1

1

Economics

Session #1:

Getting started

Prof. Dr. Hanno Beck

2

Getting started

About this lecture

How to study and why

What is Economics?

Catwalk: Germanys next Top-Model

3

• 14 chapters • every chapter has

– one topic: basic ideas, examples, case studies, political implications, discussion

– reading assingments: see syllabus for details

• you are supposed to – do the reading assigments before the lecture – repeat what you have learned in the lecture;

answer questions and discuss them with your fellow students

• Questions, comments: Office-Hours; E-Mail; after (or during) the lecture

About this lecture

2

4

• How many days do you need to finish your term paper / thesis? (Bühler, Griffin Ross 1994)

– Expectations: on average 34 days; optimistic students: 27 days

– real time needed to finish paper: 55 days

• Huh, you are not supposed to do such mistakes? A simple question: – how do you pronounce the capital of Kentucky:

Loo-ee-ville or Loo-iss-ville?

– how many Euros are you willing to bet that you know the right answer?

• Empirical findings: We suffer from overcon-fidence, illusion of control, and self serving bias

How to study

5

• Neuroeconomics: your brain has two different areas – limbic system: affective system; basic survival; immediate satisfaction

– cognitive system (präfrontal Cortex): self-control; willpower

• As long as the limbic systems rules our behavior (as it in fact does), we

– smoke, drink, eat to much

– Don‘t learn enough, start learning to late

• Solution: self-committment – tight schedule; learning routinely, regulary

– learning with fellow students

– learning with good students improvesyour own grades (Sacerdote 2002)

– compare your learning goals with your real learning efforts by means of a diary

– promise yourself a reward (after you finished)

How to study

6

• more money, prestige…

• The economics of education: – going to university is like an investment

– a economics student costs 40.000 Euro

– this is how an investment works: sacrifying consumption today for more consumption tomorrow

• Tuitition fees: – an investor has to pay for his investment (class rooms, teaching staff,

etc.).

– investments are usually financed by credit (bonds) or equity. This does not work for an investment in human capital because there is no collateral

– Tuitition fees: if your investment (your visit of the university) pays off, you are able to pay back your fees. As long as the return of teh investment is > than the costs of your investment it makes you better off

– A matter of fairness: who really pays if your studies are for free?

Why should you study?

3

7

Homework: reading assignments

Reading assignments:

A letter from London

At LSE, we don‘t have one single book for one course.

The amount of literature is huge: 900 pages for three courses, that is 120 pages

per day. For example, the capital markets session requires the reading of nine

research Papers, seven articles from newspapers, selected readings from seven

books plus the slides from the lecture. Source: F.A.Z.

Please get all the slides and the literature you are supposed to read for this

lecture. From now on, you ought to read all the reading assigments before the

lecture. You have to read them anyway, so why not before the lecture?

8

What is economics?

• „Economics is making best out of life“

The problem with life: so many wishes, but so little

means to fulfill these wishes. Economics means to

organize an economy in order to reduce scarcity in the

most efficient way

• „People respond to incentives“

Economists think of people as selfish beings – rewards

make them work; punishment makes them behave

properly

• „Economists as policy advisers“

Economics is not an selfish art: reducing scarcity is one

common political goal.

9

What is economics?

• Why do we need models? They are like a map to solve economic problems

• Methods: – ceteris paribus-analysis (holding other things constant )

– make your assumptions transparent (people maximize utility)

– make explanations (how do people maximize utility)

– make predictions (if you increase prices, consumption will decrease)

• Three ways to craft a model: – verbal description

– graphical representation

– mathematical representation (exact)

• Statistics: testing theories and models with empirical observation

• Positive vs. normative theory

4

10

Catwalk: Germanys next Top-Model

Brazilian top-model Gisele Bündchen is – according to the Forbes-

list – the best-paid model of the world. She earns 33 million Dollar

(23,9 million euro) per year. Born in 1980, she is paid up to 40 000

Euro per show.

Top-model Kate Moss is ranked as the second-best paid model.

Aged 33, she earns 9 million Dollar (6,5 millionen euro) per year.

After leaving her friend, babyshambles-singer Pete Doherty, and

loosing her contracts with Burberry and Agent Provocateur she

made a comeback: she is the new Chanel-girl.

Heidi Klum earns 8 million Dollar (5,8 million euro) per year.

Born in Bergisch-Gladbach, she still is on the catwalk, doing

promotion for several compamies and is hosting TV-shows

(„Germany´s Next Topmodel“, „Runway“).

source: Gala

11

• Ein paar Fragen:

- warum wollen so viele Frauen Model werden?

- warum werden Models so hoch bezahlt?

- sollte man die Gehälter für Models nach oben

begrenzen?

Ökonomisches Denken: Germanys next Top-Model

A few questions

12

Economics

Session #2:

Economic thinking

Prof. Dr. Hanno Beck

5

13

Economic thinking

Scarcity, Incentives, property rights

Opportunity costs

Specialisation

Economics, freedom and Markets

14

Economic thinking: Scarcity

• Scarcity: the cookie-experiment

- test person is asked to try a cookie and to tell her willingness to

pay for that cookie

- Two groups: cookie-jar #1 ist full; cookie-jar #2 is almost empty

- variation I: show a full jar, replace it with an almost empty jar

- another experiment: the toys-partitionwall-experiment

- Empirical findings: humans are focussed on scarce

ressources

- explanations: - if other people value something as valuable, then it must be

valuable

- scarcity means a loss of options; people don‘t like the idea of

loosing options (i.e. freedom)

15

Under discussion: scarcity

• Scarcity: Consequences and political implications – why is coffee at Frankfurt Main station so expensive?

And who earns the money from the expensive coffee?

– in 15. Century, the black death killed almost one-third of the population. Afterwards, wages increased; the system of serfdom and lords of the manor disappeared. Why?

– What justifies huge salaries and profits?

• The power of scarcity: If there is a deal to be done and one of the contractors is in possesion of a scarce, unique ressource, then the profits will go to the owner of the scarce resource. Always ask yourself: who owns the scarce resource?

6

16

Economic thinking: Incentives

• Incentives: the cobra-effect – In the 19th Century, the English government in India tried to fight a

cobra-plague in India by paying money for every cobra caught. What

happened?

– 1965: “Unsafe at Any Speed” by Ralph Nader forced a wide array of

automobile safety legislation – cars became much safer. Consequence:

the number of accidents increased. Two effects: More accidents, fewer

drivers killed (side effect: more pedestrians killed)

• Basic idea of economics: pepole respond to incentives

– selfishness: pepole tend to maximise their own utility

– politics: if you want people to behave in a certain way, watch out

for the incentives they are exposed

– banning certain behavior: costs of controlling and prosecution;

people will always try to evade a ban

– Wrong incetives lead to a desaster: theory of oilspots

17

Case study: paying farmers for nothing

• Incentives: oilspot-theory

• E.g. agricultural policy in the E.U.: – goal: a minimum income for farmers

– policy: guaranteed prices

– consequence: excess suply

– next step: destroying excess suplly; paying farmers for not growing agricultural products

– Next step: fraud

– consequence: more and closer monitoring of farmers

– result: you are paying people for not to work and spending a whole lot of money for controlling if they really do not work

• Oilspot-theory (W. Eucken): once you start with a wrong policy, your mistakes start to spread over your economy like oil over water

• Homework: taking a cab

18

Homework: Taking a cab

Taking a cab in Prague

Journalists from the daily newspaper

Mlada fronta Dnes claimed to be foreign tourists

while taking a cab in Prague. In six out of ten cases,

they were charged extremely high prices. In one case,

they had to pay a price eight times as high as the price

allowed. The city council of Prague said that it controlled 755

cab-drivers; 1.5 percent of them charged a price too high.

How would you like to pay a cab-driver assuring that he will not

cheat you? How do you think a physician should be paid?

7

19

Economic thinking: property rights

• Property rights: pay the piper, call the tune – why are there so many expensive restaurants in

Frankfurt City and who is willing to pay for the expensive food?

• Who pays the bill? – you: maybe you’ll choose McDonalds instead – your company: you may order champagne instead of table water

• If you have to pay your bill by yourself, you will take care of your expenses and your property

• Property rights ensure an efficient allocation of ressources; if your boss pays the restaurant, you make a decision about hispropoerty, not yours

• Private property is neccesary for a market-economy • For a world without property rights see former eastern-

european socialist economies

20

Case study: Tokio Hotel serving for the army?

Tokio Hotel:

You‘re in the army now?

Instead of staging concerts, Tom and Bill Kaulitz from Germany‘s most sucessfull pop group Tokio Hotel may soon be serving for the german army. They got their call-up-order recently, as „Bild“, a tabloid newspaper, wrote. „We do not make any exeptions for prominent people, actors or musicians“ says Uwe Ullrich from the draft comission Stendal. „If they don‘t show up at the recruiting station they may be forced by the police to do so.“ (Source: Bild-Zeitung)

21

Opportunity costs

• Opportunity costs: should the german army draft Tokio

Hotel? (from an economic point of view)

– should Tiger Woods mow his own lawn?

– should you bake your own bread?

– the costs of some action might not be as obvious as it

seems – what about your time?

– opportunity costs of an item is what you give up to get

that item. There is no free lunch – whatever you choose

to do, you do it at expense of the next best alternative

• So what is more expensive: compulsory military services or

volunteers?

8

22

Homework: Too busy for university?

Too busy for university?

What do Bill Gates, David Beckham an Kylie

Minougue have in common? None of them has a

university degree. In fact many extremely sucessfull

people – especially those in careers like acting or athletics,

where starting early in life is especially crucial – do not attend

university. On the other hand, Queen-guitarist Brain May just

recently finished his Ph.D. in astrophysics – more than 30 years

after he left university to rock the world.

Do you think Mr Beckham or Mrs. Minougue should have finisehd

their studies before making a fortune? Should you leave university

for a career as singer/manager? And do you think that it was

clever from Mr. May to finish his Ph.D.?

23

• Specialisation: should Tiger Woods mow his own

lawn?

– the principle of specialisation: everybody should

specialise in the activities he is best at

– the division of labor (i.e. specialisation) constitutes

modern market economies: journalists, lawyers, car

makers, baker etc.

– idea: everybody does what he is best at and trades the

fruits of his work on the market

– division of labor is ALWAYS welfare-increasing

– division of labor on an international level: globalisation

– Ricardo: the principle of comparative advantage

Specialisation

24

Economics, freedom and markets

• freedom – as a value; people want to enjoy the benefits of liberty – efficiency needs freedom: voluntary contracts between

rational, equally entiteled parties are welfare-maximising

• Problems – equally entiteled partners? One needs to protect wekaer

parties and minorities – rational parties: unintended, unforeseen consequences of

our actions – contracts bothering third parties: enviromental policy;

speed limit to protect other drivers – here, policy has to step in and restrict personal freedom in

order to protect consumers, weak parties, third parties. Markets need additional policy.

9

25

• Policy

– to protect weaker parties (labor market, information

asymmetries, subsistence level)

– to protect consumers from their selves (obligation to

save for retirement, compulsory health insurance, drug

policy, education)

– to protect third parties (enviromental policy, speed limit)

• What should this policy be designed?

– marginal utility should equal marginal costs

– efficient and effective

– use the power of incentives instead of coercion

Economics, freedom and markets

26

Economics, freedom and markets

• markets are

– specialisation: you can only specialise in what you are good at if

you can exchange your production on an market

– therefore you need the right to exchange with whom you want

and the right to choose the job you want to do

– the distribution of the gains from specialisation is done by the

market according to the scarcity of the goods exchanged

– incentives: I will only exchange goods if it makes me better off

and if I am sure that I can reap the benefits form this exchange.

