E
83
• Do you prefer expensive brands?
– Müller Milchreis or „Elite“-Milchreis (40 %)
– Nestlé-Eis or Classic Choco Vanilla from Lidl?
– Hochland-Feta or Mitakos-Feta?
• Separate customers by their income (lawyers, consultants,
„families (pensioners) pay half the price“)
• Different discounts to different customers (car sales)
• „Slighty imperfect“ products with discount
• out-of-fashion products
• „professional“ vs. „homeworker“ edition
• hardcover vs. paperback edition
• Premium vs. non-premium brands
• Perfect price discrimination: E-Bay
Case study: hardcover or paperback?
84
P
S
D
q1 q0 q2
A
B
C
q
Rent ceiling
D
E
Price ceilings: rent control
Are rent controls a good
idea to protect tenants
from exploitation?
29
85
• Are rent controls a good idea
to protect tenants from
exploitation?
• Rent ceiling: demand
increases from m0 to m2
• Supply decreases to m1
• Excess demand m2 – m1
• PS: decreases by A+C;
• CS: increases by A
• deadweight loss: B+C
p
Price ceilings: rent control
p
S
D
m1 m0 m2
A
B
C
q
rent ceiling
86
Price ceilings: rent control
• Rent controls make the economy as a whole worse off – supply decreases; shortage of cheap appartments
increases (C)
– some tenants don‘t get an appartment anymore (B)
– If you get an appartment, you win (A), but on the expense of the landlord
• consequences:
– Under-the-table-payments; subcontracting
– in the long run: supply decreases even more
– who gets the cheap appartment? The needy?
w
w
S D wmin
L1 L0 L2
A B
C
D
E
• Demand for labour (for hours
worked) = L1, supply of labour
(hours worked) = L2
• unemployment L2 –L1
• L1 hours are actually employed
CS (rent of those who demand
labour; i.e. employers)
decreases by A (higher wages
for those who still have a job)
and B (those who loose their
job due to higher wages)
• PS increases by A (higher
wages for those who still have
a job); decreases by C (those
who loose their job )
• Deadweigh loss: B+C
Minimum wages
30
88
• Minimum wages hurt some
workers; but do they help all
workers as a group?
• Loss of PS for workers: A – C
• If the demand curve is flat
(elastic demand for labour) B
> A, i.e. workers as a group
loose
• Empirical findings: demand for
low-skilled labour is more or
less elastic, because one can
replace it with machines
w
L
Minimum wages
w
S D
wmin
L1 L0 L2
A B
C
89
Minimum wages
• You don‘t need minimum wages for high-skilled workers but for low-skilled workers. consequences: – total loss of welfare to workers as a gruop (B > A)
– wage sum: Lmin * workers payed decreases if demand is elastic; wage increases, but the number of persons receiving this higher wage dereases (see session #4)
• A few questions concerning minimum wages: – in Germay, we are talking about different minimum wages for
different industries – why, if the MW shall provide workers with a minimum income to make their living?
– minimum wages for self-employed persons?
– minimum wages lead to more unemployment; but: what, if employers are able to pass the increased wages to their customers. If the demand for their product is inelastic, minimum wages don‘t lead to unemployment; but the higher wages are paid by the customers
90
Minimum wages and social market economy
• Social market economy: use efficient markets and provide social protection by additional social policy
• say: free wages, no minimum wages plus additional govermental payments on the wage. Consequences: – no unemployment
– social protection is now payed by the tax-payer, not by companies who employ employees for minimum wages or their customers
– minimum wages in germany: Hartz IV
• Concepts: so-called Kombilohnmodelle (Mainzer Model), negative income tax (USA)
31
91
• Taxes / SSC make supply
curve shift to S‘
• Consumers pay gross price
pG, producers receive net
price pn.
• difference pb – pn = t
• Consumers loose B+C
• producers loose A+D
• tax revenues: B+A; shared by
consumers (B) and producers
(A)
• C+D = excess burden;
deadweigh loss of a tax
Taxes
p
S D
q1 q0
B
A
S‘
t
C
D
q
E
F
pG
pN
92
• Now: demand inelastic; supply
elastic
• Tax burden (A+B) is now
being shouldered mainly by
the consumer (B) because of
their dire need of the product
• the more inelastic part of the
market bears the main burden
of a tax
• Inelastic demand yields a
larger tax revenue
• Inelastic demand: cigarettes,
alcohol, gasoline – so why are
taxes on these goods so
popular?
p
p
S
D
pn
q1 q0
B
A
Taxes
S‘
C
D
pG
q
93
Homework: EU-agricultural policy
A sea of milk
Since 1957, the Europeam Union has a common
agricultural policy. The goal of this policy was to
provide an income for farmers. Brussels promised
to buy the entire production of dertain crops.
Cheap imports from abroad were heavily taxed via tariffs.
With the Uruguay-round, the EU was forced to change its system
of agricultural subsidies and price controls. Since 1993, farmers were
payed direct transfers.
What happens if the EU promises to buy any production? Show the
consequences for consumer- and producer-surplus.
32
94
Economics
Session #6:
Production
Prof. Dr. Hanno Beck
95
p
Homework: EU-agricultural policy
p
S D
pmin
q1 q0 q2
A B C
q
• Government promises to buy
the whole production for
minimum price pmin
• CS: loss of A, which is
redistributed to producers;
loss of B for those who stop
consuming
• PS: gain A+B+C
• Government: buys surplus
production q2-q1; i.e. totals
costs are pmin(q2-q1)
(speckled rectangle)
• Guess who pays this policy?
• Net welfare loss: depends on
what happens to the product-
ion the government buys
D
96
Production
Production function
Costs
Cost function
Shareholder and Stakeholder
33
97
• Why learning about production? – Goal: efficent production; avoiding waste of time
and inputs
– companies need profits to survive
– employees need companies
– companies play a crucial role for employment and welfare of a country
• What do you need to know?
– production function
– costs
– owner, shareholder
Production function
98
• The jelly baby-experiment – your product: delivery of jelly-babys from chair A to B
– time: 15 seconds
– amount of workers variies
– we may use more capital
• Please write down the results of the
experiment – total output
– average output (output per worker)
– marginal product (additional output produced as input is
increased by one unit )
Production function
99
Production function
#W TO AP MP
1
2
3
4
5
6
7
8
9
• W = worker; MP =
marginal product; AP =
average product; TO =
total output
34
100
Production function
• w = worker; TO = total
output; AP = average
product; MP = marginal
product
• Law of diminishing returns:
the more workers we use,
the lower is the additional
output
• most times: starting with
increasing MP, later on
decreasing MP
• Sources: Synergies;
division of labour; learning
w TO AP MP
1 3 3 3
2 5 2,5 2
3 8 2,66 3
4 12 3 4
5 17 3,4 5
6 23 3,83 6
7 26 3,71 3
8 28 3,5 2
9 29 3,2 1
10 29,5 2,95 0,5
101
Production function
TO
w
102
Costs
• Costs: – opportunity costs
– explicit and implicit costs (do not require a cash outlay)
– cost of capital: loans (interest) and equity (opportunity
costs)
• measures of costs – total costs
– fixed costs (do not vary with output)
– variable costs (depend on output)
– average costs (total costs divided by quantity of output)
– marginal costs (increase of total costs that arises from
an extra unit of production)
35
Fixed costs = 100;
wage: 10 € per worker
TO = total output
TC = total costs
VC = variable costs
AC = average costs
MC = marginal costs
(change of total costs / additional
output),
i.e.: 5 = (120-110) / (5-3)
103
w TO TC VC AC MC
1 3 110 10 36,6 10
2 5 120 20 24 5
3 8 130 30 16,25 3,33
4 12 140 40 11,6 2,5
5 17 150 50 8,8 2
6 23 160 60 6,95 1,67
7 26 170 70 6,54 3,34
8 28 180 80 6,43 5
9 29 190 90 6,55 10
10 29,5 200 100 6,78 20
Costs
104
Costs
TC
TO
• Most times:
total cost curve
is S-shaped
• i.e.: MC are
decreasing at
the beginning;
they tend to
increase with
increased
output
• Reason: first
increasing MP;
decreasing MP
as output
increases
105
• AC: decreasing at
the beginning;
increasing with
increased output
• Reason for
decreasing AC: fixed
costs
• application: natural
monopolies
Cost function
AC
TO
36
106
Case study: The Bundesnetzagentur
The federal agency for postal services and
telecommunication is responsible for for postal services,
energy services and the telecommunications industry.
