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Lecture 1 - Opportunity Cost

 Positive question – has correct answer

 Normative question – no right or wrong answer (what should be done)
 Economics – the study of scarcity and choice using theory and statistics / the study of how
society manages scarce resources
 Scarcity - the limited nature of society’s resources
o if a resource is scarce/limited – its use involves an opportunity cost
 Key Questions
o who makes which choices?
o how much information do they have?
o what factors affect decision making?
 Economics is math based – allows for visualization and specific assumptions
 Rationality and Choice
o economist generally assume people are rational, where Rationality = behaviour that can
be modelled
o i.e people have reasons for doing something, therefore economists can figure out said
reasons
 Opportunity Costs
o choices amongst limited resources imply forgone alternatives
o the cost of the next best alternative (ex. sleep, wages, experience, etc.)
 Cost – Benefit Analysis
o what is the expected benefit?
o what is the expected cost?
 Value of Time – key issue for opportunity cost (what should I do vs. what do I want to do)
 Marginal Decisions – smaller quantity-based decisions (ex. how many uni classes do you take?)
 Concept of “Sunk Costs”
o non-refundable costs – cannot get back after making a decision
o past costs (sunk costs) no longer effect a new opportunity cost
o includes time, deposits, etc.
o effects rational decision making -> stocks (people tend to hold onto non-profiting stocks
longer than they should simply because the value has not yet exceeded the sunk cost –
what they bought it for)
 Productions Possibilities Frontier (Curve)
o graph showing combinations of 2 product outputs
o highlights trade offs, opportunity cost, efficiency, growth
o can be curved or straight
o feasible points – inside the line (feasible but not completely efficient)
o efficient points – on line
o moving from point A to point B involves both a benefit and opportunity cost
o more efficient does not mean better

Lecture 2 - Economic Models

 Measuring Rich and Poor

o in developing countries – better measurement of lower incomes
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o in developed countries – better measurement of higher incomes

o measure through taxes, taxes effect government policies
 Modeling Economic Activities
o models simplify a core element of a problem
o use “unrealistic” assumptions – cannot function with all worldly intricacies (i.e. markets
assumed to be perfectly competitive, PPF only use two goods)
 PPF
o given data for a PPF – if only endpoints are given = straight line
o a line is straight (linear) if the opportunity cost is constant
 i.e. slopes are constant at any point
o a curved line means the opportunity cost is changing as you produce more of one good
 i.e. increasing/decreasing slopes at any point
 can be due to specialization of labour – may require more hours of labour
 (population is good at making both products)
 resources are not perfectly transferable (ex. country has a lot of wood – better
at making houses than cars)
o PPF can bend inward towards the origin
 means all labour is better at producing only one product – branching out is
inefficient
o opportunity cost of X (axis/variable) is the (negative) slope
o opportunity cost of Y (axis/variable) is the reciprocal of the slope
o consider in terms of hours of labour – how much of one’s day does it take to make X,
times Y by that fraction of the day
 Marginal Cost – cost of making either the last good OR another unit of the good
 Marginal Profit – what is the profit gain of producing another singular good?
 Shifting PPF
o caused by an increase in population, specialization, economic boom, new resources,
technologic innovation, etc.
o if the pop. becomes better at making the X good – point on the axis shifts to the right,
but point on the y-axis stays
 therefore, the opportunity cost of making more X goods decreases while
opportunity cost of making Y goods increases (reciprocals)
o intercepts can move towards the origin (left) due to war/natural disaster/etc.

Lecture 3 - Demand and Supply

 Housing market – most common example for supply and demand

o Demand – incomes, population, preferences, prices of other products (interest rates)
o Supply – input prices, technology, number of suppliers
o housing as a competitive market
 supply and demand model only works in a competitive market
 (Canadian data is most often Toronto data)
 What is a Market?
o group of buyers and sellers of a g/s
o can be organized or disorganized
o size of market depends of the nature of the good
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o Canadian Competition Bureau – ensures a innovative and competitive Canadian

marketplace
o very few “perfectly competitive” markets actually exist
 What is Competition?
o competitive markets require many buyers with free choice
 homogeneous products – no brand difference
 numerous buyers and sellers
o only one seller – monopoly
o few sellers – oligopoly
o perfect competition is more of an idealistic model (useful starting point)
 Demand Terminology:
o Quantity Demanded
 amount of a good buyers are willing and able to purchase at a given price
o Law of Demand
 as price rises, quantity demanded falls
o Demand Schedule
 table showing the relationship between price and quantity demanded
o Demand Curve
 graph of demand schedule
o Market Demand vs Individual Demand
 market demand adds up individual demand
 summing individual demand curves horizontally
 Shifting Quantity Demanded
o key difference between changes in demand (shifting of curve) vs. shifting quantity
demanded (moving to another point)
o quantity demanded changes when the price of a good changes – all other changes will
result in a shift in the demand curve
o (shifting to the left = decrease, shifting to the right = increase) [RI-LD]
 Demand Curve Shifters (shifts curve)
o Income
 rising income increases demand of normal goods
 rising income decreases demand of inferior goods
o Prices of related goods
 increase price of X increases demand for Y - substitutes
 increase price of X decreases demand for Y – complements
o Tastes
 difficult to predict (can be measured)
 think trends, marketing, etc.
o Expectation
 important but extremely important
 future prices of a durable good
 ex. if you expect the price to drop in 6 months, you will wait to buy the good
until the price drop
o Number of Buyers
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 affects market demand

 if more people are buying, more demand (ex. population increase)
 Supply Terminology
o Quantity Supplied
 amount of a good that sellers are willing and able to sell
o Law of Supply
 as price rises, supply of a good rises (sellers are willing to provide more at higher
price points)
o Supply Schedule
 table showing the relationship between price and quantity supplied
o Supply Graph
 graph of supply schedule
o Market Supply vs Individual Supply
 market supply adds individual supply
 sum individual supply curves horizontally
 Shifting Quantity Supplied
o key difference between changes in supply (shifting of curve) vs. shifting quantity
supplied (moving to another point)
o quantity supplied changes when the price of a good changes – all other changes will
result in a shift in the supply curve
o (shifting to the left = decrease, shifting to the right = increase) [RI-LD]
 Supply Curve Shifters (shifts curve)
o Input prices
 wages, supplies, capital cost
o Technology
 ability to produce with fewer inputs
o Expectations (of sellers)
 future prices of a durable good (if prices will raise, sellers will look to sell in the
higher price point future)
o Number of Sellers
 more sellers within the market will increase supply
 Intersection of Supply and Demand
o Equilibrium
 intersection of supply and demand
o Equilibrium Price
 price that balances supply and demand
o Equilibrium Quantity
 quantity supplied and demanded at the equilibrium price
o Excess Supply
 when quantity supplied is greater than quantity demanded
o Excess Demand
 when quantity demanded is greater than quantity supplied
 Analyzing Changes in Equilibrium
o which curves shift? (supply, demand, both?)
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o which direction?
o draw the graphs, note shift in Price and Quantity
 How Do We Ensure Competitive Markets?
o cases against bid-rigging (happens to gov) /price-fixing (happens to consumer)
o investigation of pricing by credit card companies
o cases of false advertising (people need to know that alternatives exist)
o merger companies – reduces evolution of monopolies, will require selling capital to
lessen hold on market

Lecture 4 - Elasticity

 substitutes and compliments in production

o either produce less of one or increase supply of both
 elasticity is of greater importance than supply & demand
 When does Elasticity Matter?
o Business strategy – optimal strategies for companies
o Tax Policy – what happens if we raise taxes on the richest 1%
o Environmental Policy – carbon tax
o International Issues – why are food prices highly volatile?
 What is Elasticity?
o proportionally, how much does one factor change as we vary another
o price elasticity of demand:
 formula – Ed = percentage change in quantity demanded
percentage change in price
o price elasticity of supply:
 formula – Es = percentage change in quantity supplied
percentage change in price
 Graphing:
o Inelastic Demand: E < 1 (i.e. 0.4)
 steep demand curve (price rapidly increases as quantity demanded minimally
decreases)
o Elastic demand: E > 1 (i.e. 4)
 less steep demand curve (quantity demanded rapidly decreases as price
minimally increases)
o Inelastic Supply: E < 1 (i.e. 0.4)
 steep supply curve (price rapidly increases as quantity supplied minimally
increases)
o Elastic Supply: E > 1 (i.e. 4)
 less steep demand curve (quantity supplied rapidly increases as price gradually
increases)
 Price Elasticity of Demand
o basic question: are there any close alternatives?
o Necessities vs Luxuries?
 inelastic demand for pharmaceuticals
 elastic demand for leisure travel
o Definition of the market
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 rice is a substitute for wheat

 market of food (no substitutes) or market of wheat
 elastic of demand for food will be lower than for wheat
o Time Horizon
 alternatives take time to exploit
 demand for gas is inelastic in the short term, elastic in the long term
 (products become more elastic overtime as alternatives emerge)
 Price Elasticity of Supply
o basic question: how quickly can supply adjust?
o Access to the inputs to production
 supply of beachfront property is inelastic
 access to storage – supply that can be stored during a recession can be saved
until prices are higher
o Time Horizon
 supply of many good can’t respond within the short term
 short term supply of food, apartments, doctors, etc. is inelastic
 long-term supply becomes more elastic as production ramps up
 Elasticity of Food
o elasticity of demand for the food market is always inelastic (short and long term)
o elasticity of supply for the food market is short-term inelastic
o international market for food is incredibly volatile – supply shocks increase the price
while minimally decreasing quantity
o even when supply is more elastic, supply shocks still rapidly increase price
o famine – price mechanism allocating food, not the actual supply of food (those who can
afford it buys it, those who can won’t)
 Calculations:
o E = percentage change in quantity demanded/supplied
percentage change in price
o to calculate the elasticity between two points on a demand curve: (Q1,P1) and (Q2,P2)
o Percentage change in quantity: A
 (Q2 - Q1)__
[(Q2 + Q1) / 2]
o Percentage change in price: B
 (P2 - P1)__
[(P2 + P1) / 2]
o Price elasticity of demand:
 A/B
o positive/negative signs don’t matter
o uses average elasticity values (why you divide by 2)
 Unit Elastic – E = 1
o true of any linear demand curve
 Elasticity and Revenue
o how should firms set prices? (not in a competitive market – firms can’t affect market
prices)
o Revenue = (price)(quantity)
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o if company is in the inelastic portion of the demand cure, as prices rise, revenue
increases
o if company is in the elastic portion of the demand curve, as prices rise, revenue
decreases
o basically: as long as firms set prices, would never set prices in the inelastic demand
portion
o firms set prices just before elastic area – highest price at the point almost everyone will
buy it
 Effects on Revenue:
o Inelastic - increasing price increases revenue, decreasing price decreases revenue
o Unit elastic – increasing or decreasing price, no effect on revenue
o Elastic - increasing price decreases revenue, decreasing price increases revenue
 General Elasticity Measures:
o E = Percentage change in one variable
Percentage change in another variable
o Two important measures
 income elasticity of demand – change in quantity demanded as income changes
 cross-price elasticity of demand – change in quantity demand for one good, as
the price of another good changes
 Income Elasticity of Demand:
o as income rises, how much more do we demand of a particular good?
o E = Percentage change in quantity demanded
Percentage change in income
o Inferior Goods
 income elastic is negative (E < 0)
 bus transportation, potatoes (Canada)
o Necessities
 income elasticity is less than one (0 < E < 1)
 food (generally), poultry, beer (Canada)
o Luxuries
 income elasticity is greater than one (E > 1)
 poultry (Sri Lanka), wine (Canada)
 Cross – Price Elasticity:
o how does the demand for a good change if the price of other goods change?
o E= percentage change in quantity demanded of one good
percentage change in price of other good
o Complements
 cross-price elasticity is negative (E < 0)
 increased price of gasoline reduces demand for cars/trucks that consume a lot
of fuel
o Substitutes
 cross-price elasticity is positive (E > 0)
 increased price of gasoline will increase demand for public transportation
 increased price of wheat increases demand for corn or rice
Lecture 5 - Government Intervention
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 Price Ceilings and Floors