Therefore you need property rights (Art. 14 GG)

• A exchange of goods via markets makes both parties

better of is is always welfare-increasing

27

Economics, freedom and markets

• what makes markets work

– competition; no power resulting from scarcity or

monopolies

– protection from sweating

– rational consumers and voters

– no externalities

• Policy to make markets work

– competition policy (GWB)

– Social protection against hardships of life (Art. 20 GG)

– consumer protection; (alcohol, drugs etc.)

– protection of third parties from externalities (enviromental

policies)

10

28

Economics

Session #3:

How markets work

Prof. Dr. Hanno Beck

29

Homework: Taking a cab

• passenger: wants to get to his destination fast and cheap

• cab driver: wants to maximise his income

– pay per hour: driving lot of roundabout ways or traveling at speed

of light

– pay per kilometer: no good idea

– fixed price: fear for your life

– bonus for reaching destination as fast as poassible: see fixed

price

– Fixed price plus bonus if the passenger reaches destination

without suffering from the roman disease

• Other examples: profit sharing schemes in companies;

payment of physicains; managers salaries

30

Homework: Too busy for university?

• Opportunity costs: opportunity costs of an item is what you give up to get that item

• What about Bill,Kylie and David? – the costs of their studies are the foregone profits from their career – David and Kylie: they are making their fortune in young years –

maybe they should go to university after they finished their active career

• Brian: – leaving university for Queen was a good decision – now, the Brians opportunity costs are decreasing due to the

decreasing marignal utility of money (why?)

• Should you leave university? – it depends on your opportunity costs – it depends on the changes of making it to the charts / Bayern

München; the higher the risk of failing, the closer you should stick to your studies

11

31

How markets work

The hog-cycle

The path to equilibrium

Supply and demand

Markets in action

32

The hog cycle

The year of the golden pig

„Economists are remebered of the so-called hog-cycle taught in economics-courses in the first year at university. It explains why prices are volatile – because productions responds not immideately to changes in demand. In 2004, the price for pigs was not higher than today. Then, high prices made farmers to raise more pigs. In consequence, prices dropped dramatically, what in turn made farmers stop raising pigs. As an inevitable result, the price for pork increased to todays high level – this may lead to lower prices in the next years. (Economist, June 9th 2007; p. 59)

33

The hog cycle

• More examples: teachers, doctors

• How does this work, anyway?

– scarcity as a sign of demand for a product / service

– scarcity leads to higher prices

– higher prices as an incentive for producers to increase production – as long as he can reaps the profits from his increased production (property rights!)

– as prices rise, supply rises, which helps to reduce scarcity

– this happens only as long as prices are allowed to change and producers are allowed to profit from their increased efforts

• Result of free markets: equilibrium

12

34

The path to equilibrium

• You are in a supermarket: which cash desk to choose?

• That’s how markets work: Incentives (save time) trigger behavior (search for the shortest queue); that will bring markets into equilibrium (all queues do have the same expected time to wait)

• Incetives, property rights and freedom make disequilibria dissapear – supplier: seeks for profit

– consumer: seeks for cheapest contract

• markets channel egoims of supplier and consumer to a social efficient result

• Adam Smith: „invisible Hand“

• In fact, there are two invisible hands: Supply and demand

35

• A markets consists of consumers (demand) and

producers (supply)

• the price is the crucial variable that coordinates

supply with demand

• requirements for well-functioning markets:

– free prices; no obstacles to changes in prices

– property rights, incentives

– freedom to choose job, supplier, contract partner

– competitive marktes: no single supplier; no exploitation

• Graphical representation: Supply-demand-

diagramm

Supply and demand

36

Supply and demand

5

4

3

2

1

1 5 10 20 30

price

quantity demanded

price quantity

5 1

4 5

3 10

2 20

1 30

• Law of demand: as p decreases, D increases

• substitiution

• Income-effect

• but: ceteris-paribus-assumption

D

13

37

Supply and demand

5

4

3

2

1

1 5 10 20 30

price quantity

1 1

2 5

3 10

4 20

5 30

• Law of supply: as p increases, S increases, too

• Selling more promises more profits

• but: ceteris-paribus-assumption

price

quantity supplied

S

38

Supply and demand

5

4

3

2

1

1 5 10 20 30

price D S

1 30 1

2 20 5

3 10 10

4 5 20

5 1 30

• equilibrium: supply = demand

• Excess suplly: S > D

• Excess demand: D > S

price

quantity

S D

39

Markets in action

5

4

3

2

1

1 5 10 20 30

p

q

p old new

5 1 0

4 5 1

3 10 5

2 20 10

1 30 20

• Change of a exogenous variable: demand-curve shifts; loosening the ceteris-paribus-assumption

• This is not a movement along the curve (endogenous variable)

D

14

40

Markets in action

• The government decides to increase the tax on income

• The demand for Playstations: a new version enters the market

• The interest rate is rising

• The government introduces a new minimum wage legislation

• The price of your playstation is increasing

• Discuss the demand-curve for

– hard drugs

– silicon

41

• with the 1996 BSE-crisis, consumers switched from beef to pork

• farmers switched from rearing cows to pigs

• what happened to the price of beef?

• what happened to the price of pork?

p

q

S

D

D‘

S‘

Case study: the BSE-crisis

42

• For the last years, demand for natural ressources was steadily increasing

• Prices for natural ressources were steadily decreasing

p

q

S D

S‘

D‘

Case study: natural ressources

15

43

• What can politics do against drug-consumption?

• More punishment, more prosecution

• more educational work

• What if government decides to give heroin to addicted people for free?

p

q

S D

Case study: drug policy

D S‘

44

Case study: cheap food no more

• findings:

– Food-prices are rising

– Inventories are decreasing

– record crops worldwide

• Why are prices rising?

– China and India are getting richer; demand for meat is

increasing; meat needs more grain as input

– Demand for (state-sponsored) biofuels increases

– bad harvest in Australia

• measurements

– politics: price controls; export restruictions

– farmers: producing gen-food; re-activate fallow lands

45

• Demand curve shifts due to

- increasing incomes

- increasing demand for biofuels

• Supply curve shifts due to

- bad harvest in australia

- but: supply-curve may shift back due to reactivated fallow land

p

q

S

D S‘ D‘

Case study: cheap food no more

16

46

• Before price controls and export restrictions:

- Domestic suppliers produce S1; exports: S1-D1 sold at price P1

- Price controls; export restrictions

- price decreases to p2

- demand increases

- supply decreases

- consequences: more fallow land; smuggling; black markets

p

q

S D

Case study: cheap food no more

S1 D1

p1

p2

47

Homework: Beating the traffic

Beating the traffic

All big cities have traffic problems, and many

ities try to discourage people from driving into

the crowded city centre. If we think of a car journey

into the city as a good that people consume, one can

use the economics of demand and supply as a tool to analyze anti-

traffic policies. Here are a few strategies: One could reduce the

prices of substitutes (making bus or rail-tickets cheaper) or raise

the price of complements (high taxes on commercial car parks;

shorter times on the parking meters). The city of London imposed

a congestion charge on cars entering the city during the business

hours. Some cities restrict the number of cars allowed to enter the

city during the rush-hours.

Show graphically what happens to the market for car journeys to

the city if you implement the policies described above .

48

Economics

Session #4:

Elasticities and welfare analysis

Prof. Dr. Hanno Beck

17

49

• Reducing demand by taxes on carparks; higher costs of parking in the city shifts demand curve to the left

• Lower prices for substitutes shift demand curve to the left

• What happens if the government decides to restrict the number of cars allowed to enter the city?

p

q

Homework: Beating the traffic

D‘ D S S‘

50

Elasticities and welfare-analysis

Elasticity of demand

Elastic and inelastic demand

Other elasticities

Consumer- and Producer-Surplus

51

• Who needs protection in social and economic

life – and why?

– tenants / lodgers

– employees

• What is the problem with drugs?

• Should we sell life-saving medicine via

markets – and if not, why?

• What is exploitation and what is the root of it?

Elasticitiy of demand

18

52

Elasticitiy of demand

• Basic idea of marktes: supply and demand react to changes in prices

• How can we measure the reaction of supply / demand to changes in prices? („sensity of demand to price changes“)

• We may use

– the absolute decline of demand (supply) per Euro

– decline of demand (supply) in percent per Euro

– elasticities

53

• Elasticity: percent change in demand divided by the corresponding percent change in its price

• p decreases by -20 % = -(5 – 4) / 5

• demand increases by 11,11 % = (100 – 90) / 90

• elasticity: 11,11 / (-20) = -0,55

• If the price decreases by one %, demand increases by 0,55 %

• unit-free number enables comparisons between different goods; PE is independent from the price level

p

q

Elasticitiy of demand

D

5

90

4

100

54

• What if the price increases?

• p increases by 25 % = (5 – 4) / 4

• q decreases by -10 % = -((100 – 90) / 100)

• elasticity: (-10) / 25 = -0,4

• The value of PE depends on whether the price increases or decreases

• solution: averaging

p

q

Elasticitiy of demand

D

5

90

4

100

19

55

elasizität • Price on average:

(5 – 4) / 4,5

• p changes by 22 %

• average quantity: (100 – 90) / 95

• q changes by 10,5 %

• elasticity: 10,5 / 22 = 0,47

• Lets omit the „-“-sign

• bow elasticity

• Elasticity is NOT the slope of a curve (ΔQ/Δp); but it is an important part of it: PE = (ΔQ/Δp) (p/q)

p

q

Elasticitiy of demand

D

5

90

4

100

4,5

95

change in price mean price

change in quantity mean quantity

56

Homework: some elasticities

Oscar Angela p demand p demand

2 20 2 19

4 15 4 18

6 12 6 18

8 11 8 12

10 5 10 4

57

• elasticity: if the price decreases by one %, demand increases by Є %

• inelastic demand: Є < 1. (0,19)

• elastic demand: Є > 1 (1,6)

• Isoelastic demand: Є = 1. (113 – 90) / 101,5 (5 – 4) / 4,5

p

q

Elastic and inelastic demand

D

5

90

4

130

D

94

20

58

• Complete inelastic demand: demand does not react to a change in price; Є = 0. E.g. drugs.

• Totally elastic demand: if p increases only slightly, demand goes to zero;if p decreases only slightly, people every quantity

offered. Є = . Perfect substitutes; demand in the case of polypol

p

q

Elastic and inelastic demand

D

D

59

• Hard drugs (heroin): completely inelastic demand

• Soft drugs: elastic demand (pott; alcohol, cigarettes)

• consequence: drug policy has to distingiush between hard and soft drugs

• prosecution: shift of the supply-curve. Helps with soft drugs; not with hard drugs

• education: shift of demand-curve; does not work that well with soft drugs because as p decreases; demand increases again. Helps with hard drugs.

p

q

S D

Case study: hard and soft drugs

60

• What determines elasticity of demand?

• Essentials or luxury goods

– travelling, restaurants

– gasoline, basic foods

• Availability of substitutes – are there good

substitutes? (I-Pod and telecom)

• Supply; i.e. competition prevents consumers from

being exploited (GWB)

• Time

– gasoline: in the long rund demand is more elastic

– Cars (durables): in the long rund demand is more inelastic

Elastic and inelastic demand

21

61

• revenue: price times quantity

• revenue at p = 5: 90 * 5 = 450

• revenue at P = 4: 100 * 4 = 400

• revenue has decreased altthough demand has increased: reason: the decrease of the price. Inelastic demand

p

q

Elastic and inelastic demand

D

5

90

4

100

62

• revenue: price times quantity

• revenue at p = 5: 90 * 5 = 450

• revenue at P = 4: 120 * 4 = 480

• if demand is elastic; a decrease of price increases revenues

• Elasticity of demand depends also on the actual price

• as p declines, PE declines, too

p

q

Elastic and inelastic demand

D

5

90

4

120

63

Other elasticities

• Elasticity of supply – %-change of quantity supplied divided by %-change of price

– shows how supply reacts on changes of market data (how long does it take to close a gap between demand and supply?)