Since January 2006 it is responsible for the railway-infrastructure,
too. It is obliged to assure that every competitor has access to the
infrastructure of its industry. Natural monopolies arise when there are
huge fixed costs. They lead to a market where one company is able to
satisfy the whole market demand. The most visible natural
monopolies are utilities (water, gas), electricity, and phone services.
107
Cost function
• MC: decreasing
with small output;
increasing with
increasing output
• Reason for
decreasing and
(later) increasing
MC: law of
diminishing returns
MC
TO
108
0
20
40
60
80
100
120
0 2 4 6 8 10 12
AFC
FC
AC
- FC: fixed costs
- AC: average costs
- MC: marginal costs
- AFC: average fixed costs
- Minimum of average costs:
where AC = MC (why?)
output
Cost function
MC
37
109
Homework: Jelly-Babies, Baby
The Gummi Bear
The Gummi Bear originates from Germany where it
is hugely popular under the name Gummibär
(rubber bear) or Gummibärchen (little rubber bear).
Hans Riegel of Bonn invented bear-shaped sweets
and started the Haribo company in 1922, which first produced and
introduced its Gold-Bear product in the 1960s. In the United States,
Haribo gummi bears usually come in raspberry (red), orange,
strawberry (green), pineapple (clear), and lemon (yellow), however,
many offshoot companies (typically the health-related gummi bears)
may use more exotic flavors and colors.
Please complete the table for the jelly-baby-experiment. Calculate
different costs (one worker is 5 €; fixed costs are 100 €)
110
Shareholder Value and Stakeholder Value
• Shareholder value – the more profit a company earns, the more valuable it is
– a sucessfull company is valuable
– idea: high market capitalisation means a valuable company; i.e. a
sucessfull company
– goal: increase market value of the company (market capitalisation =
shareprice * number of shares
– problems: short-term-thinking of shareholders (?); what about stakeholder‘s interets
• Stakeholder Value: interest of companies‘ business
partners (workers, customers, government,
creditors)
111
Case study: 12 million euros
• Why is Josef Ackermann earning 12 million Euro per year? – scarcity? – international competition for excellent management-
talents? – negligent shareholders? („devil may care“)
• Why do shareholders not care about the income of the CEO – one share, one vote – small amount of shares, small influence on decicions
concerning the company – why should you care about voting if your influence is that
small – similiar problem with democracies
38
112
Shareholder Value and Stakeholder Value
• Should there be a legal limit on CEO‘s salaries?
– „unearned“ income? Remember the super-models
– lack of control by owner (shareholder) and supervisory board
– high salaries of CEO‘s lead to mistrust in market economies
– consequences: lack of supply of good CEO‘s; under-the-table-payments
• Other policy measures – shareholders: compulsory voting
– legal framework for salary schemes
– shareholder activism; especially asset management firms
– education
113
Economics
Session #7:
supply
Prof. Dr. Hanno Beck
114
Supply
Revenue and profit
Profit maximisation
Supply-curve and competition
Taxes, Social security contributions and supply
39
115
Revenue and profit
q R AR MR
1 12 12 12
2 24 12 12
3 36 12 12
4 48 12 12
5 60 12 12
6 72 12 12
7 84 12 12
8 96 12 12
9 118 12 12
10 120 12 12
• q = quantity supplied; R=
revenue; AR = average
revenue; MR = marginal
revenue
• price is always the same
and is 12 €
• average revenue =
revenue dividedby quantity
sold (€ per unit sold)
• marginal revenue =
revenue added by the last
unit sold
116
• the additional revenue from one more unit sold must at least
equal the additional costs caused by the production of this
unit
• i.e:
– if marginal revenue exceeds the marginal costs one should produce
one more unit
– if marginal revenue is below the marginal costs one should decrease
production
– i.e.: profit-maximum when marginal revenue equals marginal costs
– marginal revenue if the price remains unchanged: p (one unit
produced times its price)
– P = MC applies as long as an increase (decrease) in supply does not
lead to an decrease (increase) of the price
Profit maximisation
117
Profit maximisation
q P TC R MC MR Pr MR-MC
0 - 10 0 0 -10
1 12 25 12 15 12 -13 -3
2 12 36 24 11 12 -12 1
3 12 44 36 8 12 -8 4
4 12 51 48 7 12 -3 5
5 12 59 60 8 12 1 4
6 12 69 72 10 12 3 2
7 12 81 84 12 12 3 0
8 12 95 96 14 12 1 -2
9 12 111 108 16 12 -3 -4
10 12 129 120 18 12 -9 -6
40
118
P; MC; AC
q
B
Profit maximisation
AC
MC
P
C D
E
O qG
• Profit-maximisation where p = MC
(B)
• Revenue = quantities sold qG * p;
i.e. OEBqG
• Total costs: costs per unit
(=average costs) * q; i.e.
ODCqG
• profit: revenue minus costs,
i.e. DEBC
• in the long run cost must at
least equal revenues; i.e. D =
minimum price producer must
charge in the long run
• if p < AC (D), the company
should exit the market
119
P; GRK; DK
q
B
Profit maximisation
AC
MC
P A
O qG
• Profit-maximisation where p = MC
(B)
• Revenue = quantities sold qG * p;
i.e. OABqG
• Total costs: costs per unit
(=average costs) * q; i.e.
ODCqG
• profit: revenue minus cost,
here: zero
• p = minimum of AC is the least
price the company must
charge
• If p < minimum of AC, company
must exit the market in the
long run
120
P, MC;
ATC; AVC
q
A
B
Profit maximisation
ATC
AVC
MC
P
C D
E
F
O qG
• If p < minimum of AC, company
must exit the market in the
long run
• In the short run?
• As long as p > AVC the
company should continue to
produce (contribution margin)
• Total costs: ODCqG
• Revenue: OEBqG
• Loss: EDCB
• Variable Costs: OFAMG
• Contribution margin: FEBA;
part of fixed costs that are
covered by revenues
41
121
Homework: Is it Dumping?
Cheaper flights In November 2001, the german airline Germania Charged 99 € for flights between Berlin und Frankfurt. Deutsche Lufthansa, which held the largest market share For flights between Berlin and Frankfurt, reacted quick: it reduced the price for its tickets by 60 percent to 100 respectively 105 €. Additional services (Catering, Miles & More, more connections) made Lufthansa‘s offer more attractive than Germanias. Assume that Lufthansa is selling its tickets below total costs. Do you think that Germania should accuse Lufthansa for dumping? Is Lufthansa right to sell tickets below total costs?
122
• In p = 1 supply is q1
• In p = 2 supply is q2
• In p = 3 supply is q3
• In p = 4 supply is q4
• ABCD: as pincreases, supply
increases, too
• ABCD = supply curve
• Supply in the long run: starts
from minimum of TAC
• Supply in the short run: starts
with minimum of VAC
p
q
Supply-curve and profit maximisation
1
2
3
4
A
B
C
D
MC
q1
AC
q2 q4 q3
123
• Supply curve: marginal-cost-curve; starting from minimum of
TAC
• Total market supply: sum of all MC-curves of all firms
• Total market supply in the long run:
– if firms in the market are already profitable, new firms will have the
incentive to enter the market
– new entrants will increase the number of firms in the market; supply
increases; price decreases
– at the end of this process, economic profit in the market will be zero;
if there would be a profit higher than in any other sector, more supply
would shift to this sector
– economic profit is zero - i.e. p will equal minimum of average costs
– but: economic profit = accounting profit; economic costs include
opportunity costs of the owner (time, work etc.)
