INTRODUCTION ACTITVITY
ZOO GAME

http://welkerswikinomics.com/blog/2012/08/08/introduction-to-basic-economic-concepts-the-economics-of-zoo-keeping/


UNIT I. Basic Economic Concepts (8–12%) Textbook chapter 1, 2, 3, 4
A. Scarcity, choice, and opportunity costs
B. Production possibilities curve
C. Comparative advantage, absolute advantage, specialization, and exchange
D. Demand, supplies, and market equilibrium
E. Macroeconomic issues: business cycle, unemployment, inflation, and growth

GREAT WEB SOURCE
http://reffonomics.com/TRB/INPROGRESS/index12.html






1) WEB RESOURCES

1) Introduction to economics http://www.reffonomics.com/TRB/chapter1/whatiseconomics1.swf 2) invisible hand http://www.credoaction.com/comics/2010/06/invisible-hand-of-the-free-market-man/

2) Very comprehensive look at the whole of unit 1 very good summary http://welkerswikinomics.com/downloads/Unit%201%20Introduction%20to%20Economics.pdf 4) SHIFTS AND MOVEMENTS IN SUPPLY AND DEMAND INTERACTIVE GRAPHS http://reffonomics.com/TRB/INPROGRESS/index12.html http://www.reffonomics.com/TRB/chapter4/SDshiftsbuttons.swf 4) INTERACTIVE TERMS- part 1 http://reffonomics.com/TRB/chapter1/Chapter1termsB.swf part 2 -http://reffonomics.com/TRB/chapter1/Chapter1Aterms.swf

2) INTRODUCTION TO ECONOMICS

Individuals have wants that are, for practical purposes, unlimited. But the total resources of society, including natural resources, human resources, capital goods and entrepreneurship, are limited, so that scarcity exists. As a result, it isn't possible for everyone to have everything he or she wants. No society has ever had enough resources to produce the full amount and variety of goods and services its members wanted. In a world of scarcity, producing any one good or service means that other goods and services cannot be produced, and trade-offs are inevitable.

Productive resources are used to produce goods and services. Productive resources are classified into four categories. Land stands for natural resources or gifts of nature such as oil, iron ore, forests and water. Labor refers to human resources. Labor is more than the number of people willing and able to work. Labor also reflects the abilities of people and includes people's health, strength, education, motivation and skills. Capital refers to goods and services such as buildings, equipment, roads, dams and machinery. The level of technology also influences capital. Finally, entrepreneurship is a special kind of labor that represents the characteristics of people who assume the risk of organizing public resources to produce goods and services.


Decision making refers to the process by which rational consumers seeking their own happiness or utility will make choices. The process begins by defining the range of options that are possible. The next steps are to evaluate the costs, benefits and trade-offs involved in each choice and to reach a decision. Since people have different preferences and face different life situations, there is no expectation that all people will make the same ultimate decision. Not even economists believe that people always follow this decision-making process carefully since decision making is costly. But economists do believe that, at least implicitly, people do consider their options and trade-offs and try to make the choice that brings them the greatest satisfaction.

Cost-benefit analysis is a technique for deciding whether an action should be taken by comparing its benefits and costs. It can be applied by individuals, firms or governments. However, difficulties often arise when cost-benefit analysis is used by individuals and government; for example, it can be difficult for a government agency to compare anticipated costs and benefits. If a cost of $100 million means that the view over the Grand Canyon is improved by 20 percent, how can an unbiased analyst decide if the benefit exceeds the cost? Thus, cost-benefit analysis often ends up using somewhat controversial assumptions to put monetary values on lives saved, days of sickness avoided, wildlife habitat protected and so on. Nevertheless, cost-benefit analysis provides a useful way of summarizing a great deal of information and organizing decision making.