– ES is determined by availability of inputs, time, profits

• income elasticity – %-change of demand divided by %-change of income

– inferior goods: food (IE<1); superior goods: travelling (IE>1)

• cross-price-elasticity – %-change of demand for good 1 supplied divided by %-change

of price for good 2

– important for competition policy

– close substitutes: CPE is small and < 0; complements: CPE > 0

22

64

PE

tomatoes 4,6

legal gambling 1,9

marijuana 1,5

cigarettes 0,51

cinema 0,87

IE

cars 2,5

restaurant 1,4

clothes 1,0

margarine -0,2

source: Samuelson 1998

Empirical estimates

65

Home work: the boll weevil

Boll Weevil Monument, Enterprise, Alabama

From 1910 – 1915, the boll weevil, a bug from

mexico, destroyed almost the entire harvest of

the local cotton farmers, exspecially in Enterprise,

Alabama. In december 1919, a monument was built

in the heart of the city to remind of the bug. It was

manufactured in Italy, the city payed 1800 dollars for it.

It is the only monument worldwide built in honor of a parasite.

Why should the city build a monument in honor of the boll weevil?

66

Consumer- and producer surplus

5

4

3

2

1

1 2 3 4 5

p

q

p q

5 1

4 2

3 3

2 4

1 5

• Demand curve represents the willingness to pay of every single consumer; i.e the utility they derive from consuming the product

• What if the price is below the willingness to pay?

D

23

67

• If p = 4 Euro, consumer #1 and 2 buys one unit;

• consumer #1 pays 4 Euro for something he is willing to pay 5 Euro this increases his total welfare by 1 Euro

• Is p = 2 Euro, so the increase in welfare for #1 = 3 Euro #2 = 2 Euro #3 = 1 Euro

Consumer- and producer surplus

5

4

3

2

1

1 2 3 4 5

p

q

D

68

• Consumer surplus: welfare increases if p is below the willingness of the consumer to pay

• If p decreases, total welfare increases

• graphically: area between market price and demand curve

Consumer- and producer surplus

5

4

3

2

1

1 2 3 4 5

p

q

D

69

Consumer- and producer surplus

5

4

3

2

1

1 2 3 4 5

p q

1 1

2 2

3 3

4 4

5 5

p

q

S

• Supply curve represents the willingness to offer a good for a given price; i.e. his total costs

• what if p is above costs?

24

70

Consumer- and producer surplus

5

4

3

2

1

1 2 3 4 5

p

q

S • with p = 2 euro, supplier

#1 gains 1 € on top; #2 just breaks even

• with p = 4 Euro, the additional gains are: #1 three Euro #2 two Euro #3 one Euro #4 breaks even

71

Consumer- and producer surplus

5

4

3

2

1

1 2 3 4 5

p

q

S • Producer surplus:

increase in producers welfare, if market price is above total costs of production

• if p is increasing, total welfare increases, too

• graphically: area between supply curve and price

72

Consumer- and producer surplus

5

4

3

2

1

1 5 10 20 30

p

q

S D

• CS and PS represent consumers‘ and producers‘welfare from market transactions

• Overall welfare (OW): CS plus PS

• CS = total utility consumers receive from the good – payments to producer

• PS = consumers‘ payments – costs

• OW = total utility of consumers – costs

25

73

Markets revisited

• markets are efficient: – if p is above equilibrium price, total utility consumers derive from

consuming the good is larger than costs of production

– if p is below equilibrium price, total utility consumers derive from consuming the good is smaller than costs of production

– on markets, goods are allocated to the customers with the highest willingness to pay

– on markets, customers by at the companies with the lowest costs (price)

– remember: markets need freedom of coalition; freedom to buy where ever and what ever you want; freedom to sell what ever you want a which price you want

• on markets, goods are only distributed by ability to pay, not by needs

• markets do not provide equity

74

• Before price controls and export restrictions:

- domestic suppliers produce S1; exports: S1-D1 sold at price P1

- PS: 0p1B

- CS: p1CDE

- Price controls; export restrictions

- PS: 0p2A; producers lose p2p1CBA

- CS: p2ADE; consumers gain p2p1CA

- Net loss of welfare: CBA

p

q

S D

Case study: cheap no more (revisited)

S1 D1

p1

p2 A

0

B C

E D

p

q1

p1

p2

A

B C

E

D S

q2

PS with free trade : ABC CS with free trade: E PS with export restrictions : A CS with export restrictions: EB Loss of welfare: C

Case study: cheap food no more (revisited)

26

76

• Should one pay organ donors?

• Some people would spent even

without pay (S‘)

• Those who receive an organ gain

A, those who do not get one,

loose B

• voluntary donators loose A; those

who would spent their organs for

pay loose C

• but:

- who shall receive organs?

- does a professional market

for organs undermine the

willingness to spent without

pay?

p

q

Case study: organ donations

p

S

D

q1 q0

A

B

C

D

S‘

77

Economics

Session #5:

How markets work:

Price controls and taxes

Prof. Dr. Hanno Beck

78

Homework elasticities: Oscar

q p dq dP Mold +Mnew

2

Pold +Pnew

2

(3) / (5) (4) / (6) PE:

(7) / (8)

5 10 - 2

11 8 6 - 2 8 9 0,75 - 0,22 - 3,3

12 6 1 - 2 11,5 7 0,08 - 0,28 - 0,3

15 4 3 - 2 13,5 5 0,22 - 0,4 - 0,55

20 2 5 - 2 17,5 3 0,28 - 0,66 - 0,4

q = quantity; p=price; dM=change of quantity; dP = change of price; Mold = quantity before change of price;

Mnew = quantity after change of price; Pold = old price; Pnew = new price

27

79

Homework elasticities: Angela

q p dq dP Mold +Mnew

2

Pold +Pnew

2

(3) / (5) (4) / (6) PE:

(7) / (8)

4 10 - 2

12 8 8 - 2 8 9 1 - 0,22 - 4,5

18 6 6 - 2 15 7 0,4 - 0,28 -1,4

18 4 0 - 2 18 5 0 - 0,4 0

19 2 1 - 2 18,5 3 0,05 - 0,66 - 0,08

q = quantity; p=price; dM=change of quantity; dP = change of price; Mold = quantity before change of price;

Mnew = quantity after change of price; Pold = old price; Pnew = new price

80

• why should one built a monument for a parasite?

• the destruction of the harvest shifts the supply curve to the left. consequence: revenues are increasing

• With inelastic demand, revenues are increasing

• Second reason: weevil made farmers switch to other products (peanuts)

p

q

Homework: the boll weevil

D S S

81

Analysis of competitive markets

Price strategy and consumer surplus

Price ceilings

Minimum wages

Taxes

28

82

• Basic idea: capturing consumer surplus by charging customers according to their willingness to pay

• Two prices: expensive pt and cheap Pb

• Old CS: A+B+C

• New CS: A+C

• Old PS: D+E

• New PS: D+E+ B

p

q

N

Price strategy and consumer surplus

pt

qM

A

pb

A

B C

D E

83

• Do you prefer expensive brands?

– Müller Milchreis or „Elite“-Milchreis (40 %)

– Nestlé-Eis or Classic Choco Vanilla from Lidl?

– Hochland-Feta or Mitakos-Feta?

• Separate customers by their income (lawyers, consultants,

„families (pensioners) pay half the price“)

• Different discounts to different customers (car sales)

• „Slighty imperfect“ products with discount

• out-of-fashion products

• „professional“ vs. „homeworker“ edition

• hardcover vs. paperback edition

• Premium vs. non-premium brands

• Perfect price discrimination: E-Bay

Case study: hardcover or paperback?

84

P

S

D

q1 q0 q2

A

B

C

q

Rent ceiling

D

E

Price ceilings: rent control

Are rent controls a good

idea to protect tenants

from exploitation?

29

85

• Are rent controls a good idea

to protect tenants from

exploitation?

• Rent ceiling: demand

increases from m0 to m2

• Supply decreases to m1

• Excess demand m2 – m1

• PS: decreases by A+C;

• CS: increases by A

• deadweight loss: B+C

p

Price ceilings: rent control

p

S

D

m1 m0 m2

A

B

C

q

rent ceiling

86

Price ceilings: rent control

• Rent controls make the economy as a whole worse off – supply decreases; shortage of cheap appartments

increases (C)

– some tenants don‘t get an appartment anymore (B)

– If you get an appartment, you win (A), but on the expense of the landlord

• consequences:

– Under-the-table-payments; subcontracting

– in the long run: supply decreases even more

– who gets the cheap appartment? The needy?

w

w

S D wmin

L1 L0 L2

A B

C

D

E

• Demand for labour (for hours

worked) = L1, supply of labour

(hours worked) = L2

• unemployment L2 –L1

• L1 hours are actually employed

CS (rent of those who demand

labour; i.e. employers)

decreases by A (higher wages

for those who still have a job)

and B (those who loose their

job due to higher wages)

• PS increases by A (higher

wages for those who still have

a job); decreases by C (those

who loose their job )

• Deadweigh loss: B+C

Minimum wages

30

88

• Minimum wages hurt some

workers; but do they help all

workers as a group?

• Loss of PS for workers: A – C

• If the demand curve is flat

(elastic demand for labour) B

> A, i.e. workers as a group

loose

• Empirical findings: demand for

low-skilled labour is more or

less elastic, because one can

replace it with machines

w

L

Minimum wages

w

S D

wmin

L1 L0 L2

A B

C

89

Minimum wages

• You don‘t need minimum wages for high-skilled workers but for low-skilled workers. consequences: – total loss of welfare to workers as a gruop (B > A)

– wage sum: Lmin * workers payed decreases if demand is elastic; wage increases, but the number of persons receiving this higher wage dereases (see session #4)

• A few questions concerning minimum wages: – in Germay, we are talking about different minimum wages for

different industries – why, if the MW shall provide workers with a minimum income to make their living?

– minimum wages for self-employed persons?

– minimum wages lead to more unemployment; but: what, if employers are able to pass the increased wages to their customers. If the demand for their product is inelastic, minimum wages don‘t lead to unemployment; but the higher wages are paid by the customers

90

Minimum wages and social market economy

• Social market economy: use efficient markets and provide social protection by additional social policy

• say: free wages, no minimum wages plus additional govermental payments on the wage. Consequences: – no unemployment

– social protection is now payed by the tax-payer, not by companies who employ employees for minimum wages or their customers

– minimum wages in germany: Hartz IV

• Concepts: so-called Kombilohnmodelle (Mainzer Model), negative income tax (USA)

31

91

• Taxes / SSC make supply

curve shift to S‘

• Consumers pay gross price

pG, producers receive net

price pn.