o why input those restrictions if they reduce economic surplus?
o consumers don’t view prices as justified – restrictions provide a sense of “fairness”
 Who is Affected by Taxes?
o Does it matter if taxes are assessed on buyers or sellers?
o Debate around who should pay for increased gasoline taxes
o Payroll taxes (CPP and EI) have employer and employee portions
o Do these divisions matter for tax incidence? - no
o Should carbon taxes be assessed on consumers or suppliers?
o excise tax = tax per unit
 Taxes – Graphically
o on consumers – supply and demand curve
 demand decreases, price and quantity demanded both decrease
 lowers the price suppliers pay, increases consumer price (gap between price
points = tax = payed by consumers)
o on suppliers
 supply decreases (increased costs), price increases, quantity supplied decreases
 net effect – consumers pay more than the supplier
 Tax incidence – effect of a tax on net prices
o distance between supply curves is the tax wedge – larger wedge is payed by consumers,
smaller wedge payed by seller
o suppliers profit goes down by equilibrium price – x
o consumers payed price goes up by equilibrium price + x
 Elasticity and Tax Incidence
o elasticity of supply and demand determines tax incidence
o inelastic side of the market bears bulk of tax effect
o low elasticity of demand:
 consumers pay the brunt of the tax incidence
o high elasticity of demand:
 tax incidence is less on the buyer and more on the seller
 Demand and Supply Reconsidered
o Demand curve identifies the maximum consumers would pay for a product
 “willingness to pay curve” – value placed on product (surplus value if you were
willing to pay more)
 interpret this maximum as equal to the value received
o Supply curve identifies minimum price at which sellers will sell
 “willingness to supply at price curve”
 interpret this minimum as cost
 Economic Surplus
o surplus exists between demand and supply (value vs. cost)
o between meaning from the y axis to the equilibrium price (triangle area = total
economic surplus)
o Economic Efficiency - maximizing economic surplus
 product all the way up to the EP (whole triangle area)
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 dead weight loss – value of trades that would have happened before tax was
put in place but that no longer exists
 Competitive Markets and Efficiency
o Equilibrium in a competitive market - intersection of supply and demand
 Maximizes economic surplus
 efficient economic outcome
o Key Caveats
 true for competitive markets, but not all markets are competitive
 positive or negative externalities in production/sale/consumption would mean
this isn't true (lower efficiency)
 Price Ceilings
o maximum price that can be charged in a market
o examples – rent controls, rules against raising prices during disasters, gas prices in the
70’s, price controls during WWII
o price ceilings are not necessarily binding
 Understanding Price Ceilings
o is the ceiling binding?
 is EP higher than the price ceiling? (ceilings only matter if the prices actually get
that high)
o how elastic are supply and demand?
 if both are elastic, effects will be larger
o why is the price ceiling in place?
 Price Ceilings and Shortages
o binding price ceilings cause excess demand = shortage
o (not binding [important] if above EP, binding if below EP)
o reduces quantity (supplied) and reduces economic surplus (only if the people who value
the product the most still get it)
o inelastic supply –
o elastic supply –
 Why are Shortages Inefficient?
o rationing mechanisms can be inefficient – discrimination/classism/racism/etc.
o price ceiling can create an underground economy – bribery/splitting costs
 Price Floors
o examples – minimum wage laws, alcohol pricing, supply management in agriculture
o price floors are not always binding (if under EP, non-binding and unimportant, if over EP
= binding)
o understand why they are in place?
 Price Floors and Surpluses
o binding price floors cause excess supply = surplus
o reduces quantity (demanded) and reduces economic surplus
o inelastic demand –
o elastic demand –
 Minimum Wage
o can we think of the labour market as a competitive market? and would firms hire less if
minimum wage increased? (elasticity of labour)
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 Output Quotas
o used in a variety of markets – food/taxis/etc.
o similar to the concept of price ceiling or floors, just in output and not prices
 horizontal line before EP – works like a price floor – lowers supply of product
 (look in textbook)
 (taxi licenses and uber)
Lecture 6 - Basis of Consumer Behaviour

 Utility as a Concept
o Utility is a conceptual measure of consumer satisfaction or value
o assumes that consumers make choices to maximize utility
o asses utility based on (observed) consumer choices
 circular nature of the argument
 assume consumers value the things they choose to consume
 Diminishing Marginal Utility
o key concept in utility theory – consumers derive less value from successive units of
consumption (less pleasure from consuming more) (i.e. value first cup of coffee in the
morning over the second one – each additional cup adds SOME utility, but less than
previous)
o focuses on incremental changes – the consumption of one more (in comparison to
thousands)
 Total Utility vs. Marginal Utility
o total utility - concave arch (total utility is increasing but at a decreasing rate)
 Utility on the y axis, quantity consumed on x axis
o marginal utility – decreasing (doesn’t matter if constant or at what rate – just
decreasing)
 Utility Maximization
o the consumption decision – do I buy another cup of coffee? (a marginal decision)
o benefit is the marginal utility of the next unit purchased
o what is the opportunity cost?
o what is the marginal utility of my next best purchase option?
 MUx = MUy
Px Py
o (where x and y are different products)
 Marginal Utility and Demand
o to go from marginal utility to demand – if MU is high, demand is high, if MU is low,
demand is low
o go from individual MU curves, to multiple MU curves, to demand curves
o units are different, so the MU and D curves are not equal
o utility is not mathematical – correct as along as it corresponds to the choices people
make (ex. people will have greater marginal utility if they think the wine is expensive)
 Demand Curves
o individual demand curves derived from utility maximization
 MU is declining
 as price increases, number of units purchased falls
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 individual demand curves slope downward

o market demand – just individual demand curves added together
o always slope downward

 Downward Sloping Demand

o substitution effects – how do relative prices affect behaviour?
 generally, price increases increase the rate of substitution
o income effects – when consumers feel richer or poorer, how do their decisions change?
 will look the same as inferior/superior goods
 Substitution Effect
o when the price of coffee increases, other products become relatively cheaper (i.e. tea)
o maximizing utility requires substituting towards consuming more of other products
(consume less coffee)
o substitution effects are always negative – increasing relative price of a good reduces
consumption of that good (marginal utility decreases if you don’t)
 Income Effect
o changing prices can make consumers feel richer or poorer
o increasing the price of coffee reduces the set of choices I can afford to buy
 when small budget items increase in price, income effect is very small
 but if the price of housing goes up, consumers buy more/less of something –
income effect is greater
 (expectations and environment of the market changes consumer behaviour)
o when I feel poorer, do I buy more of a product or less of a product?
 Price Changes and Normal Goods
o when you feel poorer, you buy less of a good
o when price rises, you by less of a good (sub effect)
o you now feel poorer, so you buy even less of the good (income effect)
o downward slope
 FOR A NORMAL GOOD – sub and income effects work in the same direction
 Price Changes and Inferior Goods
o when you feel poorer, you buy more of the good
o when price rises, you by less of a good (sub)
o BUT – you now feel poorer, so you buy more of the inferior good
o steeper downward slope
 FOR AN INFERIOR GOOD – sub and income effects work against each other
 Price Changes and Giffen Goods
o when you feel poorer, you buy more of a good
o when price rises, you buy less of a good (sub effect)
o BUT – you now feel poorer, so you by more of the good (good is so inferior that it is not
a large part of your budget – consume in large quantities) (income effect)
o upward sloping curve
 FOR AN INTENSELY INFERIOR GOOD - income effect is greater than the sub
effect
 Economic Surplus
o value for consumers – the demand curve
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o marginal cost to sellers defined – the supply curve

o triangle area

 Consumer Surplus
o measures value to consumers minus the price paid for the product
o difference between demand curve and price
o area of the triangle above the EP
 Paradox of Value
o high total value (water, food)
o high marginal value (diamonds)
o (look in textbook)

Lecture 7 - Indifference Curves

 Basic Concepts
o Budget Constraints
 given an amount of money, what are the consumer’s options?
 (much like a production possibility frontier – but for consumers not producers)
o Indifference Curves
 graphical demonstration of how consumers compare their options
 represent options seen as equally good by a consumer
o Optimization under constraints
 choose the best available option
 What Can Consumers Afford
o budget constraints identity feasible options for consumers
o always a linear constant
o spend all your money on one good, the other good, or a mix (opportunity cost)
o slope of a budget constraint represents relative prices – same as opportunity cost
 Graphing Budget Constraints
o slope of the budget constraint is determined by relative prices
o two different goods on the x and y axis’s
o max points on each axis (intercepts) is income divided by the price of good x (or y)
o slope = -Px/Py
 Effect of Changing Income
o increased income shifts the curve outward (parallel)
o decreased income results in a parallel shift inward
 Effect of Changing Prices
o increased price of good x shifts the x-intercept inwards
o decreased price of y shifts the y-intercept outwards
 Preferences and Indifference Curves
o indifference curves represent combinations of goods that are valued equally
o consumers value all bundles on the same indifference curve equally
o slope of the curve = marginal rate of substitution (how much of y do I give up to be
happy with another unit of x)
 rate at which a consumer is willing to trade goods off against each other
 Graphing Indifference Curves
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o more of each good is preferred

