Download - MBA Economics Copenhagen 21 – 24 May Associate Professor Ivar Bredesen Copenhagen 21 – 24 May Associate Professor Ivar Bredesen.

MBA EconomicsCopenhagen 21 – 24 May

Associate Professor Ivar Bredesen

Copenhagen 21 – 24 May

Associate Professor Ivar Bredesen

Economics December 2002

Case studyExpanded model of income determination

Essay questionsEssay 1: Economic efficiency

Essay 2: Fiscal and monetary policy, the ISLM-model

Economics June 2002

Case studyMarginal productivity theory, factor demand

and factor rewards


Essay 2: Macroeconomic theory and policy

Economics December 2001

Case studyPrice theory, prices and income

Essay questionsEssay 1: Economic efficiency and

economic circulation

Essay 2: Macroeconomic theory, multipliers and subsidies

Economics June 2001

Case studyEfficiency, consumer demand

Essay questionsEssay 1: Economic efficiency, factor

demand and factor rewards


Economics A

Case studyPrice theory, monopoly


Essay 2: Fiscal policy, the ISLM-model

Economics B




Economics C

Case studyPrice theory, prices and revenue



Economics D

Case studyCosts and supply, equilibrium

Essay questionsEssay 1: Theory of supply


Economics E



Essay 2: Fiscal and monetary policy, the ISLM-model, open economy macro-economics

Economics F

Case studyTheory of costs, capital budgeting

Essay questionsEssay 1: Economic theory, definitions


My advice would be…

In the microeconomics section, you need to be thoroughly familiar withSocial efficiency

Theory of price determination

In the macroeconomics section, you need to masterThe ISLM-model (which incidentally sums up

many other chapters in this section)

Social efficiency

The purpose of the economic system is to allocate the scarce resources of the economy to the production of goods and services for the use of individuals. This allocation should be done efficiently

In his Manuel D`Economie Politique (1906) Pareto laid down some marginal conditions that must be satisfied if economic efficiency is to be avoided.

Pareto optimumhttp://cepa.newschool.edu/het/essays/paretian/paretocont.htm

A Pareto optimum is defined as a state of affairs such that no one can be made better off without at least one other person being made worse off

A change in the use of resources is said to constitute a Pareto improvement if at least one person if at least one person is made better off without anyone being made worse off

Pareto optimum

Three basic conditions must be satisfied if Pareto efficiency is to be attainedEfficiency in the use of outputs in

consumptionEfficiency in the use of inputs in

productionEfficiency in matching production to

consumption

Rational choices

In economics, we define a rational person as a person who will choose to do an activity if the gain from so doing exceeds any sacrifice involved.

In other words, whether as a producer, a consumer or a worker, a person will gain by expanding any activity whose marginal benefit (MB or MU) exceeds it marginal cost and by contracting any activity whose marginal costs exceeds its marginal benefit. Only when MB = MC can no further gain be made.

Private and social efficiency

When MU = MC, we have private efficiency. In the absence of externalities, private costs and benefits match social costs and benefits

Why is social efficiency achieved: If MU > MC, there would be a Pareto improvement if

there was an increase in the activity. For example, if the benefit to consumers from additional production of a good exceed the cost to producers, the consumers could fully meet the cost of production in the price they pay, and so no producer loses, and still there would be a net gain to consumers. Thus society has gained.

Social (economic) efficiency

Economists argue that under certain conditions the achievement of private efficiency will result in social or economic efficiency alsoThere must be perfect competition throughout

the economy

There must be no externalities. Externalities are additional costs and benefits, over and above those experienced by the individual producer and consumer

ProducerSurplus

Between 0 and Q0 producers receive

a net gain from selling each product--

producer surplus.

ConsumerSurplus

Consumer and Producer Surplus

Quantity0

Price

S = MC

D = MU

5

Q0

Consumer C

10

7

Consumer BConsumer A

Between 0 and Q0 consumers A and B

receive a net gain from buying the product--consumer surplus

Economic efficiency, contd. In practice, consumers to not consider just one

good in isolation. They make choices between goods. Likewise firms make choices as to which goods to produce and which factors to employ.

In chapter 3 we learned that a consumer will maximise utility from a given income when that income is allocated to goods and services so that the marginal utility divided by price is equal

N

N

B

B

A

A

P

MU

P

MU

P

MU ...

