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Welcome to ECON 372:

Comparative Economic Systems

By: Dr. Jacqueline Khorassani

Week Four Lecture SlidesSource: Chapter 2 & Jackie

(pp 25-39)

Marietta College, Spring 2011

Notes1. Exam 1: Wednesday, February 92. Team 1 paper is on Japan, Sweden

and France and is due on Monday, February 28

3. On Monday, January 31, expect an in class assignment on last Friday’s class + the first 15 slides on Week 4 (this week) lecture slides.

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27th Milton Friedman Lecture

Dr. Lynne KieslingSenior Lecturer

Department of EconomicsNorthwestern University

Sunday January 30, 2011

7:30pm McDonough Auditorium

Topic:Regulation and Technological

Change: The Case of Electricity

Free and Open to the Public

This is an opportunity to collect more bonus points

2 points for attending 2- 5 points per question 2-10 points for summarizing the

talk

Social Indifference Curve Assumptions

1.Only two goods are consumed.

2.Fixed taste. 3.All members of the society

have the same taste.4.More is better.

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Social Indifferent Curve

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Roses

Guns10 20 300

95A

Indifference Curve

50

40

B

C

Why is it downward sloping?If increase both happiness goes upWhy is it bowed in?Why are we willing to give up fewer roses for 10 additional guns as we consume more guns?

Diminishing utility

Social Indifferent Curve

Roses

Guns10 20 300

95A

Indifference Curve

50

40

B

C

D *

*F

Do we like D better than B?Yes, on a higher indifference curveDo we like F better than B?No, on a lower indifference curve

Social Indifference Map

Can a society’s indifference curves cross each other?

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Roses

Guns

I1I2

• If indifferent between A and C• If indifferent between A and B• Then must be indifferent between B

and C (not true, because B and C are on different indifferent curves)

• Given no change in taste indifference curves can not intersectA*

B*C*

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Social Indifference Map

Indifference curves of a society are parallel to each other.

Roses

GunsI1I2

I3

I3 is better than I2 why?

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PPF and indifference map Is B better than M? Is C better than M?

Roses

Guns10 20 30 400

9580

BC

M

The highest indifference curve we can reach given what is available = efficiency in production and consumption. Why?1. Efficiency in production =

maximizing out put , given resources and technology

2. Efficiency in consumption= Can’t have more of both goods=can’t make someone better off without making someone else worse off

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How does this model relate to distribution of income? Consumption efficiency has

nothing to do with distribution of income– If one person gets it all, it is still

efficient as long as to make some one else better off you have to make this person worse off by taking something away from him.

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How do market supply and demand in a competitive market related to efficiency?

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Let’s look at supply and demand in a completive market

If the maximum amount of output is sold efficient

P

Q50

D

S100

70

50

30 80

At P = 100, how much is sold?At P = 50, how much is sold?At p = 70, how much is sold?Which one is efficient?This result is achieved under competitive, full information general equilibrium.

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Definitions Marginal cost = increase in total

cost as a result of producing one more unit of a good = MC

Marginal revenue = increase in total revenue as a result of selling one more unit of a good = MR

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What is the profit maximization rule in a market economy?

1. As long as producing one more unit of a good adds more to your revenue than to your cost (as long as MR> MC) produce more

2. If producing one more unit of a good adds more to your cost than to your revenue (If MC>MR) produce less

3. Profits are maximized when you produce the quantity of output at which MC = MR

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In the short run, when you have at least one fixed input of production MC eventually increases as

you increase production Why?

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Example Output = shirts Inputs

▪ Labor (L)▪ Capital (K, sewing machine, which you

only have one) If you keep on hiring more workers

and don’t buy any more sewing machines, new workers can not produce as many shirts for you as the old workers but you pay them the same wages as your old workers you cost per additional shirt goes up. MC of additional shirt goes up

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How is the price and the quantity of output determined in a competitive market?

Market Firm 1

P P

D

S

P

MC

$10

220

=ΣMC

What is MR for this firm?$10

=MR

Quantity Quantity

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Monopoly

What is it?– Extreme case

One producer produces a unique good or service for which there are no close substitutes in the market

Has power to control the price.

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Now suppose a firm buys all of the little firms in a the market

Market Firm 1 = monopoly

P P

D

S

P

MC

$10

220

=ΣMC

MC

DDoes monopoly produce 20 units?

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Monopoly is facing the same demand but S = MC

Market

P

D

S =MC20

1

18

2

If monopoly wants to sell one unit, it can charge $20 What is MR of the first unit?$20If monopoly wants to sell 2 units, it can charge $18.What is MR of the 2nd unit$16Why?MR = ΔTR/ ΔQMR = 16/1

MR

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How should the monopoly maximize profits?