o curves are downward sloping
o curves are bowed inward (marginal rate of substitution is increasing)
o curves do not cross
 looks like – decreasing at a decreasing rate
 if you are on the curve and are offered another point along the curve – you are
indifferent
 point on a lower curve - not as good as on the line
 point on a higher curve – better than on the line (further away from the origin =
better)
 marginal rate of substitution
 at the steep points of the curves, youre willing to give up a lot to move
closer to the y axis
 at the flattest parts of the curve – to get more units of x, youre less
willing to give up y
 Perfect Substitutes and Complements
o if perfect substitutes – indifference curves are linear (marginal rate of substitution is
constant) [can be 1:1 or 2:1 or whatever – whole number slope]
o if perfect complements – indifference curve is an L shape (special case where marginal
rate of substitution goes from zero to infinity very quickly) (only value to more up with
some of both)
 Optimization under Constraints
o consumers choice is an example of constrained optimization
o budget constraint defines the set of possible choices
o indifference curves define preferences
o optimal point = where an indifference curve is tangent to the budget constraint
 Budget Constraints; Indifference Curves
o set of indifference curves with one budget constraint
o what’s the best point on or inside of the budget curve? – optimized consumer will
choose where both budget is maximized and indifference curve is “most pleasing”
 Optimal Choice
o slopes of the two lines are equal
o at the optimum – marginal rate of substitution equals the relative price
o trade-off by consumers equals trade-offs in the market
 Increasing Income
o changing income shifts the budget constraint
o increasing income results in a new indifference curve and will lead to
 increased consumption of a good – normal good
 reduced consumption of a good – inferior good
 Increasing Income: Graphically
o Normal Goods - budget constraint shifts outward and a higher (better) indifference
curve is reached
o Inferior Goods – budget constraint shifts outward but on the indifference curve, a point
where you consume less of the inferior good is reached
 Changing Prices
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o a change in prices rotates the budget constraint

o an increase in prices will (usually) lead to reduced consumption
o Income effects:
 changing prices alters the possible consumption choices
o Substitution effects:
 changing prices alters the marginal rate of substitution

 Price Changes and Consumption Choice

o price of good x goes down; therefore, you are able to buy more of x – budget x-intercept
shifts outward
o shift is new possibilities of budget constraint to find a point on the same indifference
curve as before (substitution effect)
o to completely new curve (income effect)
 Deriving the Demand Curve
o consumer theory provides choices at different prices
o can translate from consumer choice to a demand curve
o hold the price of the other good constant
o graphically –
 budget constraint and indifference curve – keep reducing the price of a good,
new indifference curves intersect the moving budget constraint
 quantity increases – therefore, in a regular demand curve you get the negative
correlation slope
 law of demand – consume more at lower prices
 Income/Substitution Effects – Examples
o Giffen goods – when would increasing prices increase demand?
o Wages and labour supply - when does increasing wage reduce labour supply?
o Interest rates and savings - does increasing interest rates increase or reduce savings?
 In all cases - income and substitution effects work in opposite directions
Lecture 9 - Producers in the Short Run

 Organization and Financing

o Analyzing production – focus on companies
 household/government production is important, but fundamentally different
o Firms take many forms – book lists 6 different types
o Firms raise financial capital by selling equity and debt
 economists use the word "capital" for real assets used in production (ie.
machinery, buildings, inventory, etc.)
 differentiating between capital and financial capital (stocks/bonds/money)
(macro economics)
 Assumptions About Firms
o make two assumptions about firms
 act as a single decision-making unit
 make decisions to maximize economic profits
o Neither assumption is critical - both are simplifications
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 Use simplifications when analyzing different questions

 Significant cant research into sub-firm decision making, actions of non-proft
companies, corporate social responsibility, etc.
o Corporate social responsibility, ethical behaviour, etc. can (or can not) be profit
maximizing
 What Do Firms Do?
o Firms make things using a variety of inputs
 land and natural capital
 physical capital (tools, machinery, computer, etc.)
 labour
 intermediate inputs (goods/services bought from other firms)
o Mathematically, combine inputs in a productions function
 Q = f (K,L)
 output produced using capital and labour, f is a function that incorporates firm
technology, other inputs, etc.
 Economic Profit VS. Accounting Profit
o revenue calculated consistently
o economic costs are not equal to accounting costs
o opportunity cost includes both economic and accounting costs (explicit and implicit)
o economic profit not equal to accounting profit
o assumption – firms act to maximize profit
 pie = TR – TC
 Profits and Resource Allocation
o profits act as an incentive for efficient resource allocation
o people start companies that will be profitable – enter industries where profit is likely,
exit industries where losses are being made
o drives the results seen in competitive and monopolistically competitive markets
 Time Horizon and Decision Making
o Short run – some factors are fixed
 divide costs into variable and fixed costs
 companies decide to produce or not, and how much
o Long run – all productive factors can be changed
 factories can be built, or resized
 companies may enter or exit markets
o Very long run – technology can change
 technology changes both intentionally and unintentionally
 Productions in the Short-Run
o some factors are fixed – assume capital is fixed, labour is variable, firms adjust use of
labour to adjust output
o total product – measured in output quantity
 TP = f (K,L)
o average product – output per unit of labour
 AP = TP/L
o marginal product
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 MP = change in TP / change in labour

 Diminishing Marginal Product
o Law of diminishing returns
 holding one factor constant, increasing the amount of the other factor will
eventually lead to diminishing returns
o For small amounts of the variable factor, may have increasing returns
 two workers may be more efficient than one
 (division of labour is important)
o Average Vs. Marginal product
 if MP > AP, AP is increasing
 if MP < AP, AP is decreasing
 Total Product and Marginal Product – Graphically
o Q on the y axis (output), L on the x axis (labour)
o TP looks like half of positive parabola
 increases rapidly until it reaches appoint where it rises only slightly
o MP looks like a negative parabola
 increases rapidly until reaches the same point where (slope of zero) and
decreasing returns
 Production in the Short-Run
o Short run - some factors are fixed, some costs are sunk
o Total cost = Total fixed costs + Total variable costs
o Total fixed costs
 cost of fixed factors such as capital (buildings, equipment, etc.)
 does not change with the level of output
o Total variable costs
 Cost of variable inputs, such as labour
 increases with the level of output
 Average and Marginal Costs
o Three different average cost measures
 Average total cost: ATC = TC/Q
 Average variable cost: AVC = TVC/Q
 Average fixed cost: AFC = TFC/Q
 This is spreading overhead over more units
 Always decreasing as quantity increases
o Marginal cost
 Increase in variable costs for an additional unit of output
 (fixed costs don’t affect this)
 may decrease or increase
 Production Function and Total Cost Curve
o assume diminishing marginal product
o TP graph
o TC graph – y-intercept is the fixed costs
 looks like a cubic function (costs even out and the increase)
 production rises while costs even out
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 production rapidly increases as total cost is flat

 production evens out as costs increase
 Total Cost and Short Run Costs
o assume diminishing marginal product
o same TC graph
o SRC (marginal/average/short-run costs) graph
 TFC - flat line with same y intercept (fixed costs = horizontal line)
 TVC – looks like total costs but at the origin (TC – FC)
 Capacity and Efficient Scale
o Efficient scale - the lowest level of output with minimum average total costs
o Capacity - the largest level of output with minimum average total costs
 ATC looks concave – quad function (doesn’t have a y- intercept – goes to
infinity)
 efficient scale is where your average costs are no longer going down (1/3 of
graph)
 producing more would actually be cheaper/same price
 capacity is where average total costs start rising (2/3 of graph)
 producing more will make your product more expensive to produce
o marginal cost crosses AVC and ATC at their minimum
 Shifting Cost Curves
o How do cost curves shift when labour prices increase?
 ATC curve – shifts upward
 MC curve – shifts upward
o How do cost curves shift if a firm shifts some costs to be fixed costs?
 (I.e. shifting labour to automation)
 ATC curve – if firm is not productive – ATC shifts upward
 MC curve – possibly nothing happens (doesn’t change much) – goes through
new ATC curve at the minimum
o companies do this because:
 mono/oligarchy markets – block people out of a market (barrier to entry – have
to compete with high producing firm)

Lecture 10 - Producers in the Long Run


 Time Horizon and Decision Making
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o Short run – some factors are fixed

 divide costs into variable and fixed costs
 companies decide to produce or not, and how much
o Long run – all productive factors can be changed
 factories can be built, or resized
 companies may enter or exit markets
o Very long run – technology can change
 technology changes both intentionally and unintentionally
 Production Function and Total Cost Curve
o assume increasing and then diminishing marginal product
 Short Run Cost Curves
o average total cost (ATC), average fixed costs (AFC), average variable cost (AVC), marginal
cost (MC)
o AFC – always downward sloping (decreasing at a decreasing rate
o AVC – u shape, increasing at decreasing rate
o ATC – combined AFC and AVC
o MC – goes through AVC and ATC at minimums
 (this is the cost situation of a competitive industry/market)
 The Long Run: No Fixed Factors
o Long run – firms choose how much capital and labour to use in production
o profit maximization implies cost minimization
 cost minimization – choosing the least costly way to produce a given quantity of
output
 profit maximization also requires selecting the correct amount of output to
produce
 Marginal Productivity
o long run cost minimization – equate marginal productivity per dollar spent across
categories
 MPk / Pk = MPl / Pl
o if this was not true – adjust use of capital and labour to reduce cost
 Principle of Substitution
o if input prices change, firms will adjust production to use more of the relatively cheaper
input, and less of the relatively more expensive factor
o similar to substitution effect for buyers
o ex. banks automating as wages increase (computing costs decline), production in
countries with low wages use more labour and less capital
 Isoquants and Isocost
o capital on the y axis, labour on the x axis
o isocost – downward sloping line (like a budget curve)
 different combinations of capital and labour that cost the same amount
o isoquant – looks like indifference curves
 different combinations of capital and labour that will produce the same amount
of output
 Increasing the Cost of Labour
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o x intercept shifts in
o isoquant curves move – (to produce at the same cost, move to the new point)
 Substitution
o marginal rate of substitution – ability to switch between inputs holding output constant
o changes in relative prices cause a shift to relatively cheaper inputs
 Long Run Average Total Cost Curves
o short-run ATC curves generally U-shaped
 firms can only adjust labour
o long run – firms can also adjust capital
 can choose between a wide variety of short run ATC curves
 e.g. different curves for a company with one factory, two factories or three
factories
o u shaped ATC for a company in the short run (for a particular choice of capital)
o shifts to the right if you want to produce more (more effective)
o adjusting the minimum point on the parabola to meet the quantity desired (to be most
effective)
o long run! – combine all possible options – big U shaped curve that has points
somewhere between all short run curves
 i.e. lower envelope
o LR ATC
 increasing returns to scale – as you increase quantity of output, costs fall
 constant returns to scale – expanding Q doesn’t change average (or marginal)
costs
 decreasing returns - as you increase Q, average costs increase
 The Very Long Run: Technology
o Short run – firms vary labour inputs
 choose one spot on a short run ATC curve (U-shaped)
o Long run – firms choose how much capital and labour to use in production
 choose one spot on a long run ATC curve
o Very Long run – firms can change technology
 change the long run ATC curve
o Wide range of options for firms
 lower costs, or increase capacity
 produce entirely new products
 Technology Change and Long-Run Growth
o technological change considered core driver of long run economic growth
o overall measures of technology growth are difficult – focus on productivity (output per
employed worker)
o rate of growth of productivity in Canada lower than in the US and UK
 Technology Change
o technology change can be demand driven
 new products or modifications to existing products
o or driven by supply factors
 changing production techniques to use fewer or cheaper inputs
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 improving the quality of inputs, may lower costs, or alter products

o government policy can affect technology change
 patent law
 subsidized private or public research (tax incentives, universities)
 Long Run or Very Long Run
o how do firms respond to changes in the prices of inputs, like wages?
o Automation – substitute to capital through automation
o Outsourcing – substitute to different labour in another country
o Innovation – develop new production techniques that use less labour, or produce more
output for a given amount of labour
 Technology and Cost Curves – Graphically
o saucer shape LR ATC curve
o tech change means literally anything – as long as LRATC curve shifts downward
(beginning point stays the same – end shape changes)

