Economics Lecture Ten
At this point we have covered most of what is taught in "Microeconomics", and most of what is on the CLEP exam for college credit. There are still some important topics that we need to cover in the remainder of this course, such as:
- production possibilities
- comparative advantage
- derived factor demand
- market distribution of income
- government policy
- public and private goods
- regulation and antitrust law
- market failure and imbalances in information
- capital and banking
About 10% of the CLEP Microeconomics exam questions are on government policy, a higher percentage than one would expect for a course about individual market-based decisions. Also, nearly 5% of the exam asks about "production possibilities," which is not a particularly important concept in Microeconomics. But we'll cover all these topics so that you will be prepared if you want to take the CLEP and earn college credit.
“Externalities” are costs or benefits that are external to the seller and buyer of a good or service, for which no compensation is made. Stated another way, externalities to a transaction are costs or benefits that hit other people. These direct costs or benefits spill over without anyone paying directly for them.
This is a new concept in our course. Until now we assumed that transactions were entirely between a buyer and seller, like buying a chocolate bar. No one else is affected. The buyer gives $1 to the cashier, and gets the bar in return. More generally, a company produces a good at its expense, and sells to a buyer who pays for it. The buyer bore the cost and received the benefit of the good itself. The seller bore the cost of producing the good, and received the payment for selling it. What else could be going on here?
After all, when you buy gas, you pay the cost and you receive the benefit. It’s a transaction between you and the service station. What cost or benefit does anyone else receive?
But look more closely. The next time you’re traveling in a car, take a look at the exhaust pipe on the car in front of you. Pollution comes out of it. That harms other people who did not sell or buy the gas. People who do not drive, or children, are slightly affected by that pollution. In some poor neighborhoods, it’s customary (and illegal) for car owners to modify their cars so that their engines have higher miles-per-gallon, but produce more pollution. You can smell the difference when you are stuck behind one of those cars. Airport taxicabs are notorious for putting out more pollution than the average car. Airplanes themselves put out substantial pollution at airports as they idle. In New Jersey, there is now a law against idling one's engine for longer than a few minutes. At truck stops, truckers are encouraged not to idle their engines for long periods of time, but many do anyway.
So the buyers and sellers of gas do not pay the full cost. The public is bearing the small cost of the pollution. This is called a “negative externality” because it imposes costs on people who did not buy the good. A negative externality has a negative effect on others.
Car pollution is often unnoticeable. But sometimes pollution can be severe and dangerous. If a company can dump toxic waste into a river for free, then that is going to be cheaper for it than disposing of the waste in proper manner. The company will make more profits by dumping its waste at less cost to it. But those who like to swim or fish in the river will suffer the harm. Either they will have to curtail their activity, interfering with their utility, or they could become sick from it. Environmental harm is the most obvious type of "negative externality." Another example of a negative externality is excessive noise at heavy metal rock concerts, which may disturb neighbors who never bought or sold a ticket.
But there are many “positive externalities” too. These create benefits for the public without requiring some to pay for it. If you happen to live next to an outdoor classical concert facility, then you may enjoy listening to music without buying an admission ticket. The people paying for the concert receive the benefit they want, but you would receive a free benefit as a “positive externality.” Or perhaps you have a view of fireworks from your front porch on July 4th. You do not have to pay to see the fireworks, but you freely benefit from the positive externality of the display.
Dealing with Negative Externalities
The internet is filled with activities that create both positive and negative externalities. The positive externality is the enormous amount of free and useful information posted on websites at someone else’s expense, but available to the public. The negative externality is all the pornography that destroys those who fall victim to it, creating costs for society in dealing with them. FBI agents say that the one common attribute of every criminal residence that they raid is the discovery of pornography there.
Professor Lawrence Lessig is a champion of the “commons” on the internet. The “commons” is a term from medieval England, when anyone could bring their sheep to graze on public land. Ultimately, all the grass was eaten and then the commons was not of much use, so the story goes. Professor Lessig supports free books, music, etc., over the internet. He took a case to the U.S. Supreme Court fighting a long extension in the duration of copyrights protecting works all the way back to 1923 (Eldred v. Ashcroft, 537 U.S. 186 (2003)). In the end, some Justices seemed worried about the impact on private property of his theories, and he lost.
