Problems by Command
1. Information collection
3. Disagreement among multiple decision-makers. Arrows’ impossibility theorem. Paradox of voting. 4. Enforcement
Coordination by Market
Princes as signals of scarcity/abundance
Requires much less info
No enforcement costs
No principal-agent problem
No problem with multiple decision makers
Qualification: some command systems exist within a market (eg firms)
Has free-rider problem due to non-excludability.
Can only be provided by a coercive authority that can force users to pay for these goods. Taxes.
Provide benefits for a group.
Cartels and Unions
Has free riding problem.
Prevent by sanctions
Non-excludable but exhaustible
Natural resources goods
Lack of well-defined property rights encourages overuse. The tragedy of the commons. Solve by asserting ownership rights over common resources.
Markets generate themselves for property transfer that internalize externalities.
Adverse selection & Moral hazard
Market price based on expected quality
Reward people for not maintaining quality
High quality sellers drop out
FDI promotes technology transfer without moral hazard.
Equilibrium – no one has an incentive to change their behavior.
Cause a shortage due to excess demand
Leads to rationing or preferential allocation, long queues, inefficiency. Those who do get will benefit from the lower prices.
Eg Minimum wage
Only those workers who don’t lose their jobs benefit from the higher wages.
When price goes down, CS increase due to 2 reasons. Existing buyers pay less. More buyers are able to enter market. Producer surplus
Markets select low cost suppliers.
Only those whose costs of production are below the market price enter. When price goes down, ‘marginal seller’ drops out.
When price goes up, PS increases due to 2 reasons. Existing producer get a higher price. More producers can enter. Total welfare = CS + PS
Govt intervention decreases this
Factors of demand
Income & substitution effect
Change in tastes
Expectation of future prices
Change in number of buyers
Factors of supply
Change in technology
Change in input prices
Expectation of future prices
Change in number of sellers
Price elasticity of demand for a good is the % change in demand when the good’s price falls by 1%. Elasticity along a linear demand curve decreases with a decrease in price. Factors affecting elasticity of demand
Number of substitutes/whether the good is a necessity/time frame/broadness of category
Income elasticity of demand is the % increase in its demand for a 1% rise in income. Indifference curve
Non-lexicographic and non-satiation
Convex to origin – preference for variety
Cant cross each other due to consistency and transitivity
Marginal rate of substitution(MRS)
Negative of an indifference curve’s slope at any point
Equal to the ratio of marginal utilities of the 2 goods at that point
Slope of budget line is the negative of the relative prices of the 2 goods. At tangent, slope of budget line and slope of indifference curve must be equal. MRS=relative prices at this point The ratio of marginal utility to price is equal for both goods at the point chosen (equimarginal principle)
Income and substitution effect
AFC=TFC/Q, AVC=TVC/Q, ATC=AFC+AVC
AFC declining with Q. AVC first falls then rises. U shaped.
Rising marginal cost.
No supply curve.
P=MC, lead to losses for natural monopoly, which govt can subsidize. But tax has its own deadweight loss. P=ATC , zero profits.
Alternative, public ownership
Increase monopolist profits
First degree – extract entire CS, socially optimal but unlikely Second degree – Charge buyers based on observable characteristics...
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