Marginal Equivalency

We also know that a competitive firm will maximize profit by producing at a level which price equals marginal cost

Substituting the marginal costs (MC) for price in the equation for consumer optimality, we get

BBAA MCPMCP and

B

A

B

A

B

B

A

A

MC

MC

MU

MU

MC

MU

MC

MU or

Marginal Equivalency Should we have that

Whether as a producer, consumer or worker, a person will gain by expanding activity A relative to activity B

Activity A is giving greater utility relative to its cost than activity B

Also, if for example the marginal utility from to consumers from good A relative to good B were greater than the marginal cost to producers from good A relative to good B, then if more A was produced relative to B, the additional gain to consumers would be greater than the additional cost to producers. Thus consumers could fully compensate the producers (in the price they pay for A) and still have a net gain.

B

B

A

A

MC

MU

MC

MU

Perfect Competition

Q Q

P PMarket Individual FirmD S

Q0

P0 P0

D = MR = P

q0

LRACLMC

Lostprofit

P1

Q1

Lostprofit

MC

AC

Quantity

$ perunit ofoutput

D = AR

MR

P*

Q*

Maximizing Profit When Marginal Revenue Equals Marginal Cost

P2

Q2

BA

Lost Consumer Surplus

Deadweight Loss

Because of the higherprice, consumers lose

A+B and producer gains A-C.

C

Deadweight Loss from Monopoly Power

Quantity

AR

MR

MC

QC

PC

Pm

Qm

$/Q

Externalities

NegativeAction by one party imposes a cost on

another party

PositiveAction by one party benefits another

party

External Cost

ScenarioSteel plant dumping waste in a river

The entire steel market effluent can be reduced by lowering output (fixed proportions production function)

External Cost

ScenarioMarginal External Cost (MEC) is the

cost imposed on fishermen downstream for each level of production.

Marginal Social Cost (MSC) is MC plus MEC.

MC

S = MCI

D

P1

Aggregate social cost of

negativeexternality

P1

q1 Q1

MSC

MSCI

When there are negativeexternalities, the marginalsocial cost MSC is higher

than the marginal cost.

External Costs

Firm output

Price

Industry output

Price

MEC

MECI

The differences isthe marginal external

cost MEC.

q*

P*

Q*

The industry competitiveoutput is Q1 while the efficient

level is Q*.

The profit maximizing firmproduces at q1 while the

efficient output level is q*.

External Cost

Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.

Externalities

Positive Externalities and InefficiencyExternalities can also result in too little

production, as can be shown in an example of home repair and landscaping.

MCP1

External Benefits

Repair Level

Value

D

Is research and development discouraged by positive

externalities?

q1

MSB

MEB

When there are positiveexternalities (the benefitsof repairs to neighbors),marginal social benefits

MSB are higher thanmarginal benefits D.

q*

P*

A self-interested home ownerinvests q1 in repairs. Theefficient level of repairs

q* is higher. The higher priceP1 discourages repair.

Public Goods

Public Good CharacteristicsNonrival

For any given level of production the marginal cost of providing it to an additional consumer is zero.

NonexclusivePeople cannot be excluded from

consuming the good.

Public Goods

Not all government produced goods are public goodsSome are rival and nonexclusive

EducationParks

D1

D2

D

When a good is nonrival, the social marginalbenefit of consumption (D) , is determined by

vertically summing the individual demand curves for the good.

Efficient Public Good Provision

Output0

Benefits(dollars)

1 2 3 4 5 6 7 8 109

$4.00

$5.50

$7.00

Marginal Cost

$1.50

Efficient output occurswhere MC = MB at 2

units of output. MB is$1.50 + $4.00 or $5.50.

Asymmetric Information

When one part in a transaction knows more about the characteristics of a good or service than the other party, we have asymmetric informationThis is a very widely used concept in many

transactions

Since buyers (or sellers) may not know what the good or service is worth, the market will not secure efficiency.

George Akerlof Wins Nobel Prize in Economics

The market for lemons

Assume that a used car is either good or bad In American terminology a good used car is a

”plum” and a bad one a ”lemon”Assume that the supply of used cars is given at

that the distribution between plums and lemons is 50/50

Assume that plums are worth $10 000 both for sellers and buyers, while lemons are worth 5000

The market would have secured an efficient solution had both buyers and sellers had perfect information.

The market for lemons

Assume that only the seller knows if the car is a plum or a lemonBuyers will not offer 10 000 for a car since half

of them are lemonsFor the same reason it is unrealistic to offer

5 000Buyers offer expected value of average price

which is (10 000+5 000)/2 = 7 500This is insufficient for the owners of plum to sell,

but more than enough for the owners of lemons. We end up with only lemons being offered for sale – adverse selection