ECONOMICS. A brief introduction

1. Economics. What is this?.

1

Scarcity: wants vs. limited resources

F Why do people demand (want) health care?

(i) People want to be healthy.

(ii) Population aging. Elderly people require morehealth :UK 1995/96:41% NHS expenses devoted to people over 65.people over 65 account for 16% of population.

(iii) Increasing real income- US: people with mild osteoarthritis of the knee of-ten have an operation than give up golf.- 4 income → 4 people’s expectations of healthcare: less prepared to put up pain, discomfort, lackof mobility, ...

(iv) Improvement in medical technology:- Technology increases range of possible treatments- Newer technology, more expensivee.g. kidney dialysis → prevent kidney failure fromkilling people ⇒machine is expensive and patients are treated longer.

1-a

F Resources: inputs, factors of production.- land (physical resources of the planet)- labor (human resources)- capital (resources created by human to aid in pro-duction: tools, machinery, factories, ...)

entreprise: organization of resources to produce goodsand services.

F Main concepts related with scarcity:

Efficiency

Opportunity cost

Production Possibility Frontier

1-b

2. The elements of the analysis.

2.1 Consumers.

2

Individual vs. aggregate demand

Individual demand → solution of

maxx,y

U(x, y) s.t. M = Pxx + Pyy

x∗(Px, Py, M)

y∗(Px, Py, M)

2-a

Consider 2 individuals x1(Px, Py, M1) and x2(Px, Py, M2).The aggregate (market) demand for good x is thehorizontal sum of individual demands.

2-b

Effects on demand

Changes along the demand curve

- ↑ Px, x ↓: some consumers buy less and someothers leave the market.

- ↓ Px, x ↑: some consumers buy more and someothers enter the market.

Shifting the demand curve

- ↑ M , (Py constant), −→ increase demand x andy: demand moves outwards.

2-c

Impact of ↑ Py (M constant) on x three possibilities:

(i) x and y independent, e.g. (x,y)= (coffee, gaso-line):

↑ Py →↓ y → demand of x unaffected

(ii) x and y substitutes: satisfy similar needs, e.g.(x,y) = (butter, margarine): ↑ Py →↓ demandof y →↑ demand of x

(iii) x and y complements: joint consumption, e.g.(x,y) = (coffee, sugar): ↑ Py →↓ demand ofy →↓ demand of x.

2-d

Elasticity

How to measure impact of ∆Px on x?

Method 1: Direct and simple

∆Px

∆x

Problem: dependent on units:

∆Px

∆x

∣∣∣∣EUR

=−5

6= −0.83

∆Px

∆x

∣∣∣∣Pts

=−5

1000= −0.01

2-e

Method 2: Index invariant to units Elasticity

Own-price elasticity∣∣∣∣εx

∣∣∣∣ = ∣∣∣∣ %∆x

%∆Px

∣∣∣∣ = ∣∣∣∣ ∆xx

∆PxPx

∣∣∣∣ = ∣∣∣∣∆xPx

∆Pxx

∣∣∣∣∣∣∣∣εx

∣∣∣∣ > 1 elastic (overreaction)

∣∣∣∣εx

∣∣∣∣ < 1 inelastic (underreaction)

Cross-price elasticity

εxy =%∆x

%∆Py=

∆xx

∆PyPy

=∆xPy

∆Pyx

Income elasticity

ηx =%∆x

%∆M=

∆xx

∆MM

=∆xM

∆Mx

2-f

2.2 Producers.

3

Consider a hospital with 10 surgeons. If all performheart operations → 50 heart operation/week;If all perform hip replacements → 50 replacements/week.

Points A, B, C ∈ feasible production set. Repre-sent production of hospital (supply).Points B, C ∈ PPF.

Production possibility frontier:Set of all the maximum combinations of operationsthe hospital can achieve given the quantity and pro-ductivity of resources available.

3-a

Efficiency.

An allocation of resources is efficient if it is impossi-ble to change that allocation to make a person bet-ter off (perform one more operation) without makinganybody else worse off (reducing number of opera-tions).

Efficiency refers to allocations of resources yield-ing the maximum possible output, i.e, allocations inPPF.

Hence, allocation A is not efficient, while allocationsB, C are efficient.

From a social point of view, there is interest in mov-ing from A to B (or C). The hospital is able to in-crease its output with the same inputs.