– result: competition drives prices down to minimum average costs
Supply-curve and profit maximisation
42
124
• competition – makes firms produce as cost-efficient as possible (in minimum of
TAC); this makes products as cheap as possible
– makes firms adapt to changes in market data (otherwise you loose
profit and revenue)
– gives incentives for innovation; innovation leads to lower costs /
higher demand; gives you a leading edge on your competitors
– firms are producing according to the wishes of the customers
• Competition needs: – free entry to the market
– property rights (Art. 14 GG)
– many suppliers
– market transparency
Supply-curve and competition
125
Taxes and supply curve
• What happens to supply if we introduce taxes or
social security contributions?
– tax on fixed costs: total costs increase; marginal costs
remain unchanged; average costs increase. AVC-curve
shifts upwards
– taxes on inputs: MC and AC increase; AC-curve and MC-
curve shift upwards
– taxes on profits: cost-curves remain unchanged; marginal
supplier leaves the market
• As we introduce taxes (or social security
contributions), supply decreases and thereby
employment
126
Taxes and supply curve
W TR TC VC AC MC
1 5 110 10 22 22
2 11 120 20 10,9 1,6
3 18 130 30 7,2 1,4
4 27 140 40 5,18 1,1
5 37 150 50 4,05 1
6 45 160 60 3,5 1,25
7 50 170 70 3,4 2
8 54 180 80 3,3 2,5
9 57 190 90 3,3 3,3
10 58 200 100 3,4 10
FC= 100;
wage: 10 € per worker
TR= total revenue
TC = total costs
VC = variable costs
AC = average costs
MC = marginal costs
Now: 20 % tax on
TC (social security
contributions)
43
127
Taxes and supply curve
W TR TC VC AC MC
1 5 132 22 26 26
2 11 144 44 13 2
3 18 156 56 8 1,7
4 27 168 68 6 1,3
5 37 180 80 4,8 1,2
6 45 192 92 4,2 1,5
7 50 204 104 4 2,4
8 54 216 116 4 3
9 57 228 128 4 4
10 58 240 140 4,2 12
FC= 100;
wage: 10 € per worker
TR= total revenue
TC = total costs
VC = variable costs
AC = average costs
MC = marginal costs
Now: 20 % tax on
TC (social security
contributions)
128
0
5
10
15
20
25
30
0 10 20 30 40 50 60 70
Taxes and supply curve
AC-curve before and after taxes
total revenue
AC
129
0
1
2
3
4
5
6
0 10 20 30 40 50 60
Taxes and supply curve
MC-curve before and after taxes
total revenue
MC
44
130
Taxes and supply curve
• Previous analysis: minimizing cost; maximising profits by choosing the adaequate level of output
• Now: minimizing costs by choosing the right combination of production factors
• Basic idea: - use cheap inputs whenever you can; avoid using
expensive inputs
- use inputs which are more productive than others
- balancing costs and productivity of an input: if it is expensive, avoid using; if it is productive, use it
- So: balancing marginal productivity of an input (output per unit input) and its marginal costs
131
Taxes and supply curve
Labour
wage in € 10
output per unit labour 10
capital
Interest in € 5
Output per unit capital 4
Labour
wage in € 10
output per unit labour 8
capital
Interest in € 5
Output per unit capital 4
• Spending one € for work yields one
more unit output
• Spending one € for Capital, yields
0,8 more units of output
• i.e.: employ more workers
• With increasing amount of labour
employed; marginal productivity of
work decreases (from 10 to 8)
• as prices remain unchanged, capital
as an input is becoming more
attractive
132
Taxes and supply curve
• the marginal productivity per Euro
- how do I spent the next Euro if I want a maximum of additional productivity?
- it is not only the price of an input or its marginal produtivity, but the marginal productivity per Euro spent for this input
- as the price increases, MP per Euro decreases. The same productivity is now more expensive
- as MP increases, MP per Euro increases; one should increase the use of this input
• Implications for the labour market?
MP labour MP capital
price for labour Price for capital =
45
133
Case study: productivity-oriented wage policy
„In the conception of the council of economic
advisors, room for higher wages depends on the
marginal productivity of labour. If wages remain
below the increase of the marginal productivity of
labour, one can say that wage policy may help to
boost employment.“
(SVR, 2007)
134
Economics
Session #8:
Monopoly and imperfect competition
Prof. Dr. Hanno Beck
135
Homework: is it Dumping?
• Why should Lufthansa sell below cost price?
– contribution margin: temporarily selling beloe cost price because of
fixed costs
– seasonal/closing-out sales; persihable goods
– marketing strategy to lure in new customers
• But: what about cut throat pricing?
– German competition authority (Kartellamt): Lufthansa is selling tickets
below cost price
– this strategy makes only sense if it is supposed to help to squeeze
Germania out of the market and to raise prices afterwards
– the Kartellamt restrained Lufthansa form charging low prices, because
Lufthansa dominates the market; has enough money to bridge
temporarily losses and the barriers to (re-)enter the market are very
high
46
136
Monopoly and imperfect competition
Monpoly
Other market forms
Competition policy
German antitrust law
137
Monopoly
• Monopoly: only one supplier
• Sources of monopoly power?
- control of inputs (patents; know-how, copy-rights)
- Branding, elasticity of demand
- production function (natural monopolies)
• consequences - consumer: loss of freedom
- Monopolist may gain political power
- loss of efficiency and welfare
- Pricing in monopoly: marginal revenue equals marginal costs
138
Monopoly
q P TR AR MR
1 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
8 3 24 5 -4
9 2 18 2 -6
10 1 10 1 -8
• q = quantity supplied; TR=
total revenue; AR =
average revenue; MR =
marginal revenue
• As quantity supplied
increases, price decreases,
because the monoppolist is
the sole supplier in the
market
• average revenues
represent demand curve
• revenue = q * p
• As q increases, there are
two effects on revenues:
q increases
p decreases
47
139
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
0 2 4 6 8 10 12
Monopoly
Average revenues and marginal revenues
total revenue
AR
MR
p
140
• In monopoly, demand curve
equals average revenue (see
table) because the monopolist
is the sole supplier
• MR is always below demand-
curve (AR) (see table)
• Profit maximisation in
monopoly: marginal costs =
marginal revenues (Cournots
Point)
p
q
MR
Monopoly
demand = AR
141
• Profit-maximisation in
monpoly: first, find point where
MC = MR (where MC-curve
intersects MR-curve)
• Find the quantity qM, where
MC = MR
• Find price corresponding to qM
p
q
pM
demand = AR
MR
MC
C
qM qC
pC
Monopoly
48
142
• Monopolist‘s profit: revenue –
total costs
• revenue: quantities sold *
price (PM • qM)
• Total costs: average costs *
quantity supplied (ACM • qM)
• Profit: ACMpMDC
p
q
pM
demand = AR
MR
MC
C
qM
Monopoly
AC
ACM
D
143
• Compared to perfect
competition (PP):
• Consumer surplus in
monopoly: consumers loose A
plus C
• Producer surplus in monopoly:
monopolist gains A (from the
consumers) and looses B
• Deadweight loss: BC
• Monopolies always lead to a
loss in total welfare
p
q
pM
MC
qM qP
pP
Monopoly
A
B
C
MR
demand = AR
144
• Sources of monpoly power
• Elasticity of demand
– the higher elasticity of demand, the lower the monopolist‘s power
– determinants of the elasticity of the firms demand: product
differentation, marketing, substitutes, branding
• Number of competitors
– the monopoly power of a firms increases as the number of
competitors is decreasing
– the monopoly power of a firms increases as the barriers of entry
increase
• Interaction among firms (collusion vs. competition)
• there are (almost) no perfect monopolies and no perfect
competition. More realistic: Oligopolies and monopolistic
competition
Monopoly
49
145
• Rule of thumb for pricing in a monopoly:
(p – MC) / p = - 1 / ED
• Left side of equation: markup on MC in percent
– perfect competition: ED approaches infinity, so 1/ED
approaches zero. So p = MC; no mark-up on MC possible
due to completely elastic demand
– the smaller ED, the higher is the right-hand side of the
equation,i.e. the higher is the mark-up on MC. Inelastic
demand means high market power
• Re-arrange as a simple price-formula:
p = MC / (1+(1/ED))
Monopoly
146
Other market forms
• Monopoly: demand curve is demand of the whole market
• Oligopoly: few suppliers; strategic interaction between suppliers – Oligopoly I: very few suppliers; acting in concert, maybe even
without explicit communication
– Oligopol II: more suppliers; fierce competition as a result
• Monopolistic competition: demand curve is the demand curve for the product of each supplier – heterogeneous products
– limited market power of every supplier in a narrow range
– branding
– price differentitation
– supplier has a limited degree of market power
• perfect competition: demand curve for the single supplier ist the price, because he has no market power
147
• Competition needs additonal policy to ensure that there is a sufficient degree of competition
• questions: – what is „a sufficient degree of competition“?
