Principles of Microeconomics – Mr. Lilly

Topic 9 Skills

1.      Know that the belief that we have entered the “Age of Markets” has both theoretical and empirical support.  Know that its theoretical support comes from the First Theorem of Welfare Economics, and that its empirical support comes from such recent observations as:

a.       The fact that the Soviet Union gave up on communism in the late 1980’s.

b.      The fact that China is experimenting with capitalism with great success.

c.       The fact that most of the world’s remaining communist countries, such as North Korea and Vietnam, are quite poor.

2.      Know that today’s most successful economies, including the United States, Great Britain, Japan, and Germany, are not purely market-driven.  That instead, they combine many elements of socialism (state-run services, government “safety net” programs, and high tax rates,) with markets; and that is why they are called “mixed economies.”  So the real question is not “which is better, capitalism (100% reliance on markets) or communism (0% reliance on markets,)” but rather “when and where should markets be used in an economy, and what should the role of government be?”

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3.      Know the six assumptions listed on slide 9-5 and the seven assumptions listed on slide 9-6.  Know in addition the assumption that consumers are rational.

(Slide 5) The Set-Up: The Idealized World of the Neoclassical Model

•Every decision maker is an autonomous individual (presumably a healthy, prime-age adult).

•Each individual is endowed with a certain set of resources (money, property, brains, skills, good looks, etc.)

•There’s no such thing as a physiological need.  Everything is a want.

•Future generations and other species are not independently present in the model.

•Consumption and leisure are the only things on which utility depends.

•All production is performed by firms.  None is performed by households.

(Slide 6) The Set-up: The 7 Key Assumptions

•All markets are perfectly competitive.

•There is free entry and exit in all industries.

•Everyone has perfect information about products, prices, workers, available inputs, and profit opportunities.

•There are no transaction costs.

•There are no significant internal economies of scale, because these might lead to the formation of a monopoly.

•There are no externalities.

•         There are no public goods.

4.      Understand the two key limitations of Pareto efficiency; namely that:

a.       There can be multiple allocations of resources that are Pareto efficient, and

b.      The initial distribution of resources, if uneven, can produce a Pareto efficient outcome that 9 out of 10 “benevolent dictators” would not choose on the grounds that it does not maximize the collective welfare of society.

(Slide 7) The Normative Standard: Pareto Efficiency

•In an ideal world, the happiness conferred by all products and services on all persons could be summed into a single measure of happiness, and economists would be able to measure utility directly and compare utility gained with utility lost.

•But alas, direct utility measurements and interpersonal utility comparisons cannot be made.

•That is why, beginning in about 1938, economists embraced the standard of “Pareto Efficiency.”

(Slide 8) Pareto Efficiency: Exists when there is no opportunity to make at least one person better off without making someone else worse off.

•          Specifically, we say that a given allocation of resources (mix of final goods and services) is Pareto efficient if and only if there is no redistribution of resources to which two or more parties would voluntarily agree, with all other parties being unaffected.

5.      Be able to identify which allocations of resources are and are not Pareto efficient if presented with a table such as Table 18.1 on page 18-5.  (See also slide 9-9.)

The Main Problem with Pareto Efficiency

•We must not make the mistake of believing that a Pareto efficient allocation of resources is the SAME THING as a collective utility-maximizing allocation of resources.

•It may well be the case that an INVOLUNTARY reallocation of resources – such as that a benevolent dictator might impose – would GREATLY increase the collective utility of society!

Example: Take $100 from Bill Gates and give it to the poorest person in America.

•It follows that government programs that redistribute wealth from the rich to the poor may be socially desirable!

6.      Understand that the second limitation of Pareto efficiency described in skill 4 is more than sufficient justification for two types of government intervention commonly seen in modern mixed economies:

a.       Programs to redistribute wealth from rich to poor (such as high, progressive income taxes and extensive social safety net programs,) and

b.      Programs to provide for the basic physiological needs of the least fortunate members of society (such as food for the hungry, housing for the homeless, and medical care for sick indigents.)

(Slide 11) The “Big Tradeoff”

•However, most government programs that redistribute wealth from rich to poor also reduce the incentives to work hard and create value that are present in markets.

•High, progressive tax rates on income

•Extensive “social safety net” programs for the unemployed, the elderly, the weak and infirm.

•This creates “The Big Tradeoff” for governments:

–Be careful how much redistribution of wealth and income you engage in, because the more of it you do, the less effort and the less market activity people will engage in.

–If you do too much, the poorest in society will actually become worse off!

7.      Understand however that the two types of government intervention described in skill 6 tend to reduce the motivation and effort of both the poor and the rich, and therefore tend to reduce the overall gross national product of the economy.  This unfortunate trade-off between compassion and economic output is called “The Big Tradeoff,” and it dictates that modern mixed economies use restraint, judgment, and possibly also cleverness to try to minimize the negative impact on economic output of government “compassion” programs.

8.      Know the seven other roles of government listed on slides 9-12 through 9-15, and be able to name the assumption of the neoclassical model that does not hold true in the real world that “goes with” or justifies each particular type of government intervention.

Other Roles for Government

1. Passing and enforcing laws, and performing on-site inspections to stamp out externalities.

•Air pollution laws, water pollution laws, and the Environmental Protection Agency.

•Contracts for murder.

•Sale of uzi’s.

2. Passing and enforcing laws to stamp out monopolies (or to eliminate their negative effects.  More on this in topic 10.)

•The Sherman Antitrust Act, the Robinson-Patman Act, The Clayton Act, and the Securities and Exchange Commission.

3.Passing and enforcing laws to ensure that consumers have the information they need to make sound choices between products.

•The Federal Trade Commission and its “truth in advertising” regulations.

•The Food and Drug administration and its standard nutritional information on foods.

•Standard disclosures required in real estate transactions, loans, and for prescription medicines.

•Disclosures required by California’s Prop. 65.

4.Passing and enforcing laws to protect consumers from their own irrationality or inability to choose wisely.

•Heroin is illegal.

•Prostitution is illegal in most states.

•It’s illegal to sell minors alcohol or cigarettes.

5. Passing and enforcing laws to prohibit transactions that only take place when one of the parties has vastly superior bargaining power.

•Selling yourself into slavery.

•Prostitution.

6. Provision of public goods.

•          As we learned in topic 3, public goods (goods which are both nondimishable and nonexcludable,) will tend to be under produced by market participants.

•          Examples include national defense, police and fire protection, and basic scientific research.

7. The vigorous protection of private property rights and enforcement of contractual obligations to keep transactions costs to a minimum.

•          This means having an effective court and jail system and a police establishment that is absolutely free of corruption.

9.      Understand and be able to explain the two additional reasons for government intervention listed as “frontiers for the future” on slides 9-16 and 9-17 suggested by some observers of the modern economy.

1. Rights for future generations.

•          Future generations have no current income or wealth and so have no vote in what gets produced and what resources get maintained.

•          Our unsustainable use of fossil fuels, fisheries, and forest resources could lead to the economic impoverishment of future generations, because natural systems provide free services valued at almost half of world GDP!

•          Further, geneticists have argued that there is a sort of “free-rider” problem occurring.

2. Rights for other species.

•          Other species have very little representation in economic decision making.

•          Some people say this will lead to outcomes that are ethically wrong.  (Specifically, it is estimated that as much as one-third of all living species may be driven to extinction by man by the year 2100!)

•          Should government step in and protect the rights of other species?  Some people say yes.