• difference pb – pn = t

• Consumers loose B+C

• producers loose A+D

• tax revenues: B+A; shared by

consumers (B) and producers

(A)

• C+D = excess burden;

deadweigh loss of a tax

Taxes

p

S D

q1 q0

B

A

S‘

t

C

D

q

E

F

pG

pN

92

• Now: demand inelastic; supply

elastic

• Tax burden (A+B) is now

being shouldered mainly by

the consumer (B) because of

their dire need of the product

• the more inelastic part of the

market bears the main burden

of a tax

• Inelastic demand yields a

larger tax revenue

• Inelastic demand: cigarettes,

alcohol, gasoline – so why are

taxes on these goods so

popular?

p

p

S

D

pn

q1 q0

B

A

Taxes

S‘

C

D

pG

q

93

Homework: EU-agricultural policy

A sea of milk

Since 1957, the Europeam Union has a common

agricultural policy. The goal of this policy was to

provide an income for farmers. Brussels promised

to buy the entire production of dertain crops.

Cheap imports from abroad were heavily taxed via tariffs.

With the Uruguay-round, the EU was forced to change its system

of agricultural subsidies and price controls. Since 1993, farmers were

payed direct transfers.

What happens if the EU promises to buy any production? Show the

consequences for consumer- and producer-surplus.

32

94

Economics

Session #6:

Production

Prof. Dr. Hanno Beck

95

p

Homework: EU-agricultural policy

p

S D

pmin

q1 q0 q2

A B C

q

• Government promises to buy

the whole production for

minimum price pmin

• CS: loss of A, which is

redistributed to producers;

loss of B for those who stop

consuming

• PS: gain A+B+C

• Government: buys surplus

production q2-q1; i.e. totals

costs are pmin(q2-q1)

(speckled rectangle)

• Guess who pays this policy?

• Net welfare loss: depends on

what happens to the product-

ion the government buys

D

96

Production

Production function

Costs

Cost function

Shareholder and Stakeholder

33

97

• Why learning about production? – Goal: efficent production; avoiding waste of time

and inputs

– companies need profits to survive

– employees need companies

– companies play a crucial role for employment and welfare of a country

• What do you need to know?

– production function

– costs

– owner, shareholder

Production function

98

• The jelly baby-experiment – your product: delivery of jelly-babys from chair A to B

– time: 15 seconds

– amount of workers variies

– we may use more capital

• Please write down the results of the

experiment – total output

– average output (output per worker)

– marginal product (additional output produced as input is

increased by one unit )

Production function

99

Production function

#W TO AP MP

1

2

3

4

5

6

7

8

9

• W = worker; MP =

marginal product; AP =

average product; TO =

total output

34

100

Production function

• w = worker; TO = total

output; AP = average

product; MP = marginal

product

• Law of diminishing returns:

the more workers we use,

the lower is the additional

output

• most times: starting with

increasing MP, later on

decreasing MP

• Sources: Synergies;

division of labour; learning

w TO AP MP

1 3 3 3

2 5 2,5 2

3 8 2,66 3

4 12 3 4

5 17 3,4 5

6 23 3,83 6

7 26 3,71 3

8 28 3,5 2

9 29 3,2 1

10 29,5 2,95 0,5

101

Production function

TO

w

102

Costs

• Costs: – opportunity costs

– explicit and implicit costs (do not require a cash outlay)

– cost of capital: loans (interest) and equity (opportunity

costs)

• measures of costs – total costs

– fixed costs (do not vary with output)

– variable costs (depend on output)

– average costs (total costs divided by quantity of output)

– marginal costs (increase of total costs that arises from

an extra unit of production)

35

Fixed costs = 100;

wage: 10 € per worker

TO = total output

TC = total costs

VC = variable costs

AC = average costs

MC = marginal costs

(change of total costs / additional

output),

i.e.: 5 = (120-110) / (5-3)

103

w TO TC VC AC MC

1 3 110 10 36,6 10

2 5 120 20 24 5

3 8 130 30 16,25 3,33

4 12 140 40 11,6 2,5

5 17 150 50 8,8 2

6 23 160 60 6,95 1,67

7 26 170 70 6,54 3,34

8 28 180 80 6,43 5

9 29 190 90 6,55 10

10 29,5 200 100 6,78 20

Costs

104

Costs

TC

TO

• Most times:

total cost curve

is S-shaped

• i.e.: MC are

decreasing at

the beginning;

they tend to

increase with

increased

output

• Reason: first

increasing MP;

decreasing MP

as output

increases

105

• AC: decreasing at

the beginning;

increasing with

increased output

• Reason for

decreasing AC: fixed

costs

• application: natural

monopolies

Cost function

AC

TO

36

106

Case study: The Bundesnetzagentur

The federal agency for postal services and

telecommunication is responsible for for postal services,

energy services and the telecommunications industry.

Since January 2006 it is responsible for the railway-infrastructure,

too. It is obliged to assure that every competitor has access to the

infrastructure of its industry. Natural monopolies arise when there are

huge fixed costs. They lead to a market where one company is able to

satisfy the whole market demand. The most visible natural

monopolies are utilities (water, gas), electricity, and phone services.

107

Cost function

• MC: decreasing

with small output;

increasing with

increasing output

• Reason for

decreasing and

(later) increasing

MC: law of

diminishing returns

MC

TO

108

0

20

40

60

80

100

120

0 2 4 6 8 10 12

AFC

FC

AC

- FC: fixed costs

- AC: average costs

- MC: marginal costs

- AFC: average fixed costs

- Minimum of average costs:

where AC = MC (why?)

output

Cost function

MC

37

109

Homework: Jelly-Babies, Baby

The Gummi Bear

The Gummi Bear originates from Germany where it

is hugely popular under the name Gummibär

(rubber bear) or Gummibärchen (little rubber bear).

Hans Riegel of Bonn invented bear-shaped sweets

and started the Haribo company in 1922, which first produced and

introduced its Gold-Bear product in the 1960s. In the United States,

Haribo gummi bears usually come in raspberry (red), orange,

strawberry (green), pineapple (clear), and lemon (yellow), however,

many offshoot companies (typically the health-related gummi bears)

may use more exotic flavors and colors.

Please complete the table for the jelly-baby-experiment. Calculate

different costs (one worker is 5 €; fixed costs are 100 €)

110

Shareholder Value and Stakeholder Value

• Shareholder value – the more profit a company earns, the more valuable it is

– a sucessfull company is valuable

– idea: high market capitalisation means a valuable company; i.e. a

sucessfull company

– goal: increase market value of the company (market capitalisation =

shareprice * number of shares

– problems: short-term-thinking of shareholders (?); what about stakeholder‘s interets

• Stakeholder Value: interest of companies‘ business

partners (workers, customers, government,

creditors)

111

Case study: 12 million euros

• Why is Josef Ackermann earning 12 million Euro per year? – scarcity? – international competition for excellent management-

talents? – negligent shareholders? („devil may care“)

• Why do shareholders not care about the income of the CEO – one share, one vote – small amount of shares, small influence on decicions

concerning the company – why should you care about voting if your influence is that

small – similiar problem with democracies

38

112

Shareholder Value and Stakeholder Value

• Should there be a legal limit on CEO‘s salaries?

– „unearned“ income? Remember the super-models

– lack of control by owner (shareholder) and supervisory board

– high salaries of CEO‘s lead to mistrust in market economies

– consequences: lack of supply of good CEO‘s; under-the-table-payments

• Other policy measures – shareholders: compulsory voting

– legal framework for salary schemes

– shareholder activism; especially asset management firms

– education

113

Economics

Session #7:

supply

Prof. Dr. Hanno Beck

114

Supply

Revenue and profit

Profit maximisation

Supply-curve and competition

Taxes, Social security contributions and supply

39

115

Revenue and profit

q R AR MR

1 12 12 12

2 24 12 12

3 36 12 12

4 48 12 12

5 60 12 12

6 72 12 12

7 84 12 12

8 96 12 12

9 118 12 12

10 120 12 12

• q = quantity supplied; R=

revenue; AR = average

revenue; MR = marginal

revenue

• price is always the same

and is 12 €

• average revenue =

revenue dividedby quantity

sold (€ per unit sold)

• marginal revenue =

revenue added by the last

unit sold

116

• the additional revenue from one more unit sold must at least

equal the additional costs caused by the production of this

unit

• i.e:

– if marginal revenue exceeds the marginal costs one should produce

one more unit

– if marginal revenue is below the marginal costs one should decrease

production

– i.e.: profit-maximum when marginal revenue equals marginal costs

– marginal revenue if the price remains unchanged: p (one unit

produced times its price)

– P = MC applies as long as an increase (decrease) in supply does not

lead to an decrease (increase) of the price

Profit maximisation

117

Profit maximisation

q P TC R MC MR Pr MR-MC

0 - 10 0 0 -10

1 12 25 12 15 12 -13 -3

2 12 36 24 11 12 -12 1

3 12 44 36 8 12 -8 4

4 12 51 48 7 12 -3 5

5 12 59 60 8 12 1 4

6 12 69 72 10 12 3 2

7 12 81 84 12 12 3 0

8 12 95 96 14 12 1 -2

9 12 111 108 16 12 -3 -4

10 12 129 120 18 12 -9 -6

40

118

P; MC; AC

q

B

Profit maximisation

AC

MC

P

C D

E

O qG

• Profit-maximisation where p = MC

(B)

• Revenue = quantities sold qG * p;

i.e. OEBqG

• Total costs: costs per unit

(=average costs) * q; i.e.

ODCqG

• profit: revenue minus costs,

i.e. DEBC

• in the long run cost must at

least equal revenues; i.e. D =

minimum price producer must

charge in the long run

• if p < AC (D), the company

should exit the market

119

P; GRK; DK

q

B

Profit maximisation

AC

MC

P A

O qG

• Profit-maximisation where p = MC

(B)

• Revenue = quantities sold qG * p;

i.e. OABqG

• Total costs: costs per unit

(=average costs) * q; i.e.

ODCqG

• profit: revenue minus cost,

here: zero

• p = minimum of AC is the least

price the company must

charge

• If p < minimum of AC, company

must exit the market in the

long run

120

P, MC;

ATC; AVC

q

A

B

Profit maximisation

ATC

AVC

MC

P

C D

E

F

O qG

• If p < minimum of AC, company

must exit the market in the

long run

• In the short run?

• As long as p > AVC the

company should continue to

produce (contribution margin)

• Total costs: ODCqG

• Revenue: OEBqG

• Loss: EDCB

• Variable Costs: OFAMG

• Contribution margin: FEBA;

part of fixed costs that are

covered by revenues

41

121

Homework: Is it Dumping?

Cheaper flights In November 2001, the german airline Germania Charged 99 € for flights between Berlin und Frankfurt. Deutsche Lufthansa, which held the largest market share For flights between Berlin and Frankfurt, reacted quick: it reduced the price for its tickets by 60 percent to 100 respectively 105 €. Additional services (Catering, Miles & More, more connections) made Lufthansa‘s offer more attractive than Germanias. Assume that Lufthansa is selling its tickets below total costs. Do you think that Germania should accuse Lufthansa for dumping? Is Lufthansa right to sell tickets below total costs?

122

• In p = 1 supply is q1

• In p = 2 supply is q2

• In p = 3 supply is q3

• In p = 4 supply is q4

• ABCD: as pincreases, supply

increases, too

• ABCD = supply curve

• Supply in the long run: starts

from minimum of TAC

• Supply in the short run: starts

with minimum of VAC

p

q

Supply-curve and profit maximisation

1

2

3

4

A

B

C

D

MC

q1

AC

q2 q4 q3

123

• Supply curve: marginal-cost-curve; starting from minimum of

TAC

• Total market supply: sum of all MC-curves of all firms

• Total market supply in the long run:

– if firms in the market are already profitable, new firms will have the

incentive to enter the market

– new entrants will increase the number of firms in the market; supply

increases; price decreases

– at the end of this process, economic profit in the market will be zero;

if there would be a profit higher than in any other sector, more supply

would shift to this sector

– economic profit is zero - i.e. p will equal minimum of average costs

– but: economic profit = accounting profit; economic costs include

opportunity costs of the owner (time, work etc.)