– how shall we estimate the market power of a company?
– how shall we define a market (time / product / place)
– how shall we idetify anti-competitive, unfair behaviour?
• Problems of competition policy – Collusion: prohibiting agreements or practices that restrict free
trading and competition between business entities. (e.g. cartells)
– abusive behaviour and anti-competitive practices: banning abusive behaviour by a firm dominating a market, or anti-competitive practices that tend to lead to such a dominant position. Practices controlled in this way may include predatory pricing, tying, refusal to deal and others.
– concentration of market power (takeovers; merger)
Competition policy
50
148
• collusion: negogiations between suppliers aimed to reduce the pressure of competition – horizontal: between competitors
– vertical agreements: between firms at different levels of the supply chain
– acting in concert
• problems: – finding evidence of collusion (smoking gun)
– distinguish between collusion and behaviour resulting from the pressure of competition
• Germany‘s competition law (GWB): horizontal cartells and collusion aimed to restrict competition are forbidden
Competition policy
149
Competition policy
The great vitamin conspriracy In 1999 some of the worlds largest drug companies agreed to pay billions of dollars in damages to customers after being convicted of a huge conspiracy to rig the world vitamin market. The conspriacy began in 1989 when Roche and BASF began secret talks about raising prices for vitamins; soon Rhone-Poulenc and other japanese companies joined. The members of the group met regularly in hotels or private homes to set prices and divide up markets for bulk vitamins mainly sold to other companies (e.g. animal feed makers). The animal feed companies grew suspicious about the prices they were charged, which led to a series of investigations. The case broke down when Rhone-Poulenc made a deal with competition officials in the US to provide evidence about the conspiracy.
150
• abusive behaviour and anti-competitive practices – Germany: the abusive exploitation of a dominant position by one or
several undertakings is prohibited – abusive behavior against competitors and other firms in the supply
chain
• examples: – price discrimination: dominant firm demands payment or other
business terms which differ from those which would very likely arise if effective competition existed;
– predatory pricing: a company offers goods or commercial services not merely occasionally below its cost price, unless there is an objective justification for this
– boycott: small firms depend on one single supplier / buyer (Uhren-Krämer / Seiko; adidas)
– exclusive commitments and contracts: (Meto-Handpreisauszeichner)
• Problems: definition of dominant position and abusive behaviour versus regularly business policy
Competition policy
51
151
Competition policy
Uhren-Krämer versus Seiko
Seiko, a manufacturer of watches, refused to
deliver his watches to Uhren-Krämer (Berlin). Krämer
went to courts and accused Seiko of unfair hindrance:
Seiko refused deliverey because Krämer did not commit to the
price recommended by Seiko – if he would stick to this price,
Seiko would deliver the watches. Seiko had a market share of 75
percent in Berlin
Adidas versus SB-Kauf
Adidas refused to deliver his products to SB-Kauf (who intended
to sell the shoes with a large discount) and claimed that it intended
to have its shoes only sold by specialty stores. The cartell
authorities recognised adidas as market-dominant company.
152
Homework: T-Mobile and the I-Phone
No I-Phone in Australia? Queensland University of Technology (QUT) law
researcher Dale Clapperton has questioned whether
Apple could release the I-Phone in Australia under the
same conditions that has seen it locked to a single carrier
in the US, UK, Germany and France. That said, an appeal
was placed in Germany by Vodafone to force Deutsche Telekom to offer
an unlocked version, but this was successfully challenged in court.
Customers will now only be able to buy the phone for a 399-euro offer
with a binding two-year contract. After two years, users can have the
iPhone unlocked so they can switch to other providers, T-Mobile said.
The French I-Phone can be purchased in an unlocked configuration, but
can reportedly only be used with SIM cards from other French
companies – not any SIM from any carrier worldwide.
Is it abusive behaviour if Apple refuses to deliver the I-Phone to
other telecoms? What do you think about the french solution?
153
• Better than preventing dominant companies from abusing their power: preventing the rise of a dominant market position
• Internal and external growth may lead to a dominant market position
• concentration
– Horizontal,
– vertical or conglomeral
• policy:
– control of concentrations (supervising mergers and acquisitions)
– breaking up market-dominant firms
– supervising market-dominant firms
Competition policy
52
154
German competition law
Hertie und Karstadt
In 1993, the largest department store Hertie
took over the third-largest department store,
Karstadt. The cartell authority approved the
merger; although the number of department store-chains
in Germany was being reduced to two. The authority found
evidence for market-dominance only in some local areas; but it
said that department stores compete also with local specialised
stores. Competition would be only reduced in some special areas.
So Hertie had to sell only some lines of business (for examples the
sale of records in Kiel)
155
German competition law
• Act against restraints of competition (GWB) is made of three parts – #1: Prohibition of agreements restricting competition (cartels)
– #2:market dominance, restrictive practices
– #3: control of concentrations
• Enforcement: cartell authority (Bundeskartellamt)
• European competition law (Art. 81, 82 EG-treaty) – restrictions of competition are forbidden if they affect the trade
between member states of the European community
– national law applies as long as the trade between community members is not affected
– primary competence for applying EU competition law rests with European Commission and its Directorate General for Competition
– public procurement: state aid, control of direct and indirect aid given by EU Member States to companies (Article 87 EC)
156
German competition law
• GWB #1: Prohibition of agreements restricting competition (cartels) – horizontal cartells and collusion aimed to restrict
competition are forbidden
– vertical contracts are forbidden if they restrict one of the parties of the contract in closing other contracts with third parties
– this applies to an acting in concert even if there is no contract
– exemption permits for some cartells and cooperation of small companies
53
157
German competition law
• GWB #2: control for market dominance and abusive behaviour: abusive behaviour is forbidden
• market-dominant companies: – if 1 (3 / 5) companies share 33 (>50 / 66) percent of revenues in
the relevant geographic market
– relevant geographic market: elasticities of demand and supply
• abusive behaviour – predatory pricing: prices differ from what you expect them to be
with competition (rebates, price discrimination)
– restrictive practices: market-dominant companies restrict possibilities / opportunities of customers or stakeholders
158
German competition law
• GWB #3: Control of concentrations to keep markets
competitive; acting before a market-dominant company
rises
• Principles – the provisions on the control of concentrations shall apply if in the
last business year preceding the concentration: 1. the combined
aggregate worldwide turnover of all the undertakings concerned
was more than EUR 500 million, and 2. the domestic turnover of
at least one undertaking concerned was more than EUR 25
million.