Economic decisions are always made on the basis of marginal costs and marginal benefits. For example, the marginal cost of producing a good is the additional cost of producing one more unit of the good. Similarly, the marginal benefit of consuming a good is the additional value of consuming one more unit of it. Marginalism is critically important in understanding decision making because almost all of the decisions we make are marginal, as opposed to all-or-none decisions. For example, we don't make decisions between spending the entire day watching TV or the entire day studying. Instead, we choose between spending a little more time studying and a little less time watching TV, or vice versa. So a decision between studying and watching TV involves comparing the marginal benefit of studying with the marginal benefit of watching TV, not comparing their total benefit. The total benefit of studying could be far greater than the total benefit of watching TV, but after several hours of studying, the marginal benefit of studying could be less than the marginal benefit of watching TV.



Comparative advantage is the principle which holds that every country should produce and trade the good in which it has a comparative advantage. A nation's comparative advantage occurs when it focuses on producing the good in which the opportunity cost of production is lowest. To understand why this is so, remember that the opportunity cost is the cost of one good in terms of the reduced production of other goods that could have been produced. When a nation focuses on producing the good at which its productivity advantage is greatest, or at which its productivity disadvantage is smallest, it, in effect, chooses to produce the good for which the trade-off with other goods in terms of opportunity cost is smallest.
The principle of comparative advantage shows how benefits of trade are available to all parties who participate, both those with a productivity advantage and those with a productivity disadvantage. But it's also important to remember that international trade offers economic benefits for other reasons: it increases competition between firms; it increases the variety available to consumers; it often increases the level of training about matters such as accounting, management and law in low-income countries; and it disseminates new technologies and production methods.

To understand the intuition behind comparative advantage, consider a group of volunteers who gather to build a home. One of the volunteers is an expert builder who is better at all tasks than anyone else in the group. However, if that person has to build the house alone, it will take him or her a long time. Comparative advantage says that the skilled builder should focus on the tasks at which that person's advantage is greatest, that is, at which the person's efforts would be hardest to replace. Others should each take on the tasks at which their disadvantage is smallest. In this way, all parties can benefit from the division of labor. Similarly, a high-productivity economy like the United States can benefit from trading with a low-productivity economy like Mexico or certain nations in Africa, because it will be better for all parties if the United States focuses on those products at which its productivity advantage is greatest, and trades with the other countries as they produce those goods in which their productivity disadvantage is least. The gains from trade will be largest when the parties focus on producing in their area of comparative advantage.




DEMAND

Demand refers to a relationship between price and the quantity of a good or service that consumers demand. A higher price for a good leads to a smaller quantity demanded. Demand is typically illustrated as a downward-sloping curve on a graph with quantity on the horizontal axis and price on the vertical axis.
A change in demand means that at every possible price, a different quantity will be demanded. For example, a rise in income levels will increase the demand for normal goods, so that a greater quantity is demanded at every given price. A higher price for substitute goods will cause demand for the original good to increase, while a lower price for substitute goods will cause demand for the original good to decrease. Demand for a good will increase if the good becomes more popular, but demand will decrease if the good becomes less popular.

A change in demand is different from a change in quantity demanded. The quantity demanded is a specific amount at a particular price. A change in quantity demanded is caused by a change in the price of that good or service and is illustrated on a graph as a movement along the demand curve. However, demand is a relationship that shows the quantity demanded at each price. A change in the demand for a good or service is caused by something other than the price of that good or service. On a graph an increase in demand is illustrated by a shift to the right and a decrease in demand is illustrated by a shift to the left.



Supply refers to a relationship between price and the quantity of a good or service that firms are willing to produce. A higher price for a good leads to a greater quantity supplied. Supply is typically illustrated as an upward-sloping curve on a graph with quantity on the horizontal axis and price on the vertical axis.
A change in supply means that at every possible price, a different quantity will be supplied. For example, a change in natural conditions can affect the supply of farm products. A drought can cause the supply of farm products to decrease, while especially good weather can cause it to increase. A fall in the price of key inputs causes supply to increase; a rise in the price of key inputs causes it to decrease. An improved production technology that reduces the cost of production will cause the supply curve to increase.

