Summary with the 3rd European edition of Principles of Microeconomics by McDowell

How can we think like an economist? - Chapter 1

This chapter’s learning goals are:

1. Explaining the concepts of scarcity and choice, the cost-benefit principle, and the importance of incentives.
2. Evaluating and identifying costs and benefits.
3. Understanding the concept of economic rationality.
4. Understanding why what happens “in the margins” is important.
5. Distinguishing between positive and normative statements in economics.

How does an economist reason? We look at this by focusing on the following statement: smaller classes are better for the child’s education.

An economist will first wonder whether there is any evidence for the hypothesis before accepting it. What would indicate that making classes smaller would result in better education for a child?

Second, an economist will look for motives, because people will often act on their self-interest (incentives matter). A teacher, for example, benefits from smaller classes, because that would result in less work. Perhaps that is the reason why this person would argue for smaller classes. There are exceptions, here, of course—individual altruism does exist (for instance, environmentalists).

Third, the economist will make a cost-benefit analysis: do the potential advantages (benefits) of creating smaller classes outweigh the potential disadvantages (costs) (cost-benefit analysis)?

Finally, the economist will likely emphasize that there is a point where reducing class size will no longer lead to a positive result.

How do we study choice under conditions of scarcity?

Economics is the study of how people make choices under conditions of scarcity, and how these choices affect society.

The scarcity principle (also known as the no-free-lunch-principle) means that, despite people having infinite wants, resources available to us are limited, which means that having more of one thing often means having less of another thing. That is where the cliché comes from, there ain’t no such thing as a free lunch, or TANSTAAFL.

Inherent in the fact that a person must make choices is the cost-benefit principle, which entails that an individual (or a firm, or a society) should only take action when the additional benefits of that actions are at least as great as its additional costs.

Consider also that concepts such as time and energy are scarce: both can run out. This is why rich people make different choices from poor people: they often value time over money.

How do we apply the cost-benefit principle in practice?

In the study of choice we constitute, first, that people are rational, which means that they have specific goals that they wish to fulfill as well as possible. One of the biggest issues with the cost-benefit analysis is that certain goals do not have a specific monetary value, so priorities are difficult to establish.

Example: you have two choices: buying a computer game for 25 euros nearby your house, or buying one for 15 euros in the city center, which is a 30-minute walk away. A cost-benefit analysis makes clear that a person will only save her 10 euros when she thinks it’s worth a 30-minute walk.

An economic surplus is the benefits minus the costs of an action taken. Say the costs of the 30-minute walk in the example above are 9 euros, that leaves an economic surplus of 1 euro.

Now say that you could have invested the time you would in studying for a test, instead. In that case we say that the opportunity costs, the value of what you have sacrificed (that is, time to study), are high. This way, you will be less likely to sacrifice that time.

What is the role of economic models?

Economists know that people do not constantly reason like this. However, it is important to realize that rational choice is, either implicitly or explicitly, based on weighing the costs and benefits. The cost-benefit principle is an abstract model, which means that it offers a simplified description of certain essential elements in a given situation, so that we can analyze the situation logically.

What are four important pitfalls?

The first pitfall is measuring the costs and benefits in proportions of absolute amounts. Example: it is more valuable to save 100 euros on a 2000 euro plane ticket than to save 90 euros on a 200 euro plane ticket (even though in the first case you save only 5% and in the second you save 45%).

The second pitfall is ignoring opportunity costs. Example: the question is not “Should I walk to the pub”, but rather, “should I walk to the pub, or watch a movie at home?” It is essential to appreciate the value that you sacrifice for a certain action.

The third pitfall is taking sunk costs into account. Sunk costs are costs that you have already made at the moment you make a decision. Example: you bought a ticket for a movie one week ago. Tonight is the screening, but you don’t feel like going. You have already spent the 10 euros, so that should not be taken into consideration in deciding whether you will go or not.

The fourth pitfall is to fail to understand the difference between average and marginal. Marginal costs are costs that result from executing an additional unit of an activity. Marginal benefits are benefits that result from the execution of an additional unit of activity. Example: when a government tries to decide whether they will spend extra money on a certain subsidy, it doesn’t matter whether they increase it from 2 to 3 billion, or from 5 to 6 billion. The marginal costs, so the cost of every extra, individually spent euro should be lower than the marginal benefits to justify the extra expenses.

The average costs and benefits, on the other hand, are the total costs (or benefits) of executing n number of units of an action, divided by n.

What are the differences between microeconomics and macroeconomics?

Microeconomics is the study of individual choice under conditions of scarcity and the implications of this for the behavior of prices and amounts in individual markets. Macroeconomics is the study of how national economies function and how governments use policies in attempt to improve such functioning. The scarcity principle and the fact that resources are limited are very important in both disciplines.

What are two important lessons?

First, it is important to try to become an economic naturalist—someone who applies economic insights to everyday events.

Second, it is important to know the difference between positive and normative statements. Example: a climatologist can establish the effects of different greenhouse gasses on the climate in the coming decades. Such conclusions would be positive (descriptive). However, say the climatologist would say: we ought to avoid this scenario by banning the use of private automobiles, then that statement would be normative (prescriptive).

How do we make calculations in economics?

It is also important to make calculations in economics.

An equation is the mathematical expression which describes the relationship between two or more variables. A variable is a quantity that is free to take different values. We have the dependent variable, which is a variable in an equation whose value is determined by the value taken by another variable in the equation, and the independent variable, which is a variable in an equation whose value determines the value taken by another variable in the equation. Aside from this, there is the constant (or parameter), which is a quantity that is fixed in value.

In other words, in the equation B = 5 + 0.10T, B is the dependent variable and T the independent variable.

In making graphs there is the vertical intercept: in a straight line this is the value taken by the dependent variable when the independent variable equals zero (the value on the x-axis). Then there is the slope: in a straight line this is the ratio of the vertical distance the straight lien travesl between any two points to the corresponding horizontal distance. In the example above, the vertical intercept equals 5 and the slope equals 0.10.

How do you calculate the slope of a curve in a graph?

There is an important problem: how do you calculate the slope? In a straight line this is simple: you take two random points on the line and you calculate how much the line has risen on the y-axis per distance traveled on the x-axis. However, when calculating the slope of a curve, this is more difficult. For this, you have to differentiate (. Differentiating means calculating the slop or the change in a function by using algebra rather than geometry.

In the expression Y = a + bX + cX² + dX³ you differentiate (dY/dX) like this:

dY/dX = b + 2cX + 3dX²

In economics, price is P and quantity is Q.

So, when the expression is Q = 2000 - 350P + 5P²

Then we can find the slop, dQ/dP, by differentiating and solving:

dQ/dP = -350 + 10P

So we can see that at different prices (value in P) there are different quantities (value in Q).

How do markets, specialization, and economic efficiency work? - Chapter 2

This chapter’s learning goals are:

1. Explaining the difference between absolute and comparative advantage.
2. Understanding how comparative advantage enables gains from specialization and exchange, even when there is absolute disadvantage in international trade.
3. Understanding what increasing opportunity costs are.
4. Using the concept of production possibility curve.
5. Understanding how comparative advantage can change and be changed.
6. Explaining what the difference is between technical and economic efficiency.

What is the principle of comparative advantage?

One of the most important insights in the modern economy is that when two people (or countries) have different opportunity costs in executing different tasks, they can always increase their total combined value by trading available goods and services with each other. See the following table:

Paula has an absolute advantage, an advantage that a person has over another when she can earn more by spending one hour on a specific activity than what the other person earns by spending one hour on that same activity.

However, the fact that Paula is a better web programmer than Beth does not mean that she has to do this work herself. Beth has a comparative advantage to Paula in web programming: she is relatively more productive than Paula. Compared to each other, Beth can fix 1 bike while she updates a web page, while Paula can repair 2 bikes when updating a web page. The table now looks as follows:

This lead us to conclude that Beth and Paula should specialize, so that they can achieve the highest combined productivity together. This is the reason that we don’t spend 5% of our time on building cars, 10% on producing food, and 25% on building houses, but become fulltime car producers and leave the other tasks to other people.

Where does comparative advantage come from?

With people, comparative advantage does not only come from differences in talent, but more often from differences in education and experience. With countries, this difference can come from different available resources. However, it can also come from non-economic factors: people from English-speaking countries have an advantage in the international labor market, because English is the most-used language there.

What is the relationship between comparative advantage and production possibilities?

Imagine an island where only two goods are produced: coffee and pine nuts. Workers can choose to put all their time in the production of coffee, or all their time in the production of pine nuts, or in any alternative that lies between those options. Al those options taken together are called the production possibilities (PPC).

Say that when you spend your entire day (6 hours) producing coffee, and you can produce 4kg of coffee per hour, or that you spend you entire day producing pine nuts, and that you can produce 2k of pine nuts per hour, then the PPC goes from 24kg of coffee and 0kg of pine nuts to 0kg of coffee and 12kg of pine nuts.

The opportunity costs are presented as:

OC pine nuts = loss in coffee/profit in pine nuts. And the other way around.

OC coffee = loss in pine nuts/profit in coffee.

Every point that is on the PPC or inside it, is an attainable point, meaning that it is attainable with the current production possibilities. Every point outside it is an unattainable point, meaning with the current production possibilities. Points that are inside, but not on, the line are inefficient points, points on which the production of product A does not lead to a reduction in the production of product B. Efficient points, on the other hand, are points that are on the PPC line. It is important to remember that comparative advantage is only interesting when looking at two people (or, for example, countries).

Now say that A and B live on an island. A has both an absolute and a comparative advantage in producing pine nuts and B has both an absolute and a comparative advantage in producing coffee. When A and B decide not to specialize, and they both produce coffee as well as pine nuts, that leads to unexploited potential. However, when they do specialize, it still matters how they do it. If they do it in the most efficient way—in this case, when A only produces pine nuts and B only coffee—then that creates a production possibility frontier (PPF) in the graph.

Remember, however, that it is possible that there are certain economies where the demand is higher for one product than for another. Even if A and B created optimal efficiency by focusing on their best product (producing, for example, 12kg of coffee and 12kg of pine nuts), it could still be possible that it is not advantageous for their specific economy to fully specialize. For example, when there is demand for only 6kg of coffee and 20kg of pine nuts, A and B could best have B produce 6kg of coffee and for the remainder of her time help in producing pine nuts.

An important rule in such choices between comparative advantages is that the opportunity costs for producing a product increase as the economy produces more of that product. In other words, the higher the production, the higher the opportunity costs. This leads to the low-hanging-fruit principle (also known as the principle of increasing opportunity costs): given the fact that resources have different opportunity costs, we should always exploit the resources with the lowest opportunity costs first.

Which factors change a society’s PPF?

It is always a trade-off to increase the production of a product’s PPF, because it reduces another product’s PPF. Over time, however, it is possible to increase the PPF of all products in an economy: this is called economic growth.

An important aspect in constituting economic growth is investing in new production possibilities. This way, workers’ and firms’ productivity can be increased.

Another factor is population growth: more people can be productive this way. However, this does not necessarily improve the standard of living, because there are also more “mouths” to feed.

Perhaps the most important factor in constituting economic growth is knowledge and technology. Improvements in these areas lead to great jumps in productivity.

An interesting question is: “If specialization works so well, why do people in poorer countries not specialize?”

Population density is an important factor here. We have seen in history that productivity in cities was higher than in rural areas. When there are big distances between individual people, then it becomes more difficult to exchange goods, and with it, to specialize. However, population density is not the only factor. Different laws and traditions in countries also have an effect. Finally, market size also affects the ease with which a country can specialize.

It is also possible to have too much specialization. At a certain point, fragmentation can occur. However, it is of course unclear when this happens.

