MBA Economics

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

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

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

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. 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. 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. 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. 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. 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. Pareto optimumhttp://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. 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. 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. 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. 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. 10 Consumer Surplus S = MC 7 Between 0 and Q0 consumers A and B receive a net gain from buying the product-- consumer surplus 5 Producer Surplus Between 0 and Q0 producers receive a net gain from selling each product-- producer surplus. D = MU Q0 Consumer A Consumer B Consumer C Consumer and Producer Surplus Price 0 Quantity

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. Marginal Equivalency • We also know that a competitive firm will maximize profit by producing at a level which price equals marginal costSubstituting the marginal costs (MC) for price in the equation for consumer optimality, we get

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. D S LMC LRAC P0 P0 D = MR = P q0 Q0 Perfect Competition Market Individual Firm P P Q Q

24. MC P1 P* AC P2 Lost profit D = AR Lost profit MR Q1 Q* Q2 Maximizing Profit When Marginal Revenue Equals Marginal Cost $ per unit of output Quantity

25. Because of the higher price, consumers lose A+B and producer gains A-C. Lost Consumer Surplus MC Deadweight Loss Pm A B PC C AR MR Qm QC Deadweight Loss from Monopoly Power $/Q Quantity

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

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. 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. The differences is the marginal external cost MEC. The profit maximizing firm produces at q1 while the efficient output level is q*. When there are negative externalities, the marginal social cost MSC is higher than the marginal cost. MSC MSCI MC S = MCI The industry competitive output is Q1 while the efficient level is Q*. Aggregate social cost of negative externality P* P1 P1 MECI MEC D q* q1 Q* Q1 External Costs Price Price Industry output Firm output

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

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. When there are positive externalities (the benefits of repairs to neighbors), marginal social benefits MSB are higher than marginal benefits D. MSB A self-interested home owner invests q1 in repairs. The efficient level of repairs q* is higher. The higher price P1 discourages repair. D P1 MC P* MEB q1 q* External Benefits Value Is research and development discouraged by positive externalities? Repair Level

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

35. When a good is nonrival, the social marginal benefit of consumption (D) , is determined by vertically summing the individual demand curves for the good. Marginal Cost D2 Efficient output occurs where MC = MB at 2 units of output. MB is $1.50 + $4.00 or $5.50. D $1.50 D1 Efficient Public Good Provision Benefits (dollars) $7.00 $5.50 $4.00 Output 0 1 2 3 4 5 6 7 8 9 10

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. George Akerlof Wins Nobel Prize in Economics

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. 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