Lecture 11 - Competitive Markets

 Competition
o a perfectly competitive market has four main features
o goods offered by sellers are largely the same (homogeneous goods)
o consumers have information about available prices/quality
o many buyers and many sellers
 no single buyer or seller affects the market price – price takers
o firms may enter and exit the industry
 critical force in determining long-run supply
o profit in an industry is an economic signal for new firms
 Demand Curves in a Competitive Market
o industry – downward sloping demand curve
o firm – horizontal line at whatever price the market sets (vertical line until zero, then L
shape)
o raising price – zero customers
o no incentive to lower the price, therefore they are literally price takers (will take
whatever price is set)
 Revenue of a Competitive Firm
o Total Revenue = Price x Quantity
o firms do not affect prices
 if firms double quantity, revenue doubles
 raise prices = sell nothing
o average revenue = total revenue/quantity = price
o marginal revenue = price = average revenue
 Profit Maximization
o how does a firm determine their level of supply?
o basic assumption – firms maximize economic profit
o what level of production (i.e. quantity) is consistent with profit maximization?
o Graphically
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 price and quantity axis

 horizontal line = Average revenue = marginal revenue
 MC curve
 produce up to the point where marginal cost = marginal revenue
 if a MC curve crosses the MR line while sloping downward = profit minimum
 To Produce or Shut-Down
o Firm produces nothing – pay fixed costs, no revenue:

o if a firm produces, profits equal:

o produce if profitability is greater:

o cancel fixed costs, divide by quantity – produce if:
 P ≥ AVC
o Decision to shut-down – graphically
 produce if P ≥ AVC, otherwise shut down
 all the cost curves
 shifting from higher price and high quantity to lower price & quantity = loss of
money, but covering costs in the long run
 three stages moving towards the origin – profit, loss, shut-down
 can operate in these stages anytime – seasons, days, hours, etc.
 Short Run Firm Supply Curve
o MC, ATC, AVC curves
o individual firms –
 shut down where MC crosses ATC (or behind it)
 produce above said point along the MC curve (loss)
 above where MC crosses ATC = profit
 (nothing until shut down point, then follows MC curve up)
 Market Supply – Short Run
o assume no entry or exit of firms
o fixed (and large) number of suppliers
o assume identical firms (though it is not necessary in the short run)
o at any given price, add up the quantity of supply of all firms
 market supply is the number of firms x firm-level of supply
o Graphically -
 firm – same as above
 industry (50 firms) – looks the same, but the scale changes
 if a individual firm produces 100 units, 50 firms, shut down point (where
supply curve starts) becomes 5000 unites
 Short Run Profitability
o graphically –
 all cost curves
 looks at MC, ATC
 profit is the area under MC at set price and above ATC (under that MC point)
 profitability = (price – ATC) x quantity
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 if price is at the top of the rectangle = profit, if under the rectangle = loss
 The Decision to Enter a Market
o in the long run, all costs are variable
o if a firm produces nothing:

o if a firm produces, profits equal:

o should operate in a market if:
 P ≥ ATC
o graphically –
 exit if price is below minimum of LRATC curve
 enter if above (or equal too) minimum of LRATC curve
 Exit Decision and the Firm Supply Curve
o LRATC curve, MC curve
o if price is below where MC crosses LRATC, firm produces nothing
o if above, follows MC up
 Market Supply – Long Run
o firms may enter and exit
o assume all firms have access to the same technology
o if existing firms are profitable – new firms will enter
o if existing firms are making a loss – some firms well exit
o entry/exit – firms earn zero profits in the long-run
o long run market supply at minimum of ATC curve
o graphically –
 firm – as above
 industry – horizontal line at point where firm supply curve starts
 Equilibrium Changes
o in the short run:
 number of firms is fixed
 supply curve is upward sloping bc of diminishing marginal product
o in the long run:
 number of firms is flexible
 firms enter/exit until firms make zero profit
 supply curve is horizontal at minimum of ATC curve
 Changes in Demand Factors
o what happens with an increase in demand?
 short run –
 standard demand curve, firm supply curve
 price and quantity increase
 firms that were breaking-even before now make a profit
 long run –
 standard demand curve, horizontal supply curve
 price stays the same, quantity increases
 firm revenue increases
o short run invites new firms, increase competition, lower back down price to long run
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Lecture 12 - Monopoly

 Long Run Average Total Cost Curves

o LRATC curve (bowl shape)
o natural monopoly (i.e. utilities) – downward sloping, decreasing (concave)
 Why do Monopolies Exist
o a monopoly is a firm that is the sole seller of a product without close substitutes
o both natural and created barriers to entry
 Natural Entry Barriers
o one large firm produces more efficiently than small firms
o average total cost is downward sloping
 utilities (water, sewers, cable television, land-line phones)
 bridges and road networks
 manufacturing if markets are very small
o Network effects: number of buyers increases demand
 technology – operating/file systems, social networks, etc.
 these tend to be limited by technology
 Created Entry Barriers
o government grants monopoly rights
o patent laws, copyright laws
 optimal length of patents/copyrights?
o professional organization (doctors, CPA’s, etc.)
o exclusive business licenses (eg. Canada Post)
o threats of predatory pricing
 Monopolies vs. Competitive Firms
o maintain assumption of profit maximization
o firms set marginal revenue = marginal cost
o for a monopolist: marginal revenue is NOT equal to price
o to increase quantity – must find new buyers (move along the demand curve)
o to find buyers, firms must lower prices
 Demand and Competition vs. Monopoly – graphically
o what are the demand curves for a competitive or monopoly firm?
o comp – sell as much quantity as you want at a market set price (horizontal demand
curve)
o mono – sales move along the demand curve (to change quantity you must change price)
 Marginal Revenue
o total revenue is still Price x Quantity
o average revenue = price
o for a monopolist: marginal revenue is not equal to price
o change in revenue due to quantity increases is a trade off
 output effect: quantity increases lead to higher revenue
 price effect: quantity increases caused by lower prices
 Output Effects and Price Effects – Graphically
o price and quantity point on the demand curve
o moving from one point to another – the two rectangles are the profit change
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 total profit achieved is the increase in profit minus the decrease in profit (green
minus pink)
o from Q1 to Q2 – output effect (increased revenue caused by additional sales)
o from P1 to P2 – price effect (decrease in revenue caused by a lower price)
 comp firm has no price effect
 Marginal Revenue, Cost and Price
o monopolists choose quantity where marginal revenue = marginal cost
 but marginal revenue is less than price (i.e. set price at demand curve above)
o at the optimal quantity, price is found on the demand curve
o price is higher than marginal cost and marginal revenue
o graphically –
 standard demand curve – starts at the same point, closer to the origin
 goes past the x axis bc can reach a point where marginal revenue is
negative
 linear demand curve – MR line would be the same y intercept, twice the slop of
the demand
 Monopoly Profit
o profit is total revenue – total cost
o can be written as:
 profit = (TR/Q – TC/Q) * (Q)
 or, note that average revenue = price
 profit = (P – ATC) * (Q)
o graphically –
 demand curve, MR curve, MC curve – to find profit you need to find ATC curve
 profit equals price – total cost (x quantity)
 on graph, profit is rectangle between y axis, quantity (price point minus ATC
point)
 Deadweight Loss of Monopolies
o MC, MR, and D curves
o competitive outcome – price equals marginal cost
o monopolist reduces quantity and increases price – DWL is the triangle between
monopoly price point, point where MR = MC, and where MC equals the monopoly price
o inefficiently needed to generate the product that you want
 Examples of Price Discrimination
o price discrimination is the practise of selling the same good at different prices to
different consumers
 airline pricing
 coupon clipping, line-ups for discounted tickets
 quantity discounts
 age/student discounts
 university financial aid
 country pricing differences (pharmaceuticals, books, cars)
 When is Price Discrimination Possible?
o firms can set prices – market power
o consumers have different values for the same product
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o arbitrage (secondary purchasing) is limited or prevented

 arbitrage is impossible for goods that cannot be resold
 Perfect and Imperfect Price Discrimination
o perfect price discrimination
 charge everyone their willingness to pay
 consumer surplus is entirely eliminated
 outcome is efficient
o imperfect price discrimination
 charge groups based on different willingness to pay
 increases profits (otherwise they wouldn’t do it)
 effect on efficiency is uncertain – depends on a variety of factors
 Mechanisms of Imperfect Price Discrimination
o pricing by buying volume (loyalty programs)
o market segmentation
 age/student discounts, financial aid
 gender/country specific pricing
o Hurdle Pricing
 coupons, airline pricing, hardback/paperback books
 Price Discrimination – Loyalty (graphically)
o demand function
o if you set one price, consumer will buy a certain quantity of it
o to get the consumer to buy more, need to decrease price (i.e. loyalty programs)
o links to diminishing marginal satisfaction (try to generate additional sales)
 Price Discrimination – Segmentation
o two (or more) groups of consumers with different demand functions
o separately optimize pricing for each group
o charge more to the group with a lower elasticity of demand
 they are less willing to switch to an alternative product
o graphically –
 for students – demand is fairly flat,
 for non-students – demand is steeper
 MR is twice the slope of the lines
 same MC for both
 results in a lower price for students than non-students
 Hurdle Pricing
o in many cases, consumer types are not identifiable
o firms still want to charge high value consumers more
 high-value and low-value consumers may be different in other ways
 timing, willingness to spend time to get a lower price, etc.
o a costly activity is the hurdle to get a lower price
 Consequences of Price Discrimination
o firms are more profitable
 additional sales don’t affect prices
o firms will produce more output
 increase in economic surplus
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 (usually) some consumers are better off, some are worse off
 uncertain effect on consumer surplus
Lecture 13 - Monopolistic Competition