What is the relationship between comparative advantage and profit from international trade?

If people benefit from specialization, then countries do as well. Countries can agree to specialize in products, for example, country A in butter and country B in weapons (in other words, products that have nothing to do with each other). Together, they can increase the PPF of their society through trade. Most of the time both countries will profit from trade, but it is possible that one country profits more than the other.

This chapter’s learning goals are:

1. Explaining the difference between absolute and comparative advantage.
2. Understanding how comparative advantage enables gains from specialization and exchange, even when there is absolute disadvantage in international trade.
3. Understanding what increasing opportunity costs are.
4. Using the concept of production possibility curve.
5. Understanding how comparative advantage can change and be changed.
6. Explaining what the difference is between technical and economic efficiency.

How do markets, demand, supply, and elasticity work? - Chapter 3

This chapter’s learning goals are:

1. Understanding the problem with coordination for a society.
2. Understanding how sellers respond to pries and are affected by changes in income and taste.
3. Understand how producers respond to prices and how their reaction is influenced by changes in costs and technology.
4. Understanding and applying the concept of a market equilibrium.
5. Showing the impact of intervention in the market.
6. Measuring and using the concept of elasticity.
7. Understanding and commenting on different elasticity measures.

What is the role of buyers and sellers in markets?

A market for a good consists of buyers and sellers for that good. We used to think that the price for goods came from the costs of production. After that, we thought that the price of a product came from the value it had for a person. Nowadays, we know that both are a little bit true: price is derived from demand and supply.

The demand curve is a graph in which the quantity of a product is shown that buyers want to buy per price. For example: at a price of 4 euros per pizza slice, buyers want to buy 8000 pizza slices and at a price of 2 euros per slice, buyers want to buy 16000 slices.

A fundamental rule of the demand curve is that it is downward-sloping: the lower the price, the higher the demand. An important factor in this is the substitution effect: when buyers can switch to a similar product (in the case of pizza, this can be a chicken and fries), they will do that when the price (of the pizza, in this case) becomes too high. Another important factor is the income effect: when a price becomes higher, consumer can spend less money on other products. There is also the buyer’s reservation price: buyers determine the price they want to pay for a product in advance, so when the price increases, less people will be willing to pay it.

The demand curve can be interpreted horizontally and vertically. Horizontal interpretation tells us the quantity of demand for a product as a function for the price of a product. Vertical interpretation tells us the market price for a product as a function of the quantity of demand for a product.

The supply curve is a graph in which the quantity of a product that sellers want to sell at a specific price is shown. For example: at a price of two euros per slice, sellers want to sell 8000 slices and at a price of 4 euros per slice, sellers want to sell 16000 slices.

The question for sellers of pizza slices is whether the price (and, so, the benefits) of every additionally sold pizza slice is higher than the opportunity costs. These rising opportunity costs ensure that the demand curve is upward sloping. The supply curve can also be horizontally and vertically interpreted. Horizontal interpretation gives us the quantity that producers want to sell as a function fot he price they expect to receive. Vertical interpretation gives us the price that must be paid for a given quantity as a function of the quantity.

There is also a reservation price for sellers: this is equal to the marginal costs, meaning the costs for every additionally produced pizza slice.

The point where the demand and supply curves meet is the price equilibrium.

What is the market equilibrium?

A system is in equilibrium when there is no reason for the system to change. There is a dynamic equilibrium (the system is in motion, but at a constant/fixed pace) and a static equilibrium (a system is not in motion and stays constant/fixed). Example: inflation can be a dynamic equilibrium when the height of inflation remains constant.

When we want to know the equilibrium price and equilibrium quantity in a given market, we have to find the equilibrium for that specific market. This is the point where the demand curve and supply curve cross each other. At this point, all sellers and buyers are “satisfied” with the current state of affairs and there is a market equilibrium. In the pizza example, this would be the price that is exactly between 2 and 4, namely 3 euros per slice. At a price of 4 euros, there would be excess supply and at 2 euros there would be excess demand.

The notable thing about markets is that they guide the price and quantity of their products toward the market equilibrium. For example, when the price of a pizza slice is 4 euros, then one of the producers will try to raise demand (and take it away from competitors) by selling slices for 3.95 euros. And the other way around: when a buyer cannot buy a pizza slice because the offered quantity is very low at a low price, then she will be willing to pay a higher price to eat pizza anyway. The price will increase because of this.

With this in mind we can look at government intervention in the housing market. Say that in paris the market equilibrium for a house in the center is 1600 euros per month, at which point 20000 houses are rented out. However, the circumstances change and the demand starts to increase, so the rent increases to 2000 euros per month, at which point 30000 houses are rented out. As a measure against the risen price, the government implements a rent control, whereby the maximum price for rent is put back at 1600 euros. However, demand has increased, so that it is now at 37500 houses, while at a price of 1600 euros per month only 20000 houses will be offered: there will be a shortage of 17500 houses.

The purpose of such a rent control is, of course, to allow people with lower incomes to move into a neighborhood, but oftentimes the market finds ways to prevent this anyway. In this example, owners can discriminate between renters without suffering economic backlash, as would happen in a “satisfied” market.

Rent control is one form of a price ceiling, a law that prescribes a maximally allowed price. Such a measure often leads to excess demand.

How can we predict and explain changes in prices and demanded quantities?

First, it is important to distinguish between a change in the demanded quantity and a change in the demand. The former is a change across the demand curve, whereas the latter is a movement of the entire demand curve.

The same goes for a change in the supplied quantity and a change in the supply.

There are different possible causes for a change in the demand: a change in the prices of complements and substitutes; changes in incomes and taste; and changes in expectations (for example: when a new Iphone will soon be on the market, the demand for the current model will go down).

Complements are goods that go well with (complement) each other and are worth more together than they are apart. For example: tennis balls and tennis courts. When the price of tennis courts goes down (so it becomes cheaper to play tennis), then the price for tennis balls will go up. Substitutes, by contrast, are goods whereby a lower price of one good leads to a lower price for another good. For example, when the price for internet access goes down, the demand for mail deliverers will go down also (because more people will use electronic mail).

Demands in incomes also affect demand. With normal goods the demand for the product will increase when people’s incomes increase (because people will simply have more money to spend). With inferior goods the price of the product will go down as people’s incomes go up (because people will be able to buy better goods).

Changes in the supply curve occur when there are changes in the production costs. This includes input prices, changes in technology, and in taxes and subsidies.

Four rules of changes:

1. An increase in the demand will lead to an increase in both the equilibrium price and the equilibrium quantity.
2. A decrease in demand will lead to a decrease in both the equilibrium price and the equilibrium quantity.
3. An increase in the supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity.
4. An decrease in the supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity.

What is price elasticity and how do we measure it?

The price elasticity for the demand of a good is a percentage change in quantity demanded that results from a 1% change in price. Example: when the price of meat goes down with 1%, and the demanded quantity increases with 2%, then meat has a price elasticity of the demand with a value of -2 (namely, -2 / 1 = -2). The outcome of such a calculation is always negative, so we often leave out the minus (-) and say the price elasticity of the demand equals 2.

Some goods have an inelastic demand, like salt, which means that the demanded quantity barely responds to a price change. In such cases, the elasticity is between 0 and 1. Other goods have an elastic demand, which means that the elasticity is greater than 1. Finally, there are goods that are unit elastic, which means the elasticity equals 1.

Most of the time the price elasticity of the demand for a good or service is greater when there are substitutes for the good, when the good takes up a larger portion of the consumer’s budget, or when consumers have more time to adapt to a price change (for example: when you’ve just bought a car, you will not quickly adapt to a change in the price of gasoline, because you’re not immediately going to buy a new car that is more economical.

In a formula the price elasticity looks as follows:

Price elasticity = Ɛ = (ΔQ/Q) / (ΔP/P)

“Δ” means the changing price or demanded quantity.

Example: at a price of 100, 20 units are sold. At a price of 105, 15 units are sold. That way ΔQ/Q = 5 (because there are 5 units sold less) / 20 (because that was the original amount). ΔP/P = 5/100

ΔP/ΔQ is mathematically equal to the slope. In other words: ΔQ / ΔP = 1 / slope. This means that if you want to calculate the price elasticity at point A, denoted ƐA, the formula looks like this:

ƐA = (P / Q) x (1 / slope)

We can calculate the slop by dividing the y-axis with the x-axis.

When the demand curve has a straight line, it always goes down (from the top-left to the bottom-right). An important rule, here, is: the further you go down the line, the lower the elasticity. There are two exceptions, namely with perfect elasticity and perfect inelasticity. With the former, the line goes exactly horizontally (meaning that even with the slightest increase in price, consumers switch to a substitute), and with the latter the line is vertical (meaning that consumers can never switch).

To calculate the midpoint of the demand curve with a straight line, you take two points on the line: the point with the highest price and the point with the lowest price. When those points are QA, PA, and WB, PB, then the formula looks as follows:

Ɛ = (ΔQ / (QA + QB)) / (ΔP / (PA + PB))

It is important to realize that the demand curve often does not have a straight line. To calculate the slop, we again use the (ΔQ/Q) / (ΔP/P) method (differentiating).

One of the most important questions for producers is: do I get a higher revenue when consumers buy many products at a low price, or when consumers buy few products at a high price? The answer strongly depends on the price elasticity.

It is important to assume that the total expenditure (of consumers) is always equal to the total revenue (of producers). Say that a cinema sells tickets per day against a certain price. At a price of 2 euros per ticket the cinema sells 500 tickets, which adds to 1000 euros in expenditure (and revenue), at a price of 4 euros 400 tickets, etcetera. In a table that would look like this:

In a demand curve with a straight line the total expenditure reaches a maximum price that corresponds to the midpoint of the demand curve. Maximum revenue is realized when the price elasticity is unit elastic (1).

Remember that the elasticity of the demand is not given by the price, but also by prices of substitutes and complements, or even by differences in incomes. In the first case, this is called cross-price elasticity of the demand and in the second case it is called income elasticity of the demand. These forms of elasticity of the demand can be positive or negative. The income elasticity of the demand for inferior goods is negative (when incomes go up, the price goes down), whereas with normal goods it is positive (as incomes increase, demand also increases). With cross-price elasticity, when the elasticity is positive, the goods are substitutes (for example, peanuts and cashews), whereas when it is negative, the goods are complements (tennis courts and tennis balls).

Aside from the elasticity of the demand, there is also price elasticity of the supply. This works similar to the elasticity of the demand and can be calculated in the same way. As with the elasticity of the demand, there is also perfect inelasticity of the supply and perfect elasticity of the supply. An example of the former would be land in Hong Kong. As in all markets, certain quantities of land are sold at a certain price, but because there can be no variance in the supplied quantity, because the amount of land does not change, there is a vertical line. With perfect elasticity of the supply, there is a horizontal line.

The most important aspect in figuring out how elastic the supply of goods is, is to know how additional units of input in the production process can be acquired. Generally speaking, the easier it is to acquire extra units of input, the higher the price elasticity of the supply.

The following factors determine how easily additional units can be acquired:

• The input’s flexibility (can the input be used for different ends?)
• The input’s mobility (can the input be relocated?)
• The skill to produce a substitute-input (for example, fake diamonds)
• Time (in the long term, price elasticity of the supply is higher than in the short term, because producers need time to adapt)

The ultimate bottleneck for supply is a unique input. Take a football club that wants to attract a talented player: there simply aren’t many players as good as Lionel Messi. Some input, moreover, can simply be essential. Take, again, a football club: you can spend money on good players all you want, but in the end there are only 4 English teams that qualify for the Champions League (while there are 20 teams that spend millions of euros).

What is the effect of markets on social goals?

