Ariely ques+ons for Wednesday Why is free (zero) special and how does it affect ra+onal behavior? (Consider the Halloween chocolate and the credit card examples) Note: be sure to read the appendix to chapter 3 as an example of how the book is a cri+que of the standard model Why do social norms conflict with being paid for some ac+vi+es (Thanksgiving dinner!) and what are the implica+ons for ra+onal behavior?
Market Failure. Is the Competitive Market Efficient? Market failure arises when a market delivers in inefficient outcome. Too little of an item is produced (underproduction) or Too much of an item is produced (overproduction).
Is the Competitive Market Efficient? Price regulations sometimes put a block of the price adjustments and lead to underproduction. Quantity regulations that limit the amount that a farm is permitted to produce also leads to underproduction.
Is the Competitive Market Efficient? An apartment owner would provide an external benefit if she installed an smoke detector. Does she?
Is the Competitive Market Efficient? Public Goods and Common Resources A public good benefits everyone and no one can be excluded from its benefits. It is in everyone s self-interest to avoid paying for a public good. This is the free-rider problem, which leads to production.
Is the Competitive Market Efficient? A common resource is owned by no one but can be used by everyone. It is in everyone s self interest to ignore the costs of their own use of a common resource that fall on others (called tragedy of the commons). The tragedy of the commons leads to overproduction.
EYE on PRICE GOUGING Should Price Gouging be Illegal? Following a hurricane, the demand for camp stoves increases to D 1. With no price gouging law, the price jumps to $ and the quan+ty increases to stoves per day. This outcome is efficient because the marginal cost of a stove equals the marginal benefit from a stove.
EYE on PRICE GOUGING Should Price Gouging be Illegal? If a strict price gouging law requires the price a\er the hurricane to be $20. At this price, the quan+ty of stoves supplied remains at 5 per day. Where is the deadweight loss? The price gouging law is inefficient, but is it fair?
Is the Competitive Market Fair? It s Not Fair if the Result Isn t Fair. Utilitarianism: principle that states that we should strive to achieve the greatest happiness for the greatest number. Fairness necessary for efficiency
Is the Competitive Market Fair? If everyone gets the same marginal utility (MU) from a given amount of income, and if the marginal benefit (MB) of income decreases as income increases, then taking a dollar from a richer person and giving it to a poorer person increases the total benefit..
Is the Competitive Market Fair? What is desirable income distribu+on? Only when income is equally distributed has the greatest happiness been achieved
Is the Competitive Market Fair? Graph shows how redistribution increases efficiency. Tom is poor and has a high marginal benefit of income. Jerry is rich and has a low marginal benefit of income. Taking dollars from Jerry and giving them to Tom until they have equal incomes increases total benefit.
Is the Competitive Market Fair? What s missing? Cost of transfers of income Recognizing these costs leads to the big tradeoff between efficiency and fairness. A modification to utilitarianism: John Rawls proposed that income should be redistributed to point at which the poorest person is as well off as possible.
Is the Competitive Market Fair? It s Not Fair If the Rules Aren t Fair The idea that it s not fair if the rules aren t fair is based on the symmetry principle. Symmetry principle is the requirement that people in similar situations be treated similarly.
Is the Competitive Market Fair? Equality of opportunity, not equality of income. Robert Nozick: two rules for fairness: 1. The state must create and enforce laws that establish and protect private property. 2. Private property may be transferred from one person to another only by voluntary exchange.
Efficiency and fairness Implication of Novick s argument: if resources are allocated efficiently, they may also be allocated fairly.
Is the Competitive Market Underproduction The efficient quan+ty is 10,000 pizzas a day. If produc+on is restricted to 5,000 pizzas a day, there is underproduc+on and the quan+ty is inefficient. A deadweight loss equals the decrease in total surplus the gray triangle. This loss is a social loss. Efficient?