 Market Structures Recap

o perfect competition – many firms sell identical products
o monopoly – one firm sells a product
o monopolistic competition – many firms selling similar products
o oligopoly – a few firms sell similar products
 Key Features of Monopolistic Competition
o Many sellers
 choices of any one seller don’t affect the market
 similar to competitive firms
o Product Differentiation
 firms produce products with some variation
 each firm is a monopolist with regard to their own product
o Free entry and exit
 firms will enter or exit the market in response to opportunities for profit
 entry and exit is identical to competitive firms
 Monopolistic Competition – the Short Run
o profit maximization looks like a monopolist in the short run
o firm faces a downward sloping demand curve for its product
o has to choose quantity where MR = MC (marginal revenue = marginal cost)
o short run – firms may make profits or losses
o graphically –
 MR, D, and MC (flat) curves
 quantity where MC=MR, price above that
o Profit vs Loss (graphically) – add in ATC
 profit – if ATC is below price, profit
 loss – if ATC is above price, loss
 (rectangle between ATC at Q1 and P at Q1)
 Profit or Loss and Long-Run Decisions
o firms that make a loss may choose to exit the industry
 reduction in firms increases demand for remaining products
 increased demand leads to reduced losses for remaining firms
o if existing firms are making a profit, firms may choose to enter
 increase in firms reduces demand for existing products
 reduced demand leads to lower profits for remaining firms
o either process continues until profit are zero
 LR Monopolistic Competition – graphically
o ATC must be a tangent to the demand curve
o ATC meets the demand curve at Price Point
 LR Characteristics
o firms act like a monopoly in the short run
 price exceeds marginal cost
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o market looks like a competitive market in the long run

 firms enter/exit until profits equal zero
 long-run price = average total cost
 Excess Capacity and Efficient Scale
o firms produce less than efficient scale (if they produced more than ATC would fall)
 MR, MC, D, and ATC
 have excess capacity (can always handle more – just can’t find more customers
at their price (would have to lower price for more customers))
 Efficiency and Monopolistic Competition
o competitive markets: price = marginal cost
o monopolistic competition: price > marginal cost
o firms making zero profits – hard to encourage higher production
o optimal number of firms?
 product-variety externality
 business-stealing externality
o may be too many, or too few, firms in the market
 Market Structure, Markup and Efficiency
o markup is a measure of allocative efficiency – maximized when price = marginal cost
o Average markup [(price – cost)/ (cost)] – affected by market structure
 perfect competition – markup equals zero (P=MC)
 monopoly – markup is positive (P>MC)
 generally – markup increases with firm-level price elasticity of demand
o globally, pricing markups rising – suggestive that the economy is getting less efficient
overtime
 i.e. De Loecker and Eeckhout, 2018, NBER
 1980 – average markup of 10%
 2016 – average markup of 60%
 Economics of Advertising
o advertising involves spending money to attract demand
 providing information directly about the product
 aspirational advertising – viewers want to be like the people in the ad
 name recognition, with no additional information
o relatively large amounts of money – 2% of firm revenue spent on advertising
o is advertising a social benefit, or a waste?
 Arguments About Advertising
o the critique of advertising
 advertising is wasteful and manipulative
 exists to exaggerate differences between firms’ products, increasing markup,
lowering efficiency
o The defence of advertising
 advertising provides useful information
 informed buyers more responsive to price/quality differences
 advertising enhances competition, leads to lower markups, greater efficiency

 Information or Exaggeration
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o start with same market – MR, MC, D curves, P1 and Q1

o information – will flatten out of demand curve (less steep), MR becomes less steep
 end up selling more product at a lower price
o increasing difference between products (exaggeration) – will increase slope of demand
curve and MR
 end up selling less product at a higher price
 Conclusions
o monopolistic competition is characterized by:
 firms that have a monopoly on a differentiated product
 firms may enter or exit, affecting demand for other products
 firms charge prices above marginal cost, produce at less than efficient scale
 in the long run, firms make zero profits
o Product differentiation leads to advertising
 both may be wasteful or informative
o Not obvious how government policy can promote welfare in these markets

Lecture 14 - Oligopoly

 Market Structures Recap

o perfect competition – many firms sell identical products
o monopoly – one firm sells a product
o monopolistic competition – many firms selling similar products
o oligopoly – a few firms sell similar products
 Key Features of Oligopoly
o only a few sellers (2 or more)
 if there are two sellers, it is a duopoly
o firms cannot enter/exit the market – entry barriers are important
o firms act strategically
 choose pricing and/or production in response to choices of other firms
o Applied game theory
 study of how people/firms behave in strategic situations
 game theory is critical to understanding oligopoly
 Competition and Monopoly
o demand curve, constant MC
o comp firm – set quantity at point where MC equals price
o monopoly – quantity where MR=MC, price on demand curve above that
o oligopoly – somewhere inbetween
 Oligopoly, Cartels and Monopoly
o assume there are only two sellers (duopoly)
o what choice would they make if they could agree?
 monopoly outcome maximizes total profit
 sellers would need to agree on division of output
o firms agreeing on production or price are in collusion, and may be defined as a cartel
o What if firms cannot cooperate on production?
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o strategic analysis – given the choice of firm A, what production maximizes profit for firm
B?
 take as given the production choice of firm A
 shifts the effective demand curve for firm B
o Nash Equilibrium:
 when economic actors are choosing their best strategy given the strategies of
others
o will two firms each producing half of monopoly production be an equilibrium? - NO
 Oligopoly and Production
o From monopoly, increasing quantity has two effects on revenue
 Output effect – increasing quantity increases revenue
 price effect – increasing quantity lower price, reducing revenue
o in an oligopoly, how are these different?
 Output effect – no change, increasing output increases firm revenue
 Price effect – part of the price effect is borne by the other firm
o marginal revenue from a quantity increase is higher for oligopoly than monopoly
 Oligopolies and Welfare
o Perfect competition is efficient - maximizes total surplus
o Monopoly leads to too little output
o Oligopoly falls in between
 Less production than competition, more than monopoly
 Higher prices than competition, lower than monopoly
o Oligopoly therefore has some deadweight loss, but less than monopoly
 Competition, Monopoly, Oligopoly
o graph from before
o oligopoly produces at a point between others on demand curve
 move closer to competitive outcome
 The Size of an Oligopoly
o Two effects to a firm increasing quantity
 OE – benefit to firm that increases output
 PE – costs spread across all firms
o As the number of firms increases:
 the lower the firm-level consequence of the price effect
 firms have a larger incentive to increase production (cheat)
o when the number of firms gets very large:
 price effect effectively disappears – only an output effect
 firms increase quantity if Price > MC
 converges to competitive outcome – and efficiency
 Competition and International Trade
o oligopolies with few sellers create inefficiency
 too little production
o with more firms, inefficiency is reduced
o a secondary benefit to international trade
 even without comparative advantage countries benefit from trade
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 increases the number of sellers in various industries

 larger benefit in smaller countries
 Game Theory
o game theory is the analysis of strategic behaviour
o players make choices based on outcomes
 strategic behaviour – outcomes depend on other player’s choices
o Dominant Strategy
 a strategy that is one’s best strategy regardless of the choice of other players
o Nash Equilibrium
 a set of strategies where each player’s strategy is a best response to everyone
else
 Oligopolist’s Dilemma
o consider a duopoly deciding on production
o Qm is the production level a monopoly would produce
 both have dominant strategy to produce more
 nash equilibrium – both over-produce
 lowers prices, helps consumers
o collusion would lead to higher prices
o profit-seeking by firms lowers prices
o sustaining collusion is difficult, but profitable
 Cartels and the Incentive to Cheat
o fsdf
 Other Examples
o Advertising, campaign spending
 Both sides spend large sums of money to attract consumers/voters
 effect on outcomes is minimal – but neither side can afford to stop
 welfare impact is probably negative
o Common pool resources – fish, water, oil, grazing
 companies/individuals can access common resources
 if I don’t extract the resource, the other firm will
 extract too much – negative effect on social welfare
o Arms Races
 Prisoners Dilemma and Cooperation
o many situations where people cooperate
o key is punishment for those who don’t cooperate
 when cooperation is beneficial, promote collusion
o with cartels, society benefits from inability to cooperate:
 firms can’t sign contracts to maintain collusive outcomes
o with other issues – cooperation is critical
 Repeated Interaction and Cooperation
o future actions punish those that break agreements
o cartel members may increase production at key times
o may sustain cooperation at monopoly/cartel price
o easier to sustain if:
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 fewer members
 limited turnover of firms (entry/exit barriers)
 long time horizons
 Explicit and Tacit Collusion
o Oligopolies collect higher profits if they collude on monopoly production:
 Reduction in consumer surplus associated with collusion as prices increase
 Reduction in total surplus when production falls
o Explicit collusion is illegal
o Tacit collusion is harder to regulate
 Matched price increases, or price reductions
 Advertising to "Match lowest advertised price"
 Entry Barriers
o Higher prices maintained through limited competition
o Entry barriers are critical, and take many forms
 Brand proliferation
 Advertising
 Predatory pricing
o Entry barriers reduce expected profitability of potential entrants
 Conclusions
o Oligopolies are characterized by:
 A few sellers that produce similar or identical products
o Firms in an oligopoly act strategically - respond to the choices of other firms
 Game theory is used to analyze firm choices
 Nash equilibrium - firms choose mutual best responses
o More firms lead to greater production/efficiency
o Government policy emphasizes competitive behaviour
 Limit collusion and cartelization
 Restrict firm strategies that act as tacit collusion
o *acting strategically gives you an outcome that is worse for both firms* (below nash EQ)

Lecture 15 - Efficiency

 Market Structures Recap

o perfect competition
 many firms sell identical products
 price equals marginal cost
o monopoly
 one firm sells a product
 price is greater than marginal cost
o monopolistic competition
 many firms selling similar products
 price is greater than marginal cost
o oligopoly
 a few firms sell similar products
 generally, price is greater than marginal cost
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 Competition and Monopoly

o downward demand curve
o horizontal marginal cost
o quantity where demand equals MC (allocative efficiency)
o monopoly – produce where MR equals MC
 deadweight loss in triangle between monopoly output and allocative efficient
output
 therefore – monopolies are not allocatively efficient
 Efficiency
o Remember, efficient is not synonymous with good
o Productive efficiency
 are firms efficient? produce at lowest cost
 is the industry efficient? marginal costs equalized across firms
o Allocative efficiency
 Are we producing the goods that people want to buy?
 Is price equal to marginal cost for each good produced?
o no economy is efficient – but some are more efficient than others
 Productive Efficiency
o do firms minimize costs?
o profit maximizing firms will generally act to minimize costs
o are industries efficient? is output produced at the lowest cost firm? are marginal costs
equalized across firms?
 Perfectly competitive markets are productively efficient
 monopoly is productively efficient
 monopolistic competition will tend to lead to (approximate) productive
efficiency
 no reason to believe oligopolies lead to productive efficiency – limited
entry/exit allows inefficiency to exist
o graphically –
 same increasing MC curve for Firms A + B
 shift quantity produced by both firms until they have the same marginal cost
 Productive Efficiency and the PPB
o are we on the PPB?
 any point on the PPB is productively efficient
 points inside the PPB are not productively efficient
 Allocative Efficiency and the PPB
o are we at the right point on the PPB?
 point in the middle of the PPB is allocatively efficient
 move to a point closer to y-axis? point B cannot be allocatively efficient
 (look at textbook – but he wont ask to find the allocative point)
 Allocative Efficiency
o allocative efficiency is about what is produced
o are we producing at the right point on the PPB?
o consider price and marginal cost:
 If price > marginal cost - we should produce more of that good
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 If price < marginal cost - we should produce less of that good

