MEPS – Preparatory and Orientation Weeks Lectures by Kristin Bernhardt

Home , Giffen good, Inferior good, Ordinary good

MEPS – Preparatory and Master of Science March 2012 Orientation Weeks in Economic Policy

Lectures by Kristin Bernhardt Fundamentals of Microeconomics

1. Markets 2. Consumers and Households 3. Enterprises 4. The Public Sector What‘s ECONOMICS??

• Economy: ▫ ‘one who manages a household‘ (Greece)

• Economics: ▫ How does a society manage its scarce resources 1.2 Elasticity 1.3 Taxation Markets

• Modern microeconomics is about supply, demand, and market equilibrium.

• A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price.

• Perfect Competition

Market Forms

• Monopoly

• Oligopoly

• Monopolistic Competition MARKET EFFICIENCY

• Three Insights Concerning Market Outcomes

▫ Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. ▫ Free markets allocate the demand for goods to the sellers who can produce them at least cost. ▫ Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

• Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it.

• -> laissez faire

Market Power

• If a market system is not perfectly competitive, market power may result.

▫ Market power is the ability to influence prices. ▫ Market power can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand. 1.1 Elasticity

• … allows us to analyze supply and demand with greater precision.

• … is a measure of how much buyers and sellers respond to changes in market conditions.

The Price Elasticity of Demand

• Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

, = 푑푑 � • , > 0 = Giffen-휂 good푥 푝 푑푑 � • , < 0 = normal good 휂푥 푝

푥 푝 Percentage change in quantity demanded Price휂 elasticity of demand = Percentage change in price The Price Elasticity of Demand

• Inelastic Demand ▫ Quantity demanded does not respond strongly to price changes. ▫ Price elasticity of demand is less than one.

• Elastic Demand ▫ Quantity demanded responds strongly to changes in price. ▫ Price elasticity of demand is greater than one. The Price Elasticity of Demand

b c

(a) Perfectly Inelastic Demand: Elasticity Equals 0 (b) Inelastic Demand: Elasticity Is Less Than 1 (c) Unit Elastic Demand: Elasticity Equals 1 (d) Elastic Demand: Elasticity Is Greater Than 1 (e) Perfectly Elastic Demand: Elasticity Equals Infinity Responsiveness to Responsiveness to PRICE changes INCOME changes

Giffen Good Inferior Good < 0

휀 Luxury Good / Superior Good > 1 Ordinary Good Normal Good 휀 > 0 Necessary 휀 Good < 1

휀 Total revenue and the Price Elasticity of Demand • Total revenue is the amount paid by buyers and received by sellers of a good.

• With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

• With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

The Income Elasticity of Demand

• Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.

, = < 0 = 푑푑 � • , inferior휂 good푥 푖 > 0 = 푑푑 � • 푥,푖 superior good 휂 Percentage change 푥 푖 in quantity demanded 휂 Income elasticity of demand = Percentage change in income Cross-Price-Elasticity of Demand

, = 푑�푖 �푗 휂푥푖 푝푗 푑�푗 �푖 • , > 0 = substitutive goods

• 푖 푗 < 0 = complementary goods 휂푥 ,푝 푖 푗 휂푥 푝

The Price Elasticity of Supply

• Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.

Percentage change in quantity supplied Price elasticity of supply = Percentage change in price The Price Elasticity of Supply

a b c

(a) Perfectly Inelastic Supply: Elasticity Equals 0 (b) Inelastic Supply: Elasticity Is Less Than 1 (c) Unit Elastic Supply: Elasticity Equals 1 (d) Elastic Supply: Elasticity Is Greater Than 1 (e) Perfectly Elastic Supply: Elasticity Equals Infinity 1.2 Taxation

• Tax incidence is the study of who bears the burden of a tax.

• Taxes result in a change in the market equilibrium.

• Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

Figure 2 Tax on Buyers

Price of Ice-Cream Price Cone Supply, S1 buyers pay $3.30 Equilibrium without tax Tax ($0.50) Price 3.00 A tax on buyers without 2.80 shifts the demand tax curve downward by the size of Price Equilibrium the tax ($0.50). sellers with tax receive

0 90 100 Quantity of Ice-Cream Cones

Price of Ice-Cream A tax on sellers Price Cone Equilibrium S2 shifts the supply buyers with tax curve upward pay by the amount of $3.30 S1 Tax ($0.50) the tax ($0.50). Price 3.00 without 2.80 Equilibrium without tax tax

Price sellers receive

Demand, D1

• In what proportions is the burden of the tax divided?