A change in supply is different from a change in quantity supplied. The quantity supplied is a specific amount at a particular price. A change in quantity supplied is caused by a change in the price of that good or service and is illustrated on a graph as a movement along the supply curve. However, supply is a relationship that shows the quantity supplied at each price. A change in the supply of a good or service is caused by something other than the price of that good or service. On a graph an increase in supply is illustrated by a shift to the right and a decrease in supply is illustrated by a shift to the left.






3)CHAPTER 4 The Market Strikes Back

1)Price controls
-Price ceiling
--Price floor
2)Quantity controls
-Quota
-Excise tax
-Inefficiency
3)Price ceilings often lead to inefficiency in the forms of:
-Inefficient allocation to consumers
-Wasted resources
-Inefficiently low quality
-They also produce black markets.
4) Price floors often lead to inefficiency in the forms of:
-Inefficient allocation of sales among sellers
-Wasted resources
-Inefficiently high quality
-They can also can provide an incentive for illegal activity (Ex.: black labor).
5)Excise Tax: Key Terms
-Tax incidence
-Excess burden
-Deadweight loss
-Tax revenue










4) MY CLASS NOTES
A price ceiling is a legally established maximum price. Governments enact price ceilings when they fear that the price might be higher than they desire it to be. Examples of a price ceiling are rent-control laws that limit the rent that can be charged (or limit the increase in rents from year to year). When a price ceiling is lower than the market price that would otherwise prevail, the result is that quantity demanded in the market (which is encouraged by the lower price) exceeds quantity supplied (which is discouraged by the lower price). Economists call this outcome a shortage.

One unintended consequence of a price ceiling is that although the price ceiling is meant to make the good more affordable and benefit consumers, it instead creates a situation in which some of those who demand the good won't be able to buy it at all. A second implication is that price ceilings open up incentives for an illegal market, which refers to sales which happen at an illegal price.

A price floor is a legally established minimum price. Governments enact price floors when they fear that the price might be lower than they desire it to be. Examples of price floors include farm products and the minimum wage. When a price floor is higher than the market price that would otherwise prevail, the result is that quantity supplied in the market (which is encouraged by the higher price) exceeds quantity demanded (which is discouraged by the higher price). Economists call this outcome a surplus.


One unintended consequence of a price floor is that although the price floor is meant to benefit providers of the good or service, it creates a situation in which some of those providers won't be able to sell their goods or services. This is because at the price floor, an insufficient quantity is demanded. With farm price supports, the government has often stepped in to purchase the surplus products. With minimum wage laws, a basic concern is that although the minimum wage will help those who continue to keep their job, it will injure those who lose a job (or are not hired or are hired for fewer hours) as a result of the minimum wage.

The concept of allocation function of markets explains that the U.S. economy relies mainly on the market system to determine what goods and services are produced, in what quantities and at what prices. Some markets fail to allocate resources efficiently because all of the benefits and costs of choices are not fully captured by the market. This situation is called market failure. One reason for market failure involves externalities or spillover effects. An externality is a cost or benefit imposed on people other than producers and consumers of a good or service and which is not fully reflected in market prices. Externalities occur only where property rights are poorly defined or poorly enforceable











