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

2. Slide 2 Economics December 2002 Case study Expanded model of income determination Essay questions Essay 1: Economic efficiency Essay 2: Fiscal and monetary policy, the ISLM-model

3. Slide 3 Economics June 2002 Case study Marginal productivity theory, factor demand and factor rewards Essay questions Essay 1: Economic efficiency Essay 2: Macroeconomic theory and policy

4. Slide 4 Economics December 2001 Case study Price theory, prices and income Essay questions Essay 1: Economic efficiency and economic circulation Essay 2: Macroeconomic theory, multipliers and subsidies

5. Slide 5 Economics June 2001 Case study Efficiency, consumer demand Essay questions Essay 1: Economic efficiency, factor demand and factor rewards Essay 2: Fiscal and monetary policy, the ISLM-model

6. Slide 6 Economics A Case study Price theory, monopoly Essay questions Essay 1: Economic efficiency Essay 2: Fiscal policy, the ISLM-model

7. Slide 7 Economics B Case study Price theory, monopoly Essay questions Essay 1: Economic efficiency Essay 2: Fiscal and monetary policy, the ISLM-model

8. Slide 8 Economics C Case study Price theory, prices and revenue Essay questions Essay 1: Economic efficiency Essay 2: Fiscal and monetary policy, the ISLM-model

9. Slide 9 Economics D Case study Costs and supply, equilibrium Essay questions Essay 1: Theory of supply Essay 2: Fiscal and monetary policy, the ISLM-model

10. Slide 10 Economics E Case study Price theory, monopoly Essay questions Essay 1: Economic efficiency Essay 2: Fiscal and monetary policy, the ISLM-model, open economy macro- economics

11. Slide 11 Economics F Case study Theory of costs, capital budgeting Essay questions Essay 1: Economic theory, definitions Essay 2: Fiscal and monetary policy, the ISLM-model

12. Slide 12 My advice would be… In the microeconomics section, you need to be thoroughly familiar with Social efficiency Theory of price determination In the macroeconomics section, you need to master The ISLM-model (which incidentally sums up many other chapters in this section)

13. Slide 13 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.

14. Slide 14 Pareto optimum http://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

15. Slide 15 Pareto optimum Three basic conditions must be satisfied if Pareto efficiency is to be attained Efficiency in the use of outputs in consumption Efficiency in the use of inputs in production Efficiency in matching production to consumption

16. Slide 16 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.

17. Slide 17 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.

18. Slide 18 Social (economic) efficiency Economists argue that under certain conditions the achievement of private efficiency will result in social or economic efficiency also There 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

19. Slide 19 Producer Surplus Between 0 and Q 0 producers receive a net gain from selling each product-- producer surplus. Consumer Surplus Consumer and Producer Surplus Quantity 0 Price S = MC D = MU 5 Q0Q0 Consumer C 10 7 Consumer BConsumer A Between 0 and Q 0 consumers A and B receive a net gain from buying the product-- consumer surplus

20. Slide 20 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

21. Slide 21 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

22. Slide 22 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.

23. Slide 23 Perfect Competition Q Q PP MarketIndividual Firm DS Q0Q0 P0P0 P0P0 D = MR = P q0q0 LRACLMC

24. Slide 24 Lost profit P1P1 Q1Q1 Lost profit MC AC Quantity $ per unit of output D = AR MR P* Q* Maximizing Profit When Marginal Revenue Equals Marginal Cost P2P2 Q2Q2

25. Slide 25 B A Lost Consumer Surplus Deadweight Loss Because of the higher price, consumers lose A+B and producer gains A-C. C Deadweight Loss from Monopoly Power Quantity AR MR MC QCQC PCPC PmPm QmQm $/Q

26. Slide 26 Externalities Negative Action by one party imposes a cost on another party Positive Action by one party benefits another party

27. Slide 27 External Cost Scenario Steel plant dumping waste in a river The entire steel market effluent can be reduced by lowering output (fixed proportions production function)

28. Slide 28 External Cost Scenario Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production. Marginal Social Cost (MSC) is MC plus MEC.

29. Slide 29 MC S = MC I D P1P1 Aggregate social cost of negative externality P1P1 q1q1 Q1Q1 MSC MSC I When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. External Costs Firm output Price Industry output Price MEC MEC I The differences is the marginal external cost MEC. q* P* Q* The industry competitive output is Q 1 while the efficient level is Q*. The profit maximizing firm produces at q1 while the efficient output level is q*.

30. Slide 30 External Cost Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.

31. Slide 31 Externalities Positive Externalities and Inefficiency Externalities can also result in too little production, as can be shown in an example of home repair and landscaping.

32. Slide 32 MC P1P1 External Benefits Repair Level Value D Is research and development discouraged by positive externalities? q1q1 MSB MEB When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. q*q* P* A self-interested home owner invests q 1 in repairs. The efficient level of repairs q* is higher. The higher price P 1 discourages repair.

33. Slide 33 Public Goods Public Good Characteristics Nonrival  For any given level of production the marginal cost of providing it to an additional consumer is zero. Nonexclusive  People cannot be excluded from consuming the good.

34. Slide 34 Public Goods Not all government produced goods are public goods Some are rival and nonexclusive  Education  Parks

35. Slide 35 D1D1 D2D2 D When a good is nonrival, the social marginal benefit of consumption (D), is determined by vertically summing the individual demand curves for the good. Efficient Public Good Provision Output 0 Benefits (dollars) 12345678109 $4.00 $5.50 $7.00 Marginal Cost $1.50 Efficient output occurs where MC = MB at 2 units of output. MB is $1.50 + $4.00 or $5.50.

36. Slide 36 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 information This 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.

37. Slide 37 George Akerlof Wins Nobel Prize in Economics

38. Slide 38 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.

39. Slide 39 The market for lemons Assume that only the seller knows if the car is a plum or a lemon Buyers will not offer 10 000 for a car since half of them are lemons For the same reason it is unrealistic to offer 5 000 Buyers offer expected value of average price which is (10 000+5 000)/2 = 7 500 This 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