• How do the effects of taxes on sellers compare to those levied on buyers?

• The answers to these questions depend on the elasticity of demand and the elasticity of supply.

Figure 5 How the Burden of a Tax Is Divided

(a) Elastic Supply, Inelastic Demand

Price 1. When supply is more elastic than demand . . . Price buyers pay Supply

Tax 2. . . . the incidence of the Price without tax tax falls more heavily on Price sellers consumers . . . receive

3. . . . than Demand on producers.

0 Quantity

(b) Inelastic Supply, Elastic Demand

Price 1. When demand is more elastic than supply . . . Price buyers pay Supply

Price without tax 3. . . . than on consumers. Tax

2. . . . the Demand Price sellers incidence of receive the tax falls more heavily on producers . . .

0 Quantity

• The incidence of a tax refers to who bears the burden of a tax.

• The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.

• The incidence of the tax depends on the price elasticities of supply and demand.

• The burden tends to fall on the side of the market that is less elastic. The Deadweight Loss of Taxation

• A tax places a wedge between the price buyers pay and the price sellers receive.

• Tax Revenue ▫ T = the size of the tax ▫ Q = the quantity of the good sold T × Q = the government’s tax

revenue

Figure 7 Tax Revenue

Price

Supply

Price buyers Size of tax (T) pay Tax revenue (T × Q)

Price sellers receive

Quantity Demand sold (Q)

0 Quantity Quantity Quantity with tax without tax

Price

Supply Price A buyers = P B pay B Price C without tax = P 1 E Price D sellers = P S

receive F

Demand

0 Q2 Q1 Quantity

• The losses to buyers and sellers exceed the revenue raised by the government. • This fall in total surplus is called the deadweight loss. DETERMINANTS OF THE DEADWEIGHT LOSS

• The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price.

• That, in turn, depends on the price elasticity of supply and demand.

• The greater the elasticities of demand and supply…..??

Figure 13 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes

(a) Small Tax Price

Deadweight loss Supply

PB Tax revenue

Demand

0 Q2 Q1 Quantity

(b) Medium Tax Price

Deadweight P loss B Supply

Tax revenue

PS Demand

0 Q2 Q1 Quantity

PB Deadweight loss Supply revenue Tax

Demand

0 Q2 Q1 Quantity

(b) Revenue (the Laffer curve) Tax Revenue

0 Tax Size

2.1 The Theory of Consumer Choice

• The theory of consumer choice addresses the following questions:

▫ Do all demand curves slope downward? ▫ How do wages affect labor supply? ▫ How do interest rates affect household saving?

The Budget Constraint

• The budget constraint depicts the limit on the consumption “bundles” that a consumer can afford.

• The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.

• Any point on the budget constraint line indicates the consumer’s combination or tradeoff between two goods.

Figure 1 The Consumer’s Budget Constraint

Quantity of Pepsi B 500

C 250

Consumer’s budget constraint

• An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction.

• Four properties of indifferent curves: 1. Higher indifference curves are preferred to lower ones. 2. Indifference curves are downward sloping. 3. Indifference curves do not cross. 4. Indifference curves are bowed inward.

Representing Preferences with Indifferent Curves

• The Consumer’s Preferences

• The Marginal Rate of Substitution

▫ The slope at any point on an indifference curve is the marginal rate of substitution. Figure 2 The Consumer’s Preferences

Quantity of Pepsi C

B D

MRS I2 1 Indifference A curve, I 1 0 Quantity of Pizza

• Perfect Substitutes ▫ Two goods with straight-line indifference curves are perfect substitutes. ▫ The marginal rate of substitution is a fixed number.

• Perfect Complements ▫ Two goods with right-angle indifference curves are perfect complements.

Figure 3 Perfect Substitutes and Perfect Complements

• Combining the indifference curve and the budget constraint determines the consumer’s optimal choice.

• Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.