Illegal drugs create perhaps the largest negative externality. The transaction is between the drug dealer and the drug addict, but when that drug addict runs out of money due to his habit then he is going to turn to crime. Soon he will be robbing and even killing people to obtain money to feed his addiction. The victims of this crime bear the negative externality.
Libertarians promote a philosophy of "let everyone do what they want." But that approach ignores the harm caused by negative externalities. Letting someone get drunk will sometimes result in his driving drunk, and then killing an innocent person who had nothing to do with the purchase and sale of the alcohol. Should alcohol companies pay for the negative externalities caused by their good? Many would say "yes". Should abortionists and Planned Parenthood pay damages for the enormous and lifelong negative externalities caused by abortion? Many would answer "yes" to that also.
Let's consider what can be done about positive and negative externalities. It is desirable to eliminate or minimize the negative externalities, so that sellers bear all the costs of their production and sales. How can they be required to pay all of their costs, rather than pushing those costs onto the public?
Taxes are one way to pay for negative externalities, at least in theory. Government imposes a gasoline tax, supposedly to help pay for the negative externalities caused by cars. But then try to find out where those taxes are spent. Often they are spent on salaries for government workers, rather than helping people who are hurt by the negative externalities.
“Public choice theory” recognizes that self-interested politicians can act contrary to public interest. Politicians are known to maximize their own interests, such as their own relative salaries and pensions and control over others, in setting tax policy, rather than maximizing public interests.
Remember the economist Ronald Coase? He would say that the reason for externalities is transaction costs. If it were practical to give everyone a right to be free from pollution, and then allow them to sell it without incurring transaction costs, then pollution would become a good that is bought and sold like any other good and it would no longer be a negative externality. Most people would accept small payments from Exxon and other oil companies in exchange for allowing a little pollution in their lives, if transaction costs weren’t larger than the payments. We would not need additional taxes on gasoline by an inefficient government.
The news is not all bad about externalities: some are positive. Jesus Christ's Passion, Crucifixion and Resurrection constituted the greatest positive externality in history, opening the way to salvation for all.
There are positive externalities in engineering. The transistor was invented by AT&T Bell Labs here in New Jersey, and that patented invention became the basis for almost every electronic good manufactured today: computers, IPods, cell phones, televisions, etc. AT&T did not profit from all these goods. Instead, its invention created a trillion dollar benefit for many other people, as a positive externality of its discovery. Sometimes this is called "technology spillover."
In fact, the unique American patent system put in place by the Founding Fathers is based on the positive externalities created by the publication of each new patented invention. The Founding Fathers included patent protection in the U.S. Constitution, and the First Congress then passed a law setting forth the details. The approach taken was to encourage inventors to publish details about their inventions in the form of a patent, so that others could benefit from the ideas and perhaps build on them with more inventions of their own.
Supporters of the Second Amendment observe that there is a positive externality when many in a community own guns: burglars and criminals stay away from that community, and there is less crime. John Lott researched many different regions and found that the more guns there were, the less crime there was. He entitled his famous book, "More Guns, Less Crime." That is hard for some to understand ... until they learn the concept of positive externalities. Gun ownership has the effect of deterring crime, and that benefit extends throughout the community because criminals do not know who has a gun for self-defense and who does not.
Some argue that the government should provide subsidies for goods that have a positive externality, because the benefits far exceed the costs. But just as taxes on goods having negative externalities do not usually help the people who need it, taxes to provide subsidies for positive externalities rarely end up helping anyone.
A “public good” is something, like music in public, which provides a benefit to one person without reducing the benefit to others. (Let's assume it's good music!) One listener does not lose benefit by the presence of other listeners. Unless earphones are used, it is impossible to exclude others nearby from freely hearing it. Food, in contrast, is not a public good, because one person can eat an entire meal without allowing others to eat it also!