 Only true in the absence of market failure - more to come in chapter 16 and 17
o only competition leads to allocative efficiency
 Economic Surplus, Revisited
o demand curve, MC curve
o in perfectly competitive outcome – entire triangle between y-axis and intersection point
is consumer surplus
o monopoly – add in MR curve, area above monopoly price is consumer surplus, area
below that is producer surplus, area between monopoly quantity and original
intersection point is deadweight loss
 Government Regulation
o Wide range of regulatory agencies (federal, provincial and local)
o Canadian Competition Bureau
 Assesses mergers/monopolies
 Assesses price-fixing and unfair trade practices
o CRTC regulates rates for cell-phone and cable services
o OSFI regulates banks and insurance companies
o Resource extraction regulated provincially
 Natural Monopolies
o one firm can efficiently serve the market
o demand curve, MC line, ATC slightly below Demand
o ATC falls towards MC but never gets there
 Regulating Natural Monopolies
o Marginal cost pricing
 require firms to set price/quantity where market demand intersects marginal
cost
 leads to allocative efficiency
 firm loses money unless subsidized
o two-part tariffs
 marginal cost pricing per unit, plus a lump-sum payment for service
 allocative efficiency, might be profitable
o average cost pricing
 set price equal to average cost – LRATC intersects demand curve
 zero profits
 no incentive for investment
 Marginal Cost Pricing – Graphically
o natural monopoly curves (D, MC, ATC0
o must produce at intersection of MC and D – firm loses rectangle above MC and below
ATC
 Average Cost Pricing – Graphically
o set price at ATC
 Regulating Monopolies/Oligopolies
o Few industries characterized by perfect competition
o Can a government regulate efficiency?
o Very difficult for government to stay ahead of innovation, or to promote innovation
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o Some push for government to get out of the way

o Some regulation is still needed - patent policy is one version of this

Lecture 17 - Factor/Capital Markets

 Factor Markets
o Factors of Production – land, labour, capital
o For this class – land, physical capital, financial capital
 Demand and supply of factors
 Intro to factor price differentials
 Transfer earnings and economic rent
 Present value of future income streams
o Next class – labour markets
 Competitive labour markets
 Wage differentials
 Minimum wage, unions, inequality
 Demand for Factors
o Value of one additional unit of a factor
 Marginal product measures quantity produced by an additional unit
 Marginal revenue measures revenue produced by additional quantity
o Marginal revenue product is marginal product x marginal revenue
 MRP = MP x MR
o Firms willing to pay if price is less than marginal revenue product
 From Marginal Product to Demand – Graphically
o output quantity on the y axis, input quantity on the x axis
 diminishing marginal product – downward sloping line
o demand for factor markets
 price (willing to pay) on the y-axis, quantity input on x-axis
 demand for the input looks just like marginal product (only thing that changes is
the scale – i.e if the MP of an output is 10 units, and the price is 10, demand
curve is at 100)
 Changing Demand for Factors
o What changes the demand for factors?
 Changes in marginal product
 Changes in marginal revenue
o Firms willing to pay if price is less than marginal revenue product
 Present Value
o Often evaluating value of future payments
o Payment to be received in the future must be discounted
o If received today, could be invested and earn interest
o Present value of $1,000 earned in one year:
 PV = $1000
(1 + i )1
o More generally, if a unit of capital generates marginal revenue product in the future:
 PV = MRP
(1 + i )t
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 Demand for Financial Capital

o Two factors affect investment demand
 Marginal revenue product of physical capital
 Interest rates - price of borrowing money
o Natural to think of interest rates as the "price" of investment
 Then investment demand does not change when interest rates change (more
along the curve)
 If returns to physical capital (MRP) increase, demand for investment increases
o Investment Demand – Graphically
 price = interest rate (lower case i) on y axis
 quantity on x axis
 financial markets – downward sloping (inverse relationship)
 increase in MRP of capital – shift to the right
 Supply of Land
o Total area is fixed, quality of land somewhat variable
o immobility of land makes supply more inelastic (not perfectly inelastic at the industry
level)
o changing use of land takes time – more elastic in the long-run
 Supply of Physical Capital
o Physical capital (equipment, buildings, etc.)
 Produced by firms in the economy
 Often inelastic supply in the short-run
 Elasticity of supply elastic in long-run
o Factor mobility is critical
 Can capital be repurposed across industries?
 Equipment is often specialized, buildings might be
o Supply of factors to individual firms are normally assumed to be elastic (competitive
markets)
 Supply of Financial Capital
o Households are the primary source of savings
 Various reasons for households to save (more on this in EC140)
 Generally, focus on smoothing consumption over time
o Because of this, income affects saving
 Increase in current income causes an increase in saving
 Increase in future income causes a decrease in saving
 Interest rates are the return to saving - higher interest rates generate more
savings
o Supply of Financial Capital – graphically
 interest rates (y) and Quantity of financial capital (x)
 if people feel richer today – decrease saving – shift to right
o Equilibrium in the Capital Market –
 interest rates (y) and Quantity of financial capital (x)
 supply and demand curves
 increased demand leads to more investment and a higher interest rate
 Factor Price Differentials
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o Similar factors paid differently

o Temporary differentials
 eliminated by factor mobility
o Equilibrium differentials
 Intrinsic differentials
 Acquired differences
 Compensating differentials
o Temporary Differentials – Graphically

 Transfer Earnings and Economic Rent
o Transfer Earnings
 opportunity cost of a factor
 depends on alternative use
o Economic Rent
 earnings above transfer earnings
o Transfer earnings vs. economic rent depends on perspective
o graphically –
 upward sloping supply curve for a factor of production
 transfer earnings are the triangle below the supply curve up to a given point
(equilibrium) – look like cost of production (opportunity cost)
 economic rent is the other triangle (above) – looks like profit

Lecture 18 - Labour Markets

 Factor Markets
o Factors of Production – land, labour, capital
o Labour markets are different
 labour contracts are per unit of time – minimal concern with present value
issues
 issues of fairness, socially optimal outcomes affect policy
o Why do wages vary so much? both demand and supply matter
 Demand for Labour
o Value of one additional unit of labour (hourly/yearly/other)
 Marginal product measures quantity produced by an additional unit of labour
 Marginal revenue measures revenue produced by additional quantity
o Marginal revenue product is marginal product times marginal revenue
 MRP = MP x MR
o Firms willing to pay if wage is less than marginal revenue product
o graphically –
 MP graph – quantity of labour and output
 as you add more labour, the MP of that labour falls (downward sloping)
 MRP = Demand graph
 wage on y axis, quantity of labour on x axis – downward sloping
 Supply of Labour
o Supply of labour is very different in different markets
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o Labour market mobility is very complicated

 Are people willing/able to move?
 Are people willing/able to switch industries?
o How narrowly a labour market is defined determines elasticity of supply
 supply is more elastic for narrow markets (i.e. supply of accountants in waterloo
vs. GTA)
o Some labour markets require extensive training - supply is more inelastic
 Labour Market Equilibrium – Graphically
o assuming perfectly competitive labour market
o equilibrium point where wage equals quantity of labour (no unemployment)
 difference between unemployed and not willing to work
 Wage Differentials
o Equilibrium differentials
 Intrinsic differences - ability, height, attractiveness (things that are true
permentantly)
 Acquired differences - educational differences
 Compensating differentials - working conditions
 Discrimination by customers
o Temporary Differentials
 Changes in prices changing marginal revenue product
 Discrimination by employers in a competitive market
 graphically –
 example of accountants in Toronto and accountants in Waterloo
 TO – equilibrium point is higher than WL (already account for
equilibrium differential)
 demand for accountants in TO increases – wage increase
 therefore, the supply of accountants in WL falls – reaches TO’s previous
equilibrium point
 temporary – movement of both curves
 equilibrium differentials – with both the start and end points, you’ll get
a difference in wages
 Discrimination
o Discrimination is a source of wage variation
 Women are paid less than men
 Partially explained by differences in industry, hours, experience
 Important to recognize those differences may also reflect discrimination
o Causes of discrimination matter for persistence
 Discrimination by government policy
 Discrimination by employers - competition matters (discrimination lowers as
competition increase – firms are motivated to find the best workers at a given
wage)
 Discrimination by customers
o Discrimination – Graphically
 Market for Doctors – higher wage (ED) – “Women Can’t be doctors” – decreases
supply for doctors, increases supply of nurses
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 Market for Nurses – lower wage (ED)

 Non-Competitive Markets
o Perfectly competitive labour markets
 Many buyers (firms), many sellers (workers)
o What happens if we don't have competitive markets?
o Unions bargain collectively - only one seller of labour
o Monopsony is when there is only one buyer (think old coal-mining towns)
 Unions – Graphically
o standard demand and supply
o competitive market wage – equilibrium point
o union wage – behind on the demand curve (higher wage with less supply)
o union negotiate for both wage and number of position available – functionally increases
the demand for labour (brings union wage above originally EP)
 Monopsony – Graphically
o downward sloping MRP and a supply curve
o like monopoly concept – to hire another worker, you have to raise the wage you pay
everybody else
o MC curve is higher than wage (increases quickly)
o profit max – MC = MRP therefore hire the quantity below MC=MRP and pay them where
supply equals quantity (monopsony wage)
 Minimum Wages
o Legislated minimum wages are a popular policy tool
o Primarily affect low wage labour - which looks like a competitive market
o Competitive labour market theory suggests that they should cause unemployment
o But empirical evidence on employment effect is mixed:
 Some studies show reductions in employment, some don't
 Time horizon is likely critical - labour demand elasticity
o Minimum Wages – Graphically
 in a competitive market – min. wage exists as a price floor (pushes up wages),
and leads to more unemployment
o Minimum Wages with Monopsony – Graphically
 min. wage not causing unemployment
 monopsony market – MRP, S, and MC
 already paying less than MRP or equilibrium point – so if Min. wage is at
MC=MRP or S=MRP, just paying more (along the MRP curve)
 Income Inequality
o Inequality is a critical topic for policy
 Focus on income inequality
 Could focus on other dimensions - wealth, consumption
o Measurement of inequality is challenging
 Income shares of different groups (top 20%, top 1%, bottom 20%)
 Ratios (ie. income of 90th percentile to 10th percentile)
 Lorentz curve - mapping out income shares
o Inequality has been rising over time
 Pre-Tax or After-Tax Income
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o Should we measure inequality before taxes or after?