• The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price. Figure 4 The Consumer’s Optimum

Quantity of Pepsi

Optimum

B A

I2 I1 Budget constraint 0 Quantity of Pizza

Budgetrestriction: + Budget Line: �1�1 �2�2 ≤ 푀 = 푀 �1 Optimal Choice: �2 − �1 �2 �2 = 푑�2 �1 The marginal rate of substitution equals the negative price ratio. − 1 2 Utility Function: 푑푑 � ( , )

1 2 푈 � � Maximization with Budget Restriction

Max , subject to = +

1 2 1 1 2 2 Lagrangian: 푈 � � 푀 � � � � , , = , ( + )

1 2 1 2 1 1 2 2 FOC: 퐿 � � 휆 푈 � � − 휆 푀 − � � � � 1. = = 0 휕퐿 2. = = 0 = = 휕푥1 푈1 − 휆�1 휕퐿 푼ퟏ 풅풅ퟐ 풑ퟏ 3. 2= 2 2 = 0 − 휕푥 푈 − 휆� 푼ퟐ 풅풅ퟏ 풑ퟐ 휕퐿 1 1 2 2 휕휕 푀 − � � − � � Marshall‘s Demand Function: ° = ( , , ) ° = 푀( , , ) 1 1 1 2 � �푀 � � 푀 �2 �2 �1 �2 푀 Minimization under given Utility Level

Min + subject to , = 0 1 1 2 2 1 2 Lagrangian: � � � � 푈 � � 푈 , , = + [ , ] 0 FOC: 퐿 �1 �2 휇 �1�1 �2�2 − 휇 푈 �1 �2 − 푈 1. = = 0 휕퐿 2. = = 0 = = 휕푥1 �1 − 휇푈1 휕퐿 푼ퟏ 풅풅ퟐ 풑ퟏ 3. = 2 , 2 + = 0 휕푥2 � − 휇푈 ퟐ − ퟏ ퟐ 휕퐿 0 푼 풅풅 풑 1 2 휕휕 −푈 � � 푈 Hick‘s Demand Function: = ( , , ) ∗ = 퐻( , , 0) 1 1 1 2 �∗ �퐻 � � 푈0 �2 �2 �1 �2 푈 2.2 Income and Substitution Effects

▫ The income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve.

▫ The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution. Income and Substitution Effects

• A Change in Price: Substitution Effect ▫ A price change first causes the consumer to move from one point on an indifference curve to another on the same curve.

• A Change in Price: Income Effect ▫ After moving from one point to another on the same curve, the consumer will move to another indifference curve. Figure 8 Income and Substitution Effects

Quantity of Pepsi

New budget constraint

C New optimum Income effect B Initial optimum Substitution Initial effect budget constraint A I2

The total effect: = 푀 퐻 푀 1 1 1 휕� 휕� ∗ 휕� ° − �1 (with = ) 휕�1 휕�1 휕푀 ∗ is devided into �1 �1

• a Substitution Effect, which equals the reaction of Hick‘s

demand on a price change 퐻 and 휕푥1 휕푝1

• a Income Effect 푀. ∗ 휕푥1 −�1 휕� 3.1 The Costs of Production 3.2 Firms in Competitive Markets 3.3 Monopoly Theory

3.1 The Costs of Production

• Total Revenue: The amount a firm receives for the sale of its output.

• Total Cost: The market value of the inputs a firm uses in production.

• Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

Costs as Opportunity Costs

• A firm’s cost of production includes all the opportunity costs of making its output of goods and services.

• Explicit and Implicit Costs  Explicit costs are input costs that require a direct outlay of money by the firm.  Implicit costs are input costs that do not require an outlay of money by the firm.

Production and Costs

• The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

• The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.

• Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Marginal Costs

• Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.

• Marginal cost helps answer the following question:

Elasticities

Elasticity to Scale

( , ) = = = 푑푑⁄� 푑푑⁄푑푑 휕휕 �푏 𝑏 ⁄휕� Partial휀푥푥 Product Elasticity � 푑푑⁄� �⁄� �⁄� �=1

( , ) = = 휕휕(�, 퐿)⁄휕퐿 퐿�퐿 휀푥퐿 = = 퐿 � 휕휕 � 퐿 ⁄휕� 퐿�퐾 휀푥퐾 � � Economies and Diseconomies of Scale

• Economies of scale refer to the property whereby the long-run average total cost falls as the quantity of output increases.

• Diseconomies of scale refer to the property whereby the long-run average total cost rises as the quantity of output increases.

• Constant returns to scale refers to the property whereby the long-run average total cost stays the same as the quantity of output increases.