Let's try to define a "public good" in a more rigorous manner. A "public good" is a good which has indivisible benefits such that others cannot be excluded from the benefit even though they do not pay for it. Here are some examples:
- fire protection
- national defense
- radio transmission
- network (non-cable) television
- public parks
Most public goods are provided by government because people are unwilling or unable to pay for them. People would say, why pay for this when I can let others pay for it and still enjoy the benefits? Many public goods have low marginal cost, such as public parks that do not require much upkeep.
Can you think of other public goods?
Public transportation is not a public good because it is easy to keep people off who do not pay. But the cost of riding is usually much lower than the true cost, and taxpayers subsidize most of the cost of public transportation.
Garbage collection in most cities is a public good because voters want all of the garbage collected, whether someone wants to pay for it or not. But in rural areas, including much of New Jersey, people do pay privately for garbage collection. The small town governments do not pay for it.
Question: Are websites on the internet, like Conservapedia, public goods?
A "private good" is the opposite of a public good. Specifically, a "private good" is an item which is consumed by someone and is no longer available to someone else. Food and clothing are examples of private goods.
Most of the items that we have discussed in this course are private goods. Examples of private goods include a ticket to a Yankees' game, a chocolate candy bar, and a few hours of services provided by a doctor or lawyer. Private firms typically provide private goods, rather than the government. However, a postage stamp to mail a letter is also a private good: once you use it, it cannot be used by anyone else. A subway token is also a private good which enables one, and only one, to ride the subway.
The significance of a "private good" is its distinction from a "public good." Rarely does an economics exam ask about private goods, but there are several questions on the CLEP exam about public goods.
Public v. Private goods compared
Keep in mind that public goods are provided by government because it is difficult to exclude people from using them. The theory is that taxes should pay for them rather than trying to charge people individually, because it is so difficult to get individuals to pay when they can enjoy the good without paying. Private goods do not have that problem of charging people individually, so there is no need for the government to provide private goods.
Regulation, including Antitrust Laws
The response of the government to externalities and to the very different problem of monopolies is this: regulation. Regulate the polluters; police the trading of music over the internet; and break up the monopolies like Standard Oil, AT&T, and perhaps Microsoft (which barely avoided a break-up by the skin of its teeth!).
Negative externalities and monopolies become popular targets for politicians from time to time. Democrats campaign on a platform of increasing regulation to protect the environment against big business. “Don’t let companies pollute your lake and streams,” environmentalists say. A hundred years ago, President Teddy Roosevelt broke up big monopolies and cartels and became immensely popular for it.
There are more poor consumers who vote than wealthy businessmen, and many politicians think the road to election is paved with appeals to consumer interests. As long ago as 1890, the Sherman Antitrust Act was passed to prohibit combinations, trusts and conspiracies that restrict trade and prohibit cartels. The Clayton Act of 1914 went further and even prohibited price discrimination if not justified by cost differences. Accordingly, the term “price discrimination” is rarely used by businesses, because it sets off alarm bells of illegality. But in practice, virtually every business does engage in price discrimination in some form.
Sometimes the pendulum swings the other way. Ronald Reagan became president by ridiculing the vast amounts of regulation of free enterprise. “Get the government off the back” of businesses and the people. He sought “less government.” He would tell stories of senseless regulations, like one requiring American Indians working on high bridges to wear life-preservers in case they fell. First of all, the life-preservers were unbearably hot and of doubtful value even to those who fall. Second of all, the regulations applied even when there was no water below!
In the free market, change is nearly instantaneous to new developments. When a company announces it is bankrupt, its stock value drops to near $0 within minutes. However, it can take the government months or years to adjust to a new development. The Post Office is far behind Federal Express in technology and efficiency.
An additional problem with regulations has arisen in the past ten or twenty years. Big businesses have learned how to influence regulators by holding out the possibility of hiring them. Fifty years ago, large companies had policies against hiring those who regulated them. But today, “regulatory capture” is pervasive. Regulators curry favor with the companies they regulate in order to obtain jobs at twice their government salary. The regulators end up helping the large companies at the expense of smaller companies and the public. The regulators have been effectively “captured” by big companies. The fox ends up guarding the chicken coop.