Since sellers (producers) and buyers (consumers) exchange in markets, consumer surplus and producer surplus can sometimes occur, which together makes the total surplus. A consumer surplus is the reservation price of the consumer minus the (market) price paid by the consumer. A producer surplus is the received (market) price minus the reservations price. Example: a consumer wants to pay 4 euros for a pizza slice and a producer wants to receive 2 euros for a pizza slice. The consumer buys the pizza slice for 3 euros. In this case the total surplus of this exchange is 4 – 2 = 2 euros, of which 4 – 3 = 1 euro is consumer surplus and 3 – 2 = 1 euro is producer surplus.

Certain regulations (such as price ceilings) prevent the market from achieving the optimal market equilibrium, and, therefore, achieving the highest possible total surplus. When this happens, we say there is “cash on the table,” because some cash remains on the table, instead of going into someone’s pocket. These are called unexploited opportunities.

The social optimal quantity of every good is the quantity that maximizes the total economic surplus. In markets, this is achieved through economic efficiency, or efficiency, which occurs when all goods and services are produced and consumed on the most optimal levels. The efficiency principle is therefore: efficiency is an important social goal, because it grows the economic “pie,” which makes it possible for everyone to get a bigger slice.

However, in some cases, there are production costs involved that are not for the producer, but for third parties. Take environmental pollution: that is a collective cost, not an individual one. This ensures that a situation can develop in which a producer continues increasing production, because her marginal benefits outweigh her marginal costs, when the marginal benefits for the society taken together are actually lower than the marginal costs.

That is why the equilibrium principle goes as follows: a market in equilibrium leaves no unexploited opportunities for individuals, but may not exploit all benefits that are possible through collective action.

What are the differences between free markets and centralized markets?

Societies can take different shapes. One possibility is to take all decisions in a centralized fashion, so by one person or a small group of people. Well-known examples of this are communist societies, such as the Soviet Union.

Another possibility is to create a completely free market, where there are no regulations for the workings of the market.

In reality, there are no real examples of pure free markets or pure centralized markets: almost all economies are a mixed bag, although most Western countries have less and less regulations.

This chapter’s learning goals are:

1. Understanding the problem with coordination for a society.
2. Understanding how sellers respond to pries and are affected by changes in income and taste.
3. Understand how producers respond to prices and how their reaction is influenced by changes in costs and technology.
4. Understanding and applying the concept of a market equilibrium.
5. Showing the impact of intervention in the market.
6. Measuring and using the concept of elasticity.
7. Understanding and commenting on different elasticity measures.

How does the demand side of the market work? - Chapter 4

This chapter’s learning goals are:

1. Understanding that the demand curve comes from the cost-benefits principle.
2. Understanding the concept of consumer equilibrium in relation to prices.
3. Explaining how changes in the price of a good (and of other goods) affects the quantity sold of that good.
4. Using the indifference curves to show that the demand curve has a downward slope.
5. Understanding the income and substitute effects of a price change.
6. Understanding and applying the concept of consumer surplus.

What is the law of demand?

The law of demand goes as follows: people do less of an action when they costs of that action increase. This is a direct result of the cost-benefit principle, as taking an action is only done when the marginal benefits are larger than the marginal costs.

Wants (also called preferences or tastes) play an important role in determining the price of a product. These wants can change over time: many books came out on the Titanic disaster of 1912, but they only started selling well after the 1998 film became so successful.

Peer influence is also important in determining the price of a product: when a teenager buys drugs, the price does not so much affect this decision as does his social environment. The same goes for products of well-known brands.

Needs are something different: people do have wants, but they can do without. However, a person cannot be without needs: food, clothing, a house.

How are wants translated to demand?

There is no limit to the wants of people, but there is a limit to our capabilities to fulfill these wants. Even when we had unlimited money, time and energy would still be limited. So, an important question is: how do we spend our incomes to fulfill our wants as well as possible?

The goal of people to fulfill their wants as well as possible is also called utility maximization. Goods have a certain utility. The utility of most goods rises with a diminishing rate at additional consumption. Example: eating ice cream serves the purposes of feeling happier. However, the amount with which we become happier by eating ice cream becomes smaller with each additional unit of ice cream, until we actually become less happy (as we become noxious, for instance). See the table:

Simply put: two ice creams make us happier than one ice cream, but the second ice cream makes us less happy than the first. This is where the term marginal utility comes in, which is the added utility by consuming one additional unit of a good. This tendency for the marginal utility to decrease as consumption increase is called diminishing marginal utility (DMU). DMU is true for most goods.

Of course, people have to achieve utility maximization from many different goods. As someone consumes more of good A, the marginal utility of good A goes down, creating an incentive to start consuming good B, because the marginal utility is higher here (low-hanging fruit principle). Eventually people have to look for the optimal combination, which leads to the highest total utility. This optimal combination comes from the rational spending rule: expenses should be divided over goods so that the marginal utility per euro is the same for every good. This rule only goes for goods that are easily to divide, such as milk and gasoline. Some goods, however, are not, as with cars and televisions. The rational spending rule follows directly from the cost-benefit principle, and is therefore not a basic principle (though it is important).

We can also explain the substitute and income effects by looking at utility maximization. When the price of a product with many substitutes goes up, consumer will switch to those substitutes to achieve the same amount of utility. As for income, the height of one’s income directly affects how much money a person can spend, and therefore, on which goods she will spend her money.

How do we apply the rational spending rule?

An important example of the substitute effect were the 1970s. The oil crisis made gasoline prices go up, so people started carpooling and taking public transport.

An important example of how we can apply the rational spending rule to the income effect is by looking at different houses of richer and poorer people. Rich people buy bigger houses because their utility maximization works as with the ice cream: a bigger house leads to more utility than a smaller house, but not to as much utility as compared with having no house.

What is the relationship between the individual curve and the market demand curve?

If we know the individual demand curve of every individual, then we can put these curves together to create the entire market curve. Example: if person A at a price of 4 euros per can buys 6 cans of tuna each week and person B buys 2 cans, then the market demand is 8 cans of tuna per week. If we plot this in a graph, we call it a horizontal addition. When 1000 individual demand curves are equal, then we get the market curve on the x-axis by indicating that the numbers are x1000.

To make a proper cost-benefit analysis it is sometimes necessary to make clear the total consumer surplus. Imagine a market with 11 potential buyers wherein consumers can only buy one unit per day. Each individual buyer has a different reservation price: the first for 11 euros, the second for 10 euros, the third for 9 euros and so on. The graph then looks like a “staircase.” Now say that the seller offers a price of 6 euros per unit. That way, five potential buyers are removed (namely the ones whose reservation price is 1-5 euros). The six remaining consumers whose reservation prices are 6-11 euros will buy the product. The total consumer surplus (market price minus reservation price) would be (11 - 6) + (10 - 6) + (9 - 6) + (8 - 6) + (7 - 6) + (6 - 6) = 5 + 4 + 3 + 2 + 1 = 15 euros.

This chapter’s learning goals are:

1. Understanding that the demand curve comes from the cost-benefits principle.
2. Understanding the concept of consumer equilibrium in relation to prices.
3. Explaining how changes in the price of a good (and of other goods) affects the quantity sold of that good.
4. Using the indifference curves to show that the demand curve has a downward slope.
5. Understanding the income and substitute effects of a price change.
6. Understanding and applying the concept of consumer surplus.

How does the supply side of the market work? - Chapter 5

This chapter’s learning goals are:

1. Understanding why supply curves of firms in the short term, based on marginal costs, are presented with an upward slope.
2. Predicting how changes in the prices of factors of production affect the technology that firms use to produce goods.
3. Using and measuring elasticity of the supply.
4. Understanding and explaining how profit-seeking firms decide how to produce.
5. Measuring the producer surplus.

What is the importance of opportunity costs?

Say you have a job as a dishwasher, with which you earn 6 euros per hour. You can work as many hours as you want. Another way of earning money is to clean up cans on a big terrain. The number of cans you can find, goes as follows:

You earn two cents per can you clean up. How much time should you spend cleaning up cans?

The answer depends on the opportunity costs. The first hour you search for cans you earn (600 x 0.02) = 12 euros. The second hour you earn (400 x 0.02) = 8 euros. The third hour you earn (300 x 0.02) = 6 euros. And the fourth hour you earn (200 x 0.02) = 4 euros. The alternative is to wash dishes, which earns you 6 euros per hour. In other words, the best strategy is to clean up cans for three hours, because after that, the marginal benefits are lower than the opportunity costs.

When you break even on the opportunity costs, we call it the redemption price. You can calculate this with the following formula:

p(ΔQ) = 6

The redemption price for the second hour would be p(400) = 6 euros, which comes down to p = 1.5 euro cents.

The supply curve has an upward slope because of the low-hanging-fruit principle: in the case of cleaning up cans, you will first go looking for the cans that are most easily found, which makes your first hour of work the most effective. In addition, sellers respond to their opportunity costs: they stop offering a product a certain point, because they can choose for more profitable alternatives.

Now imagine a company that makes bottles. The only costs the company has are found in paying its employers and renting a bottle-making machine. The employers and the machine, here, are the factors of production, the input that is used in the production of goods and services. We call it production in the short run when the factors of production are fixed for a certain period. We call it production in the long run when the period is long enough that the factors of production are variable.

As it works with cleaning cans, so does it work with hiring employees: eventually there will be a point that the output of each employee goes down. This is called the law of diminishing returns. Oftentimes this stems from a form of congestion. Example: it’s better to work with three people behind a bar, because with, say, ten people, you will only get in each other’s way.

An important concept for the supply side of the market is fixed costs, costs that are not dependent on the output. In the example of the bottle company this is the bottle-making machine: the rent is always the same, whether you use it to produce 80 bottles per day, or 350. Aside from these costs, there are also variable costs, costs which are dependent on the output. With the bottle company these are the employees, because it requires more employees to make 350 bottles than it does to produce 80. Together the fixed costs and variable costs make up the total costs. The marginal costs, finally, are the costs in the difference in output. See this table:

Perhaps the most important concept is the average total costs, which can be calculated by dividing the total costs by the output. It is important to realize that, in a graph, the line of the marginal costs cuts across the line of the average total costs (and this is also true for the line of the average variable costs). This makes sense, because the average costs go up because the marginal costs for the next, additional product are higher than the average costs so far.

What is the relationship between input prices, production capabilities, and the costs of the supplier?

The bottle company was an example in the short run. In the long run, it is possible for a company to replace labor (the employees) and capital (the machines) and to make use of technological development to create a more efficient (at lower cost) output. This means that the law of diminishing returns isn’t so important. Besides, a company can expand and benefit from economies of scale in the long run, which can bring the price down (for example because they can acquire their input, or factors of production, more cheaply).

What determines the supply?

As mentioned earlier, the following five factors largely determine the supply (the cost side):

1. Technology (innovations)
2. Input prices (labor and capital)
3. The number of sellers (competitors)
4. Expectations (is a new model coming out? Will there be a price change?)
5. Price changes in other products

What about revenue?

So far we have focused on the costs for sellers. The other important aspect is the size of the revenue. What are the goals of a producer?

One of the most frequent goals is profit maximization. This means that a seller sets a goal to acquire the highest profit possible. Profit is calculated by subtracting the total costs from the total revenue.

When talking about profit-seeking companies, it is often assumed that they operate in a market with perfect competition, which means that no seller has any influence on the market price of the product (as a seller in a monopoly would). When this is the case, such firms are called price takers.