Definition

Production Function = ( , ) > If , = , holds for all (K,L) and all > 1 , then the production < � � � 퐿 � �푏 𝑏 𝑏 � 퐿 � function has returns to scale. �푛푛푛푛푛푛�푛푛 �푐𝑐푐𝑐푐 푑𝑑𝑑𝑑푑𝑑

> 1 = 1 < 1 �푛푛푛푛푛푛�푛푛 휀푥푥 푓𝑓 �푐𝑐푐𝑐푐 𝑟�푟𝑟� 𝑡 𝑠�푠� 푑𝑑𝑑𝑑푑𝑑 Production Maximization Max F( , ) subject to = + 0 Lagrange-Function� 퐿: 퐶 푤� 𝑟

( , , ) = ( , ) + ( + ) 0 Firstℒ Order� 퐿 휆 Conditions� � 퐿 : 휆 퐶 − 푤� 𝑟 → 푚𝑚

1. = = 0 2. 휕� = = 0 = = 휕퐿 �퐿 − 휆푤 3. 휕ℒ = + = 0 풘 푭푳 풅� 휕퐾 �퐾 − 휆� − 휕ℒ 0 풓 푭푲 풅� 휕� 퐶 − 푤� 𝑟

3.2 Firms in Competitive Markets

• A perfectly competitive market has the following characteristics: ▫ There are many buyers and sellers in the market. ▫ The goods offered by the various sellers are largely the same. ▫ Firms can freely enter or exit the market.

• A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. ▫ Buyers and sellers must accept the price determined by the market.

Profit Maximization

Profit = ( )

Profit Maximization휋 � 푅 � − 퐶 � ( ) = = 0 푑휋 �푥 ′ ′ 푅 �=푥 −(퐶 )� 푥 푑푑 ′ Marginal R푅evenue�푥 =퐶퐶 Marginal�푥 Profit Profit Maximation

Profit Equation = ( )

FOC 휋 � � ∙ � − 퐶 � = ′ 0 ′ 0 휋 � = �(− 퐶) � 0 • In a market with free entry� 퐶퐶 and� exit, profits are driven to zero in the long run and all firms produce at the efficient scale. • In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.

3.3 Monopoly Theory

• A firm is considered a monopoly if . . . ▫ it is the sole seller of its product. ▫ its product does not have close substitutes.

• The fundamental cause of monopoly is barriers to entry. Its sources are: ▫ Ownership of a key resource. ▫ The government gives a single firm the exclusive right to produce some good. ▫ Costs of production make a single producer more efficient than a large number of producers.

Natural Monopolies

• An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.

• A natural monopoly arises when there are economies of scale over the relevant range of output.

Figure 7 Economies of Scale as a Cause of Monopoly

Cost

Average total cost

0 Quantity of Output

(a) A Competitive Firm’ s Demand Curve (b) A Monopolist’ s Demand Curve

Price Price

Demand

0 Quantity of Output 0 Quantity of Output

• A Monopoly’s Marginal Revenue

▫ A monopolist’s marginal revenue is always less than the price of its good.

▫ When a monopoly increases the amount it sells, it has two effects on total revenue (P × Q). Figure 9 Demand and Marginal-Revenue Curves for a Monopoly

Price $11 10 9 8 7 6 5 4 3 Demand 2 Marginal (average 1 revenue revenue) 0 –1 1 2 3 4 5 6 7 8 Quantity of Water –2 –3 –4

Costs and Revenue 2. . . . and then the demand 1. The intersection of the curve shows the price marginal-revenue curve consistent with this quantity. and the marginal-cost curve determines the B profit-maximizing Monopoly quantity . . . price

Average total cost A

Marginal Demand cost

Marginal revenue

0 Q QMAX Q Quantity

Costs and Revenue

Marginal cost

Monopoly E B price

Monopoly Average total cost profit

Average total D C cost Demand

Marginal revenue

0 QMAX Quantity

For Monopolies the same profit maximization equation as for firms in competitive markets holds:

1 = ( ) = ( ) 1 ′ , 푅 �푥 퐶퐶 �푥 � � − 휂푥 푝

The Welfare Cost of Monopoly

• In contrast to a competitive firm, the monopoly charges a price above the marginal cost.

• From the standpoint of consumers, this high price makes monopoly undesirable.

• However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable. The Deadweight Loss

• Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost.

▫ This wedge causes the quantity sold to fall short of the social optimum. Figure 12 The Inefficiency of Monopoly

Price Deadweight Marginal cost loss

Monopoly price

Marginal revenue Demand

0 Monopoly Efficient Quantity quantity quantity

• Government responds to the problem of monopoly in one of four ways.

▫ Making monopolized industries more competitive. ▫ Regulating the behavior of monopolies. ▫ Turning some private monopolies into public enterprises. ▫ Doing nothing at all. GAME THEORY AND THE ECONOMICS OF COOPERATION

• Game theory is the study of how people behave in strategic situations.

• Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action. The Prisoners‘ Dilemma

• The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation.

• Often people (firms) fail to cooperate with one another even when cooperation would make them better off.

