Overview:
Eleven Ideas
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Idea 1
Markets create surplus because sellers
want to create as much surplus as they
can, so they can sell it.
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Problem
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What quantity maximizes surplus if the quantity supplied of gasoline is
Q = 11 (P-5) if P>5 and Q = 0 if P <5, and quantity demanded is Q = 125 – P?
Answer: Equating quantity supplied to quantity demanded gives 11 (P-5) = 120 –P, so
11P –55 = 125-P so 12P = 180 and P = 15, so Q = 110.
Note that the inverse demand curve is P = 125-Q and the inverse supply curve is P
= 5 + 1/11 Q. Thus, the total surplus is the triangle with area (.5) (125-5) 110 =
6600.
But why is that the maximum surplus possible?
Because if output is increased, the extra cost, from the supply curve, is greater than
the extra benefit, from the demand curve.
Idea 2
Markets fail to maximize surplus if:
1. Property rights are not enforced.
2. Contracts are not enforced.
3. Sellers or buyers have market power.
4. Externalities are present.
5. Buyers and sellers have different information.
Otherwise, if you see a need for regulation, it’s
not because of surplus maximization--- it’s because
you want income distributed differently, or you think
the objectives of other people are wrong.
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Problem
If the cost of production is constant at 10, and the demand
equation is Q = 120- 2P, but there is a negative externality of 2
and the industry is cartelized, what will be the surplusmaximizing output and what will be the actual output?
The social cost of production is really 12 here. If the price were
12, the equilibrium quantity would be Q = 120-2*12 = 96.
The cartel will note that the inverse demand curve is
P = 60 - Q/2…
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Idea 3
Goverments are made up of individual
humans, each with his own personal
objective.
Thus, they will not automatically
maximize surplus.
They are thinking about their own
careers too.
Problem
Acme Widgets is considering moving its Terra Haute
factory to Mexico, which would result in 200 fewer jobs in
Terra Haute. The State of Indiana offers Acme $2 million to
stay in Terra Haute, saying that this will benefit Indiana
because of all the jobs saved.
Why should we be skeptical?
Answer: People in Terra Haute will care deeply about this
policy. People elsewhere in Indiana will be rationally ignorant.
Thus, we should expect the surplus of Terra Haute citizens to
be overweighted in government calculations.
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Idea 4
8
Governments can be designed to reduce
the effects of government failure by giving
better incentives to officials and citizens
to maximize surplus.
Problem
We currently are taxing both computers and
restaurants at a rate of a 5% tax on sellers and a 3% tax on
buyers. The elasticity of supply is the same for both
products, at 1.2. The elasticity of demand is -.8 for
computers and - .6 for cellphones. Can we do anything to
improve our tax system? If we allow the government to
change the rates, do we need to worry about government
failure?
Answer: It seems we should increase the tax on cellphones
and reduce the price on computers. If we allow such
differentiation between industries, though, we allow room for
industry lobbying, and government failure.
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Idea 5
10
Discount rates depend on the opportunity cost of
spending money now instead of later.
Suppose you are given a choice between X dollars
now and Y dollars a year from now. If you have the
X dollars now, you could invest them at interest rate r
and have X + rX a year from now. So unless Y > X
(1+r), you will prefer the X now. You are indifferent
if X = Y/(1+r).
Problem
If a pollution tax on nitrogen dioxide emissions from cars
will result in immediate engine-adaptation costs of $50
million and increased engine production costs of $12
million/year thereafter, but will reduce externalities by
$15/million per year, and the discount rate is 10%, is the tax
a good idea?
Answer: The present value of the policy is -50 - 12/.1 +
15/.1 = -50 - 120+ 150 = -20 million, so we should not
adopt it.
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Idea 6
Pollution taxes and tradeable permits can achieve the same
goals in terms of emissions and revenues.
That applies to liquor licenses as well as to sulfur dioxide
emission allowances.
It is in contrast to command-and-control regulation that
requires the same emissions from each source, regardless of
the cost to it of compliance.
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Problem
If the production of paper requires production costs of
20 + 45Q + 2Q2
and creates negatives externalities of Q2 but paper has the
inverse demand curve P = 120-Q, what pollution tax is
optimal?
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Idea 7
Just because something is a
nonrenewable resource doesn’t mean you
shouldn’t use it up.
That kind of thrift is really miserliness.
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Problem
15
Suppose we suddenly discover that there are only 9 billion
barrels of oil in the ground, but we consumed 3 billion
barrels last year, at a price of $50/barrel. The only alternative
to natural oil is synthetic oil, made from coal, which costs
$100 per barrel. Assume the discount rate is 0%. What will
be the price path of oil over time, and when will it be used
up? Does this maximize surplus?
Answer: The price will be $100/barrel and constant. We
will consume something less than 3 billion barrels per year
until the oil runs out.
Idea 8
Monopoly creates market failure because a
market participant with power over prices uses
that power to take surplus rather than make it.
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Problem
17
Two firms wish to merge. Their marginal cost is 10. The
demand is Q = 120- 2P. Currently the price is 20. If they merge,
their costs will fall to 5, but they will act as a monopoly. Will
total surplus increase?
Idea 9
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Sometimes having one firm as monopoly
does maximize surplus.
The problem is how to regulate that firm.
Problem
19
Microsoft has the lion’s share of the desktop and
laptop operating systems market (though remember
cellphones!). Should Microsoft be broken up into
competing companies? Should it be regulated in its
prices? Discuss arguments in favor and against.
Answer: Because of network externalities, there should
be just one operating system provided. If its price is
regulated, that would result in more sales, which is good.
We would have to worry about government failure,
however, because the government has a short-term
outlook. Also, by limiting “home run” profits, we would
discourage innovation in general.
Idea 10
A minimum-quality requirement is appropriate when
almost all consumers would choose that quality if they
had full information and rationality.
That reduce the transactions cost of finding out the
product’s quality.
Otherwise, it is a bad idea, because some consumers
will have higher surplus from lower quality and lower
price.
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Problem
21
The average apartment size in the United States
has been estimated to be 982 square feet, which is about 40 feet
by 25 feet. New York requires a minimum size of 150 square
feet--- 10 by 15 feet. Does this regulation makes sense from the
point of view of surplus maximization?
Answer:
No, it doesn’t. Most people in the U.S., and probably even in
New York, want larger apartments. Some want above all to save
money. It is easy to figure out the size of an apartment, so the
savings in transaction costs from requiring them to be larger is
trivial. Thus, this regulation doesn’t make sense from the point
of view of landlord and tenant.
Idea 11
Mandated fringe benefits reduce total surplus
and the surplus of employees and employers
unless there is market failure.
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Problem
Suppose labor supply by workers is L = 6w and labor
demand by employers is L = 32-w. Providing release time for
taking care of aged parents is valued at 2 by each
employee but costs each employer 3. If this fringe benefit is
mandated, what happens to employment in this industry?
Initially, 5w = 32 – w, so w=7 and employment is 42.
After the mandate, the inverse labor supply curve changes from
w = L/6 to w = L/6-2.
The inverse labor demand curve changes from w = 32-L to
w = 29-L.
Thus, the equilibrium is L/6-2 = 29-L and 31 = 7/6 (L) so
L is about 27.
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