There are four aspects in a market with perfect competition:

1. All companies sell the same standardized product. This does not mean that every product is exactly the same, but it does mean that we are talking about products where it is possible for buyers to switch to a different seller, without losing quality.
2. The market has numerous buyers and sellers, who individually exchange only a small part of the total quantity.
3. Productive resources are mobile. This means that it is not difficult to enter the market and to start one’s own firm.
4. Buyers and sellers are well informed. This means that they know about alternative products and that it is impossible to vary in price.

Since perfect competition companies have no influence over the market price, they are required to keep their costs as low as possible. Firms in a market with imperfect competition do have some influence over price, but they cannot deviate from it endlessly.

How do we use costs and revenues to determine how profits are maximized?

Remember the bottle-making firm. Say the market price is 35 cents per bottle: how many bottles should the firm produce to maximize profit? Following the cost-benefit principle, the bottle company should continue production as long as the marginal benefits outweigh the marginal costs. The marginal benefits are 35 cents per bottle. We have seen in the table that a bottle production of 300 (so, with 4 employees) leads to a marginal cost of 0.33, and that hiring an additional (fifth) employee would lead to a marginal cost of 0.40. From this we can conclude that when the market price had been higher, the company could go for a higher output. Now assume that that wages decrease, which means that the marginal costs go down. This will also mean that the bottle company will increase the output, exactly until the marginal costs are greater than the marginal benefits.

Say a company already endures losses from the minimal production, then it had better cut its losses by stopping production and paying the fixed costs, because otherwise production will only add to more costs. This happens when the market price is lower than the minimal worth of the average variable costs.

As with a consumer surplus, there is also a producer surplus. This is the amount with which the paid price is higher than the supplier’s reservation price.

This chapter’s learning goals are:

1. Understanding why supply curves of firms in the short term, based on marginal costs, are presented with an upward slope.
2. Predicting how changes in the prices of factors of production affect the technology that firms use to produce goods.
3. Using and measuring elasticity of the supply.
4. Understanding and explaining how profit-seeking firms decide how to produce.
5. Measuring the producer surplus.

How does economic efficiency work? - Chapter 6

This chapter’s learning goals are:

1. Explaining economic efficiency of an economy in terms of generating surplus.
2. Demonstrating that a market economy is usually efficient, when subject to certain well-defined conditions.
3. Explaining that efficiency is not the only criterium by which an economic system is evaluated, but that efficiency is a prerequisite for maximum economic welfare.
4. Understanding how restrictions that prevent markets from clearing have economic efficiency implications.
5. Understanding the importance of efficient design of pricing mechanisms affecting public sector production.
6. Understand how taxes affect market efficiency and consumer welfare.

When is a market efficient?

When we say a market equilibrium is efficient, it means that when price and quantity are anything other than the equilibrium value, then there will always be a transaction possible whereby some people are better without others being off worse. This is also known as Pareto efficiency. In a sense there is something as a “free lunch.” This is not good, because this way the largest possible economic surplus is not achieved.

Generally speaking the following is then true: if price and quantity take anything other than their equilibrium values, a transaction that will make at least some people better off without harming others can always be found.

Efficiency is not the market’s only goal. In some cases, the market may be most efficient, but poorer families will not be able to buy or use the product. It is also important to remember that efficiency is not a goal in and of itself; it is a means to a goal, namely to reach the largest possible economic surplus.

What are the costs of preventing price changes?

Say that in a market for a product the equilibrium price is too high for many poor people. In such a scenario, economists will not necessarily think that a price ceiling is a good idea, because this results in a situation wherein transactions are possible where no one is worse off. Economists would rather see that the market price reaches the equilibrium, and that we give money to poor people, so that they can use the product as well. Thinking back on the economic “pie” again: it is better to make the pie as large as possible and then split it in a fair way.

Sometimes governments help people by putting subsidies on certain goods. Oftentimes these goods will be the “essential” goods such as food and energy. However, subsidies also bring down the economic surplus, as a lower price for consumers will lead to a larger demand. Normally speaking the new and larger demand would only be possible at a lower price, so that the value that the government pays is actually larger than the value that eventually reaches consumers. Poor people are helped by this, but what the government does in such a case is essentially burning/wasting money. Again: instead of subsidizing, the government should really just give more money to poor people.

Which prices do governments have to set for public goods and services?

The government’s goal should be to create the largest possible economic surplus in offering public goods (such as electricity). Prices should, therefore, be equal to the marginal costs.

An important question is how governments should tax people. They will likely want to tax firms most of all because (1) they have enough money and (2) they can’t vote. Unfortunately, many companies will react to such taxation with higher prices, meaning that eventually not only the sellers, but also the buyers in a market will pay the price.

Taxes on firms also have a negative effect on the total economic surplus, even though tax revenues make up for a significant part of this. The part that is lost, however, is called a deadweight loss. Taxes work best in markets where the equilibrium quantity is not so sensitive to changes in the costs of production. Usually this concerns products with low elasticity. A good tax would be a tax on land, because land is almost perfectly inelastic. Aside from this, other taxes that would work efficiently should focus on actions that people do too much of already, such as air pollution.

This chapter’s learning goals are:

1. Explaining economic efficiency of an economy in terms of generating surplus.
2. Demonstrating that a market economy is usually efficient, when subject to certain well-defined conditions.
3. Explaining that efficiency is not the only criterium by which an economic system is evaluated, but that efficiency is a prerequisite for maximum economic welfare.
4. Understanding how restrictions that prevent markets from clearing have economic efficiency implications.
5. Understanding the importance of efficient design of pricing mechanisms affecting public sector production.
6. Understand how taxes affect market efficiency and consumer welfare.

How does the “invisible hand” work? - Chapter 7

This chapter’s learning goals are:

1. Understanding the role of profit as the driving force for efficiency in a market economy, not as a margin of exploitation.
2. Understanding the difference between an economist’s and an accountant’s ideas on the concept of profit.
3. Explaining what the distributive and allocative function of prices is.
4. Understanding how barriers to exit as well as to entry reduce economic efficiency.
5. Understanding what is meant by the efficient markets hypothesis and its limitations.

What is the role of economic profit?

Firms want to maximize their profits. There are three kinds of profit.

Accountants will define profit as the difference between the revenue and the explicit costs, the actual payments a firm makes for the factors of production, for example. Accounting profit, then, is total revenue minus total costs.

Economists, by contrast, define profit as the difference between revenue and the implicit costs plus explicit costs. Implicit costs are the resources that a firm produces, even when no money is paid for them. These are the opportunity costs of all resources that are used by the owners of the firms. Such profit is called economic profit, or sometimes supernormal profit or excess profit.

Example: say a firm has a revenue of 400 thousands euros per year and its only cost is worker salary in 250 thousand euros per year. Besides that the firms has invested 1 million euros in machines (capital). The accounting profit would then be 150 thousand euros per year. However, the firm could have opted to not spend the money on machines, but to leave the money on the bank to draw interest. Say the rate of interest would have been 10%, then the company could have earned 100 thousands euros with that. In other words, the opportunity costs ensure that the economic profit is 150000 – 100000 = 50 000 euros per year. The difference between the accounting profit and the economic profit is called the normal profit, and it is equal to the opportunity costs.

What is the “invisible hand” theory?

Market prices have two distinct functions: distributive and allocative. The distributive function of price is to distribute scarce goods in a way that those who attach the highest value to them also receive them. The allocative function of price is to drive productive means to different sectors of the economy. Both functions are important for the theorie of the invisible hand by Adam Smith, which says that the actions of independent, self-interested sellers and buyers will often result in the most efficient allocation of resources. The reward of economic profit and punishment of economic loss would ensure this.

This driver of economic profit ensure that additional resources come to markets wherein firms make profit and leave markets where firms make losses (as people will open businesses in markets where they think they can make a profit). Since this leads to more sellers in the market, the supply will increase. This will result in a decreased price and, with it, in lower profits. All this, of course, plays out in the long run; not the short run.

This allocative function of price only works when firms can freely enter and exit markets. After all, when new firms cannot enter a market, then the supply will not increase, the price will not decrease, and economic profit will also not decrease. Certain factors that ensure that entering markets is difficult are called entry barriers. Not only entry, but also exiting is important. When firms see that it is difficult to exit a market, they will be less inclined to enter the market in the first place. Exiting, then, has to be easy. In politics, this can be a problem, as exiting is associated with job loss. Globalization, in particular, has an influence on public opinion, which is increasingly against free trade and free mobility. This has a negative effect on the economic surplus.

What is the difference between economic rent and economic profit?

Economic rent, or in economics simply “rent,” is the part of a payment for a factor of production that is higher than the owner’s reservation price. The difference between economic rent and economic profit is that the latter is driven towards zero by the invisible hand, while that does not happen with economic rent. Why doesn’t that happen? Because in cases of economic rent the seller has unique capabilities that are not easily imitated. This prevents supply from going up and, thus, the price from being driven towards zero.

What does the “invisible hand” look like in practice?

The invisible hand can lead to cost-saving innovations, because in competing markets there is a fixed price and a fixed revenue, meaning that in order to make a larger economic profit, one has to bring down the costs. Competition is key in this.

A good example of the efficiency of the invisible hand is found in the flying industry. At the end of the 1970s this industry was strongly regulated and it seemed difficult to bring costs down. In the 1990s the market was privatized and air companies such as Ryanair have brought the costs way down.

The efficient market hypothesis tells us that the current price of a stock incorporates all available information on future profits of a company. This means that when new information becomes available, the price of the stock will change. The hypothesis does not exclude the possibility of failure, but it does imply that such failure will be recovered over time. It also implies that “market analysts” are often slow in interpreting markets, and there is much research that indicates that they are barely better at choosing stocks than when someone would choose at random.

What is the difference between an equilibrium and a social optimum?

It is important to realize that the equilibrium principle, of the no-cash-on-the-table principle do not state that are never any opportunities to exploit. Such opportunities do occur, but only when the market is out of equilibrium. Usually this means that people can distinguish themselves in three ways: (1) by working extra hard, (2) by having a unique talent, (3) or by sheer luck. Aside from that, we emphasize moreover that the equilibrium ensure that opportunities are exploited; not that all resources are distributed in the socially most optimal way.

This chapter’s learning goals are:

1. Understanding the role of profit as the driving force for efficiency in a market economy, not as a margin of exploitation.
2. Understanding the difference between an economist’s and an accountant’s ideas on the concept of profit.
3. Explaining what the distributive and allocative function of prices is.
4. Understanding how barriers to exit as well as to entry reduce economic efficiency.
5. Understanding what is meant by the efficient markets hypothesis and its limitations.

How does imperfect competition work and what are the consequences of market power? - Chapter 8

This chapter’s learning goals are:

1. Understanding which kinds of imperfect competitive markets there are.
2. Defining imperfect competition and how it differs from perfect competition.
3. Understanding that market power means being able to set prices, and following what the implications of this are for profit maximization.
4. Understanding price discrimination and its implications.
5. Recognizing public policy that attempts to deal with market power.

This chapter focuses on price setters, firms that are (partly) capable of setting their own prices. These firms often have the possibility to differentiate their product from rivals’ products. When this is possible, these firms are in an imperfectly competitive market.

What does imperfect competition look like?

There are different kinds of forms that these sorts of markets can take. A pure monopoly is the first. This is a market wherein one single firm is the sole seller of a unique product. It is the exact opposite of a perfectly competitive market. An oligopoly is a market structure with only a few sellers. An example would be mobile network providers: in the Netherlands there are only 4 mobile networks. A monopolistic competition, finally, is a market wherein relatively many firms are present who each differentiate their product slightly by selling in different locations for example. We use the term monopolist to describe all three of these forms, so not just to describe a pure monopoly.

Firms that are in a perfectly competitive market have a straight horizontal elastic demand curve: as soon as they raise the price, their buyers will switch to competitors. Imperfect markets have a downward-sloping demand curve: some people will switch to competitors after a price increase, but others will stay (for instance because they feel it is easier to pay a higher price than to switch locations).