Market

P

D

S =MC

Find the quantity of output from intersection of MR and MCCharge the highest price it can charge for this much outputMonopoly produces less and charges more than a competitive marketConsumers are not consuming the maximum amount no efficiency in consumption

MR

10

15

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How likely is efficiency in production under monopoly?

Market

P

D

S =MC

Not LikelyWhy?Monopoly charges a higher price can afford to be less efficient and more wasteful than a competitive firm.Under monopoly, production is below capacity we don’t reach our PPF.

MR

10

15

10

20

Monopoly

Competitive

Question How are natural monopolies

different from unnatural monopolies?

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25

What is economies of scale?

Average cost

Quantity of production

As the firm gets bigger AC dropsWe can have one firm producing 30 units orWe can have 3 firms each producing 10 unitsWhich one is potentially more efficient?One firmThis is a cause of natural monopolyExamples?What should government do? (Rachel)Allow monopoly to exist but watch it.

$30

$12

10 30

ACEconomies of scale

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What about unnatural monopolies?

Average cost

Q

There is a short range of economies of scaleWe can have one firm producing 30 units orWe can have 3 firms each producing 10 unitsWhich one is potentially more efficient?three firmsExamples?What should government do? (Rachel)Remove the barriers to entrySherman Act, Clayton Act, FTC Act in the US

PP31-32

$30$40

10

AC

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natural & unnatural monopoly

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1. Natural monopoly enjoys economies of scale

2. Unnatural monopoly is created by artificial barriers to entry

Existing firms and/ or government make it difficult for new firms to enter

A power plant may be an example of natural monopoly

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There is no huge fixed cost involved in arts and crafts not a natural monopolies

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What are externalities?

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Costs or benefits of market activity to non-market participants– Examples of external costs

Pollution– Examples of external benefits

Scientific research Problem: When externality is

present, even a competitive market does not result in efficiency– Optimal amount of good is not produced

Example of external cost

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A chemical plant pollutes the river The factory may not be producing

the optimal amount of the chemical good

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Why not? Let’s look at external costs

Market

P

D

S =MC (private)

10

20

Competitive

The cost of pollution must be added to cost of production MC goes up

There is over-productionWhat is the role of government?

1. Define Property rights better• Nobody owns the river• Coase Theorem

• PP34-352. Provide information3. Internalize cost

• Sell emissions permits• Taxes

External cost

S = MC (social)

15= optimal

QOver production n

Example of external benefit

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Production of flu vaccines The optimal amount of vaccine may

not be produced

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Let’s look at external benefits

Market

P

D

S =MC (private)

10

20=under-production

Competitive

The external benefits must be added to demand

There is under-productionWhat should government

do? 1. Subsidize

consumersD goes up…why?

2. Subsidize producers • MC goes

down…why?3. Produce the good

Problems?25 = optimal production

Q

D + external benefit

MC-subsidy

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What is a public good?

Examples?– Education? Roads? Bridges?

Clean air? National defense? A public good has two

characteristics1. Non excludability

Non-payers can’t easily be excluded

2. No rivalry in consumption My consumption does not

significantly affect how much of the good is left for you

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Does a market economy produce the optimal amount of public good? Why or why not?

If I can benefit (can’t be easily excluded) without paying, will I pay voluntarily?– No

Who will pay?– ??? Good question!!!

Free rider problem– Everyone will hope that others will pay

and she will benefit without paying

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Market economy produces less than optimal amount of public good, why?

Observed market Demand

Actual Demand (including the free riders demand)

S

Optimal= 60Q

Current=30

P

So, maybe we need a government to collect taxes and produce the optimal amount of this good or service

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Does government always produce the optimal amount of public good?

No Suppose this public good is clean air Optimal = 60 (society as a whole

desires 60 units of clean air) Do we all vote on this? No, we elect representatives and

they vote.

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What affects our representative's votes?

May be their own self interest– Who paid for their campaign

expenditures?– Who is more likely to help them to get re-

elected?– Special interest groups– And may be the special interest groups

prefer 30 units of clean environment. They are the big corporations who pollute

the environment

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What if politicians have public interest in mind?

They may still vote for 30 units of clean environment.

Why? Because they really think that is what

the general public wants or that is the best for the public– Some voices are louder than others

Big corporations lobby– Cleaner air = higher unemployment

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Public Choice School Studies biases in collective action Even in the most democratic

systems– the optimal (efficient) amount of public

good may not be provided by government.

Result – Neither government nor the private

sector supplies an optimal (efficient) amount of a public good.