– a concentration which is expected to create or strengthen a
dominant position shall be prohibited unless the companies
concerned prove that the concentration will also lead to
improvements of the conditions of competition and that these
improvements will outweigh the disadvantages of dominance
159
Economics
Session #9:
Game theory
Prof. Dr. Hanno Beck
54
160
Hausaufgabe: No I-Phone in Australia?
• To find out wheter Apple is involved in abusive behaviour one must ask for a dominant market position and restrictive practices
• Dominant market share: – not, if the relevant market ist the market for mobile
communication. There are enough substitutes
– Apple has market power: its brand. Do we need to protect brand-addicted customers by law?
– but: may Apples brand lead to a reduction in competition on the market for mobile communication?
• restrictive practices – if Apple has market-dominance, the fact that Apple is selling its I-
Phone only locked to a singel carrier points towards the direction of abusive behaviour
– is the tariff for the I-Phone above other prices?
– the user is locked to the carrier for two years – does this reduce competition in the long run?
161
Game theory
Oligopoly
Prisoners Dilemma
Sequential games
Repeated games
162
Oligopoly
• Oligopoly: a market where only a few firms compete with each other and entry by new firms is impeded due to barriers of entry – scale economies
– patents, technology, branding
– Entry deterence
– Airlines, cigarettes, aluminium, automobile industries
• Because only a few firms are competing, all decisions involve important strategic considerations – each firm must take in account how competitors may react to a move (compete, collude)
• An example: the OPEC-Cartel
55
163
• The market for gasoline – homogenous Produkt; one can only differentiate through the price
– only a few suppliers; every move of every suppliers is visible to his competitors
• First idea: Cartel. Producers decide to collude and to maximize joint profits by charging to monopoly-price (total MR of all firms = Total MC); e.G. OPEC. Problem: every member of the cartel has an incentive to charge a lower price („cheating“)
• Second idea: price war; this may lead to parallel moves of the price each competitor charges
• evidence: prices for gasoline tend to be cointegrated; i.e. they move together – does this mean that there is tacit collusion or fierce competition?
Oligopoly
164
- Iran and Iraq agree on a cartel
- If both of them co-operate, each of them receives 50
- In case of a price war, each of them receives 40
- if one co-operates while the other one cheats, the pay-off is 60 for the cheater and 30 for the other contract party
- result: both countries will cheat
- (collude, collude) would make both countries better off
Oligopoly
cooperate Cheat
cooperate 50, 50 30, 60
cheat 60, 30 40, 40
Iraq Iran
pay-off Iraq pay-off Iran
165
Oligopoly
• A game is a situation in which the participants (players)
make strategic decisions
• strategic decisions: decisions that take into account the
actions and responses of the other players
• strategic decisions result in payoffs to the players; i.e. the
outcomes of the decisions
• strategy: a rule or plan of action for playing the game
• optimal strategy: maximise the expected payoff
• If I assume that my competitors (the other players) try to
maximise their payoffs, how shall I take their behavior in
account when making my decisions
• OPEC-example: both players have a dominant strategy
• most famous example: prisoners dilemma
56
166
- after a robbery, A and B are caught by the police
- Police may arrest them for one year for a minor offence (illegal posession of weapons); not for the robbery
- Police offers a separate deal to A and B: if one confesses while the other one denies; his charge will be dropped. The other one who remained silent gets 20 years
- if A and B confess, each of then gets 8 years
- result: both of them will confess
Prisoners Dilemma
deny confess
deny 1, 1 20, 0
confess 0, 20 8, 8
B. A.
167
Prisoners Dilemma
• In this game, „confess“ is a dominant strategy: no matter what the other players does, it is the best strategy. I‘m doing the best I can no matter what player #2 does
• Examples of prisoners dilemma: - collusion; price wars; advertising wars
- Military spending
- Sports owners and players
• Not every game has dominant strategies
• Dominant strategies: I‘m (you) doing the best I can no matter what you (I) do
• Nash equilibrium: I‘m (you) doing the best I can given what you (I) are doing
• Domimant strategies are special cases of Nash equilibria
168
Prisoners Dilemma
crunchy sweet
crunchy -5, -5 10, 10
sweet 10, 10 -5, -5
B. A.
- Two new variations of a breakfast cereal can be introduced
- but market volume is only enough for one company
- each company can only introduce only one new product
- each firm is indifferent which procuct to introduce – as long as it is not the same product as its competitor
- what if the companies must behave noncooperatively?
- two Nash-equilibria
57
169
Prisoners Dilemma
• Further applications
– Competition between suppliers: price wars, advertising,
investment decisions
– sports: Americas Cup – if you are in the lead, you should
behave like the boat which is right behind you
– hostages and hijacker: one person must start the attack
– coordination between parties (battle of sexes)
– threats (Dr. Seltsam)
– Tying ones hands
• Not every game is a zero-sum-Game (like in sports)
• Competition is not a zero-sum-game as soon as you
think about the consumers
170
Prisoners Dilemma
• Strategic move: an action that influences the behavior of the other player in a manner favorable to oneself
• commitment: you commit yourself for the future in order to change the behaviour of your counterparty; threats or commitments; constraining the partners choice by constraining own behavior
• Types of commitments and threats: – public commitment – Give power to a third party („Dr. Strangelove“) – Probabilistic threat (Kuba-crisis) – building up reputation (central banks; newspapers)
• examples: – Xenophon and the conquistadoras: burn your bridges behind
you – most favorite nation-principle: each customer gets the same
price what makes it impossible to re-negogiate
171
Homework: threads and commitments
Ice cream wars
You are the owner of the only ice-cream-parlor in
town, but now a new competitor plans to enter the
market. If he enters, you could lower prices, thereby
lowering your profits from 200 to 70. Instead of lowering prices,
you could still charge a higher price a loow your competitor to
enter the market – this would make your profits drop from 200 to
100. If your competitor enters the market, there are two possible
scenarios: you lower your prices – this will make him loose 10. If
you don‘t start this price war and charge high prices, his profits
will be 20. If you lower your prices and he keeps out of the
market, your profits drop to 130.
Will your competitor enter the market? If yes, why?
58
172
Prisoners Dilemma
right corner left corner
right corner -, + +, -
left corner +, - -, +
you
Kahn
- Which strategy should a football player choose to shoot a penalty?
- as soon as the player applies a certain pattern (RRLLRR) he will loose in the long run, as soon as the goalkeeper finds out about this pattern
- better strategy: flipping a coin, i.e. equilibrium in mixed strategies
- mixed strategy: strategies in which players make a random choice among possible actions based on a set of chosen probabilities
173
- Two new variations of a breakfast cereal can be introduced; but one cereal yields a higher revenue than the other
- without coordination this game has no single solution – as long as both players must act at the same time
- both companies would like to produce „sweet“ – as long as the other party does not produce it
- solution: sequential game; extensive form of a game
Sequential games
crunchy sweet
crunchy -5, -5 10, 20
sweet 20, 10 -5, -5
B. A.
174
- now: solving the game from the end
- if firm B reacts first, it has a first-mover-advantage
- what can A do to get the first-mover-advantage?
- but sometimes there may be first-mover-disadvantages: if you are in the lead in a game-show, you should always mimic the strategy of your competitor
- Here: buying machinery, launching an expensive advertising campaign – self commitment
Sequential games
sweet crunchy sweet crunchy -5, -5 20, 10 10, 20 -5, -5
A A
sweet crunchy
B
59
175
produce no
production
produce -10, -10 100, 0
no production 0, 100 0, 0
Boeing
Airb.