– result: competition drives prices down to minimum average costs

Supply-curve and profit maximisation

42

124

• competition – makes firms produce as cost-efficient as possible (in minimum of

TAC); this makes products as cheap as possible

– makes firms adapt to changes in market data (otherwise you loose

profit and revenue)

– gives incentives for innovation; innovation leads to lower costs /

higher demand; gives you a leading edge on your competitors

– firms are producing according to the wishes of the customers

• Competition needs: – free entry to the market

– property rights (Art. 14 GG)

– many suppliers

– market transparency

Supply-curve and competition

125

Taxes and supply curve

• What happens to supply if we introduce taxes or

social security contributions?

– tax on fixed costs: total costs increase; marginal costs

remain unchanged; average costs increase. AVC-curve

shifts upwards

– taxes on inputs: MC and AC increase; AC-curve and MC-

curve shift upwards

– taxes on profits: cost-curves remain unchanged; marginal

supplier leaves the market

• As we introduce taxes (or social security

contributions), supply decreases and thereby

employment

126

Taxes and supply curve

W TR TC VC AC MC

1 5 110 10 22 22

2 11 120 20 10,9 1,6

3 18 130 30 7,2 1,4

4 27 140 40 5,18 1,1

5 37 150 50 4,05 1

6 45 160 60 3,5 1,25

7 50 170 70 3,4 2

8 54 180 80 3,3 2,5

9 57 190 90 3,3 3,3

10 58 200 100 3,4 10

FC= 100;

wage: 10 € per worker

TR= total revenue

TC = total costs

VC = variable costs

AC = average costs

MC = marginal costs

Now: 20 % tax on

TC (social security

contributions)

43

127

Taxes and supply curve

W TR TC VC AC MC

1 5 132 22 26 26

2 11 144 44 13 2

3 18 156 56 8 1,7

4 27 168 68 6 1,3

5 37 180 80 4,8 1,2

6 45 192 92 4,2 1,5

7 50 204 104 4 2,4

8 54 216 116 4 3

9 57 228 128 4 4

10 58 240 140 4,2 12

FC= 100;

wage: 10 € per worker

TR= total revenue

TC = total costs

VC = variable costs

AC = average costs

MC = marginal costs

Now: 20 % tax on

TC (social security

contributions)

128

0

5

10

15

20

25

30

0 10 20 30 40 50 60 70

Taxes and supply curve

AC-curve before and after taxes

total revenue

AC

129

0

1

2

3

4

5

6

0 10 20 30 40 50 60

Taxes and supply curve

MC-curve before and after taxes

total revenue

MC

44

130

Taxes and supply curve

• Previous analysis: minimizing cost; maximising profits by choosing the adaequate level of output

• Now: minimizing costs by choosing the right combination of production factors

• Basic idea: - use cheap inputs whenever you can; avoid using

expensive inputs

- use inputs which are more productive than others

- balancing costs and productivity of an input: if it is expensive, avoid using; if it is productive, use it

- So: balancing marginal productivity of an input (output per unit input) and its marginal costs

131

Taxes and supply curve

Labour

wage in € 10

output per unit labour 10

capital

Interest in € 5

Output per unit capital 4

Labour

wage in € 10

output per unit labour 8

capital

Interest in € 5

Output per unit capital 4

• Spending one € for work yields one

more unit output

• Spending one € for Capital, yields

0,8 more units of output

• i.e.: employ more workers

• With increasing amount of labour

employed; marginal productivity of

work decreases (from 10 to 8)

• as prices remain unchanged, capital

as an input is becoming more

attractive

132

Taxes and supply curve

• the marginal productivity per Euro

- how do I spent the next Euro if I want a maximum of additional productivity?

- it is not only the price of an input or its marginal produtivity, but the marginal productivity per Euro spent for this input

- as the price increases, MP per Euro decreases. The same productivity is now more expensive

- as MP increases, MP per Euro increases; one should increase the use of this input

• Implications for the labour market?

MP labour MP capital

price for labour Price for capital =

45

133

Case study: productivity-oriented wage policy

„In the conception of the council of economic

advisors, room for higher wages depends on the

marginal productivity of labour. If wages remain

below the increase of the marginal productivity of

labour, one can say that wage policy may help to

boost employment.“

(SVR, 2007)

134

Economics

Session #8:

Monopoly and imperfect competition

Prof. Dr. Hanno Beck

135

Homework: is it Dumping?

• Why should Lufthansa sell below cost price?

– contribution margin: temporarily selling beloe cost price because of

fixed costs

– seasonal/closing-out sales; persihable goods

– marketing strategy to lure in new customers

• But: what about cut throat pricing?

– German competition authority (Kartellamt): Lufthansa is selling tickets

below cost price

– this strategy makes only sense if it is supposed to help to squeeze

Germania out of the market and to raise prices afterwards

– the Kartellamt restrained Lufthansa form charging low prices, because

Lufthansa dominates the market; has enough money to bridge

temporarily losses and the barriers to (re-)enter the market are very

high

46

136

Monopoly and imperfect competition

Monpoly

Other market forms

Competition policy

German antitrust law

137

Monopoly

• Monopoly: only one supplier

• Sources of monopoly power?

- control of inputs (patents; know-how, copy-rights)

- Branding, elasticity of demand

- production function (natural monopolies)

• consequences - consumer: loss of freedom

- Monopolist may gain political power

- loss of efficiency and welfare

- Pricing in monopoly: marginal revenue equals marginal costs

138

Monopoly

q P TR AR MR

1 10 10 10

2 9 18 9 8

3 8 24 8 6

4 7 28 7 4

5 6 30 6 2

6 5 30 5 0

7 4 28 4 -2

8 3 24 5 -4

9 2 18 2 -6

10 1 10 1 -8

• q = quantity supplied; TR=

total revenue; AR =

average revenue; MR =

marginal revenue

• As quantity supplied

increases, price decreases,

because the monoppolist is

the sole supplier in the

market

• average revenues

represent demand curve

• revenue = q * p

• As q increases, there are

two effects on revenues:

q increases

p decreases

47

139

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

0 2 4 6 8 10 12

Monopoly

Average revenues and marginal revenues

total revenue

AR

MR

p

140

• In monopoly, demand curve

equals average revenue (see

table) because the monopolist

is the sole supplier

• MR is always below demand-

curve (AR) (see table)

• Profit maximisation in

monopoly: marginal costs =

marginal revenues (Cournots

Point)

p

q

MR

Monopoly

demand = AR

141

• Profit-maximisation in

monpoly: first, find point where

MC = MR (where MC-curve

intersects MR-curve)

• Find the quantity qM, where

MC = MR

• Find price corresponding to qM

p

q

pM

demand = AR

MR

MC

C

qM qC

pC

Monopoly

48

142

• Monopolist‘s profit: revenue –

total costs

• revenue: quantities sold *

price (PM • qM)

• Total costs: average costs *

quantity supplied (ACM • qM)

• Profit: ACMpMDC

p

q

pM

demand = AR

MR

MC

C

qM

Monopoly

AC

ACM

D

143

• Compared to perfect

competition (PP):

• Consumer surplus in

monopoly: consumers loose A

plus C

• Producer surplus in monopoly:

monopolist gains A (from the

consumers) and looses B

• Deadweight loss: BC

• Monopolies always lead to a

loss in total welfare

p

q

pM

MC

qM qP

pP

Monopoly

A

B

C

MR

demand = AR

144

• Sources of monpoly power

• Elasticity of demand

– the higher elasticity of demand, the lower the monopolist‘s power

– determinants of the elasticity of the firms demand: product

differentation, marketing, substitutes, branding

• Number of competitors

– the monopoly power of a firms increases as the number of

competitors is decreasing

– the monopoly power of a firms increases as the barriers of entry

increase

• Interaction among firms (collusion vs. competition)

• there are (almost) no perfect monopolies and no perfect

competition. More realistic: Oligopolies and monopolistic

competition

Monopoly

49

145

• Rule of thumb for pricing in a monopoly:

(p – MC) / p = - 1 / ED

• Left side of equation: markup on MC in percent

– perfect competition: ED approaches infinity, so 1/ED

approaches zero. So p = MC; no mark-up on MC possible

due to completely elastic demand

– the smaller ED, the higher is the right-hand side of the

equation,i.e. the higher is the mark-up on MC. Inelastic

demand means high market power

• Re-arrange as a simple price-formula:

p = MC / (1+(1/ED))

Monopoly

146

Other market forms

• Monopoly: demand curve is demand of the whole market

• Oligopoly: few suppliers; strategic interaction between suppliers – Oligopoly I: very few suppliers; acting in concert, maybe even

without explicit communication

– Oligopol II: more suppliers; fierce competition as a result

• Monopolistic competition: demand curve is the demand curve for the product of each supplier – heterogeneous products

– limited market power of every supplier in a narrow range

– branding

– price differentitation

– supplier has a limited degree of market power

• perfect competition: demand curve for the single supplier ist the price, because he has no market power

147

• Competition needs additonal policy to ensure that there is a sufficient degree of competition

• questions: – what is „a sufficient degree of competition“?

– how shall we estimate the market power of a company?

– how shall we define a market (time / product / place)

– how shall we idetify anti-competitive, unfair behaviour?

• Problems of competition policy – Collusion: prohibiting agreements or practices that restrict free

trading and competition between business entities. (e.g. cartells)

– abusive behaviour and anti-competitive practices: banning abusive behaviour by a firm dominating a market, or anti-competitive practices that tend to lead to such a dominant position. Practices controlled in this way may include predatory pricing, tying, refusal to deal and others.

– concentration of market power (takeovers; merger)

Competition policy

50

148

• collusion: negogiations between suppliers aimed to reduce the pressure of competition – horizontal: between competitors

– vertical agreements: between firms at different levels of the supply chain

– acting in concert

• problems: – finding evidence of collusion (smoking gun)

– distinguish between collusion and behaviour resulting from the pressure of competition

• Germany‘s competition law (GWB): horizontal cartells and collusion aimed to restrict competition are forbidden

Competition policy

149

Competition policy

The great vitamin conspriracy In 1999 some of the worlds largest drug companies agreed to pay billions of dollars in damages to customers after being convicted of a huge conspiracy to rig the world vitamin market. The conspriacy began in 1989 when Roche and BASF began secret talks about raising prices for vitamins; soon Rhone-Poulenc and other japanese companies joined. The members of the group met regularly in hotels or private homes to set prices and divide up markets for bulk vitamins mainly sold to other companies (e.g. animal feed makers). The animal feed companies grew suspicious about the prices they were charged, which led to a series of investigations. The case broke down when Rhone-Poulenc made a deal with competition officials in the US to provide evidence about the conspiracy.