What is market power?

Firms with downward-sloping demand curves have a certain market power, the possibility to increase prices without losing their entire sales. This market power can stem from five different factors:

1. Exclusive control over important input. When a firm has all the essential input for production, they have much market power.
2. Patents and copyrights. These ensure that only those who have the patent are allowed to sell the product.
3. Government licenses or franchises. In such cases the government has given specific firms the right to produce specific products, such as mail, which brings a lot of market power.
4. Economies of scale. When firms have this, they can bring down costs of production by actually producing more. This way such firms can outcompete rivals and natural monopolies can be created.
5. Network economy. In some industries the successes of some products depend on other products. When a firm owns several of these essential products, it has market power.

What is the role of fixed costs with economies of scale?

Fixed costs play a crucial role in the constitution of certain economies of scale. When two firms compete with each other and the fixed costs are very low, then trying to increase the scale of production helps very little: it does not help to bring down the size of the variable costs, because these are dependent on the output. The fixed costs were already low, so the firms cannot outcompete each on the basis of these. However, when fixed costs are high, then increasing the scale of production does work. The fixed costs become relatively lower with each extra product that is produced. So, by producing more products than the competition, a firm in a market with high fixed costs can bring down the marginal costs of production (and, thus, increase the marginal benefits).

What does profit maximization look like for the monopolist?

The marginal revenue for a perfectly competitive firms are equal to the market price of the product. However, for a price setter, this is different because the output affects the price at which all products are sold. A perfectly competitive firm can sell as many products as it wants at the market price, which is fixed. A price setter, by contrast, can start selling more products, but has to take into account that the price for all products will decrease. Example: a monopolist sells two units per week for 6 euros per unit, which brings her 12 euros per week. Now she is going to sell a third unit per week, but all products will be sold at a different price, namely 5 euros per week, which brings her 15 euros in total. The marginal benefit here is not 6 euros, but 15 – 12 = 3 euros. With another sale per week, she will sell 4 products at 4 euros per unit, which brings in 16 euros in total. 16 – 15 = 1 euro is the marginal revenue.

The decision-making mechanism for the monopolist does stay the same: keep producing until as long as the marginal benefits are higher than the marginal costs.

Why does the “invisible hand” not work in a monopoly?

The invisible hand works to make market more efficient. However, when the monopolist goes past a certain amount of production, the price will go down, whereas this would stay the same in a perfectly competitive market. This ensure that the social optimal amount is not reached, and that the monopolist becomes socially inefficient, which in turn ensures that the economic surplus will not reach its highest potential. The problem, here, is that the marginal benefits are not equal to what people want to pay for the next product, but to the new price for all produced goods.

Given the fact that a monopoly is socially inefficient, why should we not legally prohibit such markets from being created? It is difficult to say which alternative would work perfectly.

We can measure market power with the Lerner Index by looking at the relationship between the marginal costs and the price. This index follows the following formula:

L = (P - MC) / P

What is the role of contestability?

Entry costs for a market also affect market competition. Entry costs are costs that you don’t get back after leaving a market (so, they are sunk costs). When such costs are low, the market is contestable. High contestability implies that prices are driven toward the average costs. This is sometimes used as an argument against government intervention in a market: over time there will come a form of contestability and a following decrease in prices. However, it is not so easy to establish that this contestability always occurs.

A potential way of solving the problem of social inefficiency would be price discrimination. This means that different buyers pay different prices. In that case the lower price with a higher supply would not be true for all prices, but only from a specific amount. However, two important conditions are necessary that aren’t always present: (1) concrete differences in demand from different groups and (2) the absence of the possibility to sell between different buyers. These problems can be overcome through the hurdle method of price discrimination. An example of this is to offer a product for a price and to give a coupon with which you can get a part of the price back. This extra hurdle will be taken by some, but not by others. A perfect hurdle is a hurdle that perfectly distinguishes buyers on the basis of their reservation price.

When these conditions are met, it is indeed possible to generate a higher economic surplus. In such a case we talk about a perfectly discriminating monopolist, someone who has every buyers pay their individual reservation price (which differs per person). This is also called first-degree price discrimination. When the monopolist would do this on the basis of groups instead of individuals, it is called second-degree price discrimination. Third-degree price discrimination is on the basis of entire markets. An example is Levi-Strauss, who held much higher prices in the EU than in India, for example. In practice, perfect discrimination is impossible, because no one knows every individual’s reservation price. Price discrimination is usually unpopular, because (1) people feel it is unfair and (2) some households are off worse so that a firm can make higher profits.

What does public policy concerning monopolies look like?

Since monopolies are inefficient and they make profits at the cost of buyers, governments want to limit them. With natural monopolies it is not commercially feasible to set up a different market structure, but governments can take up production themselves. If so, the problem of X-inefficiency might occur. When a government realizes a cost reduction, then the budget for that monopoly simply goes down, while a private monopoly can make actual profit by cutting costs. This incentive is lacking in the private sector.

Another way of limiting monopolies is to regulate them. This is often done through a cost-plus regulation, a method of regulation whereby the regulated firm can ask a price that is equal to the explicit production costs plus a part to cover the opportunity costs. However, there are some pitfalls here: there is much administrative work involved, it reduces incentives, and it doesn’t solve the problem of economic inefficiency.

Other methods that don’t work are to limit the profits, or to prescribe certain price rules.

One method that can work is to hire private firms to do certain kinds of work. The firms can bid for a contract and, when they get the job, they have the required incentives to work efficiently. However, there are some problems with this method, for example when the task is very complex and detailed.

This chapter’s learning goals are:

1. Understanding which kinds of imperfect competitive markets there are.
2. Defining imperfect competition and how it differs from perfect competition.
3. Understanding that market power means being able to set prices, and following what the implications of this are for profit maximization.
4. Understanding price discrimination and its implications.
5. Recognizing public policy that attempts to deal with market power.

What is the role of game theory in economics? - Chapter 9

This chapter’s learning goals are:

1. Understanding the basic elements of games and their application to economics.
2. Recognizing the importance of interdependence in analyzing how firms and individuals make decisions.
3. Understanding the concept of an outcome as an equilibrium solution to a game problem.
4. Understanding that cooperation/collusion is not always in the general interest.
5. Understanding the importance of factors affecting timing commitment and uncertainty in economic and other relations.

Game theory is an important concept in economics. In a sense, economic behavior is a certain strategy in a situation wherein the interest of people clash. John Nash won the Nobel Prize for economics in 1994 for his work in the 1950s on the equilibrium in a game, which roughly means a stable and predictable outcome of a game, given the motivations and limitations of players.

What is game theory?

An important concept in game theory is trying to figure out what your opponent will do.

Every game has three basic elements: the players, the list of possible actions (or strategies), and the potential pay-off of these strategies.

Take the following example: Lufthansa and Alitalia are the only ones offering the flight from Frankfurt to Milan and they both make an economic profit of 6000 euros per flight. If Lufthansa spends 1000 euros on marketing, and Alitalia does nothing, Lufthansa’s profits rise to 8000 euros and Alitalia’s profits decrease to 2000 euros. When they both spend 1000 euros on marketing, their profits go down slightly to 5500 euros because of the extra expenses on marketing (but the demand also rises slightly). Both firms have to make their decisions independently. What should Lufthansa do?

In such a case it can be smart to make a pay-off matrix, a table in which all possible outcomes are presented.

From the perspective of Lufthansa, Alitalia will make one of two possible calculations: either Lufthansa does spend the money on marketing, or they don’t. If they do, then Alitalia should also do so, because their profits will decrease sharply otherwise. If they don’t, then Alitalia should invest in marketing, because it will make their profits rise sharply. In other words, whatever Lufthansa does, it is best for Alitalia to spend the money, which means that Lufthansa will also spend the money.

When a player has a strategy that delivers a higher pay-off, regardless of what the other players do, then that is called a dominant strategy. If both Lufthansa and Alitalia don’t spend anything on marketing, then that would be a dominated strategy. Be careful: in this scenario Lufthansa and Alitalia will likely spend the money, which will bring down their profits to 5500 euros per flight, which could have been 6000 euros per flight if they had not acted.

When all players have chosen their best strategy, and so there will be no incentives for players to deviate from their strategy, then we have reached a (Nash) equilibrium. This can also be reached when not all players have a dominant strategy. Say Lufthansa does not have a dominant strategy, but Alitalia does. Then Lufthansa can calculate what Alitalia will do, because they will profit in all outcomes, so in that case Lufthansa can also calculate their own best strategy.

What is the prisoner’s dilemma?

The prisoner’s dilemma is a game wherein each player has a dominant strategy, but if they both use that strategy, the outcome will be less profitable than if they both used a dominated strategy.

It is a very well-known example for many behavioral scientists and it shows how acting on one’s self-interest can be disadvantageous for the collective good. When all players would work together, then the outcome would be best. However, there is no mechanism that can punish the players if they “cheat” and betray the other player.

A solution has been found for this problem when playing the game repeatedly, namely the tit-for-tat strategy: the first time you play, you choose cooperation, and from that moment on you only choose what the other player chose in the previous turn. That way, when someone cooperated, you will continue to cooperate, and when someone betrayed you, you return the favor. It is the fear of this repercussion that will prevent players from “cheating.”

How do games with timing work?

In some games it is better to make a choice tree or game tree than a pay-off matrix. For example in the ultimatum game. In this game there is 100 euros to divide, but person A can make a proposal to person B in what way to divide the money. When person B accepts the proposal, they both get the proposed amounts, but if person B declines, then they both get nothing. In this case, person A will suggest the most unfair division, namely 99 euros for A and 1 euro for B. B has no choice to accept this, because even 1 euro is better than no euros. In such a case person B can issue a threat, for example that she will accept nothing under a certain amount, but that would not be a credible threat, because it is not in the interest of B to execute the threat. There are also games where people cannot make a credible promise.

With many games there is a commitment problem, a situation wherein people cannot reach their goals because they cannot make credible threats and promises. To counter this, firms use a commitment device, a device with which incentives are changed so that a normally empty threat or promise suddenly becomes credible. Example: firms agree with each other not to lower the price for product A. The commitment device can be that they also agree to sell product B at a certain price. The seller of product A will not “cheat” because she knows that there will be a repercussion with product B.

What is the strategic role of preferences?

So far the goal for all players has been self-interest. However, in our society we often have certain feelings that make us more focused on cooperation: moral aversion against hurting another, sympathy for the people we work with, and anger at injustice.

Take the ultimatum game: in practice, the most frequent offer is not 99/1, but 50/50. And when a proposal is unfair, then it is regularly declined.

This chapter’s learning goals are:

1. Understanding the basic elements of games and their application to economics.
2. Recognizing the importance of interdependence in analyzing how firms and individuals make decisions.
3. Understanding the concept of an outcome as an equilibrium solution to a game problem.
4. Understanding that cooperation/collusion is not always in the general interest.
5. Understanding the importance of factors affecting timing commitment and uncertainty in economic and other relations.

How does game theory work in practice? - Chapter 10

This chapter’s learning goals are:

1. Understanding how game theory explains interactions in oligopolies.
2. Applying the prisoner’s dilemma to price-, investment-, and research decisions.
3. Understanding the problem with cartels.
4. Applying the elements of game theory to a case study environment of product development.
5. Using backward induction.
6. Understanding Cournot’s and Bertrand’s explanations of oligopoly.

What is the role of interdependence and behavior of firms in an oligopoly?

There are only a few players in an oligopoly, which means that—as with game theory—calculating competitor’s decisions is vital. There is, in a sense, an interdependence of decisions this way.