• The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Figure 14 The Prisoners’ Dilemma

Bonnie’ s Decision

Confess Remain Silent

Bonnie gets 8 years Bonnie gets 20 years

Confess Clyde gets 8 years Clyde goes free Clyde’s Decision Bonnie goes free Bonnie gets 1 year

Remain Silent

Clyde gets 20 years Clyde gets 1 year

• The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.

• Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

4.1 Externalities 4.2 Public Goods 4.1 Externalities

• An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.

• Externalities are created when a market outcome affects individuals other than buyers and sellers in that market.

• Externalities cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers.

• Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

Negative Externalities

• When the impact on the bystander is adverse, the externality is called a negative externality. ▫ Automobile exhaust ▫ Cigarette smoking ▫ Barking dogs (loud pets) ▫ Loud stereos in an apartment building

• Negative externalities lead markets to produce a larger quantity than is socially desirable.

Externalities and Market Inefficiency

• The Market for Aluminum

▫ The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.

▫ If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

• For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution. Figure 1 Pollution and the Social Optimum

Price of Social Aluminum cost Cost of pollution Supply (private cost)

Optimum

Equilibrium

Demand (private value)

0 QOPTIMUM QMARKET Quantity of Aluminum

• The socially optimal output level is less than the market equilibrium quantity.

• Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

• The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

Positive Externalities

• When the impact on the bystander is beneficial, the externality is called a positive externality.

▫ Immunizations ▫ Restored historic buildings ▫ Research into new technologies

• Positive externalities lead markets to produce a larger quantity than is socially desirable.

Positive Externalities

• The intersection of the supply curve and the social- value curve determines the optimal output level.

▫ The optimal output level is more than the equilibrium quantity.

▫ The market produces a smaller quantity than is socially desirable.

▫ The social value of the good exceeds the private value of the good.

The Coase Theorem

• The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.

• Transactions Costs ▫ Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.

Public Policy towards Externalities

• When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . .

1. Command-and-Control Policies

2. Market-Based Policies

3. Pigovian taxes are taxes enacted to correct the effects of a negative externality.

Figure 3 The Equivalence of Pigovian Taxes and Pollution Permits

(a) Pigovian Tax Price of Pollution

P Pigovian tax 1. A Pigovian tax sets the price of Demand for pollution . . . pollution rights 0 Q Quantity of Pollution 2. . . . which, together with the demand curve, determines the quantity of pollution.

• Free goods provide a special challenge for economic analysis.

• When a good does not have a price attached to it, private markets cannot ensure that the good is produced and consumed in the proper amounts.

• In such cases, government policy can potentially remedy the market failure that results, and raise economic well-being.

The Different Kind of Goods

• When one is thinking about the various goods in the economy, it is useful to group them according to two characteristics:

• Excludability refers to the property of a good whereby a person can be prevented from using it.

• Rivalry refers to the property of a good whereby one person’s use diminishes other people’s use.

The Different Kind of Goods Four Types of Goods:

• Private Goods ▫ Are both, excludable and rival.

• Public Goods ▫ Are neither excludable nor rival.

• Common Resources ▫ Are rival but not excludable.

• Natural Monopolies ▫ Are excludable but not rival. Figure 5 Four Types of Goods

Rival? Yes No Private Goods Natural Monopolies

Yes • Ice-cream cones • Fire protection • Clothing • Cable TV • Congested toll roads • Uncongested toll roads Excludable? Common Resources Public Goods

No • Fish in the ocean • Tornado siren • The environment • National defense • Congested nontoll roads • Uncongested nontoll roads

• A free-rider is a person who receives the benefit of a good but avoids paying for it.

• Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it.

• The free-rider problem prevents private markets from supplying public goods.

The Free-Rider Problem

Solving the Free-Rider Problem:

• The government can decide to provide the public good if the total benefits exceed the costs.

• The government can make everyone better off by providing the public good and paying for it with tax revenue.

Common Ressources

• Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them.

• Common resources are rival goods because one person’s use of the common resource reduces other people’s use.

The Tragedy of Common Ressources

• The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole.

▫ Common resources tend to be used excessively when individuals are not charged for their usage. ▫ This is similar to a negative externality.

• Important Common Ressources:

▫ Clean air and water ▫ Congested roads ▫ Fish, whales, and other wildlife

Conclusion:

The Importance of Property Rights: • The market fails to allocate resources efficiently when property rights are not well-established (i.e. some item of value does not have an owner with the legal authority to control it).

• When the absence of property rights causes a market failure, the government can potentially solve the problem.