Government regulation almost never tells a company how much to produce. In only in a few industries, like the public utilities of the gas and electric companies, does government set the prices at which goods or services are sold. In most markets in the United States, the price fluctuates freely based on supply and demand.
But there is enormous regulation in the United States of all businesses concerning matters other than price and quantity. Defenders of the massive amounts of regulations will say it is necessary to protect the public. Critics of the regulations point out that government is gaining more power and control by imposing these regulations, and the regulations frustrate the efficient operation of the free market. Sometimes a CLEP exam question will expect an answer that is favorable to regulation, but many economists (including Ronald Coase) are very critical of regulation by government.
Taxation and public expenditures are considered to be worse than regulations. Taxation and public expenditures are the most direct ways that government redistributes wealth in society. Wealth is lost as part of the redistribution, as many government workers are paid as middlemen in administering the system. Some of these government workers are very highly paid:
- In 2008, "the average salary for a federal government employee was $79,197. The average salary for a private employee in the United States was $49,935. ... Orange County Sheriff Sandra Hutchens earns almost half a million dollars a year between her current salary as sheriff and her pension from the Los Angeles County Sheriff's Department. And Ms. Hutchens is not alone. Orange County CEO, Tom Mauk also earns close to $500,000 a year with his current salary from the County and his pension from working for La Habra."
Superintendents of public school districts in New Jersey are paid hundreds of thousands of dollars each year in salaries and pensions. Some people in New Jersey voted against Jon Corzine for governor, and elected Chris Christie instead, because they felt it was time to stop the growth in spending by the New Jersey government.
Consider an example of a government regulator telling a monopoly at which price to sell his goods. This rarely happens, but public utilities (gas and electric companies) are an example where any rate increases must first be reviewed and approved by government before they can go into effect.
Monopolies sell where marginal revenue equals marginal cost, or MR=MC. But that is at a higher price than if there were perfect competition. In perfect competition, the goods sell where P=MC, or where the marginal price curve intersects the demand curve. That is at higher quantity of output than where the marginal cost curve intersects the marginal revenue curve. Always remember: the best price point for the public is the price when there is perfect competition, and there is more output at that equilibrium price in the free market. More output means more benefits to the public, and more consumer surplus.
But what if ATC > P for this monopoly? In that case, forcing P = MC for this monopoly would require a subsidy by the government. Without a subsidy, the company shuts down. Alternatively, if regulators set P = ATC for this monopoly, then it does not need a subsidy but it is not producing an optimal output Q.
Even in the case of a monopoly, government price controls are almost never desirable from an economic perspective. However, they may be popular politically.
Derived Demand and Factors of Production
It is obvious what the "demand" for a good is: it is the desire for the good by the public, in terms of how much the public is willing to pay for it.
"Derived demand" is a firm's demand for something. The firm's demand is "derived from" the public demand for what the firm makes. "Derived demand" is the demand for "something" by a firm based on how much that "something" contributes to the finished goods sold by the firm to the public.
Every firm has "factors of production" in making its goods (or services). There are four basic "factors of production":
- capital (money)
- labor (workers
- entrepreneurship (the efforts of the owners and managers who bring the business "to life" by using their creativity and contacts with others)
The owner of a firm looks at its factors of production and must determine the derived demand for each factor, which is known as the "derived factor demand."
A successful owner of a firm must make decisions about how much of each factor of production he needs. How much labor? How much capital (money)? How much land? How much entrepreneurship? To make those decisions in the best way possible, he needs to consider the "derived demand" for each factor: how much does each factor contribute to the finished goods sold by the firm? Put another way, what is the public's demand for the output produced by that factor?
Let's take an example. Suppose you own a company (a firm). How many workers should you hire? Well, to answer that question you need to know what the demand is for your firm's goods, and then determine how much a new worker contributes towards making those goods. In other words, the number of workers hired depends on the public demand for the goods that the workers help you produce.
Your demand for workers (labor) is a "derived demand" because it depends on the demand by the public for the goods your workers make. The demand by a firm to buy things is "derived from" the public demand for the goods the firm will produce.