150

• abusive behaviour and anti-competitive practices – Germany: the abusive exploitation of a dominant position by one or

several undertakings is prohibited – abusive behavior against competitors and other firms in the supply

chain

• examples: – price discrimination: dominant firm demands payment or other

business terms which differ from those which would very likely arise if effective competition existed;

– predatory pricing: a company offers goods or commercial services not merely occasionally below its cost price, unless there is an objective justification for this

– boycott: small firms depend on one single supplier / buyer (Uhren-Krämer / Seiko; adidas)

– exclusive commitments and contracts: (Meto-Handpreisauszeichner)

• Problems: definition of dominant position and abusive behaviour versus regularly business policy

Competition policy

51

151

Competition policy

Uhren-Krämer versus Seiko

Seiko, a manufacturer of watches, refused to

deliver his watches to Uhren-Krämer (Berlin). Krämer

went to courts and accused Seiko of unfair hindrance:

Seiko refused deliverey because Krämer did not commit to the

price recommended by Seiko – if he would stick to this price,

Seiko would deliver the watches. Seiko had a market share of 75

percent in Berlin

Adidas versus SB-Kauf

Adidas refused to deliver his products to SB-Kauf (who intended

to sell the shoes with a large discount) and claimed that it intended

to have its shoes only sold by specialty stores. The cartell

authorities recognised adidas as market-dominant company.

152

Homework: T-Mobile and the I-Phone

No I-Phone in Australia? Queensland University of Technology (QUT) law

researcher Dale Clapperton has questioned whether

Apple could release the I-Phone in Australia under the

same conditions that has seen it locked to a single carrier

in the US, UK, Germany and France. That said, an appeal

was placed in Germany by Vodafone to force Deutsche Telekom to offer

an unlocked version, but this was successfully challenged in court.

Customers will now only be able to buy the phone for a 399-euro offer

with a binding two-year contract. After two years, users can have the

iPhone unlocked so they can switch to other providers, T-Mobile said.

The French I-Phone can be purchased in an unlocked configuration, but

can reportedly only be used with SIM cards from other French

companies – not any SIM from any carrier worldwide.

Is it abusive behaviour if Apple refuses to deliver the I-Phone to

other telecoms? What do you think about the french solution?

153

• Better than preventing dominant companies from abusing their power: preventing the rise of a dominant market position

• Internal and external growth may lead to a dominant market position

• concentration

– Horizontal,

– vertical or conglomeral

• policy:

– control of concentrations (supervising mergers and acquisitions)

– breaking up market-dominant firms

– supervising market-dominant firms

Competition policy

52

154

German competition law

Hertie und Karstadt

In 1993, the largest department store Hertie

took over the third-largest department store,

Karstadt. The cartell authority approved the

merger; although the number of department store-chains

in Germany was being reduced to two. The authority found

evidence for market-dominance only in some local areas; but it

said that department stores compete also with local specialised

stores. Competition would be only reduced in some special areas.

So Hertie had to sell only some lines of business (for examples the

sale of records in Kiel)

155

German competition law

• Act against restraints of competition (GWB) is made of three parts – #1: Prohibition of agreements restricting competition (cartels)

– #2:market dominance, restrictive practices

– #3: control of concentrations

• Enforcement: cartell authority (Bundeskartellamt)

• European competition law (Art. 81, 82 EG-treaty) – restrictions of competition are forbidden if they affect the trade

between member states of the European community

– national law applies as long as the trade between community members is not affected

– primary competence for applying EU competition law rests with European Commission and its Directorate General for Competition

– public procurement: state aid, control of direct and indirect aid given by EU Member States to companies (Article 87 EC)

156

German competition law

• GWB #1: Prohibition of agreements restricting competition (cartels) – horizontal cartells and collusion aimed to restrict

competition are forbidden

– vertical contracts are forbidden if they restrict one of the parties of the contract in closing other contracts with third parties

– this applies to an acting in concert even if there is no contract

– exemption permits for some cartells and cooperation of small companies

53

157

German competition law

• GWB #2: control for market dominance and abusive behaviour: abusive behaviour is forbidden

• market-dominant companies: – if 1 (3 / 5) companies share 33 (>50 / 66) percent of revenues in

the relevant geographic market

– relevant geographic market: elasticities of demand and supply

• abusive behaviour – predatory pricing: prices differ from what you expect them to be

with competition (rebates, price discrimination)

– restrictive practices: market-dominant companies restrict possibilities / opportunities of customers or stakeholders

158

German competition law

• GWB #3: Control of concentrations to keep markets

competitive; acting before a market-dominant company

rises

• Principles – the provisions on the control of concentrations shall apply if in the

last business year preceding the concentration: 1. the combined

aggregate worldwide turnover of all the undertakings concerned

was more than EUR 500 million, and 2. the domestic turnover of

at least one undertaking concerned was more than EUR 25

million.

– a concentration which is expected to create or strengthen a

dominant position shall be prohibited unless the companies

concerned prove that the concentration will also lead to

improvements of the conditions of competition and that these

improvements will outweigh the disadvantages of dominance

159

Economics

Session #9:

Game theory

Prof. Dr. Hanno Beck

54

160

Hausaufgabe: No I-Phone in Australia?

• To find out wheter Apple is involved in abusive behaviour one must ask for a dominant market position and restrictive practices

• Dominant market share: – not, if the relevant market ist the market for mobile

communication. There are enough substitutes

– Apple has market power: its brand. Do we need to protect brand-addicted customers by law?

– but: may Apples brand lead to a reduction in competition on the market for mobile communication?

• restrictive practices – if Apple has market-dominance, the fact that Apple is selling its I-

Phone only locked to a singel carrier points towards the direction of abusive behaviour

– is the tariff for the I-Phone above other prices?

– the user is locked to the carrier for two years – does this reduce competition in the long run?

161

Game theory

Oligopoly

Prisoners Dilemma

Sequential games

Repeated games

162

Oligopoly

• Oligopoly: a market where only a few firms compete with each other and entry by new firms is impeded due to barriers of entry – scale economies

– patents, technology, branding

– Entry deterence

– Airlines, cigarettes, aluminium, automobile industries

• Because only a few firms are competing, all decisions involve important strategic considerations – each firm must take in account how competitors may react to a move (compete, collude)

• An example: the OPEC-Cartel

55

163

• The market for gasoline – homogenous Produkt; one can only differentiate through the price

– only a few suppliers; every move of every suppliers is visible to his competitors

• First idea: Cartel. Producers decide to collude and to maximize joint profits by charging to monopoly-price (total MR of all firms = Total MC); e.G. OPEC. Problem: every member of the cartel has an incentive to charge a lower price („cheating“)

• Second idea: price war; this may lead to parallel moves of the price each competitor charges

• evidence: prices for gasoline tend to be cointegrated; i.e. they move together – does this mean that there is tacit collusion or fierce competition?

Oligopoly

164

- Iran and Iraq agree on a cartel

- If both of them co-operate, each of them receives 50

- In case of a price war, each of them receives 40

- if one co-operates while the other one cheats, the pay-off is 60 for the cheater and 30 for the other contract party

- result: both countries will cheat

- (collude, collude) would make both countries better off

Oligopoly

cooperate Cheat

cooperate 50, 50 30, 60

cheat 60, 30 40, 40

Iraq Iran

pay-off Iraq pay-off Iran

165

Oligopoly

• A game is a situation in which the participants (players)

make strategic decisions

• strategic decisions: decisions that take into account the

actions and responses of the other players

• strategic decisions result in payoffs to the players; i.e. the

outcomes of the decisions

• strategy: a rule or plan of action for playing the game

• optimal strategy: maximise the expected payoff

• If I assume that my competitors (the other players) try to

maximise their payoffs, how shall I take their behavior in

account when making my decisions

• OPEC-example: both players have a dominant strategy

• most famous example: prisoners dilemma

56

166

- after a robbery, A and B are caught by the police

- Police may arrest them for one year for a minor offence (illegal posession of weapons); not for the robbery

- Police offers a separate deal to A and B: if one confesses while the other one denies; his charge will be dropped. The other one who remained silent gets 20 years

- if A and B confess, each of then gets 8 years

- result: both of them will confess

Prisoners Dilemma

deny confess

deny 1, 1 20, 0

confess 0, 20 8, 8

B. A.

167

Prisoners Dilemma

• In this game, „confess“ is a dominant strategy: no matter what the other players does, it is the best strategy. I‘m doing the best I can no matter what player #2 does

• Examples of prisoners dilemma: - collusion; price wars; advertising wars

- Military spending

- Sports owners and players

• Not every game has dominant strategies

• Dominant strategies: I‘m (you) doing the best I can no matter what you (I) do

• Nash equilibrium: I‘m (you) doing the best I can given what you (I) are doing

• Domimant strategies are special cases of Nash equilibria

168

Prisoners Dilemma

crunchy sweet

crunchy -5, -5 10, 10

sweet 10, 10 -5, -5

B. A.

- Two new variations of a breakfast cereal can be introduced

- but market volume is only enough for one company

- each company can only introduce only one new product

- each firm is indifferent which procuct to introduce – as long as it is not the same product as its competitor

- what if the companies must behave noncooperatively?

- two Nash-equilibria

57

169

Prisoners Dilemma

• Further applications

– Competition between suppliers: price wars, advertising,

investment decisions

– sports: Americas Cup – if you are in the lead, you should

behave like the boat which is right behind you

– hostages and hijacker: one person must start the attack

– coordination between parties (battle of sexes)

– threats (Dr. Seltsam)

– Tying ones hands

• Not every game is a zero-sum-Game (like in sports)

• Competition is not a zero-sum-game as soon as you

think about the consumers

170

Prisoners Dilemma

• Strategic move: an action that influences the behavior of the other player in a manner favorable to oneself

• commitment: you commit yourself for the future in order to change the behaviour of your counterparty; threats or commitments; constraining the partners choice by constraining own behavior

• Types of commitments and threats: – public commitment – Give power to a third party („Dr. Strangelove“) – Probabilistic threat (Kuba-crisis) – building up reputation (central banks; newspapers)

• examples: – Xenophon and the conquistadoras: burn your bridges behind

you – most favorite nation-principle: each customer gets the same

price what makes it impossible to re-negogiate

171

Homework: threads and commitments

Ice cream wars

You are the owner of the only ice-cream-parlor in

town, but now a new competitor plans to enter the

market. If he enters, you could lower prices, thereby

lowering your profits from 200 to 70. Instead of lowering prices,

you could still charge a higher price a loow your competitor to

enter the market – this would make your profits drop from 200 to

100. If your competitor enters the market, there are two possible

scenarios: you lower your prices – this will make him loose 10. If

you don‘t start this price war and charge high prices, his profits

will be 20. If you lower your prices and he keeps out of the

market, your profits drop to 130.

Will your competitor enter the market? If yes, why?

58

172

Prisoners Dilemma

right corner left corner

right corner -, + +, -

left corner +, - -, +

you

Kahn

- Which strategy should a football player choose to shoot a penalty?

- as soon as the player applies a certain pattern (RRLLRR) he will loose in the long run, as soon as the goalkeeper finds out about this pattern

- better strategy: flipping a coin, i.e. equilibrium in mixed strategies

- mixed strategy: strategies in which players make a random choice among possible actions based on a set of chosen probabilities

173

- Two new variations of a breakfast cereal can be introduced; but one cereal yields a higher revenue than the other

- without coordination this game has no single solution – as long as both players must act at the same time

- both companies would like to produce „sweet“ – as long as the other party does not produce it

- solution: sequential game; extensive form of a game

Sequential games

crunchy sweet

crunchy -5, -5 10, 20

sweet 20, 10 -5, -5

B. A.

174

- now: solving the game from the end

- if firm B reacts first, it has a first-mover-advantage

- what can A do to get the first-mover-advantage?

- but sometimes there may be first-mover-disadvantages: if you are in the lead in a game-show, you should always mimic the strategy of your competitor

- Here: buying machinery, launching an expensive advertising campaign – self commitment

Sequential games

sweet crunchy sweet crunchy -5, -5 20, 10 10, 20 -5, -5

A A

sweet crunchy

B

59

175

produce no

production

produce -10, -10 100, 0

no production 0, 100 0, 0

Boeing

Airb.