5) Economic Concepts
Efficiency The situation where society is producing the greatest amount of value given the available resources.
Externality A cost or benefit imposed on people other than the producers or consumers of a good or service and which is not fully reflected in market prices. Externalities occur where property rights are poorly defined or poorly enforceable.
Free Rider A person who receives the benefit of a good but does not pay for it.
Market Failure A situation in which a market left on its own fails to allocate resources efficiently. An externality is a type of market failure.
Subsidy A government transfer of resources, monetary or otherwise, to selected individuals. Subsidies can sometimes remedy the ill effects of externalities. Subsidies can also be used to redistribute wealth for noneconomic reasons.
Wealth Redistribution A government's transfer of wealth from one group to another. The desire to redistribute wealth derives from noneconomic motives, such as a desire to eliminate poverty.
It is assumed that individuals, for the most part, make choices based on the costs and the benefits they perceive and on the limitation imposed by their individual budget constraint.Some markets fail to allocate resources efficiently because all of the benefits and costs of choices are not fully captured by the market. This situation is called market failure. One reason for market failure involves externalities or spillover effects. An externality is a cost or benefit imposed on people other than producers and consumers of a good or service and which is not fully reflected in market prices. Externalities occur only where property rights are poorly defined or poorly enforceable.
An example of a negative externality would be a driver who adds to traffic congestion by choosing to drive during the rush hour. The driver considers only his or her benefits and costs of driving at that time and not the negative externalities of driving at that time. The negative externality is the longer driving time of all other commuters caused by the added congestion — a cost imposed on someone other than the one making the choice. In a world without externalities, the other drivers could pay the new driver to stay off the road, thus reducing congestion. But in the real world, there is no such market where the cost of an additional driver is reflected in prices.
An example of a positive externality would be when a person chooses to get a flu shot. The person gets the flu shot to avoid getting the flu, but others benefit when this person gets the flu shot because the flu is now less likely to be spread to them. The benefit to those not getting the flu shot is considered a positive externality — a benefit gained by someone other than the person making the choice.
The government often attempts to correct for externalities by developing mechanisms for including the external costs and benefits in the consumer or producer's decision.

ELASTICITY


Regarding different elasticieties along a straight line demand curve, here's my best explanation.

At high prices and low quantities, demand is relatively elastic, BECAUSE:

  • The good is expensive, therefore makes up a larger proportion of consumer's income. Additionally, at high prices fewer consumers have the good meaning it is more of a luxury item. Luxuries and goods whose price makes up a larger proportion of income tend to have elastic demand. A slight percentage decrease in price tends to attract a relatively larger percentage increase in new consumers as it becomes affordable to people who really want it (imagine the second release of the iPhone when the price fell by around 30% but the quantity of phones sold increase by, I don't know, hundreds of percent!)
At lower prices and higher quantities, demand is relatively inelastic.

  • As the price of the good falls, it becomes less of a luxury and the price makes up a smaller proportion of consumers' income. More consumers have it meaning it is harder for the producer to continue to attract more new consumers. The market is becoming saturated with the product. At exremely low prices (close to zero), the demand becomes nearly perfectly inelastic, since everyone who wants the product will already have it, it is impossible to attract new consumers even as the price falls. (Imagine the third and fourth releases of the iPhone, when the price continued to fall, but the sales of new phones did not jump nearly as much with the 2nd generation phone came out, simply because more people already had iPhones and they were now so cheap ($100 for a 3Gs vs. $400 for the first iPhone)
That's the intuitive explanation. Mathematically, you should conduct the total revenue test, and illustrate the effect of lowering price on a firm's total revenue by drawing a parabolic TR curve below the demand curve (see attached image). At high prices, a decrease in price attracts relatively more new consumers, thus the firm's total revenue increases, meaning demand is elastic. As lowering the price attracts relatively fewer new consumers, lower prices result in less revenue to the firm, so the TR begins to fall. When a change in price results in an identical percentage change in the quantity demanded, then the firm's revenue will stay the same.

I hope these explanations, both intuitive and mathematical, help!
Recall that elasticity is responsiveness. When we speak of simply "elasticity" we probably mean price elasticity of demand (to be technical). Relevant because we're asking how much (percentage wise) Qd will change given a certain (%) change in Price.

Consider each change being a one dollar decrease in price and a one unit increase in demand (very simple demand curve, slope of -1).

At high prices and low Qs a one unit increase in Q is a big percentage change. 100% when going from 1 to 2 for example. This means the numerator is big. The denominator is small because a 1$ reduction in price from 10 to 9 is only about a 10% decrease (little more if midpoint, but that isn't really necessary here). Big top and small bottom, well, we know that is a big fraction, greater than 1 and elastic.

Other end of spectrum, opposite is true, each same increment of change in Q is a smaller % change because the values are larger. Smaller numerator. Each dollar decrease in price is a bigger % change because the price is lower. So the fraction is smaller than 1, hence inelastic.