o Should inequality take transfers (welfare, EI payments, etc.) into account?
o Inequality is lower after taxes if government policy is progressive (benefits)
 Lorentz Curve and the Gini Coefficient - Graphically
o common measure on income inequality
o upward sloping line
o y axis – share of income, x axis – share of population (0% to 100%)
o Lorentz curve – upward sloping below the line – if everyone was equal, the Lorentz
curve would be the straight line
o if one person had all the money, Lorentz curve would be a backwards L shape
o Gini coefficient – represents the area between the line and the Lorentz curve divided by
the larger triangle
o so if the gini coefficient is smaller – less equality
 Why is Inequality Rising?
o Skill-biased technical change
o Globalization
o Decline of labour unions
o Increase in contract work
o Rising executive compensation
o Superstar theory
o Rising income from capital investment

Lecture 19 - Market Failure

 Functions of Government
o Monopoly on the use of force (police, military)
 checks on the use of this monopoly are critical
o Governments define and enforce property rights
 Rights and responsibilities of citizens and organizations in society
o Long-run economic development primarily determined by these two institutions
 The Case for Free Markets
o Coordination of actions of decentralized decision-makers
 People/companies only need prices to make decisions
 Price signals very difficult to replace in a command economy
 How does government know what people want?
o Pursuit of profits provides incentives for innovation
 (in theory) anyone with an idea can create new products
 not limited to the ideas of those with political power
o (Partial) decentralization of economic power
 market replaces use of violence in allocating goods and services
 Market Failure
o when is a free market not allocatively efficient? – market failure just means not
allocatively efficient
o Market Power
 monopoly, oligopoly, monopolistic competition
o Externalities
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 when costs or benefits to society are different from the costs or benefits to
those involved in a transaction
o Non-Rival or Non-Excludable Goods
 Non-rival goods - marginal cost is zero
 Non-excludable goods - price is zero
o Asymmetric Information
 Buyers and sellers have different amounts of information about product quality
or future actions
 Externalities
o Buyers and sellers of goods/services may only focus on their own profit/utility
o What happens if there are other costs or benefits?
o Negative Externality
 Costs incurred by other people
 Social costs are greater than the marginal cost (supply curve)
o Positive Externality
 Benefits incurred by other people
 Social benefits are greater than the marginal benefit (demand curve)
 Examples of Externalities
o Exhaust from automobiles
 Negative externality due to smog/air pollution
 Emission standards, gasoline taxes
o Restoration of historic buildings, spending on gardens
 Positive externality to those walking by
 Tax breaks for building restoration
o Barking dogs, and other forms of noise
 Negative externality on neighbours
 Local noise bylaws with fines for excessive noise
o Research into new technologies
 Positive externality if resulting knowledge can be used
 Patent systems, public investment in basic research
 Negative Externalities - Graphically
o supply = MC (private)
o demand = marginal benefit (MB)(private)
o lower supply curve (MC society)
o efficient outcome – total cost (including externality) is equal to market demand
o market outcome leads to overproduction, efficient outcome is that you should produce
less
o (looks like a tax – if a tax is in place you recreate the efficient outcome)
 Positive Externalities – Graphically
o supply and demand (private MC and private MB)
o increase demand curve (social MB) (social MB includes private MB PLUS smth therefore
always above)
o therefore efficient outcome is greater than market outcome – market outcome leads to
underproduction
 Taxes and Negative Externalities
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o efficiency when social cost exceeds private cost

 negative externality graph – social MC is higher
 place tax so that you create the efficient quantity (up the market price and
lower market quantity)
 lower quantity produced (think carbon tax)
 Subsidies and Positive Externalities
o efficiency when social benefit exceeds private benefit
 positive externality graph
 demand increases – (benefits to others, social MB increases)
 introduce subsidy – (shifts down the supply curve (increase))
 subsidy is a mirror of the tax
 ultimately lowers price, increases quantity
 Rivalry and Excludability
o two key characteristics of goods
o Is a good excludable?
 Can a person be prevented from accessing it?
 Environmental quality, national defence
 Others are less clear - e.g. issues of human rights
 Is a legal system, drinking water, health care etc. legally excludable?
 Practicality of excludability is an issue - can people be prevented from fishing?
o Is the good rival in consumption?
 Does the use of the good by one person limit use/value by others?
 Fire protection, radio/TV broadcasts, creation of new technology
 Four Kinds of Goods
o Private Goods
 Excludable, rival
 Food, clothes, most goods in society
o Public Goods
 Non-excludable, non-rival
 National defence, poverty reduction
 Provision likely involves a positive externality
o Common Resources
 Rival, non-excludable - cost of exclusion?
 Environmental damage, fishing, national parks?
 Use involves a negative externality
o Club goods
 Excludable but (effectively) non-rival
 Roads, national parks, museums
 Public Goods
o Pure public goods are non-rival and non-excludable
o National defence, basic research
o Poverty reduction
o Benefits from public good provision vary in the population
o Distributional issues are extremely complex
o For a given quantity, add up marginal benefit to everyone in society
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 Cost-Benefit Analysis
o a study comparing the costs and benefits to society of providing a good or service
 measuring “social benefits” is very difficult
 How much would you value poverty reduction (not your own)?
 What value would you place on Banff National Park?
 How valuable is having an NHL hockey team in K-W?
 Public Goods and Marginal Benefit – Graphically
o supply = MC
o three MB lines (a, b, c)
o add up all three – take everyone’s value for public goods and add them up to have a
definitive MB demand curve
o easy in conception, hard to actually execute (non-excludable)
 Club Goods
o Club goods are excludable, but non-rival
o Marginal cost becomes effectively zero
o Often extreme versions of natural monopolies
o Solution may be government provision to ensure allocative efficiency
 Common Resource Goods
o Rival, but non-excludable good or service
o Because non-excludable, price is functionally zero
o Marginal cost is not zero - so allocative efficiency is not possible
 Key Common Resources
o Clean air and water
 Regulations and taxes on pollution
 Exclusion is not possible
o Congested roads
 Regulations - carpool lanes
 Taxes and Fees - road tolls, gas taxes, etc.
 Exclusion is very inefficient
o Fish and other wildlife
 Regulations are common - short fishing season
 Taxes are possible, but not common
 Tradeable permits introduce concept of exclusion
 Hunting licenses auctioned off
 Moral Hazard
o A buyer or seller taking advantage of their private information
 May result in higher prices or fewer sales, creating inefficiency
o If a seller has more information about the quality of the good they are selling
o Common moral hazard issues:
 Specialty services (legal, dental, car repair) - seller may have private information
about what the buyer needs
 Insurance markets - once they have insurance, less reason to prevent losses
 Financial markets - insured deposits remove depositors incentive to bank at less
risky institutions
 Adverse Selection
o Self-selection by buyers or sellers based on private information
 May result in higher prices or fewer sales, creating inefficiency
o If a seller has more information about the quality of the good they are selling
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o Common adverse selection issues:

 Used car market - seller has more information about car quality
 Insurance markets - buyer knows more about their risk factors
 Broader Social Goals
o When does a government get involved for reasons other than allocative efficiency
 Income distribution
 Preferences for public provision
 Protection
 Paternalism
 Social responsibility
 How Does the Government Intervene?
o Public provision (education, roads, parks, police and legal systems)
o Redistribution (taxes and government spending)
o Regulation (compulsory education or military service, requirements to use seat belts)
o Costs of intervention
 Direct costs - government costs of hiring workers
 Indirect costs - changing costs of production, costs of compliance, rent seeking
 Market Failure to Government Failure
o Government provision can also fail to result in allocative efficiency
o Government intervention needs to be analyzed carefully
o Consider the government intervention as realized, not intended
o Similarly, consider market outcomes as they happen, not as idealized
Lecture 20 - Environmental Policy

 Externalities and Allocative Efficiency – Graphically

o S = private MC, D= private MB
o higher social MC
o move from market outcome to social outcome – allocative efficiency (social MC = social
MB)
 From Pollution to Abatement - Graphically
o switch from negative externality graph (Price and quantity of output) to;
o y axis price, x- axis pollution abatement (graphing reductions in pollution)
o MB - downward sloping curve - up to 100% pollution abatement (no pollution)
o MC – upward sloping curve – up to 100% pollution abatement
 allocative efficient point is where MC = MB (same quantity as negative
externality graph)
 Optimal Pollution
o Marginal cost of pollution is increasing
 marginal benefit of abatement is decreasing
o Marginal cost of abatement is increasing
 Polluters can reduce pollution in a variety of different ways
 Some are cheaper than others
o Optimal abatement - when marginal cost of abatement equals marginal benefit
 If benefits are generic to the economy, efficiency requires marginal cost of
abatement equalized across companies
 Pollution Control Options
o Direct regulation
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 rules to reduce or eliminate specific pollution sources

o Emissions taxes
 pay a tax or fee for every unit of the pollutant produced
o Tradable pollution permits (Cap and Trade)
 must own a permit in order to be allowed to emit pollution
 Direct Regulation
o Command-and-control
o Households or firms either must do something, or must not do something else
 Companies must install specific technology in industrial production
 Households may only produce specific amounts of garbage each week
o Works well if rules are clear
 Eg. Bans on leaf burning
o Less effective if complete abatement is not desirable
o graphically –
 different companies in different positions (multiple MC curves)
 direct regulation is similar to a quota – vertical line
 problem is that MC across companies is not efficient
 exception is if you ban something entirely – than MCs are equal
 Emissions Taxes
o Charge a specified fee for every unit of pollution
o Firms can save known amounts of money for each unit of pollution that is not created
 Firms will reduce pollution if the marginal cost of abatement is less than the tax
o Generates efficient abatement
o Unless we know marginal cost of abatement, does not lead to a known reduction in
pollution
o Government must be able to measure pollution output in order to tax it
o graphically –
 MC for firms a and b
 tax is horizontal line – companies produce at different quantities
 efficient in the sense that they have equal marginal costs
 don’t know MC curves when put in place – cannot measure quantity of pollution
abatement
 Tradable Permits
o Firms must have permits to emit pollution
o A set number of permits are available
 Permits can initially be sold, auctioned or given away
o Firms can trade them - a market for permits must exist
 Firms will reduce pollution if the marginal cost of abatement is less than the
cost of a permit
o Demand for permits determines the price of a permit
o Might be difficult to adjust number of permits as technology changes
o graphically –
 vertical line – two MC curves for different firms
 with no trading – firm A has a higher MC than firm B
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 with trading – horizontal line at price between the two MC points – eventually
firm A reduces pollution by less, firm B reduces pollution by more, total
pollution is less PLUS at a lower cost
 (basically – combining two features of direct regulations and emissions taxes)
 Taxes VS. Tradable Permits - Graphically
o taxes – horizontal line, permits – vertical line
o if you knew the MC of abatement – policies are equally as good
 Climate Change
o Climate change is complicated
o Doesn't mean that action on climate change is complicated
o Reducing greenhouse gas emissions requires a price on their emissions
 Stocks Vs. Flows
o Key element in managing climate change
o Stock of pollutants in the atmosphere critical to climate change
o Flow of pollutants leads to changes in the stock of pollutants
o Tradable permits would specify the flow of pollutants
o Taxes would specify the marginal cost of abatement