A cartel is a coalition of firms or producers that collude to limit production with the goal of reaching economic profit through price setting. Oftentimes agreements that cartels make are instable, because they have to deal with the prisoner’s dilemma: participants cheat. The problem with cartels is that they can artificially increase price, which allows participants to cheat by secretly lowering price and, thus, making a higher profit. A solution for this would be the tit-for-tat strategy from Chapter 9, as this makes punishments for deviating players more effective, but that strategy really only works with two players.

What is the role of timing and commitment in oligopolistic markets?

In reality, firms don’t have to make decisions at exactly the same time. In the 1990s there was a scenario wherein Airbus and Boeing pondered building a super-jumbo jet. For Boeing it was advantageous to wait for Airbus’s decision, so they did. In the meantime they actually made a threat by pretending to have started their own project. However, Airbus knew that whatever they decided to do, it was always advantageous for Boeing not to start building their own super jumbo, so Boeing’s threat wasn’t credible. Airbus, thus, started building the bigger plane. It is still not clear whether this choice was a success, but that isn’t the point. The point is that it looked advantageous for Airbus to be first in building the new model, and that Boeing couldn’t make a credible threat that they would be first.

Which factors affect the behavior of oligopolistic firms?

There are three important factors in determining the prices and output in a market, and they are categorized as follows:

• Market structure. By this we mean to what extent players in a market differ from one another and how many players there are.
• Convictions. In a prisoner’s dilemma the outcome depends on what is the conviction of what other players will do. What determines one firm’s conviction about another firm is determined by many factors.
• Competition. Firms differ in the way they compete with each other, often depending on the product they produce. Example: a car producer can mainly influence the quantity of cars produced. This is called “Cournot competition.” A life insurance provider, by contrast, differentiates by price setting. This is called “Bertrand competition.”

Which models of oligopoly are there?

The first, and possible the most important, model is the “Cournot model.” This model assumes that firms compete by determining how much they should produce and it was created by Augustin Cournot in the early nineteenth century. Examples of Cournot markets are cement- and car production. The second model is the “Bertrand model.” This model assumes that firms compete by setting the price. Examples of Bertrand markets are insurance companies and restaurants. We use these models to analyze competition and the effects of cooperation.

Concerning the Cournot model: say there are two equally large producers with comparable costs of production, and their products easily substitutable. The producers must determine how they maximize their profit. This depends on the competition’s supply. After all, when one firms produces the market equilibrium, there is simply no room for another firm. This gives us a Nash equilibrium: a quantity at which neither firm is likely to adjust their quantity. However, this Nash equilibrium is not necessarily the best outcome for both firms: the combined supply will be higher than in a monopoly, wherein there would be less supply for a higher price, and therefore, a higher profit. The described situation, then, is a prisoner’s dilemma and the firms could opt to collude, forming a cartel or something comparable to make a higher profit and, in the process, creating a higher price. However, even when they don’t collude we can conclude that in a market with few players the supplied quantity will remain lower than the most competitive output, which has negative effects on the consumer.

With the Bertrand model, on the other hand, there is competition based on price. This will always ensure that the set price will become equal to the costs, making profits equal to zero. This will happen because every lower price can deliver the entire market to a player. The fact that these firms are powerful price setters in theory, yet are driven towards zero profit, is called the Bertrand paradox. However, in reality, we do see some exceptions to this theory. For instance, when the supplied products are not perfectly substitutable, products aren’t necessarily required to have the exact same price. Moreover, setting prices is not a singular activity: oftentimes there are price strategies involved, which are used at different times and respond to certain cost pictures in different ways.

In essence, forming a cartel is a game that is played repeatedly. As we have seen, over time, “cheating” is discouraged. Firms are forbidden by law to make price agreements, so when they do so implicitly, it is called tacit collusion. Oftentimes firms can communicate with each other through standardized price strategies and signaling.

When do price wars break out?

There can be different reasons for a price war to break out. Deficient information is one possibility. When a firm sees its output decrease, and they have deficient information as to why this happens, they will come up with three reasons: (1) market demand has declined, (2) the firm has become less competitive, or (3) a competitor has increased their supply. In all three cases a firm will conclude that they should lower the price, possibly resulting in a “race to the bottom.”

This chapter’s learning goals are:

1. Understanding how game theory explains interactions in oligopolies.
2. Applying the prisoner’s dilemma to price-, investment-, and research decisions.
3. Understanding the problem with cartels.
4. Applying the elements of game theory to a case study environment of product development.
5. Using backward induction.
6. Understanding Cournot’s and Bertrand’s explanations of oligopoly.

How do externalities and property rights work? - Chapter 11

This chapter’s learning goals are:

1. Understanding how positive and negative externalities make markets less efficient.
2. Understanding what the importance is of the Coase theorem.
3. Analyzing policy reactions concerning externalities.
4. Understanding the role of property rights in markets’ efficient functioning.
5. Understanding positional externalities and their implications for efficiency.

What are external costs and benefits?

Many activities have unintended costs and benefits for people who have nothing to do with the activity. Such effects are called external costs (or negative externalities) and benefits (or positive externalities), or externalities. A good example is found in vaccinations: it is an individual choice when someone has their child vaccinated, but it also has the external benefit that other people will be further protected from sickness. We sometimes call this the spillover effect. In general the following is true: where there are positive externalities, individual choice behavior will ensure a shortage on the socially optimal quantity of these activities. In other words, since the people executing the activity do not experience the positive effect themselves, they will not bring enough of the positive effects. These effects can be very important: Adam Smith forgot to include them in his theory of the “invisible hand,” which was a significant error.

What is the effect of externalities on the distribution of resources?

Since people do not focus on externalities, they will likely execute too many activities with negative externalities and not enough activities with considerable positive externalities. This has a negative effect on the distribution of resources. Take, for example, a person who keeps bees. The bees pollinate apple trees, so the more bee hives person A keeps, the more external benefits there are for people with apple trees around person A. However, were person A not to keep bees next to people with apple trees, but to a school, then suddenly person A quickly has too many bee hives. When the wrong quantities are distributed, the market is no longer efficient.

Now for an example with figures: person A has a factory next to a river. The river’s water is used in the factory and, after it has been polluted, it is put back into the river. A has a revenue of 130 euros per day when she does not put up a filter (resulting in the water becoming polluted) and a revenue of 100 euros per day when she does. Then there is person B, a fisherman. B has a revenue of 100 euros per day when the water is not polluted and a revenue of 50 euros per day when it is. In order to reach the highest possible economic surplus, A should put up a filter, but she will not, because she doesn’t profit herself, resulting in a less efficient market.

Now say that A and B can communicate with each other. In that case, A will put up a filter, as B might for example offer A a part of the higher revenue to pay her to put it up. When people can freely negotiate activities with externalities, then they will come to an efficient solution. This is called the Coase theorem, invented by Ronald Coase.

In some cases it can be difficult to come to an agreement from negotiations, for example when a motorcycle rider makes too much noise on her motor cycle. You cannot simply stop a motorcycle rider at that very moment to tell her that she is making too much noise. Therefore, there is a job for governments to make laws that prohibit such negative externalities. However, it is important to remember that the socially optimal level of negative externalities is not necessarily equal to zero. In fact, it often isn’t: it can cost so much effort to entirely get rid of negative externalities, that it actually becomes too much effort. In such a case, it is more efficient to let a small dosis of the negative externalities exist.

What is the “tragedy of the commons”?

The tragedy of the commons means that there is a tendency to exploit a resource that has no price (a common good or service) so much that its marginal benefits decrease all the way toward zero. Example: with American fisheries they have concluded that there is a lower output per person with oyster fisheries that were publicly owned than oyster fisheries that were privately owned. This was due to overexploitation of the bio mass. When there is no price for a product, meaning that the product is collectively owned, negative externalities will occur.

It is for this reason that property rights are so important. They ensure that resources are used efficiently, resulting in the highest possible economic surplus. However, there are also situations wherein defining and maintaining property right are so costly that it is less efficient than a common good.

Examples wherein a privately owned property works better than a collective property:

• Gathering wood on a distant piece of land. Why? Because with private ownership the trees can grow taller and become more valuable over time, since when they are owned collectively, everyone will try to cut down as many trees as quickly as possible.
• Hunting whales. Why? Since with every caught (and killed) whale, the birth of a new whale is prevented. So, again, self-interest will lead people to overexploit the whale population, resulting in negative externalities.

What are positional externalities?

Sometimes pay-off depends on a relative performance. Athletes, for example, are often only good compared to others. This ensures that many tennis players will spend money on fitness coaches. In the end, however, there is still only one winner and one loser per game, no matter how much money is spent in total.

A positional externality means that when a pay-off depends on a rival’s performance, that every step to enhance one’s performance automatically means that the rival’s performance is worsened. This way, positional externalities can lead to an escalating positional arms race. Since this can lead to a lot of inefficiency, societies often have positional arms race agreements, agreements that limit an arms race. One example is starting with school: older children perform better in school, so it can be advantageous to parents to wait a year before sending their kid to school, since her performance will be better. However, we don’t want parents waiting two or three years before sending their kid to school. That is why we have compulsory education from a certain age.

In some cases there aren’t necessarily laws aginast positional externalities, but more social norms. Example: in school, students are judged on their learning curve compared to other students. When all students want to excel, they will all increase their performance, but their grades won’t go up (as they do not get better in comparison). However, the social norm in school is to not become a “nerd.”

This chapter’s learning goals are:

1. Understanding how positive and negative externalities make markets less efficient.
2. Understanding what the importance is of the Coase theorem.
3. Analyzing policy reactions concerning externalities.
4. Understanding the role of property rights in markets’ efficient functioning.
5. Understanding positional externalities and their implications for efficiency.

What is the role of information in the economy? - Chapter 12

This chapter’s learning goals are:

1. Understanding the role of information in creating efficient exchange.
2. Understanding the role of the middleman in market systems.
3. Analyzing the worth, demand side, and supply side of markets.
4. Understanding the insecurity aspect of information in markets.
5. Understanding signaling, credibility, and negative selection in markets.

Information is essential in determining someone’s reservation price. After all, someone has to make an estimation on the basis of different factors (information) of the value of a product.

How does the middleman add value?

An important problem for consumers is that they are confronted with complex products. It is not always easy to have insight in how they work and what their value is. Example: you can buy a good set of skis on the internet for 400 euros, while they cost 600 euros in the store. However, when you don’t know what makes certain skis “good,” then you will need the store assistant’s help to determine which skis are and aren’t suitable. Oftentimes the people who do the actual production work are seen as “real” workers and sellers are viewed as parasites. But is that justified?

What is the optimal amount of information?

It is better to have more information than to have less information. However, actually acquiring information costs time and energy. Therefore, gathering information has a point where it is most efficient. We, again, use the cost-benefit principle: the marginal benefits of gathering information have to outweigh the marginal costs.

What are the guidelines for rational searches?

An amount of information is difficult to quantify, which also makes it difficult how much you should know before you become inefficient. Nevertheless, there are guidelines. For example, if you are looking for an apartment in a cheaper neighborhood, you should search for a shorter time than when you are apartment-hunting in an expensive neighborhood, because your possible return on investment is smaller. On the other hand, when your costs for searching are high, you will want to search for only a short time. For example, if you are looking for a house in Sydney and you have family there, then you have a lower costs for searching than when you have to do that from a hotel room.