The other way students might get there is through analysis of marginal revenue. They should know both, but this one is more likely called for at AP test time, I think (since they deemphasize calculation problems). MR descends at twice the slope of D (proven by one of my mathy students a year or two ago spontaneously in class and I can't reconstruct, but someone in your math dept should be able to if you need it, based on MR being derivative of TR, etc...) and this means that when an additional unit is produced TR is changing positively (definition of elastic) for a while (always while MR positive and in top half of demand curve) and then maxes out and changes negatively in bottom half. It is descending most quickly when the D curve is most inelastic at the very bottom when it comes close to a price of zero.
I use an example of cars. Take away the mid-point calculations for a moment and use a 10% price difference on two cars. Ask the question, are people really going to care very much whether a used car costs $5000 or $5500? The students will usually answer probably not. Now ask, what about a new Mercedes? Are people going to care if the new Mercedes is $55,000 instead of $50,000? The students will say yes. Both examples were of a 10% increase off of the base price but there was more sensitivity to this change at a higher price.
Eat Up Idiots. A downward sloping demand curve starts out Elastic, then passes through Unitary elasticity and will eventually become inelastic. from left to right, from top to bottom, as most of us read, it is E U I. Eat Up Idiots.More important to teach mid-point formula or some other formula. but Eat Up idiots sure has worked

Elasticity is looking at relative price changes, not the slope of the curve. For example, let' say we had the follwoing demand schedule:
P Q
$10 1
9 2
8 3
7 4...so on

When the price drops from $10 to 9 (10% reduction in price), the quantity goes up by 100%. If we continue the trend, when the price drops from $2 to 1 (50% reduction), the Q changes from 9 to 10 (11% increase). At high prices, the changes are relatively small compared to the q changes.
























6) EXTERNALITY CHAPTER 4 NOTES
In economics, an externality is an impact on any party not directly involved in an economic decision. An externality occurs when an economic activity causes external costs or external benefits to third party stakeholders who cannot directly affect an economic transaction. In other words, the producers and consumers in a market either do not bear all of the costs or do not reap all of the benefits of the economic activity. For example, manufacturing that causes air pollution imposes costs on others, while planting forests (rather than other agricultural activities) would improve the water quality of those downstream.
In a competitive market, the existence of externalities would mean that either too much or too little of the good would be produced and consumed in terms of overall cost and benefit to society. If there exist external costs (negative externalities) such as pollution, the good will be overproduced by a competitive market, as the producer does not take into account the external costs when producing the good. If there are external benefits (positive externalities) such as in areas of education or public safety, too little of the good would be produced by private markets as producers and buyers do not take into account the external benefits to others. Here, overall cost and benefit to society is defined as the sum of the economic benefits and costs for all parties involved.