#1

produce no

production

produce -10, 10 100, 0

no

production 0, 120 0, 0

Boeing

Airb.

#2

Sequential games

- Commercial aircraft market has large economies of scale

- It is only economical for one firm (Airbus or Boeing) to produce a new aircraft

- In game #1 there is a clear first-mover-advantage

- Now: EU commits itself to a subsidy of 20 to airbus if it produces the plane regardless what Boeing does (#2)

- Now Boeing surrenders

- EU has shifted profit from the US to Europe

- But: what about retaliation measures by the US-Government?

176

Repeated games

• Repeated games: playing the same game several times

• Repeated games help you to learn about your competitor and his strategy; they help you to built up a reputation

• How can you built up a reputation as a trustworthy rival?

• Best solution: tit for tat. • collude as laong as the other player colludes; defect as soon as he

defects. TfT: eye for an eye

– as long as the game is infinitely repeated, it does not pay out for your competitor to cheat; cumulative loss will outweigh short-term gain

• Finite number of repetitions: equilibrium is defect right from the start (Eddy Murphy)

• In these games, reputation is everything – as a competitor

– as government / central bank

– as boy/girlfriend

177

Economics

Session #10:

Why we need governments

Prof. Dr. Hanno Beck

60

178

- The threat of a price war is not realistic, because charging a high price is a dominant strategy

- but you may change your strategy if you believe that there are more competitors to come – repeated game

- in this case, it may pay off to built up a reputation as a loggerhead who is willing to sacrify profits just in order to keep other competitors away from your market

- but: do you have the financial strengh to built up this reputation?

Homework: Ice cream wars

enter Stay away

high price 100, 20 200, 0

Low price 70, -10 130, 0

you comp.

179

Why we need governments

Market failure

Public goods

Quasi-private goods

Network externalities

180

Market failure

• Two types of market failure

– Price mechanism does not work (economic market failure)

– the outcome of the market is not accepted by politics or society (political market failure)

• Market failure is caused by – Public goods

– externalities

– networkexternalities

– social security and redistribution

– Merit goods (quasi-private goods)

– politics

61

181

- Nonrival goods: for any level of production, the MC of providing it to an additional customer are zero (lighthouse)

• Nonexclusive goods: people

cannot be excluded from

consuming it. As a

consequence, one cannot

charge them for using it. This

gives a free rider problem

(lighthouse, defense)

• How many public goods shall

the government privide? How

do you estimate the

willingness to pay for public

goods?

Public goods

exclusive non-exclusive

rival clothes, food

private goods

environment

road

Non-

rival

environment

TV

highway

army;

lighthouse

public goods

NR

NE

182

Quasi-private goods

• Idea: one has to protect people from themselves (alcohol, cigaretts) or support „good“ things (arts, public broadcasting)

• This is not a economic issue; government intervenes because it does not accept the result of the market mechanism; the price machanism is not disturbed

• goods like alcohol and cigarettes are taxed to reduce consumption; goods like arts or braodcasting are subsidized

• questions: - who decides what is „good“ or „bad“

- paternalism: what if you want to drink / smoke; what if you don‘t like public broadcasting?

- quasi-private goods are a good playground for bad politics

183

Merit wants : Public broadcasting

• Public broadcasting: wrong arguments

– Public broadcasting is not a public good

– Public broadcasting is not natural monopoly anymore

– Political education by public brodcasting = externality

– information is an experience good; but this problem is solved by

reputation

• What about the quality of private broadcasting?

- bribemoney; masked advertising: ARD

- competition and reputation prevent private broadcasters from doing a

bad job; do public broadcasters have to face competition, too?

- Lower-class-TV: spot the difference (GZSZ or „Marienhof“?)

62

184

Homework: public broadcasting and the Internet

Do we need a public broadcaster in the Internet?

The ARD (Consortium of public-law broadcasting

institutions of the Federal Republic of Germany),

is a joint organization of Germany's regional public-service

broadcasters. Together with ZDF, the secod large public

broadcaster, almost 8 bn. Euro per year are spent for public

broadcasting in Germany. The fact that ARD (and also ZDF) uses

license fees to subsidize their World Wide Web sites, and also the

non-transparency of their license fee expenditure, is the topic of an

ongoing controversy with the European Union. Public broadcasters

im Germany are spending 52,5 mn. Euro per year on the internet.

Do you think we need public broadcasting in the internet?

185

Network externalities

• Example of an network externality: telephone

• Network externality: the more people use a good, the higher the utility derived from this good for all users

• This is a so-called externality: as A buys a telephone, the utility of the telephone increases for B (who has a telephone, too) – but B has not to pay and A does not care

• Network externalities work like an epidemic; you need a critical mass to start with

• Further examples – E-bay; parship

– standards: VHS; TCP/IP; qwerty

– software (Microsoft)

– broadcasting

• network externalities may cause problems

186

Network externalities

• First-Mover-advantage („gorilla“): in case of a standard, the

winner takes it all. Winner will be the first mover, not

necessarily the best technology (see VHS vs. Video 2000)

• Problem #1: lock-in of an inferiorer technology (qwerty-

problem)

• Problem #2: the winner may exploit the market after

• Problem #3: the winner may extend his market power to other

markets (Explorer; Media Player)

• solutions:

– more competition

– license agreements

– nationalization

63

187

Economics

Session #11:

Externalities and environmental

policy

Prof. Dr. Hanno Beck

188

Homework: public broadcasting and the Internet

• The case for public broadcasting in the internet: – public broadcasting on TV and radio is threatened by the

increased use of the internet – who will be watching TV in 20 years?

– Information-chaos at the internet; public broadcasting as a torch of information in the night

– better quality of public broadcasting-information on the internet

• The case against public broadcasting in the internet – does the internet need one more broadcaster?

– enough information on the internet

– private broadcasters are threatened by a public subsidized competitor

– is the internet-user that stupid – or is he able to distinguish between „good“ and „bad“ information“?

• One question remains: why is there no subsidized newspaper?

189

Externalities

Externalities

Public policies

International policy

Property rights

64

190

• Some daily problems: – your room-mate is heavy smoker

– your neighbour is addicted to black-metal-records

– you are living near a chemical factory

• what have these problems in common? – person A is harmed by B

– A is not compensated by B

– the costs of A are not included in the calculation of B

– B gets all the benefits from his doing; he does not care about the costs imposed to A

• Externality: the uncompensated impact of one person‘s (company‘s) action on the well-being of a bystander

Exernalities

191

• What is the problem? Society‘s interest extends beyond the well-being of

buyers and sellers; it also includes the well-being of bystanders being

harmed by the actions of buyers and sellers. The person causing the

externality does not take it into his private calculation; therefore he

consumes (produces) too much (or too less)

• negative externalities: pollution

– companies don‘t care about the costs imposed to the environment

– consequence: to much production (consumption) of a good

• positive externalities: a shot aginst the flu

– if you are considering to take a shot against the flu, you don‘t care about the

positive effects on your neighbour

– More people should take a shot against the flu

• To reach a social optimum, the person causing the damage must include

the damage done to the bystanders into his private calculation

Exernalities

192

• Supply does not take include social costs of pollution into his calculation

• Social costs of production are private plus social costs; for society as a whole, SS is the supply-curve that represents total costs of production

• producing at pp,qp: the marginal social

costs of production are higher then

the marginal benefit, represented by

the demand curve

• Each unit produced above qp brings

more social costs than benefits to

consumers

• Source of inefficieny: price p reflects

only the private cost of production, not

the social costs (i.e. the cost of

pollution) • ABC – loss of welfare

p

q

Exernalities

D S SS

qP qS

PP

PS

A

B

C

65

193

• To reach a social optimum, one has to reduce (increase)

consumption (production) of goods with negative (positive)

externalities

• Private solutions to externalities

– social pressure, moral codes, sanctions

– Acting up, charities (e.g. Greenpeace)

– private contracts (Coase Theorem)

• Public policies

– regulation

– taxes and subsidies

– Tradable pollution permits (Kyoto)

Exernalities

194

• Pigou-taxes: taxing activities that have negative externalities; changing the price; shifting supply-curve upwards

• Emissions standard: a legal limit on how much a firm can emit (changing q)

• a standard offers more certainty about the level of emission

• tax: leaves it up to each company how much to abate – it takes in account the different marginal costs of abating that every company has

p

q

Public policies

D

S SP

qP qS

PP

PS

S

195

• When marginal social costs of pollution are high and marginal costs of abating are low, the costs of reducing emissions is not high – but the cost of not avoiding emissions may be high

• Standard: ensures that a certain amount of emissions will be reduced (but to which costs?)

• Tax: offers certainty about the level of abatement costs; but leaves the level of redcution uncertain

• Taxes are more efficient, standards are effective

• Can we combine both instruments to ensure the level of reduction with more effiency?

Public policies: taxes vs. standards

66

196

• Springfield has two

factories: Simpson Corp.

und Burns Inc.

• Both of them emit 5 tons

carbon dioxide per day

• Companies have different

production functions and

cost functions

• The local council estimates

the social costs of pollution

in € (s. table)

Public policies: tradable pollution permits

tons dioxide damage in €

2 30

4 40

6 60

8 106

10 155

Marginal external costs of pollution in Europe:

one ton SO2 causes in a city with 100,000

inhabitants 6000 Euro costs (Europäische

commission DG environment, Benefits table

database: Estimates of the marginal external

costs of air pollution in Europe)

197

Public policies: tradable pollution permits

Simpson Inc. Burns Corp. total

t costs MC costs MC t social

costs

total

costs

1 240 50 130 35 2 30 400

2 190 40 95 20 4 40 325

3 150 30 75 15 6 60 285

4 120 20 60 10 8 106 286

5 100 50 10 155 305

198

• The Council declares that emissions have to be reduced

by 4 t

• Standard: both companies have to abate 2 t; total costs of

abatement: 75 (50 Simpson; 25 Burns)

• tradable permits: each company is allowed to emit 3 t

- Burns is willing to emit 2 t instead of 3 t, as long as Simpson pays

at least 20 €. Simpson is willing to pay max. 30 €

- Burns is willing to emit 1 t instead of 2 t, as long as Simpson pays

at least 35 €. Simpson is willing to pay max. 20 €

- Burns abates 1 t and sells it to Simpson for 20 - 30 €

• Total emission: Simpson 4 t, Burns 2 t = 6 t

• Total costs of abating: 20 € Simpson, 45 € Burns

• Tradable emission permits

Public policies: tradable pollution permits

67

199

• Government decides how much pollution is allowed

• Each permit specifies a number of emissions that a firm is allowed to put out

• Permits are allocated among firms; the total number of permits represents the total amount of emissions allowed to put out

• Permits are marketable: they can be bought and sold

• Marginal costs of abating for 1 t > price for 1 t Emission buy emission permits

• Marginal costs of abating for 1 t < price for 1t Emission sell emission permits

• This leads to one conclusion: the price of a tradable emission permit will equal the marginal costs of abating

Public policies: tradable pollution permits

200

Public policies: tradable pollution permits

• How many rights shall be granted to the economy? E.G.: Reclaim (Regional clean air incentives market) in california failed because too many rights were granted

• How shall the rights be granted? – auctions: additional revenues / costs

– grandfathering: early action advantage

• How shall new entrants be treated?

• Period of validity?

– short: flexibility

– long: longe-range planning

• Area of validity: avoidance of „hot spots“

201

International policy

• USA: – 1974: emission trading program to reduce lead in fuels. 1987: fuels

are completely lead-free

– Acid rain program: trading in nitrogen-emissions (SO2); amount of

certificates granted to companies reduced every year

reduction of SO2 40 % above target

– Reclaim (Regional clean air incentives market) in California failed.