Is the Competitive Market Overproduction Again, the efficient quan+ty is 10,000 pizzas a day. If produc+on is expanded to 15,000 pizzas a day, a deadweight loss arises from overproduc+on. This loss is a social loss. Efficient?
Policy issues at stake Even though house prices have fallen, some rents have risen. Can governments cap rents to help renters? Can governments make housing more affordable by raising incomes with minimum wage laws?
Policy issues at stake The government taxes almost everything we buy. But who actually pays and who benefits when a tax is cut: buyers or sellers? The government limit the quan++es that some farmers may produce and subsidizes other farmers. Do produc+on limits and subsidies help to make markets efficient?
A Housing Market with a Rent Ceiling A price ceiling or price cap makes it illegal to charge a price higher than a specified level. If the rent ceiling is set above the equilibrium rent, it has no effect. The market works as if there were no ceiling. But if the rent ceiling is set below the equilibrium rent, it has powerful effects.
A Housing Market with a Rent What happens to efficiency with a rent ceiling? Ceiling Here the ceiling is $800.
A Housing Market with a Rent A deadweight loss arises. Ceiling New equilibrium is at lower quantity and higher price.
Incen+ve to be bad?
Another problem: Increased search activity The time spent looking for someone with whom to do business is called search activity. Search activity is costly and the opportunity cost of housing = rent (regulated) + the opportunity cost of the search activity (unregulated).
What about fairness of rent ceiling? Fair rules view: unfair because it blocks voluntary exchange. Fair results view: rent ceiling is unfair because it does not generally benefit the very poor.
Why so few benefits? A rent ceiling decreases the quantity of housing and the scarce housing is allocated by Lottery First-come, first-served Discrimination Bribing the super!
Regulation in the labor market A price floor makes it illegal to trade at a price lower than a specified level. A price floor in labor markets is a minimum wage.
Two cases of minimum wage If the minimum wage is below the equilibrium wage rate, it has no effect. The market works as if there were no minimum wage. If the minimum wage is set above the equilibrium wage rate, it has does affect the equilibrium price and quantity of labor.
Effect of a minimum wage If wage is higher than equilibrium Equilibrium quantity of labor hired is than the unregulated equilibrium quantity Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemployment.
A labor market with a minimum wage The equilibrium wage rate is $ an hour. The minimum wage rate is set at $ an hour. The quantity of labor employed is the quantity demanded. What is the unemployment now?
A labor market with a minimum How inefficient is this and why? wage How do we measure the inefficiency? Where is it on the graph?
Not a consensus argument anymore David Card and Alan Krueger Myth and Measurement: The New Economics of the Minimum Wage 1995 Found a minimum wage had no effect. Poli+cal Economy Research Ins+tute here at UMass has more recent evidence of no effect.
What is the minimum wage? Federal in 2012 $7.25 not raised since 2009, when it was raised from $6.55. States must pay Federal minimum for most employees For 40 hours of work, weekly pay of $290 or annual pay of $15,080 States vary: MA $8.00 GA $5.15 VT $8.46
Fairness of the minimum wage Who is hurt? Who is helped?
Taxes: Who pays them? Income tax and the Social Security tax are deducted from your pay, and state sales tax is added to the price of the things you buy, so isn t it obvious that you pay these taxes? Isn t it equally obvious that your employer pays the employer s contribution to the Social Security tax?
Tax incidence Definition: the division of the burden of a tax between buyers and sellers. Three possibilities: If the price rises by the full amount of the tax, buyers pay the tax. If the price rise by a lesser amount than the tax, buyers and sellers share the burden of the tax. If the price doesn t rise at all, sellers pay the tax.
With no tax, the equilibrium price is $3.00 a pack. A tax on sellers of $1.50 a pack is introduced. Supply decreases and the curve S + tax on sellers shows the new supply curve. Tax on sellers
How much more do consumers pay? How much more do sellers get (at the new equilibrium price)? So, who pays what? Tax incidence