external image clip_image002.png

Standard economic theory implies that any voluntary exchange is mutually beneficial to both parties involved in the trade. This is because if either the buyer and the seller would not benefit from the trade, they would refuse it. An exchange however, can result in additional effects on third parties. From the perspective of those affected, these effects may be negative (pollution from a factory), or positive (honey bees that pollinate the garden). Welfare economics has shown that the existence of externalities result in outcomes that are not socially optimal. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost.
A voluntary exchange may actually reduce societal welfare if external costs exist. The person who is affected by the negative externality in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass on their lungs, violating their property rights. Thus, an external cost may pose an ethical or political problem. Alternatively, it might be seen as a case of poorly-defined property rights, as with, for example, pollution of bodies of water that may belong to no-one (either figuratively, in the case of publicly-owned, or literally, in some countries and/or legal traditions).
An external benefit, on the other hand, would increase the utility of third parties at no cost to them. Since collective societal welfare is improved, but the providers have no way of monetizing the benefit, less of the good will be produced than would be optimal for society as a whole. Goods with positive externalities include education (believed to increase societal productivity and well-being; but controversial, as these benefits may be internalized), health care (which may reduce the health risks and costs for third parties for such things as transmittable diseases) and law enforcement. Positive externalities are frequently associated with the free rider problem. For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at high levels of vaccination, society may receive large health and welfare benefits; but any one individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others.
There are a number of potential means of improving overall social utility when externalities are involved. The market-driven approach to correcting externalities is to "internalize" third party costs and benefits, for example, by requiring a polluter to repair any damage caused. In many cases, however, internalizing costs or benefits is not feasible, especially if the true monetary values cannot be determined.
The monetary value of externalities are difficult to quantify, as they may reflect the ethical views and preferences of the entire population. It may not be clear whose preferences are most important, interests may conflict, the value of externalities may be difficult to determine, and all parties involved may attempt to influence the policy responses to their own benefit. An example is the externalities of smoking, which can cost or benefit society depending on the situation. Because it may not be feasible to monetize the costs and benefits, another method is needed to either impose solutions or aggregate the choices of society, when externalities are significant. This may be through some form of representative democracy or other means. Political economy is, in broad terms, the study of the means and results of aggregating those choices and benefits that are not limited to purely private transactions.
Laissez-faire economists such as Friedrich Hayek and Milton Friedman sometimes refer to externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily minor or localized.
Many negative externalities (also called "external costs" or "external diseconomies") are related to the environmental consequences of production and use. The article on environmental economics also addresses externalities and how they may be addressed in the context of environmental issues.
Anthropogenic climate change is attributed to greenhouse gas emissions from burning oil, gas, and coal. Global warming has been ranked as the #1 externality of all economic activity, in the magnitude of potential harms and yet remains unmitigated.
Water pollution by industries that adds poisons to the water, which harm plants, animals, and humans.
Industrial farm animal production, on the rise in the 20th century, resulted in farms that were easier to run, with fewer and often less-highly-skilled employees, and a greater output of uniform animal products. However, the externalities with these farms include "contributing to the increase in the pool of antibiotic-resistant bacteria because of the overuse of antibiotics; air quality problems; the contamination of rivers, streams, and coastal waters with concentrated animal waste; animal welfare problems, mainly as a result of the extremely close quarters in which the animals are housed." [1][2]
The harvesting by one fishing company in the ocean depletes the stock of available fish for the other companies and overfishing may result. This is an example of a common property resource, sometimes referred to as the Tragedy of the commons.
When car owners use roads, they impose congestion costs on all other users.
A business may purposely underfund one part of their business, such as their pension funds, in order to push the costs onto someone else, creating an externality. Here, the "cost" is that of providing minimum social welfare or retirement income; economists more frequently attribute this problem to the category of moral hazards.
Consumption by one consumer causes prices to rise and therefore makes other consumers worse off, perhaps by reducing their consumption. These effects are sometimes called "pecuniary externalities". Many economists do not accept the concept of pecuniary externalities, attributing such problems to anti-competitive behavior, monopoly power, or other definitions of market failures.
The consumption of alcohol by bar-goers in some cases leads to drinking and driving accidents which injure or kill pedestrians and other drivers.
Commonized costs of declining health and vitality caused by smoking and/or alcohol abuse. Here, the "cost" is that of providing minimum social welfare. Economists more frequently attribute this problem to the category of moral hazards, the prospect that a party insulated from risk may behave differently from the way they would if they were fully exposed to the risk. For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.
The cost of the storing nuclear waste from nuclear plants for more than 1 000 years (over 100 000 for some types of nuclear waste) is not included in the cost of the electricity the plant produces. The third party here is the next several hundred generations.
In these situations the marginal social benefit of consumption is less than the marginal private benefit of consumption. (i.e. SMB < PMB) This leads to the good or service being over-consumed relative to the social optimum. Without intervention the good or service will be under-priced and the negative externalities will not be taken into account.
Examples of positive externalities (beneficial externality, external benefit, external economy, or Merit goods) include:
A beekeeper keeps the bees for their honey. A side effect or externality associated with his activity is the pollination of surrounding crops by the bees. The value generated by the pollination may be more important than the value of the harvested honey.An individual planting an attractive garden in front of his house may provide benefits to others living in the area, and even financial benefits in the form of increased property values for all property owners.
An individual buying a product that is interconnected in a network (e.g., a video cellphone) will increase the usefulness of such phones to other people who have a video cellphone. When each new user of a product increases the value of the same product owned by others, the phenomenon is called a network externality or a network effect. Network externalities often have "tipping points" where, suddenly, the product reaches general acceptance and near-universal usage, a phenomenon which can be seen in the near universal take-up of cellphones in some Scandinavian countries.
Knowledge spillover of inventions and information - once an invention (or most other forms of practical information) is discovered or made more easily accessible, others benefit by exploiting the invention or information. Copyright and intellectual property law are mechanisms to allow the inventor or creator to benefit from a temporary, state-protected monopoly in return for "sharing" the information through publication or other means.
Sometimes the better part of a benefit from a good comes from having the option to buy something rather than actually having to buy it. A private fire department that only charged people that had a fire, would arguably provide a positive externality at the expense of an unlucky few. Some form of insurance could be a solution in such cases, as long as people can accurately evaluate the benefit they have from the option.
As noted, externalities (or proposed solutions to externalities) may also imply political conflicts, rancorous lawsuits, and the like. This may make the problem of externalities too complex for the concept of Pareto optimality to handle. Similarly, if too many positive externalities fall outside the participants in a transaction, there will be too little incentive on parties to participate in activities that lead to the positive externalities.
Positional externalities refer to a special type of externality that depends on the relative rankings of actors in a situation. Because every actor is attempting to "one up" other actors, the consequences are unintended and economically inefficient.
One example is the phenomenon of "overeducation" (referring to post-secondary education) in the North American labour market. In the 1960s, many young middle-class North Americans prepared for their careers by completing a bachelor's degree. However, by the 1990s, many people from the same social milieu were completing master's degrees, hoping to "one up" the other competitors in the job market by signalling their higher quality as potential employees. By the 2000s, some jobs which had previously only demanded bachelor's degrees, such as policy analysis posts, were requiring master's degrees. Some economists argue that this increase in educational requirements was above that which was efficient, and that it was a misuse of the societal and personal resources that go into the completion of these master's degrees.
Another example is the buying of jewelry as a gift for another person. In order for Person A to show that he values his spouse more than Person B values his spouse, Person A must buy his spouse more expensive jewelry than Person B buys. As in the first example, the cycle continues to get worse, because every actor positions himself/herself in relation to the other actors.
One solution to such externalities is regulations imposed by an outside authority. For the first example, the government might pass a law against firms requiring master's degrees unless the job actually required these advanced skills.