There is an essential component here: there is always insecurity involved, because you can never know all information. There’s always a small gamble. You just have to gamble rationally. You can do this by calculating the expected value of a gamble, the sum of all possible outcomes of the gamble, weighed by the likeliness of their happening. Example: say you win 1 euro when you flip a coin and it’s heads and you lose 1 euro when it’s tails. Given the fact that the chance is 0.5 that it is heads, your chances are (1/2 (1 euro) + (1/2) (-1 euro) = 0. A gamble with an expected value of 0 is called a fair gamble. Any gamble with a positive value is called a better-than-fair gamble. Example: if you were to win 2 euros when it is heads and lose only 1 euro when it is tails. A risk-neutral person is someone who would accept any fair gamble. A risk-avoiding person is someone who would not accept any fair gamble.

The cost of searching also has certain consequences for commitment. House owners will often look for people who want to rent long term and employers will look for employees who want to work long term. In both cases this is because searching takes time and energy. Thus, people often look for restrictions to total freedom for a form of security.

What is asymmetrical information?

A frequent problem is that people do not possess the same information. For example, when a car owner knows that a car is in good condition, but the potential buyers does not. We call this asymmetrical information. Usually sellers are better informed than buyers, but it can happen the other way around as well.

This problem can lead to George Akerlof’s lemon model: uncertainty about the quality of a product will lead to an inefficient market, because sellers of good products cannot prove that their products are good, resulting in in buyers only accepting lower prices. This will ensure a decline in the quality of a market’s goods since the sellers of good products will exit the market.

An important aspect, here, is the credibility problem. Sellers have an incentive to pretend that that product is better than it is and buyers have an incentive to pretend that their reservation price is lower than it is. Take someone who is applying for a job: she will make her resume look like it is slightly better. A solution for such credibility problems is to deliver provably dependable information. In the case of cars, you can give out guarantees for any defects that occur in the first six months. Such a guarantee is an example of the costly-to-fake principle: when parties with different interest want to communicate credibly with each other, they have to send out signals that are expensive or hard-to-imitate.

Another example of such a signal is buying an expensive car. If you’re a consultant and you drive an expensive car (or you wear an expensive suit), then that’s a sign that your firm is doing well (and, likely, that you’re a person who delivers). For people whose company is not doing well, this is difficult to fake (because it’s so expensive). However, buying expensive stuff when you live in a small town is not a good idea, since people often know each other in such towns, and so they already know if you’re firm is doing well or not.

In some markets there can also be a lack of information. In such cases, firms often employ statistical discrimination: they try to ascertain the lacking information through statistics. An example can be found in the insurance industry: young men statistically cause more accidents than women or young women. This will result in higher premiums for young men.

Another problem that can occur in the insurance industry is negative selection. Even if insurance companies discriminate between groups, that still makes it possible that there are differences within groups. Unfortunately, however, those who drive worse will likely be the ones that take an insurance in the first place. This raises premiums, because insurance companies have higher pay-outs this way.

Another effect that occurs in the insurance industry is the moral hazard problem. This means that people are prepared to take bigger risks when they will not experience the full consequences when things go wrong. One example of this was the 2007/2008 crisis: many banks were too big to fail, meaning that they knew the government would bail them out if things went wrong.

This chapter’s learning goals are:

1. Understanding the role of information in creating efficient exchange.
2. Understanding the role of the middleman in market systems.
3. Analyzing the worth, demand side, and supply side of markets.
4. Understanding the insecurity aspect of information in markets.
5. Understanding signaling, credibility, and negative selection in markets.

How does the labor market work? - Chapter 13

This chapter’s learning goals are:

1. Understanding the relationship between productivity, skills, and the demand for factor services.
2. Understanding how different forms of labor markets work and what technology’s impact is on income.
3. Distinguishing the various factors that cause earnings to vary between individuals and groups.
4. Explaining what the impact is of unions and regulation in the market.
5. Measuring the income distribution.
6. Understanding how policy measures alter income distribution affect outcomes.

How is it that people have different incomes? And is income inequality a problem that society should worry about (spoiler alert: it is.)?

What is the economic worth of labor?

Supplying labor is in some ways fundamentally different from supplying other goods and services. For one thing, people in most countries are prohibited from “selling” their labor and are only allowed to “hire” it. Otherwise it would be slavery, of course. But there are also similarities: as in other markets, the labor market has a demand curve and a supply curve, which combine for an equilibrium wage and an equilibrium quantity of work.

It is important for employers to try to quantify the labor (/the production) of employees, so that the marginal physical product (or marginal product, MP) can be calculated. An employee’s MP is the extra output that the firm receives as a result of hiring the employee. When we multiply an employee’s MP with the net price of every individual unit, then we get the value of marginal product (VMP). Generally, in competitive markets, workers’ wage in the long run will be equal to the VMP, which is the net contribution that she makes to an employer’s revenue.

Remember also that, in hiring new employees, employers have to deal with the law of diminishing returns: with every additionally hired worker, the average marginal production will decrease over time. Example:

So, when an employee earns 350 euros per week, an employer would hire 4 employees, but not the fifth since at that point the marginal costs are higher than the marginal benefits.

What are the equilibrium price and quantity levels?

Concerning the demand for labor: the reservation price of an employer will, in a perfectly competitive market, be equal to the VMP.

Concerning the quantity: this can be difficult. Is the demand curve upward-sloping, as with other goods and services? The substitution effect and the income effect apply here: the substitution effect tells us that when people have a higher wage, this also means that their free time is “more expensive.” After all, the opportunity costs (the alternative, here, is working) are high, as they can earn a lot of money by working. The income effect, by contrast, tells us that when consumers have a high wage, they also have more purchasing power, which will make them inclined to consume more free time. The problem of free time, then, requires not a theoretical approach, but an empirical (based on experience) one. In practice, we see that the work week has shortened throughout the last three centuries. Another example is found in taxis: on rainy days (when they can make relatively much money) taxi chauffeurs stop their day earlier (because they have already earned enough money).

Remember that markets change and so do the equilibrium wages and quantities. The demand for IT employees, for example, has significantly increased since the 1980s.

How do we explain the differences in income?

The theory of competitive markets tells us that income differences stem from different reservation prices that employers have for an employee. Some employees have better skills than others and are, therefore, able to produce more. Some employees produce more because they are more motivated than other, without necessarily having better skills. However, given that different people are equally talented and motivated, what explains the difference in income between a lawyer and a plumber? The no-cash-on-the-table principle tells us that all plumbers would simply become lawyers if there was money to be found in that vocation.

The human capital theory provides us with an answer here. This theory tells us that someone’s VMP (and so, her wage) is equal to their share in human capital, which is a mix between education, experience, training, intelligence, energy, etcetera. This theory says that some vocations are payed more because they require more human capital than others. The demand for different forms of human capital can change over time, and so too can wages.

Differences in wages can also exist because one employee is with a union and another is not. A union is an organization through which employees attempt to negotiate collectively with employers for better wages and working conditions. Unions are controversial in economics. Some think they are a positive protection of employees, and of fair wages and human working conditions. Others, however, believe that unions have the same effect on the labor market as do cartels on the production market. In other words, they think that unions stop markets form being efficient.

An important criticism, here, is the assumption that unions complicate a perfectly competitive market. However, when a specific market has too little employers, than there is an oligopoly and employers are not price takers but price setters. In other words, oftentimes such a market is not perfectly competitive, which provides employers with a lot of market power. This way, it can become possible for the monopsonist to drive down the employment level and, with it, wages. Unions can act against this by demanding a wage at which employers can hire any quantity of workers. This will result in both wages and higher employment.

However, the number of employees that are in a union is declining. This is due, in part, to globalization: foreign direct investment (FDI) is increasingly becoming important in national economies, and these foreign firms only invest in markets where they don’t have to fight unions. This incentivizes national governments to stop workers from unionizing, so that they can receive more investments.

Differences in wages also occur through different working conditions. We expect that someone who works in poor conditions is better compensated than someone who works in relatively good conditions. This compensation is called compensating wage differences.

Differences in wages can also occur as a result of discrimination (for example, racism and sexism). When this is proven, this forms a deep critique on the functioning of competitive markets, as discrimination leads to inefficiency.

One form of this is employer discrimination, which means that an employer has an arbitrary preference for one group of workers above another group. For example, when men and women are equally productive, but the employer still hires more men. In theory, discrimination is costly for the employer, as he could also opt to hire women that are equally productive as men for a lower wage. However, this is only true in perfectly competitive markets: when this is not the case, an employers doesn’t necessarily pay the economic price for his discriminating behavior.

There is also client discrimination. One example of this occurred when France spoke out against a new Gulf War in 2003. American importers of French wines started boycotting the product and the demand for French wines sharply declined.

Concerning large differences in income: some labor markets are winner-takes-all labor markets. This means that the people who have small advantages in their human capital receive enormous income advantages. Example: the market for professional tennis players. Despite the fact that there are tens of thousands of tennis players, Roger Federer literally earns millions, while other tennis players cannot make a living.

What are the trends in inequality?

Some people in European countries go to bed hungry, or don’t have a roof over their head. This is morally impossible in an environment (that is, Europe) that has so much wealth. Income inequality has risen since the 1970s, despite the fact that economic growth equaled a yearly 3% average.

It is possible to define poverty with an “absolute poverty line,” but this doesn’t do justice to the fact that living standards have risen. Thus, poverty should be measured relative to the living standard of others. An important question in economics is to what extent being poor in the present is statistically correlated to being poor in the future.

An important measure of income differences it the Gini coefficient. This measures to what extent an observed distribution differs from a hypothetical perfectly equal distribution. Graphically represented as cumulative percentages of wealth (on the y-axis) and population (on the x-axis), the Gini coefficient is the difference between a straight line from the bottom-left to the top-right and the Lorenz curve, the representation of the cumulative wealth per part of the cumulative population. For example: 50% of the people have 10% of the wealth.

Is inequality a moral problem?

The philosopher John Rawls would say it is. He reasoned as follows: when people would create a system of distribution from behind a veil of ignorance, which means that they don’t know how their skills would be valued in the system under creation, then they would implement as many rules as possible that would ensure they would be treated fairly. In other words, people would create a fully egalitarian system. One reason for this lies in the fact that most people are risk-averse. We can conclude from this that anything that deviates from the system that would be created form behind the veil of ignorance is, in principal, ethically inferior.

Economists would point out to Rawls that small forms of inequality can be desirable to give people certain incentives, such as the incentive to work hard and be on the good side of inequality. However, they would mostly agree with his statement that fairness at least requires attempts to reduce inequality.

Which methods to reduce inequality are there?

There are two methods of reducing inequality: the first is to remove the underlying factors that produce inequality and the second is to offer compensation for the outcome. An example of the first would be to give better education to children from poorer families and an example of the second would be to give certain households money. Redistribution takes place in two ways, namely by a progressive tax system (higher incomes pay more taxes than lower incomes, both absolutely and relatively) and by spending more public money on lower incomes than on higher incomes.

Economists have long argued that the most effective way of constituting social security is to simply give money to people who don’t have enough of it. This is called money payment. Another form is in-kind transfers, a way of payment that doesn’t come in the form of cash, but in the form of a good or service. Example: subsidized living, free education.

A frequently-used way of compensation in the US is means-tested, which means that a payment becomes lower as soon as the receiver earns more income. In Europe, by contrast, most countries have a universal payment.

An efficient method of redistribution is a negative income tax. This means that every civilian receives a money payment from the government, which is financed with an extra tax on income. The effect is that people who have no income receive their money, and that people who do earn income are simply taxed and receive a deduction afterwards. Incentives remain a problem here: there is a point at which it becomes advantageous for someone to keep receiving the negative income tax, instead of going to work for a relatively low wage.

A frequently-used solution for income inequality is the minimum wage. However, economists are quite skeptical about this, because it (1) makes market inefficient and (2) doesn’t offer any benefits for people who have no job. A more efficient way would be to create an earned income tax credit. This works similarly to a negative income tax, except it is only for people with jobs.