#1
produce no
production
produce -10, 10 100, 0
no
production 0, 120 0, 0
Boeing
Airb.
#2
Sequential games
- Commercial aircraft market has large economies of scale
- It is only economical for one firm (Airbus or Boeing) to produce a new aircraft
- In game #1 there is a clear first-mover-advantage
- Now: EU commits itself to a subsidy of 20 to airbus if it produces the plane regardless what Boeing does (#2)
- Now Boeing surrenders
- EU has shifted profit from the US to Europe
- But: what about retaliation measures by the US-Government?
176
Repeated games
• Repeated games: playing the same game several times
• Repeated games help you to learn about your competitor and his strategy; they help you to built up a reputation
• How can you built up a reputation as a trustworthy rival?
• Best solution: tit for tat. • collude as laong as the other player colludes; defect as soon as he
defects. TfT: eye for an eye
– as long as the game is infinitely repeated, it does not pay out for your competitor to cheat; cumulative loss will outweigh short-term gain
• Finite number of repetitions: equilibrium is defect right from the start (Eddy Murphy)
• In these games, reputation is everything – as a competitor
– as government / central bank
– as boy/girlfriend
177
Economics
Session #10:
Why we need governments
Prof. Dr. Hanno Beck
60
178
- The threat of a price war is not realistic, because charging a high price is a dominant strategy
- but you may change your strategy if you believe that there are more competitors to come – repeated game
- in this case, it may pay off to built up a reputation as a loggerhead who is willing to sacrify profits just in order to keep other competitors away from your market
- but: do you have the financial strengh to built up this reputation?
Homework: Ice cream wars
enter Stay away
high price 100, 20 200, 0
Low price 70, -10 130, 0
you comp.
179
Why we need governments
Market failure
Public goods
Quasi-private goods
Network externalities
180
Market failure
• Two types of market failure
– Price mechanism does not work (economic market failure)
– the outcome of the market is not accepted by politics or society (political market failure)
• Market failure is caused by – Public goods
– externalities
– networkexternalities
– social security and redistribution
– Merit goods (quasi-private goods)
– politics
61
181
- Nonrival goods: for any level of production, the MC of providing it to an additional customer are zero (lighthouse)
• Nonexclusive goods: people
cannot be excluded from
consuming it. As a
consequence, one cannot
charge them for using it. This
gives a free rider problem
(lighthouse, defense)
• How many public goods shall
the government privide? How
do you estimate the
willingness to pay for public
goods?
Public goods
exclusive non-exclusive
rival clothes, food
private goods
environment
road
Non-
rival
environment
TV
highway
army;
lighthouse
public goods
NR
NE
182
Quasi-private goods
• Idea: one has to protect people from themselves (alcohol, cigaretts) or support „good“ things (arts, public broadcasting)
• This is not a economic issue; government intervenes because it does not accept the result of the market mechanism; the price machanism is not disturbed
• goods like alcohol and cigarettes are taxed to reduce consumption; goods like arts or braodcasting are subsidized
• questions: - who decides what is „good“ or „bad“
- paternalism: what if you want to drink / smoke; what if you don‘t like public broadcasting?
- quasi-private goods are a good playground for bad politics
183
Merit wants : Public broadcasting
• Public broadcasting: wrong arguments
– Public broadcasting is not a public good
– Public broadcasting is not natural monopoly anymore
– Political education by public brodcasting = externality
– information is an experience good; but this problem is solved by
reputation
• What about the quality of private broadcasting?
- bribemoney; masked advertising: ARD
- competition and reputation prevent private broadcasters from doing a
bad job; do public broadcasters have to face competition, too?
- Lower-class-TV: spot the difference (GZSZ or „Marienhof“?)
62
184
Homework: public broadcasting and the Internet
Do we need a public broadcaster in the Internet?
The ARD (Consortium of public-law broadcasting
institutions of the Federal Republic of Germany),
is a joint organization of Germany's regional public-service
broadcasters. Together with ZDF, the secod large public
broadcaster, almost 8 bn. Euro per year are spent for public
broadcasting in Germany. The fact that ARD (and also ZDF) uses
license fees to subsidize their World Wide Web sites, and also the
non-transparency of their license fee expenditure, is the topic of an
ongoing controversy with the European Union. Public broadcasters
im Germany are spending 52,5 mn. Euro per year on the internet.
Do you think we need public broadcasting in the internet?
185
Network externalities
• Example of an network externality: telephone
• Network externality: the more people use a good, the higher the utility derived from this good for all users
• This is a so-called externality: as A buys a telephone, the utility of the telephone increases for B (who has a telephone, too) – but B has not to pay and A does not care
• Network externalities work like an epidemic; you need a critical mass to start with
• Further examples – E-bay; parship
– standards: VHS; TCP/IP; qwerty
– software (Microsoft)
– broadcasting
• network externalities may cause problems
186
Network externalities
• First-Mover-advantage („gorilla“): in case of a standard, the
winner takes it all. Winner will be the first mover, not
necessarily the best technology (see VHS vs. Video 2000)
• Problem #1: lock-in of an inferiorer technology (qwerty-
problem)
• Problem #2: the winner may exploit the market after
• Problem #3: the winner may extend his market power to other
markets (Explorer; Media Player)
• solutions:
– more competition
– license agreements
– nationalization
63
187
Economics
Session #11:
Externalities and environmental
policy
Prof. Dr. Hanno Beck
188
Homework: public broadcasting and the Internet
• The case for public broadcasting in the internet: – public broadcasting on TV and radio is threatened by the
increased use of the internet – who will be watching TV in 20 years?
– Information-chaos at the internet; public broadcasting as a torch of information in the night
– better quality of public broadcasting-information on the internet
• The case against public broadcasting in the internet – does the internet need one more broadcaster?
– enough information on the internet
– private broadcasters are threatened by a public subsidized competitor
– is the internet-user that stupid – or is he able to distinguish between „good“ and „bad“ information“?
• One question remains: why is there no subsidized newspaper?
189
Externalities
Externalities
Public policies
International policy
Property rights
64
190
• Some daily problems: – your room-mate is heavy smoker
– your neighbour is addicted to black-metal-records
– you are living near a chemical factory
• what have these problems in common? – person A is harmed by B
– A is not compensated by B
– the costs of A are not included in the calculation of B
– B gets all the benefits from his doing; he does not care about the costs imposed to A
• Externality: the uncompensated impact of one person‘s (company‘s) action on the well-being of a bystander
Exernalities
191
• What is the problem? Society‘s interest extends beyond the well-being of
buyers and sellers; it also includes the well-being of bystanders being
harmed by the actions of buyers and sellers. The person causing the
externality does not take it into his private calculation; therefore he
consumes (produces) too much (or too less)
• negative externalities: pollution
– companies don‘t care about the costs imposed to the environment
– consequence: to much production (consumption) of a good
• positive externalities: a shot aginst the flu
– if you are considering to take a shot against the flu, you don‘t care about the
positive effects on your neighbour
– More people should take a shot against the flu
• To reach a social optimum, the person causing the damage must include
the damage done to the bystanders into his private calculation
Exernalities
192
• Supply does not take include social costs of pollution into his calculation
• Social costs of production are private plus social costs; for society as a whole, SS is the supply-curve that represents total costs of production
• producing at pp,qp: the marginal social
costs of production are higher then
the marginal benefit, represented by
the demand curve
• Each unit produced above qp brings
more social costs than benefits to
consumers
• Source of inefficieny: price p reflects
only the private cost of production, not
the social costs (i.e. the cost of
pollution) • ABC – loss of welfare
p
q
Exernalities
D S SS
qP qS
PP
PS
A
B
C
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193
• To reach a social optimum, one has to reduce (increase)
consumption (production) of goods with negative (positive)
externalities
• Private solutions to externalities
– social pressure, moral codes, sanctions
– Acting up, charities (e.g. Greenpeace)
– private contracts (Coase Theorem)
• Public policies
– regulation
– taxes and subsidies
– Tradable pollution permits (Kyoto)
Exernalities
194
• Pigou-taxes: taxing activities that have negative externalities; changing the price; shifting supply-curve upwards
• Emissions standard: a legal limit on how much a firm can emit (changing q)
• a standard offers more certainty about the level of emission
• tax: leaves it up to each company how much to abate – it takes in account the different marginal costs of abating that every company has
p
q
Public policies
D
S SP
qP qS
PP
PS
S
195
• When marginal social costs of pollution are high and marginal costs of abating are low, the costs of reducing emissions is not high – but the cost of not avoiding emissions may be high
• Standard: ensures that a certain amount of emissions will be reduced (but to which costs?)