Supply and demand diagram
The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the externality can be monetized and valued in terms of money. An extra supply or demand curve is added, as in the diagrams below. One of the curves is the private cost that consumers pay as individuals for additional quantities of the good, which in competitive markets, is the marginal private cost. The other curve is the true cost that society as a whole pays for production and consumption of increased production the good, or the marginal social cost.
Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as effective demand in the market.
Negative externalities The graph below shows the effects of a negative externality. For example, the steel industry is assumed to be selling in a competitive market – before pollution-control laws were imposed and enforced (e.g. under laissez-faire). The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the cost of air pollution and water pollution. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit.
external image clip_image004.png
If the consumers only take into account their own private cost, they will end up at price Pp and quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, that is that production should be increased only as long as the marginal social benefit exceeds the marginal social cost. The result is that a free market is inefficient since at the quantity Qp, the social benefit is less than the social cost, so society as a whole would be better off if the goods between Qp and Qs had not been produced. The problem is that people are buying and consuming too much steel.
This discussion implies that pollution is more than merely an ethical problem; it is more than just "greedy" and profit-maximizing firms. The problem is one of the disjuncture between marginal and social costs that is not solved by the free market. There is a problem of societal communication and coordination to balance benefits and costs. This discussion also implies that pollution is not something solved by competitive markets. In fact, a monopoly might be able to use some of its excess profits to be benevolent and internalize the externality (pay the cost of the pollution). More likely, a monopoly would artificially restrict the quantity supplied in order to maximize profits. This would actually benefit society in this situation because it would mean less pollution than in the competitive case. Perfectly competitive firms have no choice but to produce according to market incentives or private costs: if one decides to internalize external costs, it implies that this producer would incur higher costs than those of its competitors and likely be forced to exit from the market. So some collective solution is needed, such as, government intervention banning or discouraging pollution, by means of economic incentives such as taxes, or an alternative economy such as participatory economics.