3-b

Opportunity cost.

The concept of opportunity cost is defined as thebenefit given up by not choosing an alternative allo-cation.

Assume we move from B to C. Consequences?

- 29 more heart operations are performed- 29 less hip replacements are performed.

Accordingly, the opportunity cost of moving from B

to C is the reduction in hip replacements due to theincrease in heart operations.

The opportunity cost is an economic concept (not inaccountancy)

3-c

How does society choose among feasible alloca-tions? VOTING mechanism.

Criteria to be used:

- Efficiency: Select only efficient allocations (rule outallocation A)

- Equity. [Normative criterion] Select allocations meet-ing society’s requirement for justice.→ people’s values

e.g. social justice is behind the set-up of the NHS.

FHorizontal and Vertical equity.

� Horizontal Equity: equal treatment of equal need.� 2 individuals with same illness and severity shouldreceive same treatment.

� Vertical Equity: unequal treatment of unequal need.� more treatment for patients with serious condi-tions than for those with trivial complaints.� passing the financing of health care to ability topay (progressive income tax)

3-d

Individual vs. aggregate supply

Individual supply → solution of

maxx

Π(x) = xPx − C(x)

That is,

x∗(Px, w)→ market structure?

NOTE: Px vs. P (x).

3-e

Consider 2 firms x1(Px, w) and x2(Px, w).The aggregate (market) supply for good x is thehorizontal sum of individual supplies.

3-f

Effects on supply

Changes along the supply curve

- ↑ Px, x ↑: some firms produce more and someothers enter the market.

- ↓ Px, x ↓: some firms produce less and someothers leave the market.

Shifting the supply curve

- ↑ w, (Px constant), same production level is moreexpensive −→↓ production: supply moves inwards.

- R& D −→ new more efficient technology −→same production level is cheaper −→↑ production:supply moves outwards.

3-g

2.3 The market.

“Place” where consumers and producers interact.

Rational behavior of agents:

- consumers: maximize utility −→ Individual de-mand −→ Market (aggregated) demand

- producers (firms): maximize profits −→ Individualsupply −→ Market (aggregated) supply

Market structures:

4

PERFECTLY COMPETITIVE MARKET

Justification:

1. Simplicity.

2. Generates the best distribution of resources (nomismanagement): efficient distribution (Pareto-optimality) [ 6= equity].

3. No need of State to achieve efficiency.

4. Benchmark to build models allowing better un-derstanding of real phenomena.

4-a

Assumptions:

1. Many sellers (producers): price-takers: giventhe prices decide production volume to max profit.

2. Many buyers (consum.): price-takers: given theprices decide consumption bundle to max sat-isfaction.

3. Homogeneous product.

4. Perfect information.

5. Free entry (and exit) of firms.

6. Partial equilibrium; Static.

4-b

Additional assumption:

7. Real Markets (no financial markets)

• markets of goods and services: firms sell,consumers buy.

• labor market: firms buy, consumers sell.

4-c

Implicit assumption: property rights

8. Firms (shareholders) hold the property right overprofits −→ incentives to reinvest to improveprofitability =⇒∆Π.

9. Consumers hold the property rights over theirincomes:

• incentives to work (increase income)

• incentives to save (increase returns of cap-ital)

=⇒∆ consumption.

A State setting incomes and profits eliminates in-centives.

4-d

Incentives

Are necessary but ... generate inequality.

Induce proper behavior if linked to profitability: higherprofitability −→ higher income.

Consequence: trade-off between incentives and in-equality.

If society offers + incentives (e.g. ∇ Tx, ∇ socialbenefits) i.e. indiv. welfare ∼ income

−→

∆ production

∆ inequality

If society offers - incentives (e.g. ∆ Tx, ∆ socialbenefits) i.e. indiv. welfare depends of income andsocial benefits

−→

∇ production

∇ inequality

Societies solve the trade-off between the two forcesthrough voting in government elections.

4-e

Prices

allocate goods and services through the market tothose with highest willingness to pay.

BUT is not the only allocation mechanism, e.g.

(i) Rationing (the consumption bundle consumer getsis smaller that what they wish)

• queuing (cinemas, primary care services, ...)−→ inefficient

• lotteries (licences, ...) −→ inefficient

• sharing rules (prorate shares in privatization ofpublic firms, food stamp programs, wartime, ...)