• Tax: offers certainty about the level of abatement costs; but leaves the level of redcution uncertain
• Taxes are more efficient, standards are effective
• Can we combine both instruments to ensure the level of reduction with more effiency?
Public policies: taxes vs. standards
66
196
• Springfield has two
factories: Simpson Corp.
und Burns Inc.
• Both of them emit 5 tons
carbon dioxide per day
• Companies have different
production functions and
cost functions
• The local council estimates
the social costs of pollution
in € (s. table)
Public policies: tradable pollution permits
tons dioxide damage in €
2 30
4 40
6 60
8 106
10 155
Marginal external costs of pollution in Europe:
one ton SO2 causes in a city with 100,000
inhabitants 6000 Euro costs (Europäische
commission DG environment, Benefits table
database: Estimates of the marginal external
costs of air pollution in Europe)
197
Public policies: tradable pollution permits
Simpson Inc. Burns Corp. total
t costs MC costs MC t social
costs
total
costs
1 240 50 130 35 2 30 400
2 190 40 95 20 4 40 325
3 150 30 75 15 6 60 285
4 120 20 60 10 8 106 286
5 100 50 10 155 305
198
• The Council declares that emissions have to be reduced
by 4 t
• Standard: both companies have to abate 2 t; total costs of
abatement: 75 (50 Simpson; 25 Burns)
• tradable permits: each company is allowed to emit 3 t
- Burns is willing to emit 2 t instead of 3 t, as long as Simpson pays
at least 20 €. Simpson is willing to pay max. 30 €
- Burns is willing to emit 1 t instead of 2 t, as long as Simpson pays
at least 35 €. Simpson is willing to pay max. 20 €
- Burns abates 1 t and sells it to Simpson for 20 - 30 €
• Total emission: Simpson 4 t, Burns 2 t = 6 t
• Total costs of abating: 20 € Simpson, 45 € Burns
• Tradable emission permits
Public policies: tradable pollution permits
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199
• Government decides how much pollution is allowed
• Each permit specifies a number of emissions that a firm is allowed to put out
• Permits are allocated among firms; the total number of permits represents the total amount of emissions allowed to put out
• Permits are marketable: they can be bought and sold
• Marginal costs of abating for 1 t > price for 1 t Emission buy emission permits
• Marginal costs of abating for 1 t < price for 1t Emission sell emission permits
• This leads to one conclusion: the price of a tradable emission permit will equal the marginal costs of abating
Public policies: tradable pollution permits
200
Public policies: tradable pollution permits
• How many rights shall be granted to the economy? E.G.: Reclaim (Regional clean air incentives market) in california failed because too many rights were granted
• How shall the rights be granted? – auctions: additional revenues / costs
– grandfathering: early action advantage
• How shall new entrants be treated?
• Period of validity?
– short: flexibility
– long: longe-range planning
• Area of validity: avoidance of „hot spots“
201
International policy
• USA: – 1974: emission trading program to reduce lead in fuels. 1987: fuels
are completely lead-free
– Acid rain program: trading in nitrogen-emissions (SO2); amount of
certificates granted to companies reduced every year
reduction of SO2 40 % above target
– Reclaim (Regional clean air incentives market) in California failed.
Reason: to much emission rights were granted; no incentives to
reduce emission of GHG
• World: Kyoto protocoll – Emission trading between indutrialized countries from 2008 on
– Industrialized countries agreed to reduce emission of green house
gas (GHG) from 2008 until 2012
– next step: Bali-Conference
68
202
• The Kyoto Protocol is protocol to the international Framework Convention on Climate Change with the objective of reducing greenhouse gases in an effort to prevent anthropogenic climate change
• As of May 2008, 182 parties have ratified the protocol. 137 developing countries have ratified the protocol, including Brazil, China and India, but have no obligation beyond monitoring and reporting emissions. Kyoto mechanisms: – emissions trading (carbon market) – the Clean Development Mechanism (CDM) allows a country with an
emission-reduction or emission-limitation commitment under the Kyoto Protocol to implement an emission-reduction project in developing countries. Such projects can earn saleable certified emission reduction (CER) credits
– joint implemetation: similiar mechanism for eastern-european countries
International policy
203
Property rights
factory fisher total
nF; nT 500 100 600
F; nT 300 500 800
nF; T 500 200 700
F; T 300 300 600
• a firm dumps its effluent in a
river, which reduces the catch
of fish
• Two options: filter system or
treatment plan
• Factory has to pay the filter,
treatment plan must be paid by
the fishermen
• Depending on the combination
of filter and treatement plan,
the factory and fishermen yield
different profits
• what happens if we allocate
property rights?
nF: no filter
F: filter
T: treatment plan
nT: no treatment plan
204
Property rights
factory fisher total
nF; nT 500 100 600
F; nT 300 500 800
nF; T 500 200 700
F; T 300 300 600
• #1: the factory owns the river; it
has the right to polute
• T gives the fischermen only
additional profit of 100
• Fischermen are willing to pay
300 to the factory if it uses a
filter
• if the fishermen have to pay
more than 300 for the filter,
nF;T becomes more attractive
(500 profit – 300 costs of filter)
• the company demands at least
200 for using a filter
• Result: fischermen pay at least
200 to the factory which uses a
filter
nF: no filter
F: filter
T: treatment plan
nT: no treatment plan
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205
Property rights
• #2: fischermen own the river;
they have the right to demand
from the factory to use a filter
• Factory is willing to pay 200 to
the fischermen if they install a
treatment plan
• fischermen demand at least
300 for installing a treatment
plan; F; nT yields 500; nF;T
yields only 200
• result: factory installs a filter
factory fisher total
nF; nT 500 100 600
F; nT 300 500 800
nF; T 500 200 700
F; T 300 300 600
nF: no filter
F: filter
T: treatment plan
nT: no treatment plan
206
Property rights
• Other possibility: suing for damages
• Fishermen are given the right for clean water
– if the firm does not install a filter, it harms the fishermen (damage =
400$); therefore fishermen can sue for 400$. Profit to firm: 500$ -
400$ (fine)
– firm installs a filter; profit: 300$
– firm will install a filter
• Factory is given the right to emit effluent
– fishermen have the right to ask firm to installing a filter, but they
have to compensate the firm
– treatment plan makes a profit of 200
– ask firm to install a filter (and pay for damage) makes a profit of
300 = 500 – 200 (compensation)
– no treatment, no filter makes a profit of 100
– fishermen will pay a filter to firm
207
Property rights
• Coase-Theorem: if private parties can bargain without costs over the allocation of ressources, then the private market will always solve the problem of externalities and allocate ressources efficiently
• The initial distribution of rights does not matter for the ability of the market to reach an efficent outcome
• but: the distribution determines the allocation of economic well-being
• Externalities rise due to a lack of property rights • problems
- transaction costs - what about the coordination of the parties involved? - Distribution of economic well-being is affected by the
distribution of the property rights
70
208
Homework: don‘t marry, be happy
Trouble in Disneyland
Donald and Daisy are married; Micky and
Minnie are married, too. The ladies want to get rid
of their men and file in for diverce. Donald (Micky)
is willing to pay 20 (10) bucks to avoid a divorce.