Beneficial externalitiesThe graph below shows the effects of a positive or beneficial externality. For example, the industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit of getting the vaccination is less than the marginal social or public benefit by the amount of the external benefit (for example, society as a whole is increasingly protected from smallpox by each vaccination, including those who refuse to participate). This marginal external benefit of getting a smallpox shot is represented by the vertical distance between the two demand curves. Assume there are no external costs, so that social cost equals individual cost. external image clip_image006.png

Supply & Demand with external benefits If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity Qs. These latter again reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered market is inefficient since at the quantity Qp, the social benefit is greater than the societal cost, so society as a whole would be better off if more goods had been produced. The problem is that people are buying too few vaccinations.
The issue of external benefits is related to that of public goods, which are goods where it is difficult if not impossible to exclude people from benefits. The production of a public good has beneficial externalities for all, or almost all, of the public. As with external costs, there is a problem here of societal communication and coordination to balance benefits and costs. This also implies that vaccination is not something solved by competitive markets. The government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If the government does this, the good is called a merit good.
Possible Solutions
There are at least four general types of solutions to the problem of externalities
1)Criminalization: As with prostitution, addictive drugs, commercial fraud, and many types of environmental and public health laws.
2)Civil Tort law: For example, class action by smokers, various product liability suits.
3)Government provision: As with lighthouses, education, and national defense.
4)Pigovian taxes or subsidies intended to redress economic injustices or imbalances.
Economists prefer Pigouvian taxes and subsidies as being the least intrusive and potentially the most efficient method to resolve externalities.
Government intervention may not always be needed. Traditional ways of life may have evolved as ways to deal with external costs and benefits. Alternatively, democratically-run communities can agree to deal with these costs and benefits in an amicable way. Externalities can sometimes be resolved by agreement between the parties involved. This resolution may even come about because of the threat of government action.
The first, and most common type of agreement, is tacit agreement through the political process. Governments are elected to represent citizens and to strike political compromises between various interests. Normally governments pass laws and regulations to address pollution and other types of environmental harm. These laws and regulations can take the form of "command and control" regulation (such as setting standards, targets, or process requirements), or environmental pricing reform (such as ecotaxes or other pigovian taxes, tradable pollution permits or the creation of markets for ecological services. The second type of resolution is a purely private agreement between the parties involved.
Ronald Coase argued that if all parties involved can easily organize payments so as to pay each other for their actions, an efficient outcome can be reached without government intervention. Some take this argument further, and make the political claim that government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the Coase Theorem, requires that
1)Property rights are well defined
2)People act rationally
3)Transaction costs are minimal
If all of these conditions apply, the private parties can bargain to solve the problem of externalities.
This theorem would not apply to the steel industry case discussed above. For example, with a steel factory that trespasses on the lungs of a large number of individuals with pollution, it is difficult if not impossible for any one person to negotiate with the producer, and there are large transaction costs. Hence the most common approach may be to regulate the firm (by imposing limits on the amount of pollution considered "acceptable") while paying for the regulation and enforcement with taxes. The case of the vaccinations would also not satisfy the requirements of the Coase Theorem. Since the potential external beneficiaries of vaccination are the people themselves, the people would have to self-organize to pay each other to be vaccinated. But such an organization that involves the entire populace would be indistinguishable from government action.



HOMEWORK
1) CH 1 & 2 TERMS- BOLD IN TEXTBOOK
2) CH 3