- without market for coupons −→ inefficient

- with market for coupons −→ efficient

(ii) Fixing prices (gasolines, house-rental, ....)

4-f

Market Equilibrium: Law of demand and supply.

Aggregate demand and supply of a commodity x

jointly determine its (partial) equilibrium price (andquantity) in a perfectly competitive market.

An equilibrium is a situation where no agents hasincentives to modify his(her) actions.

The equilibrium pair (P ∗, x∗) denotes a situationwhere firms are maximizing profits and consumersare maximizing satisfaction from consumption.

4-g

2.4 The State

Why does it exist a public sector?

The State plays a double role in the economy:

- regulates the market (taxes, transfers, minimumwages, schooling, vaccination campaigns, ....)

- agent in the market −→ PUBLIC SECTOR ( −→Mixed Economy).

Components of the Public Sector:

(a) Welfare State: Health Care Services (SS), Ed-ucation, Pensions, Defense(?).

(b) Services (Liberalization, Privatization): Railways,Mail, Telecommunications, Airlines.

(c) Industry (Privatization): Mining, Energy, Iron andsteel.

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Characteristics of the Public Sector:

(i) its objective need not be profit maximization;

(ii) managers of public firms are “reliable officials”;

(iii) the State has the right to impose duties to citi-zens and self-imposes mechanisms of control.

The role of the State in the Economy: Market fail-ures and Intervention (Regulation).

If competitive markets are efficient, why is there anyneed of State regulation?

Free competition raises problems, e.g. externalities.Also there appear market failures −→ inefficien-cies, free-riding, social complaints, ...

5-a

Mechanisms of regulation:

- direct (substituting the private sector);

- providing incentives to the private sector;

- imposing rules to the private sector;

- combinations.

Types of regulation:

- universally accepted (access kids to the labor mar-ket)

- controversial (positive action for gender/race)

- on producers/consumers (price discrimination; an-titrust laws; controls on advertising; access of con-sumers to info on the products, ...)

- on production conditions (safety at the workplace;patents; waste disposal; environmental pollution, ...)

5-b

Reasons for regulation:

- protection of working conditions (health, safety, ...)

- protection of vulnerable social groups (kids, young-sters, ...)

- protection of competitive conditions

- prevent market abuse

Instruments for regulation:

- laws

- administrative actions

- professional associations

Objective of the regulation: correct market failures.

5-c

SOURCES OF MARKET FAILURE

I. Supply side

(i) natural monopolies (scale economies) → largeinitial investment: supply of water, gas, electricity,transport, telecommunications,...

Regulation (limit monopoly power) widely accepted(prices)

(ii) oligopolies (monopoly power)

Regulation (limit monopoly power): antitrust laws

(iii) externalities (negative) → difficult to measure,diversity of effects, diversity of types.

Regulation (limit monopoly power): OK but how?

(iv) public goods: no exclusion, no rivalry. (army,public gardens, roads)

Regulation (protect “monopoly rents”)

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II. Demand side

(i) imperfect and incomplete information on products(AIDS, drugs) and markets

Regulation: control on sales of products dangerous;info on label of the products (expiry date, ingredi-ents, ...); control on advertisement campaigns.

(ii) information as a public good → private marketdoes not provide enough information (see below).

Regulation: increase volume of information.

6-a

MONOPOLY

Profit Maximization

maxxΠ(x) = xP (x)− C(x) = I(x)− C(x)

Marginal Revenue: ∆ revenue when selling one ad-ditional unit.

Marginal Cost: ∆ cost when producing one addi-tional unit.

Average Cost: Total cost/ production (unit cost)

Firm’s Problem: maxx Π(x),=⇒ MR = MC

7

OLIGOPOLY

Consider a market with two firms (duopoly) 1 and2. Now firm 1’s decision will be affected by firm 2’sbehavior. → Strategic Interaction

Firm 1 decision-making process

- Demand will depend on both prices, since con-sumers will be able to compare them: P (x1, x2).Hence

A’s Profit Maximization: find production level

maxx1Π(x1, x2) = x1P (x1, x2)− C(x1)

Solution: x1 = f(x2)

Similarly, firm 2 maximizes profits producing

x2 = g(x1)

8

Market equilibrium

(x∗1, x∗2) such that f(x2) is compatible with g(x1)

8-a