 Economic Growth and Emissions

o GHG emissions affected by three factors:
 economic activity (GDP)
 energy intensity of GDP – Energy/GDP
 GHG Intensity of Energy – GHG/Energy
o Multiplying percentage changes – just add/subtract
o GHG = (GHG/Energy) x (Energy/GDP) x (GDP)

Lecture 21 - Tax Policy

 Externalities, Taxes, and Efficiency – Graphically

o market with no externality – supply and demand curve
 higher buyers’ price, lower seller price – triangle difference leads to deadweight
loss
o market with externality – (MB, social and private MC)
 same price points – no deadweight loss
 market price inbetween price points – buyers buy less, sellers supply less
 Taxation in Canada
o Taxes on income, profit, capital gains
 personal income tax
 corporate income tax
o Consumption Tax
 GST/HST
o Property taxes
o other taxes
o health and social insurance premiums
 Taxation and Equity
o Are Canadian taxes assessed fairly?
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 normative question – no right answer

o Tax fairness assessed on two dimensions:
 Ability to pay principle – vertical/horizontal equity
 vertical – higher income is taxed more
 horizontal – same income but different life circumstances pay different
taxes (i.e. individuals vs. families)
 Benefit principle
o Overall – Canadian tax system mildly progressive
 rich pay higher fraction of income in the form of taxes
 (progressive) – tax rate rises as income does
 (regressive) – tax rate lowers as income does
 Canadian Taxes:
o revenue of Canadian government – share of Canadian income collected in taxes has
gone up in the past 5 years
 fed gov has raised taxes
 economy is doing better – collect more
 Fiscal Federalism
o Government spending very decentralized in Canada
 sub-national government responsible for a lot of spending
o Range of principals underlying fiscal federalism
 Canadians deserve similar public service across the country
 Services provided at the “correct" geographic scope
 Regional variation in preferences
 Administrative efficiency
 Social Spending in Canada
o Largest portion of government spending in Canada
o Health and education
 Provincial responsibility
 Efficiency and equity arguments to government provision
o Income support programs
 Welfare, child benefits, old-age security
 Provincial and federal responsibilities
o Self-financed programs
 Employment insurance, Canada pension plan, Quebec pension plan
 Negative Income Taxes and Basic Income – Graphically
o y axis is after-tax income, x axis is earned income
o regular – increasing at a different rate
o negative income tax – below some income point, earn tax refund (looks like a basic
income system)
o looks like tangent line basically
 Taxation and Efficiency
o taxes can be assessed for equity and/or efficiency
o Remember – efficient does not imply “good”
o Taxes necessary to raise money
o taxes also affect incentives, and therefore choices
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 Direct and Excess Burden

o Direct burden is the total amount of taxes paid by households/firms – “tax collection”
o Excess burden is the deadweight loss associated with the tax – “deadweight loss”
o For efficiency - focus on the indirect burden
o Elasticity determines side of indirect burden
o Taxes on inelastic supply/demand - much more efficient
o graphically –
 supply and demand, buyers and sellers’ price
 Direct burden – rectangle beside deadweight loss
 indirect burden – deadweight loss
 more inelastic – similar direct burden but lower excess burden
o GST (on everything) - somewhat regressive as lower income individuals spend more
money on goods and services and higher income individuals
 Labour Taxes
o Income taxes have both direct and indirect effects
o Indirect burden is inefficient
o How much does income tax affect total employment?
o Labour supply mostly inelastic
 Some groups have more elastic labour supply
 Second income-earners, people near retirement, self-employed
o Creates debate - can lowering taxes lead to an increase in total taxes?
 Laffer Curve
o wage on y axis, quantity of labour on x axis
o labour demand and labour supply curves (moderate levels of elasticity)
o vertical line tax (small)
o separate graph – Revenue on y axis, tax on x axis
 negative parabola
 as tax rate increases, initially increasing the direct burden, reach a point where
tax revenue starts going down, if nobody supplies labour you collect no tax rev.
 critical question – where is the peak point? (laffer peak)
 estimate of laffer peak for most countries – 70%
Lecture 22 - International Trade

 Gains from Trade

o Without trade – each person produces all goods themselves
 extreme case of autarky (no trade)
 obviously not optimal
o Trade allows specialization – among people, regions, countries
 People, regions or countries can specialize in producing goods that they produce
most efficiently
 trade and specialization work together
 Absolute vs. Comparative Advantage
o Absolute advantage
 When one trading partner can produce a good using fewer inputs than another
partner
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 One partner may have an absolute advantage in all goods

o Comparative advantage
 When one trading partner can produce a good at a lower opportunity cost than
another partner
 Each trading partner has to have a comparative advantage
o If each country specializes according to comparative advantage, total production
increases
 Gains from Trade – Linear
o two goods on each axis, two graphs (Canada and Japan)
o two linear lines – steeper slope means higher opportunity cost
o if they specialize – each country can consume outside their PPF
o trading price falls between the opportunity costs of the two countries (but also includes
the op costs)
 op. cost of canada ≤ trade price ≤ op. cost of japan
o that gives the slope of the trade opportunity line
 Gains from Trade – Bowed Out PPF
o bowed out curve – Autarky (A) point (no trade)
o world trade price is a linear line (steep, downward sloping) that goes through the A
point
o can choose to consume at point along the trade line
o 2 types of gains of trade
 don’t change production – trade some goods away to gain different ones
(difference between points A and B)
 specialize in what they produce (one good), consume different and more goods
(difference between points P and C – vertical line at specialization point)
 Trade and Increasing Returns
o How can trade increase output, even if costs are identical across countries?
o How can specialization increase output?
o Economies of scale
 Production is more efficient if countries specialize
 Much more important for smaller countries
o Learning by doing
 Productivity increases with greater production over time
 Sources of Comparative Advantage
o Factor endowments
o climate
o human capital
o other acquired comparative advantage
o does comparative advantage change?
 Terms of Trade
o How do we measure export and import prices?
o Terms of trade - export prices divided by import prices
o When terms of trade improve - can buy more imports for same amount of exports
o Canadian terms of trade strongly tied to price of oil
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 Improvement in the Terms of Trade – Graphically

o cars and oil on axis’s
o Linear PPF
o production at specialization point – trade line gets steeper and move to a higher point
(when price of specialized product goes up, can buy more stuff – higher profit)
 Decline in the Terms of Trade – Graphically
o same thing – but line gets less steep (can buy less)
o for bowed outward PPF – production level also changes
 Law of One Price
o For goods that are traded internationally, prices need to be similar in different places
o If not, opportunity for arbitrage
o Many widely traded goods have (effectively) a world price
o For those goods, Canada is often a small player
o Analyze supply and demand assuming Canadian policy does not affect the world price
 Exports – Graphically
o world market for x good
o supply and demand (in Canada)
o if Canada doesn’t trade – price and quantity are at equilibrium (autarky point)
o exports look like a price floor (above Equilibrium price)
o difference between supply and demand is the amount of exports
o (quantity supplied is higher than quantity demanded at world price)
 Imports – Graphically
o same as above – but price ceiling (below equilibrium price)
o difference between supply and demand is the amount of imports
o (quantity demanded is higher than quantity supplied at world price)

Lecture 23 - International Trade Policy

 Final Exam Chapter Breakdown:

o Chapters 1-6: 15 questions
o Chapters 7-12: 19 questions
o Chapters 13-18, 32-33: 46 questions
 Free Trade or Protection
o Tariffs – taxes on imported goods
 generally, most efficient trade barrier
o Non-tariff barriers
 import quotas – limits on the quantity of imports
 slow customs procedures, or institutional delays
o Non-tariff barriers can be very inefficient
 Case for Protection
o Diversification
 Are there industries Canada must have?
o Improving the terms of trade
o Protecting infant industries
 Development of industries that feature learning-by-doing
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o Earning profits in foreign markets

 Development of industries that feature learning-by-doing, or economies of
scale, or to get into a profitable industry
o Environmental or labour protection?
 Protecting specific groups (usually producers – i.e. dairy farmers in Canada)
 Other Arguments Against Trade
o Reducing spending in other countries
 What happens to Canadian dollars spent on imports?
o Protect against low-wage foreign labour
 May be equivalent to protecting producer surplus in low-wage industries
o Valuing exports over imports
 Imports improve well-being of Canadians
o Creating domestic jobs
 Jobs are also created by exports
 Trade Remedy Laws
o Dumping
 Tariffs intended to offset actions by private companies selling “too cheap”
o Countervailing duties
 Tariffs intended to offset government subsidies in another country
o Narrowly directed tariffs
 tariffs as political action
 or retaliatory tariffs
 Current Trade Policy
o International agreements
 GATT and WTO - rules on trade policies
o Regional trade agreements
 Free trade areas - NAFTA, CETA, TPP, etc.
 Customs unions - Mercosur
 Common market – EU
 Trade Diversion
o Are regional trade agreements efficient?
 In general, trade leads to improvements in total surplus
 Regional trade agreements both create and divert trade
o Trade creation
 Countries specialize according to comparative advantage
o Trade diversion
 Countries import more from less-efficient trade partners because they are part
of a regional trade agreement
 Trade diversion reduces total surplus
 NAFTA
o NAFTA has a variety of elements
 National treatment
 Most tariffs/restrictions eliminated (some remain)
 Dispute settlement process
o Most of this continues in USMCA
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o Dispute settlement process very contentious

 Bilateral dispute mechanisms continued
 Investor-state dispute settlement mechanism ended
 Import Tariffs – Graphically
o Supply and demand, world price below EP
o tariff raises the price in Canada – therefore world price increases
o therefore, decreases imports
o decreases consumer surplus, producer surplus increases (produce higher Q)
o rectangle between world price line and tariffs line = tariff revenue
o two triangles beside tariff revenue = deadweight loss
 Import Quotas – Graphically
o supply + import line – parallel to the supply curve, starts at the world price
o new equilibrium is where the supply + import line intersects demand
o price is a line through the EP
o same deadweight loss (two triangles)
 Import Quotas vs. Tariffs
o Achieve similar goals in restricting exports, raising domestic prices
o Tariffs collect revenue, quotas are very complicated
o Effect of quotas on consumer prices more hidden