"Strive in Opposition"
Some concepts in economics are surprising, just as some teachings of Christianity can be surprising to some people at first. An example common to both economics and Christianity is how difficulties or "opposition" are what makes a firm or a person stronger. Consider how a tree grows.
A tree starts out as a tiny seed with apparently little chance of survival. It must find nourishment deep in the soil, and it must defy gravity by growing towards the sky for sunlight. Typically no humans help it. The tree has to make it on its own, and deal with tornadoes, hurricanes, and hostile animals. The tree never “owns” anything.
Tree limbs are very heavy, to the point of crushing houses or killing people when they do fall. The tree has to raise and support its heavy limbs against gravity. The flow of a tree’s nutrients is also against gravity. Trees grow in unexpected places, and sometimes around pre-existing obstacles. Out West roads have even been cut through trees, and they still survive and thrive.
Yet the difficulties in surviving are what make a tree strong. Each day it grows in two directions: downward further into the soil towards more nutrients, and upwards into the sky towards more sunlight. Its growth is not easy in either direction. The more it has to reach for nourishment, the bigger and stronger it becomes. Trees that are given their nutrients, as in a laboratory, do not grow as large and powerful as trees that must struggle to survive in the wild.
It is in striving against obstacles that the tree becomes so powerful. Economics predicts that those who suffer from adversity will often become more successful or productive than those who have it easy, just as is true for trees. The adversity is what makes one stronger, more motivated and more efficient. Many of the most successful businessmen in history had very difficult childhoods, and some (like Tom Monahan, founder of Domino's Pizza) even grew up in orphanages. Poverty was the common background of most successful businessmen. In contrast, people who have had it easy rarely invent or succeed with their own businesses.
The Bible contains a similar message: it is through suffering and difficulties that Christianity became so strong. Many books in the Bible emphasize this, from Daniel to Mark. Learn to use adversity like an exercise bicycle or weights in order to make you stronger and more successful economically.
There is a Latin phrase: "nitor in adversum." It means "strive in opposition." It's a good motto.
Review: Price Elasticity of Demand
Price elasticity less than 1 is inelastic, and more than 1 is elastic. Here are specific examples (price elasticity is always negative due to the Law of Demand, but its absolute (positive) value is used for convenience):
- rice in Japan: 0.2 (inelastic because it is a basic food there)
- travel by bus: 0.2 (inelastic because it is a necessity for bus travelers)
- cigarettes: 0.5 (inelastic because of the addiction)
- gambling: 0.8 (inelastic because of the addiction)
- movies: 0.2 for teenagers (inelastic), but 2 for adults (elastic)
- beef: 1.6 (elastic because there are substitutes like chicken)
- soda: about 4 (elastic)
As review, recall that if price elasticity of demand is greater than 1, then the quantity demanded changes by more than the price change. Revenue, which is price times quantity, then decreases when the price increases. When the price elasticity is less than 1, then the quantity demanded changes by less than the price change. Revenue then increases when the price increases. When price elasticity is precisely 1, then the quantity demanded changes by the same percentage as the price change. Revenue then remains constant when the price increases.
Now we can expand on what we learned by asking this obvious question: what affects the price elasticity of demand? Here are the major factors:
- the availability of substitutes, because if there are substitutes then customers will switch to them when price increases, causing a big decrease in demand
- the cost of switching to substitutes without paying a penalty or incurring large transaction costs
- whether the good is a necessity or a luxury
- the percentage of one's income allocated to the good: if it is a large percentage, then it will have higher price elasticity
- the longer the time period, the more price elastic it will be, because in the long run demand can more fully respond to a price change
- whether the good is addictive, because an addictive good is inelastic due to how the buyers are hooked on it even when its price increases
- whether the market is at "peak" or "off-peak" demand; people want airline tickets the day before Thanksgiving, when many people traveling, even if the price increases
- the more narrowly defined a good is (e.g., a specific brand of hamburger rather than all hamburgers), the more price elastic it will be due to the availability of substitutes
Review: Returns to Scale
Next let's review “returns to scale.” Imagine using a scale of one foot in measuring the dimensions of a room. Then change to a scale of inches. All dimensions increase by a factor of 12, because there are 12 inches to a foot. That is what “scale” means: it affects everything. In economics, changing the scale means changing all inputs by the same proportion. Increasing the scale means increasing all inputs. The “returns to scale” are then what happens to the output of a company when all inputs are increased. Is "bigger" more efficient for the business?
