Economics Combined Version Edwin G. Dolan Best Value Textbooks 4 th edition Chapter 4 Choice, Markets and Government

Economic theories are based on statements about objectives, constraints, and choices  Objectives are what you want to achieve—a nutritious lunch  Constraints describe what opportunities you have in terms of prices, available goods, and so on  Choices are what you do to best achieve objectives given the constraints What’s for lunch?

 Rationality, as the term is used in economics, means acting purposefully to achieve an objective, given the constraints on available opportunities.  Rationality is a tool for understanding the world in economic terms Dolan, Economics Combined Version 4e, Ch. 4 I’ve got to get this right!

 This means that people: ◦ use available time and information, ◦ weigh the costs and benefits of available alternatives, ◦ and choose the alternative that they believe will bring them the most benefit at the lowest cost.

 This does not mean that people are innately selfish. ◦ Self-interest is not greed.  Other-regarding preferences: ◦ Altruism ◦ Good Will ◦ Peace

 Degrees of Rationality Depend upon ◦ Information available (and/or its cost) ◦ Ability to process the information ◦ Your perception of what constitutes your “best interests”  This leads to the theory of bounded rationality.  In practice, this means that people compare costs and benefits to make a decision.

 People weigh the costs and benefits of various alternatives, choosing the alternative that makes them best off. ◦ This behavior is called “economic decision making”.  Costs and benefits are sometimes referred to as negative and positive incentives. Hence incentives matter.

 Transaction costs are costs of gathering information, finding a potential partner, negotiating and enforcing agreements, and renegotiating when conditions change  Transactions cost do change outcomes  What are some of the transaction costs of finding a new apartment?

9 1. Imperfect Information 2. Externalities 3. Public Goods 4. Lack of Competition 5. Business Cycles Market Failures As Explanation of roles for Government in the economy

Copyright © Houghton Mifflin Company. All rights reserved. 10 Imperfect information leads to market failures that cause inefficiency. False information Asymmetric information Either the buyer or seller has more or better information than the other Imperfect Information

Copyright © Houghton Mifflin Company. All rights reserved. 11 Some solutions: Brand names, franchises, and product warranties may help. Government may require full and correct disclosure. (Food labels, stock prospectuses, etc.) Imperfect Information

Copyright © Houghton Mifflin Company. All rights reserved. 12 Externalities are the costs or benefits of a transaction that are borne by someone not directly involved in the transaction. Real efficiency occurs only when all the costs and all the benefits accrue to the buyer and seller Externalities

 External Benefits (Positive externalities) when someone outside the transaction is receiving benefits from the transaction. ◦ If buyers are not receiving all benefits, they will demand less than is optimal. ◦ If sellers are not receiving all the benefits from the sale, they will not produce as much as is optimal. ◦ Examples: New large business in a declining neighborhood, Education, Landscaping and painting a formerly unkempt property, Immunizations Copyright © Houghton Mifflin Company. All rights reserved. 13

 External costs (Negative Externalities): when someone outside the transaction is incurring costs related to the transaction. ◦ If buyers are not bearing all the costs of the purchase, they will demand too much. ◦ If producers are not bearing all the costs of production, then they will produce too much. ◦ Example: Pollution by a manufacturer, Second hand tobacco smoke, Smog and traffic congestion from my choice to drive alone. Copyright © Houghton Mifflin Company. All rights reserved. 14

 Government imposes costs  Government regulates to internalize external costs. ◦ Examples: Smog fees, mandated pollution controls, banns on indoor smoking etc Copyright © Houghton Mifflin Company. All rights reserved. 15

 Government produces or subsidizes the production/consumption of the good.  Government requires the consumption of the good ◦ Examples: required immunizations, public education, student aid, tax breaks to businesses that locate in run-down areas Copyright © Houghton Mifflin Company. All rights reserved. 16

Copyright © Houghton Mifflin Company. All rights reserved. 17 Public Goods are goods whose consumption by one person does not diminish the quantity or quality available to other consumers. Specifically, they: – Can be jointly consumed Individuals can simultaneously enjoy consumption of same product or service. – Are non-excludable Consumption of the good cannot be restricted to the customers who pay for it. Public Goods

Copyright © Houghton Mifflin Company. All rights reserved. 18 Non-excludability If it is produced for some, it is available to all. There is no way to exclude non-payers. No one enjoys a private property right to the good. Functioning Private Property Rights require: Exclusivity Transferability Characteristics of a Public Good

Copyright © Houghton Mifflin Company. All rights reserved. 19 Without private property rights: People have an incentive to try free ride: Free rider: a person who receives the benefits of the good without helping to pay for it. Because of the Free Rider Problem, too little will be produced; efficiency is not achieved. Characteristics of a Public Good

Copyright © Houghton Mifflin Company. All rights reserved. 20 Examples of public goods: National defense Public radio and television stations Clean air Unpolluted ground water Examples of Public Goods

 Government production  Government subsidized production  Marketization: Sometimes markets develop ways of providing public goods (e.g. use of advertising to support radio and television). Copyright © Houghton Mifflin Company. All rights reserved. 21

 Sellers may gain by restricting output and raising price. ◦ Too few units will be produced. ◦ Consumers may not be able to get needed goods.  Monopoly: a market with only one producer ◦ Example: utility companies  Oligopoly: a market with only few producers (who may operate jointly as a monopolist through a cartel). ◦ Example: OPEC  Monopsony: a market with only one buyer Copyright © Houghton Mifflin Company. All rights reserved. 22

Copyright © Houghton Mifflin Company. All rights reserved. 23 Restricting Supply to Raise Prices S 2 Price Quantity D S 1 Q2Q2 P2P2 P1P1 Q1Q1

 Anti-trust laws; ban collusion and anti- competitive behavior  License and regulate monopolies  Government provision of the good Copyright © Houghton Mifflin Company. All rights reserved. 24

Copyright © Houghton Mifflin Company. All rights reserved. 25 Public Choice Analysis Public Choice Theory: Proposes that government activity in the economy has little to do with market failures. Public Choice theory suggests that government may be brought in to benefit specific individuals or groups. People may seek government intervention to improve their own profit in comparison to the market outcome. This is referred to as rent-seeking—the use of resources to transfer wealth from one individual to another without increasing production or total wealth.

 Self-interest directs public sector activity, just as it directs market activity.  Government actions (like price ceilings or floors) are often enacted for political gain, not as a remedy for economic inefficiency.  Government action is likely to create market failure or reduce efficiency. Copyright © Houghton Mifflin Company. All rights reserved. 26