This chapter’s learning goals are:

1. Understanding the relationship between productivity, skills, and the demand for factor services.
2. Understanding how different forms of labor markets work and what technology’s impact is on income.
3. Distinguishing the various factors that cause earnings to vary between individuals and groups.
4. Explaining what the impact is of unions and regulation in the market.
5. Measuring the income distribution.
6. Understanding how policy measures alter income distribution affect outcomes.

What is the role of the government in the market economy? - Chapter 14

This chapter’s learning goals are:

1. Understanding the difference between public and private goods.
2. Defining what efficiency is in the production of public goods.
3. Recognizing the motivation for market and non-market production of public goods.
4. Understanding regulation as a solution for market failure.
5. Understanding regulation mechanisms.
6. Understanding the possibilities and consequences of regulatory failure.

Broadly speaking, the government has two tasks in the economy: producing public goods and merit goods on the one hand, and regulating how market work on the other.

How does the government produce public goods?

There are two kinds of goods that are produced through government activities: public goods and merit goods. Public goods are goods that, at least to some extent, are both non-rival and non-excludable. Oftentimes these cannot be efficiently produced by the market. Merit goods are goods that are produced under non-market circumstances by the state for political reasons. These can be produced by the market, but for political reasons, they aren’t. Examples of such goods include health care and education.

Public goods are non-rival. A good is non-rival when the availability is not lost when the good is consumed by a person. Public goods are also non-excludable. A good is non-excludable when it is difficult or expensive to exclude non-payers from consuming the good. For example, if your neighbors don’t pay taxes, then they don’t pay for the national army, but they do enjoy its protection. This is the opposite of private goods, which decrease as they are consumed. Goods that are both strongly non-rival and non-consumable are called pure public goods. Goods that are non-rival, but excludable, are called collective goods. A pure private good is a good for which a non-payer can be easily excluded and for which consumption leads to a one-on-one reduction in availability to others. A pure commons good is a rival good that is also non-excludable and it is called this because it leads to the tragedy of the commons.

Not everyone profits from public goods. Fireworks that are held by the government, for example, are not appreciated by everyone. Ideally, one would tax people at the rate of consumption of a good, but this is a practical impossibility. A poll tax is a tax that asks the same amount of money from every individual. This is an example of a regressive tax, a tax for which the proportional payed amount of tax decreases as income increases. This is problematic since people with different incomes will attach different values to public goods. A proportional income tax is a tax under which all tax payers pay the same percentage of their income.

An important difference between private goods and public goods is that with the former people are free to consume as much of it as they want, whereas with the latter, they can’t. For instance, when a government would implement a poll tax, then there wouldn’t be enough money for public goods such as parcs, which are used more by high-income people than low-income people. This is an important reason for the fact that many countries have a progressive tax, whereby the proportion of the income that is taxed increase as income increases.

The convenient thing about governments is that they can set up a tax agency which collects the necessary taxes for public goods, without having to negotiate with civilians for every individual good (as that negotiation takes place in constituting the government). However, some public goods are also delivered through private channels. Take digital TV, from which people can be excluded when they don’t pay, or take the increasingly-frequent gated communities. Such practices can lead to a smaller economic surplus.

What is the regulating role of the government?

Regulation is the legal intervention in markets for the purpose of influencing the way firms and consumers behave. This can be necessary in markets wherein firms have a lot of market power, which creates economic inefficiency. However, in preventing market failure governments can also allow regulatory failure. This has to be prevented.

An important problem for governments is to set up a working legal framework, wherein markets can operate. This does not mean that markets cannot function without: in Somalia there is a non-functioning government, which leads to the lack of a decent legal framework, and there are drug trades everywhere that operate explicitly outside of the legal framework. However, in most markets there is a legal framework at the foundation of how market exchange takes place: in Germany, for example, there were laws that forbade firms being opened at certain times, which created commercial dead zones during weekends.

That last example is a form of direct legislative regulation. Another form of regulation is delegated regulation, which means that the legislative power creates an agency to regulate an industry or a market. Think of the Environment Protection Agency in the US.

Below we shall deal with three case studies of different forms of government regulation.

• Regulation to protect the environment. As we have seen earlier, some godos can result in negative externalities. Air pollution is one such example. The government has to discourage firms in this. One way of doing so is to tax air pollution, so that firms who pollute more also pay more. The advantage of this way, moreover, is that polluting practices divert to firms who can do this the cheapest, which ensures that not much efficiency is lost. One problem, however, is that it is difficult to ascertain the specific costs of air pollution, which can result in a tax that is either too high or too low. An alternative would be to establish a maximum amount of air pollution and to divide this over certain permits that can be given out to firms. This system is called emission trade.
• Regulation to prevent exploitation from market power. Until the early 1990s, energy in the EU was produced by state companies with a monopoly. Regulation, here wasn’t important, as these were companies owned by the state. In the US, by contrast, there was a longer tradition of regulation, as energy companies were private-owned and were bound by certain rules. When in the 1990s EU energy companies were privatized, people thought the market would find efficiency on its own, but because of specific networking capabilities the private-owned firms acquired too much market power. Because of this, European governments had to started regulating the market: especially the transmission system was required to allow more competition.
• Regulation and health & safety at work. In the nineteenth century there were terrible working conditions for employees to work in: it was, simply put, dangerous. In response, governments developed regulations over time that made safety and health more important at work. Nowadays some economists will say: since employees negotiate with employers, one would say that the market eventually guarantees such kinds of safety. After all, when an employer wouldn’t do that, employees would leave him. However, many governments assume this is not the case and create safety regulations, regardless. This is because there are also economists who argue that there is little competition in the labor market, as there is often a lack of information and very little mobility for workers. This results in them accepting almost any working condition to at least earn some money.

What about public health and safety?

Politicians will not say it, but in a world of scarcity, we cannot escape the fact that when we spend money on certain things, we cannot spend money on certain other things. Unfortunately, health care and the prevention of accidents brings a lot of costs (to be perfectly clear: of course, so does letting accidents happen). It is not very popular to make a cost-benefit analysis on health care, but perhaps it is necessary. Example: economically speaking, there is a point where it is no longer efficient to put money into traffic safety since it delivers too little extra safety for too much money.

Regulations are supposed to counter market failure. However, there is no free lunch: when regulations are applied, this exposes the economy to potential regulatory failure. This can come in two shapes: (1) regulation is badly designed or (2) regulation is employed for different goals (regulatory capture). When the latter occurs, forms of regulation are actually used to protect companies—from competition, for instance. Another example: a supplier of alcohol who fights for limits on the number of bars to counter excessive consumption of alcohol.

This chapter’s learning goals are:

1. Understanding the difference between public and private goods.
2. Defining what efficiency is in the production of public goods.
3. Recognizing the motivation for market and non-market production of public goods.
4. Understanding regulation as a solution for market failure.
5. Understanding regulation mechanisms.
6. Understanding the possibilities and consequences of regulatory failure.

What are the microfoundations for a macroeconomic crisis? - Chapter 15

This chapter’s learning goals are:

1. Understanding the importance of concepts such as information asymmetry, adverse selection, and moral hazard as potential causes of economic disruption.
2. Understanding the potential consequences of regulatory failure.
3. Listing the events that led to the Great Recession of 2008.

It is important to remember that the crisis was not solely caused by the mortgage crisis in the US. That was the “tipping point,” but the underlying causes were much broader. After all, in the 1980s there already was a subprime mortgage crisis, the S&L crisis, but the impact of this crisis was nowhere near that of the 2008 crisis (even though there was a recession).

There were signs beforehand: OECD countries had relatively low growth in production and the Chinese economy grew with 11 percent per year, which was likely unsustainable.

What were the roots of the financial crisis?

The international financial crisis had a big part in the global economic crisis, so it is useful to find out what the underlying causes were. The two most important were regulatory failure and information asymmetry.

Regulation is supposed to prevent market failure, but when the rules are made up wrong, they can fail in themselves. Regulatory failure has existed for a long time. In 1986 the UK deregulated the London stock market, whereby categories of financial intermediaries disappeared: normally, banks were places to store money or to get low-risk loans, and investment banks borrowed money and invested in risky ventures, but that division disappeared because of deregulation.

The reason that the UK chose for deregulation was that there was a notion that banks suffered from overregulation, but the jump from strict regulation to light-touch regulation, whereby general rules are made but there is no daily supervision, also had some downsides. For instance, in the UK short term funds were employed to fun large finances, whereas earlier this was done through long-term funds. The regulatory organs of the banks did not work to stop gearing, the increasing rate of borrowed money as opposed to equity. Also, there was an increase in information asymmetry because of the switch from regulation to deregulation.

What were the consequences of information asymmetry?

There were two important consequences of the newly-established information asymmetry: adverse selection and moral hazard. Adverse selection happened through the subprime mortgages: normally speaking, banks know that most borrowers are “good” borrowers, who eventually pay back their money. However, these “good” borrowers will often get good loans, not the subprime loans, which bring higher costs because of their poorer quality. The loaner was also able to dump the risk of these bad loans with other financial institutions, by bundling the mortgages and selling them to a larger institution, that can assume higher risks. This creating of new financial assets that can be sold to investors is called securitization. This way, high-risk mortgages bundles were sold on and on, and banks kept taking greater risks: the moral-hazard problem.

An important difference with the S&L crisis was securitization, which led to bigger risks. Adding to that, banks were no longer merely bankers but financial conglomerates, firms who operate in different financial markets such as insurances and stocks.

Was there also a liquidity crisis?

At first, people thought the bankruptcy of Lehman Brothers was a liquidity problem, a shortage of funds that they could easily sell to manage their long-term obligations. When people take a lot of money off bank A, then bank A has to borrow money from bank B, so that bank B is now also at risk to have to few liquid funds. The shortage in liquidity ensure that banks had to pay off their loans, which ensured that money that was destined for the short term was used for the long term payments. If this perception of the crisis were true, then that implied two things: (1) that there mostly was a crisis of faith that needed to be restored and (2) that the provision of liquidity and the reducing of uncertainty would offer the required solutions.

The response of governments was to pour money into the banking world: the repo rate was brought down which means that it became cheaper to borrow money from central banks. However, it turned out that there wasn’t simply a liquidity crisis.

What is the relationship between banks and property?

An important additional problem was that banks financed real estate development. For this they gave out loans that were would likely not be payed back. That is not a liquidity crisis, but a crisis of systemically collapsing assets. Deregulation of the banks led to them meddling with the financing of housing, which was a problem in and of itself.

Were banks “too big to fail”?

Yes, banks were “too big to fail.” This means that the collapse of one bank would cause a chain reaction, which would make the entire system collapse. This is also what governments estimated, so they chose to use tax-payer money to save the banks. The problem, here, is that banks knew they were “too big to fail,” so they knew they could take huge financial risks, as they would be saved anyway. Again, the moral-hazard problem.

The solution could be to go back to the time from before 1986, when banks only lend out money and accepted small risks and other intermediaries did the large investments. That way even the biggest financial institutes would not become “too big to fail.” However, there are two problems here: (1) when would we be back at that “level”? and (2) we would lose economic surplus, because deregulation has led to profits from efficiency. However, perhaps this is a price we should want to pay.

An alternative could be to ensure that financial instiutions have enough equity on the one hand, and on the other to ensure that if market failure ensues, the “good” aspects of a bank are saved, while the “bad” aspects are seen as costs for the shareholders.

This chapter’s learning goals are:

1. Understanding the importance of concepts such as information asymmetry, adverse selection, and moral hazard as potential causes of economic disruption.
2. Understanding the potential consequences of regulatory failure.
3. Listing the events that led to the Great Recession of 2008.