Daisy (Minnie) is willing to pay 5 (15) Taler for getting divorced.
Assume that Minnie / Daisy may pay compensation to Micky /
Donald – what will happen if both of them partners have to agree to
get divorced? What, if one partner can file for divorce and his
counterpart may payahim for stepping back from the divorce?
209
Economics
Session #12:
Social Market Economy
Prof. Dr. Hanno Beck
210
Hausaufgabe: don‘t marry, be happy
Ducks Mouse
She pays for
divorce
5 15
He pays for not
divorce
20 10
No matter who owns the right
to file divorce, the results are
always the same: the Ducks
get not divorced; the Mouses
get divorced
• Family Duck:
- if one partner can file for
divorce, Donald is willing to pay
up to 20 for not getting divorced;
Daisy accepts
- if both partners are to agree,
Daisy is willing to pay up to 5 for
getting divorced, Donald will not
accept
• Family Mouse:
- if one partner can file for
divorce, Mickey is willing to pay
up to 10 for not getting divorced,
Minnie disagrees
- if both partners are to agree,
Minnie is willing to pay up to 15
for getting divorced, Mickey will
accept
71
211
Social Market Economy
Social Market Economy
Health insurance
Pension System
Poverty and inequality
212
Social Market Economy
• German „Ordoliberalismus“ (W. Eucken, A. Müller-Armack,
L. Erhard et al.) during the 1940’s and 50’s.
• Basic idea: combine the efficiency of free markets with social
justice – enforced by government policies.
• “Design” of an economic system which is efficient and
humane at the same time.
• Key elements: Free and open markets, private property,
antitrust policy, income redistribution
• Principle of subsidiarity: individuals and families should try to
solve their problems themselves - only where they are
unable to cope with their problems shall government help.
• Principle of non-distorted prices: if the government
intervenes, it should not change prices
213
• Basic idea: free markets first, but additional policy to correct for market failures – social policy
– externalities; public goods
– redistribution; quasi-private goods
• Basic framework – Property rights, freedom
– competition policy against monopolies and collusion
– tight money; open economy
• How to intervene if the results of the market mechanism are not accepted by policy / society? – Regulatory framework (Ordnungspolitik): setting a framework with
proper incentives
– intervention: principle of non-disorted prices
Social Market Economy
72
214
• The problem with cheap housing: people need an
affordable home
– bad ideas: rent ceilings; subsidies for appartments
– SME: direct transfer to needy people, financed by taxes
• Minimum wages: what if you can‘t make a living from your
job?
– bad idea: minimum wage distorts price mechanism
– SME: let the markets determine the wages; if your income is too low
to make a living, you may get a transfer (negative income tax)
• Basic idea: direct payments to the needy; financed by taxes
(i.e. by everyone) instead changing the price mechanism
Social Market Economy: applications
215
Homework: planned economies
Lets give communism another chance?
A planned economy or directed economy is an economic system in
which the state or government manages the economy. Its most
extensive form is referred to as a command economy, centrally
planned economy, or command and control economy. In such
economies, the government controls all major sectors of the economy and
formulates all decisions about their use and about the distribution of income. The
planners decide what should be produced and direct enterprises to produce those
goods. Important planned economies that existed in the past include the economy
of the Soviet Union, China and India, prior to its economic reforms in 1991 .
Beginning in the 1980s and 1990s, many governments presiding over planned
economies began deregulating (or as in the Soviet Union, the system collapsed) and
moving toward market-based economies by allowing the private sector to make the
pricing, production, and distribution decisions. Today, planned economies exist in
some countries such as Cuba, North Korea, and Burma.
How would you plan an entire economy? What are the problems of a planned
economy?
216
Health insurance
• Why do we need health insurance? – some therapies are way far to expensive to pay them from your
income
– When you are 20, do you think about the cures you may need when you are 60?
– weakness of will
– Hoping on a bail-out by the government
• problems of a health insurance – moral hazard: you may change your behaviour as soon as you are
insured (own participation necessary)
– Lack of information of the insured
– the doctor may maximize his income in expense of his patients (see cab driver-problem)
– adverse selection: only those who are in need of an insurance buy one; this makes the insurance expensive
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217
Health insurance
• increase contribution rates
• increase wages
• Increase number of insured persons: abolish private insurance schemes
• Less services
• reduce price of services
- price prescriptions
- more competition
- managed care
revenues = expenditures
contribution*wage* insured persons = services*price
218
Pension System
• Why do we need a pension system?
– when you are 20, do you think about your pension you‘d
like to have when you are 60?
– weakness of will
– Hoping on bail-out by the government
– lack of information, complex topic (finance)
• Pension system in Germany
– public pension system: pay-as-you-go system
– private pension schemes: Riester; Rürup
– corporate pension systems
– Versorgungswerke (lawyers; medicians)
219
generation 1 generation 2 generation 3
generation 0 generation 1 generation 2
contribution
pension pension pension
claims claims
Pension System: Pay-as-you-go
contribution
74
220
Pension System: Pay-as-you-go
• Pay-as-you-go can be started immidiately (war)
• implicit governmental debt
• Bad demographics and unemployment are threatening
this system
• redistribution on the expense of later generations
• winner: generation #1; old people
• looser: generation #x; last generation (at least one
generation has to pay the debt of the first generation )
• it is extremely dificult to shut this system down
• Pay-as-you-go is not a contract; not a so-called
generation-contract („Generationenvertrag“)
221
Pension System: Pay-as-you-go
• Increasing contribution rates leads to more unemployment
• increase wages: one must create more employment
• Increase # of insured persons: e.g. self-employed persons; problem:
this policy also increases the number of pensioners
• pay smaller pensions: smaller pension; later payments („pension at 67“)
• Federal subsidies, payed from taxes
• switch from pay-as-you-go to capital-based pension system
• more kids: no solution, because this will increase the number of
pensioners
revenues = expenditures
contribution*wage*#insured persons = #pensioners*pension
222
Poverty and inequality
• Social policy: markets only provide eficiency and income
according to achievement;
– extreme poverty: hunger and homeless persons
– relative poverty: poor compared to average living standards
– poverty as equality of chances
• redistribution
– as normative policy
– social inequality may cause political and social problems
• Redistribution of: income; wealth; chances
• problems:
– time dimension: students are poor, too
– definition of poverty
– Poverty trap: marginal tax rates of 100 %
– incentives and fairness
75
223
Poverty and inequality
• Definition of poverty in the EU: 60 % of the average income – shows only the amount of inequality, not poverty
– if all incomes increase, „poverty“ remains the same
– Why 60 %?
• Gini-coefficient: shows distribution of income – Lorenzcurve: how many people in % have how many % of
total income?
– Gini-coefficient: 1 = one person has 100 % of the income; 0 = every personhas exactly the same share from total income
• source: federal report on poverty and inequality
224
Poverty and inequality
0
0,05
0,1
0,15
0,2
0,25
0,3
0,35
0,4
0,45
0,5
1991 1994 1997 2000 2002 2004Gini-Coefficient market income and net income in Germany
1991 – 2004
Quelle: Sachverständigenrat 2007
225
Poverty and inequality
• What makes poor people poor – divorce; children with only one parent
– Long-term unemployment
– no education
– parents
• What determines the distributon of incomes? – Economic cycle; labour market
– self-employment
– „Agenda 2004“: the reduction of unemployment among low-skilled workers led to a reduction of average wages
• What determines the distributon of wealth? – interest rates; if you are wealthy you have more possibilities to
manage your portfolio
– real estate prices
– pension system
– parents