Week 5

• if any assumptions in the first fundamental theorem of welfare economics do not hold

  market equilibrium may not be efficient
• markets are not perfectly competitive if a buyer or seller has

  market power (the ability to affect the market price)
• externality

  a byproduct of consumption or production that affects someone other than the buyer or seller
• negative externalities


  impact on the bystander is adverse
• positive externalities


  impact on the bystander is beneficial
• social cost

  private cost + external cost
• private marginal cost (PMC)


  supply curve; the costs directly incurred by sellers
• private marginal benefit (PMB)


  demand curve; shows the value to buyers (prices they are willing to pay)
• external marginal cost (EMC)


  value of the negative impact on bystanders; ex. value of harm from smog, greenhouse gases
• public policies


  policies carried out by public sector (government)
• command and control prices

  regulate behavior directly
• market-based policies

  provide incentives so that private decision-makers will take into account the external costs and benefits of their actions

  • corrective taxes and subsidies
  • tradable pollution benefits (cap and trade)
• corrective tax (Pigouvian tax)


  a tax designed to induce private decision-makers to take account of the external costs that arise from a negative externality
• for activities with negative externalities, the ideal corrective tax would equal the ___

  external marginal cost (EMC)
• for activities with positive externalities, the ideal corrective subsidy would equal the ___

  external marginal benefit (EMB)
• corrective taxes and subsidies

  • align private incentives with society's interests
  • induce private decision-makers to take into account the external costs and benefits of their actions
  • move the economy toward a more efficient allocation of resources
• Coase theorem


  if private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own
• transaction costs

  parties may incur costs in the process of agreeing to and following through on a bargain that make it impossible to reach a mutually beneficial agreement
• stubbornness

  even if a beneficial agreement is possible, each party may hold out for a better deal
• coordination problems


  if the number of parties is very large, coordinating them may be costly, difficult, or impossible
• excludable goods


  a person can be prevented from using it

  • ex. fries
  • nonexcludable: national defense
• rival in consumption


  one person's use of the good diminishes other people's use of it

  • rival: hamburger
  • not rival: an MP3 file of Beyonce's latest single
• private goods


  rival + excludable; ex. burgers and fries
• common resources

  rival + not excludable

  • ex. fish in the ocean
• club goods (natural monopoly, marketable public good)

  excludable + not rival
• public goods

  not rival + not excludable
• profit

  total revenue - total cost
• total revenue (TR)


  $TR =$$P \cdot Q$
• average revenue (AR)


  $AR =$$\frac{TR}{Q} =$$P$
• marginal revenue (MR)


  the change in total revenue from an additional unit sold

  $MR =$$\frac{\Delta TR}{\Delta Q}$
• total cost (TC)


  $TC =$$P\cdot Q$
• average total cost (ATC)


  $ATC =$$\frac{TC}{Q}$
• marginal cost (MC)


  the change in total cost from an additional unit produced

  $MC =$$\frac{\Delta TC}{\Delta Q}$
• in competitive markets


  $MR =$$P$
• at the profit-maximizing quantity


  $MR =$$MC$
• perfect competition


  $P =$$MR$
• competitive equilibrium


  $P =$$MC$