Reason: to much emission rights were granted; no incentives to

reduce emission of GHG

• World: Kyoto protocoll – Emission trading between indutrialized countries from 2008 on

– Industrialized countries agreed to reduce emission of green house

gas (GHG) from 2008 until 2012

– next step: Bali-Conference

68

202

• The Kyoto Protocol is protocol to the international Framework Convention on Climate Change with the objective of reducing greenhouse gases in an effort to prevent anthropogenic climate change

• As of May 2008, 182 parties have ratified the protocol. 137 developing countries have ratified the protocol, including Brazil, China and India, but have no obligation beyond monitoring and reporting emissions. Kyoto mechanisms: – emissions trading (carbon market) – the Clean Development Mechanism (CDM) allows a country with an

emission-reduction or emission-limitation commitment under the Kyoto Protocol to implement an emission-reduction project in developing countries. Such projects can earn saleable certified emission reduction (CER) credits

– joint implemetation: similiar mechanism for eastern-european countries

International policy

203

Property rights

factory fisher total

nF; nT 500 100 600

F; nT 300 500 800

nF; T 500 200 700

F; T 300 300 600

• a firm dumps its effluent in a

river, which reduces the catch

of fish

• Two options: filter system or

treatment plan

• Factory has to pay the filter,

treatment plan must be paid by

the fishermen

• Depending on the combination

of filter and treatement plan,

the factory and fishermen yield

different profits

• what happens if we allocate

property rights?

nF: no filter

F: filter

T: treatment plan

nT: no treatment plan

204

Property rights

factory fisher total

nF; nT 500 100 600

F; nT 300 500 800

nF; T 500 200 700

F; T 300 300 600

• #1: the factory owns the river; it

has the right to polute

• T gives the fischermen only

additional profit of 100

• Fischermen are willing to pay

300 to the factory if it uses a

filter

• if the fishermen have to pay

more than 300 for the filter,

nF;T becomes more attractive

(500 profit – 300 costs of filter)

• the company demands at least

200 for using a filter

• Result: fischermen pay at least

200 to the factory which uses a

filter

nF: no filter

F: filter

T: treatment plan

nT: no treatment plan

69

205

Property rights

• #2: fischermen own the river;

they have the right to demand

from the factory to use a filter

• Factory is willing to pay 200 to

the fischermen if they install a

treatment plan

• fischermen demand at least

300 for installing a treatment

plan; F; nT yields 500; nF;T

yields only 200

• result: factory installs a filter

factory fisher total

nF; nT 500 100 600

F; nT 300 500 800

nF; T 500 200 700

F; T 300 300 600

nF: no filter

F: filter

T: treatment plan

nT: no treatment plan

206

Property rights

• Other possibility: suing for damages

• Fishermen are given the right for clean water

– if the firm does not install a filter, it harms the fishermen (damage =

400$); therefore fishermen can sue for 400$. Profit to firm: 500$ -

400$ (fine)

– firm installs a filter; profit: 300$

– firm will install a filter

• Factory is given the right to emit effluent

– fishermen have the right to ask firm to installing a filter, but they

have to compensate the firm

– treatment plan makes a profit of 200

– ask firm to install a filter (and pay for damage) makes a profit of

300 = 500 – 200 (compensation)

– no treatment, no filter makes a profit of 100

– fishermen will pay a filter to firm

207

Property rights

• Coase-Theorem: if private parties can bargain without costs over the allocation of ressources, then the private market will always solve the problem of externalities and allocate ressources efficiently

• The initial distribution of rights does not matter for the ability of the market to reach an efficent outcome

• but: the distribution determines the allocation of economic well-being

• Externalities rise due to a lack of property rights • problems

- transaction costs - what about the coordination of the parties involved? - Distribution of economic well-being is affected by the

distribution of the property rights

70

208

Homework: don‘t marry, be happy

Trouble in Disneyland

Donald and Daisy are married; Micky and

Minnie are married, too. The ladies want to get rid

of their men and file in for diverce. Donald (Micky)

is willing to pay 20 (10) bucks to avoid a divorce.

Daisy (Minnie) is willing to pay 5 (15) Taler for getting divorced.

Assume that Minnie / Daisy may pay compensation to Micky /

Donald – what will happen if both of them partners have to agree to

get divorced? What, if one partner can file for divorce and his

counterpart may payahim for stepping back from the divorce?

209

Economics

Session #12:

Social Market Economy

Prof. Dr. Hanno Beck

210

Hausaufgabe: don‘t marry, be happy

Ducks Mouse

She pays for

divorce

5 15

He pays for not

divorce

20 10

No matter who owns the right

to file divorce, the results are

always the same: the Ducks

get not divorced; the Mouses

get divorced

• Family Duck:

- if one partner can file for

divorce, Donald is willing to pay

up to 20 for not getting divorced;

Daisy accepts

- if both partners are to agree,

Daisy is willing to pay up to 5 for

getting divorced, Donald will not

accept

• Family Mouse:

- if one partner can file for

divorce, Mickey is willing to pay

up to 10 for not getting divorced,

Minnie disagrees

- if both partners are to agree,

Minnie is willing to pay up to 15

for getting divorced, Mickey will

accept

71

211

Social Market Economy

Social Market Economy

Health insurance

Pension System

Poverty and inequality

212

Social Market Economy

• German „Ordoliberalismus“ (W. Eucken, A. Müller-Armack,

L. Erhard et al.) during the 1940’s and 50’s.

• Basic idea: combine the efficiency of free markets with social

justice – enforced by government policies.

• “Design” of an economic system which is efficient and

humane at the same time.

• Key elements: Free and open markets, private property,

antitrust policy, income redistribution

• Principle of subsidiarity: individuals and families should try to

solve their problems themselves - only where they are

unable to cope with their problems shall government help.

• Principle of non-distorted prices: if the government

intervenes, it should not change prices

213

• Basic idea: free markets first, but additional policy to correct for market failures – social policy

– externalities; public goods

– redistribution; quasi-private goods

• Basic framework – Property rights, freedom

– competition policy against monopolies and collusion

– tight money; open economy

• How to intervene if the results of the market mechanism are not accepted by policy / society? – Regulatory framework (Ordnungspolitik): setting a framework with

proper incentives

– intervention: principle of non-disorted prices

Social Market Economy

72

214

• The problem with cheap housing: people need an

affordable home

– bad ideas: rent ceilings; subsidies for appartments

– SME: direct transfer to needy people, financed by taxes

• Minimum wages: what if you can‘t make a living from your

job?

– bad idea: minimum wage distorts price mechanism

– SME: let the markets determine the wages; if your income is too low

to make a living, you may get a transfer (negative income tax)

• Basic idea: direct payments to the needy; financed by taxes

(i.e. by everyone) instead changing the price mechanism

Social Market Economy: applications

215

Homework: planned economies

Lets give communism another chance?

A planned economy or directed economy is an economic system in

which the state or government manages the economy. Its most

extensive form is referred to as a command economy, centrally

planned economy, or command and control economy. In such

economies, the government controls all major sectors of the economy and

formulates all decisions about their use and about the distribution of income. The

planners decide what should be produced and direct enterprises to produce those

goods. Important planned economies that existed in the past include the economy

of the Soviet Union, China and India, prior to its economic reforms in 1991 .

Beginning in the 1980s and 1990s, many governments presiding over planned

economies began deregulating (or as in the Soviet Union, the system collapsed) and

moving toward market-based economies by allowing the private sector to make the

pricing, production, and distribution decisions. Today, planned economies exist in

some countries such as Cuba, North Korea, and Burma.

How would you plan an entire economy? What are the problems of a planned

economy?

216

Health insurance

• Why do we need health insurance? – some therapies are way far to expensive to pay them from your

income

– When you are 20, do you think about the cures you may need when you are 60?

– weakness of will

– Hoping on a bail-out by the government

• problems of a health insurance – moral hazard: you may change your behaviour as soon as you are

insured (own participation necessary)

– Lack of information of the insured

– the doctor may maximize his income in expense of his patients (see cab driver-problem)

– adverse selection: only those who are in need of an insurance buy one; this makes the insurance expensive

73

217

Health insurance

• increase contribution rates

• increase wages

• Increase number of insured persons: abolish private insurance schemes

• Less services

• reduce price of services

- price prescriptions

- more competition

- managed care

revenues = expenditures

contribution*wage* insured persons = services*price

218

Pension System

• Why do we need a pension system?

– when you are 20, do you think about your pension you‘d

like to have when you are 60?

– weakness of will

– Hoping on bail-out by the government

– lack of information, complex topic (finance)

• Pension system in Germany

– public pension system: pay-as-you-go system

– private pension schemes: Riester; Rürup

– corporate pension systems

– Versorgungswerke (lawyers; medicians)

219

generation 1 generation 2 generation 3

generation 0 generation 1 generation 2

contribution

pension pension pension

claims claims

Pension System: Pay-as-you-go

contribution

74

220

Pension System: Pay-as-you-go

• Pay-as-you-go can be started immidiately (war)

• implicit governmental debt

• Bad demographics and unemployment are threatening

this system

• redistribution on the expense of later generations

• winner: generation #1; old people

• looser: generation #x; last generation (at least one

generation has to pay the debt of the first generation )

• it is extremely dificult to shut this system down

• Pay-as-you-go is not a contract; not a so-called

generation-contract („Generationenvertrag“)

221

Pension System: Pay-as-you-go

• Increasing contribution rates leads to more unemployment

• increase wages: one must create more employment

• Increase # of insured persons: e.g. self-employed persons; problem:

this policy also increases the number of pensioners

• pay smaller pensions: smaller pension; later payments („pension at 67“)

• Federal subsidies, payed from taxes

• switch from pay-as-you-go to capital-based pension system

• more kids: no solution, because this will increase the number of

pensioners

revenues = expenditures

contribution*wage*#insured persons = #pensioners*pension

222

Poverty and inequality

• Social policy: markets only provide eficiency and income

according to achievement;

– extreme poverty: hunger and homeless persons

– relative poverty: poor compared to average living standards

– poverty as equality of chances

• redistribution

– as normative policy

– social inequality may cause political and social problems

• Redistribution of: income; wealth; chances

• problems:

– time dimension: students are poor, too

– definition of poverty

– Poverty trap: marginal tax rates of 100 %

– incentives and fairness

75

223

Poverty and inequality

• Definition of poverty in the EU: 60 % of the average income – shows only the amount of inequality, not poverty

– if all incomes increase, „poverty“ remains the same

– Why 60 %?

• Gini-coefficient: shows distribution of income – Lorenzcurve: how many people in % have how many % of

total income?

– Gini-coefficient: 1 = one person has 100 % of the income; 0 = every personhas exactly the same share from total income

• source: federal report on poverty and inequality

224

Poverty and inequality

0

0,05

0,1

0,15

0,2

0,25

0,3

0,35

0,4

0,45

0,5

1991 1994 1997 2000 2002 2004Gini-Coefficient market income and net income in Germany

1991 – 2004

Quelle: Sachverständigenrat 2007

225

Poverty and inequality

• What makes poor people poor – divorce; children with only one parent

– Long-term unemployment

– no education

– parents

• What determines the distributon of incomes? – Economic cycle; labour market

– self-employment

– „Agenda 2004“: the reduction of unemployment among low-skilled workers led to a reduction of average wages

• What determines the distributon of wealth? – interest rates; if you are wealthy you have more possibilities to

manage your portfolio

– real estate prices

– pension system

– parents