The phrase that something is "scalable" means its proportions increase in a similar way in all respects, like "similar triangles" in geometry. Some things are "scalable", while others are not. A software database program that works the same for 100 entries as it does for 1 million entries is "scalable"; a program that needs to be reworked and reprogrammed as the database grows larger is not scalable. One of the fabulous features of "wiki" software used by Conservapedia is that it is scalable: almost no adjustments were needed as the number of its entries increase from 1 to 1000 to over 30,000 now, or even to a million entries in the future.
“Increasing returns to scale” means that when you increase all the inputs, then your company’s output increases by an even greater proportion. For example, if you double your inputs then perhaps your output triples. That would be extremely profitable for your business. Your costs only double, but your revenue triples. Your profits skyrocket. It is a formula for success.
Wal-Mart’s “secret” to its success would is its “increasing returns to scale.” The bigger it gets, the more efficient it becomes, the cheaper it can buy goods for (because it is obtaining volume discounts), and the more output it can produce. It is not simply that Wal-Mart's output increases as it grows bigger, but its output (and revenue) increase by more than its costs do. That greater proportional increase becomes profits.
Meanwhile, there is nothing special about constant returns to scale, which is to be expected. But decreasing returns to scale is a disaster for a business that is growing. So is diminishing returns to labor.
Simple rule: If "bigger is more efficient," as it is for Wal-Mart, then there are "increasing returns to scale."
What are the returns to the scale for the world population? It likely has increasing returns to scale. Twice as many people means more than twice as much output. Humans are creative, and twice as many humans would probably mean more than twice as many inventions like the light bulb and the iPhone, as people build on the work of others.
Review: Law of Diminishing Returns
What is the Law of Diminishing Returns? That is a rule that applies to ONLY ONE input. It is when a company keeps its assembly line and factor size constant, for example, but keeps hiring more and more of one input, such as labor. Eventually each added employee will have less and less to do. The returns on the additional employees decline. But if all inputs were increased at the same time, then the Law of Diminishing Returns does not apply. Then it is a question about returns to scale.
Consider this question:
“The more someone has, the more he wants in order to be satisfied!” What economics principle would best explain that phenomenon?
(a) Law of Demand
(b) Law of Diminishing Returns
(c) Law of Diminishing Marginal Utility
(d) Coase Theorem
Choices (a) and (d) can be eliminated immediately, but selecting between (b) and (c) is more difficult. The key here is that “marginal utility” refers to consumer satisfaction, while “returns” refers to output of a company. The question is geared towards consumer satisfaction, not output by a firm. It refers to what someone wants, not what a company produces. The correct answer is therefore (c).
Know these concepts like the back of your hand, and learn from your mistakes. There will be a final exam when you can prove how much you learned.
After reading and studying the lecture, answer 6 out of 7 questions below:
1. In your own words, try to give a better definition of "externalities" than provided by this Lecture.
2. Explain what "derived demand" is, and provide an example.
3. What is your favorite question on one of the quizzes that you answered incorrectly, and why is it your favorite?
4. Give an example of a positive externality, and an example of a negative externality. The example does not have to be limited to a business.
5. Explain why private firms in the free market are unlikely to try to provide public goods.
6. Review question: the cross-elasticity of A with respect to B is positive, and C with respect to D is negative. What is the relationship (complement or substitute?) of goods A and B with each other, and C and D with each other? Explain.
7. List the four factors of production and give a very brief explanation of each.
Answer 3 out of the following 4 questions:
8. Explain why marginal revenue must be zero when total revenue is maximized.
9. Provide, in your own words, the best definition of "public good" that you can.
10. Identify a concept in economics that you found difficult to understand at first, but then explain how you were able to eventually understand it.
11. What is the price elasticity of demand for this demand curve: P=30/Q. Explain.