Session 13A&B-BYN-Firms As Neighbors & Firm in Intl Market

Session – Managerial Economics
Firms As Neighbors: External Effects*)
Lectured by B. Yuliarto Nugroho, Ph.D
*) (Summarized from Ulbrich et.al, Managerial Economics
Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 1

A. Background
 Topics discussed so far are assumed that the
firm and the buyer as independent individuals,
interacting impersonally in markets. In this
assumption, when transactions take place,
there are private matters between buyer and
seller. In fact, however, for many economics
activities this assumption is unrealistic. Many
transactions have spillover effects on third
parties, who are neither buyers nor sellers but
neighbors who incur costs or receive benefits
from other people’s economic activities. These
spillover effects are called externalities.

A. Background
 Externalities can be positive, conferring
benefits on innocent bystanders, or they can
be negative, inflicting costs on unsuspecting
third parties. If such spillovers exist, then an
economic transaction ceases to be a matter of
purely private interest between buyer and
seller, and becomes virtually all firms are
affected by the environmental regulations and
other public policies adopted to deal with
spillovers.

B. Objectives of This Session
 To identify the effects of positive and negative

externalities
 To describe situations in which private
solutions to externality problems can be
negotiated successfully.
 To describe and evaluate the various forms of
government intervention to correct
externalities.
 To understand the risks as well as the benefits
of having the government intervene to correct
externalities.

C. Firms Produce Too Much:
Negative Externalities
 When the production (or consumption) of a good
creates harmful spillovers on third parties, in the
absence of intervention by government the firm will
normally produce too much and charge too little for the
good. For instance, firm that causes air or water
pollution, health hazards, noise, or other burdens on
their neighbor are using a resource for which they are
not required to pay the full cost. They are using the air,
water, or ground as a trash dump and are not charged
for the costs they create. Because such costs are held
to an artificially low level, the firm’s marginal cost
curves (and therefore supply curves) will be below and
to the right of where they would be if the firm had to
pay all its costs, including the costs inflicted on third
parties.
(continued)
 Economists regard externality problems as a matter of poorly
defined property rights. The reason that problems of negative
externalities most often arise in air or water quality is that
property rights to air have rarely been defined at all, and
property rights to water have generally been specified in terms
of quantity rather than of quality.
 Figure 1 illustrates a negative externality, air pollution caused
by steel production. The supply curve labeled Sp represents
the sum of the marginal cost curves of the firms in the steel
industry based on their private costs – labor, raw materials,
electricity, equipment, and so on. On the basis of private
supply and demand, without taking negative externalities in
consideration, the price will be P1 and the quantity produced
and sold will be Q1. However, in the process of producing
steel, this firm discharges pollutants into the atmosphere.
Some of the effects of those pollutants on third parties –
people who are neither producers nor buyers of steel – can be
measured.
(continued)
Figure 1
A Negative Externality
P
Ss
P2 Sp
P1
Cs
Q2 Q1 Q (steel)

(continued)
 Assume that these effects can be measured and
related to the level of steel output, so that it is possible
to determine how such additional cost is imposed on
third parties for various levels of steel production.
These effects are captured in a social marginal cost
curve, Cs, in Figure 1. Adding these costs to the
existing private marginal costs curve (vertically these
costs to the existing private marginal costs for each
unit of output) results in the social supply curve Ss,
which reflects both the private and social marginal
costs of production. This supply curve intersects the
demand curve at price P2 and quantity Q2. When all
costs are taken into account, the socially optimal level
of steel output is lower and the price is higher.

(continued)
 Imposing the social marginal cost on the

production process that created the social
costs is called internalizing externalities. In
a few cases there are ways to internalize
externalities that do not include the
government, but in most cases government
intervention is needed to seek to bring
about the socially optimal price and output.

C.1. What Is The Best Way To Regulate?
 Regulation Of Forcing the Firm to Reduce Negative

Effect
This regulation may specify technology to be used –
scrubbers, chemical treatment, or other methods. For
example, the method of regulation can shift away from
specifying technology toward defining a permitted
amount of effluent. This method allows firms to seek
out the least costly technology to achieve that result. In
either case, complying with regulations has two effects
on the level of pollution. First, it reduces pollution
directly. Second, it raises the firm’s production costs
that allowing the firm to increase its price (so that at
least part of the cost of pollution now falls on
consumers of the products responsible for causing in
the pollution.
(continued)
 Regulation of Creating Tax Pollution
This regulation creates tax or fee for each unit effluent
emitted. This solution is more appealing to economist
because it simply ensures that the costs of pollution
are reflected in the price, allowing producers and
consumers of the product to make choices based on
the prices the face. The appropriate tax per unit is
measured by the vertical distance between the private
and social supply curves in Figure 1. Here, the costs of
pollution per unit of output rise as output expands, so
the appropriate tax should increase with the level of
pollution as well.

(continued)
 Regulation Of Creating Pollution Rights
This regulation creates pollution rights in order to maintain a
desired level of environmental quality since the desired level is
established. Usually, these rights are assigned to existing firms
that emit the particular pollutant. New firms that emit that pollutant
and that wish to locate in the area, or existing firms wishing to
expand their production levels, must purchase pollution rights
from other firms. Newcomers may buy out other firms in order to
acquire their pollution rights or to assist them in reducing their
emissions, thus creating some excess pollution capacity that can
then be exploited by the new or expanding firm. Private markets
develop in which pollution rights are bought and sold. Since the
desired result is air quality or water quality, rather than controlling
the emissions from specific firms or the output of particular
industries, this approach makes good sense for certain situation.

C.2. Problems of Regulating
 Problems in measuring the social cost or
damage done.
 Problem in seeking the least-methods of
achieving the desired goal (the optimal
profit)
 Problem in reducing costs due to the
bureaucratic expenses resulting from
regulations

C.3. Private Solutions
 Without government intervention, private

solutions (solutions negotiated by the private
parties) can be a way for preventing negative
externalities. This can be done since the
parties are agreed upon property rights that
they share.
 When the property rights are not clearly
defined, the right often is appropriated by the
first user of the property right.

D. Firms Produce Too Little:
Positive Externalities
 A second type of externality problem results
from positive spillover benefits associated with
the consumption or production of a particular
good. For instance, when you receive a good
education, you benefit, your family benefit,
your community benefit. Most of the benefits
accrue to you, but the community has a more
informed citizen, a more productive worker, a
person less likely to wind up dependent on the
community for support through welfare and
food stamps. There are social benefits, or
spillovers, from your education.

(continued)
 ABC Corp has flowers on its front lawn. They were
planted for the personal enjoyment of the owner, but
they create spillover benefits for everyone that passes
by. Since ABC cannot charge for their benefits, the
owner will decide how much effort to put into her yard
based on her own personal cost and benefit
calculations, ignoring the value of the spillovers.
 Farmer A sprays his farm for mosquitoes in order to
keep the livestock from being bitten on warm summer
nights. In the process he creates spillover benefits for
his neighbor, who also are less bothered by
mosquitoes.

(continued)
 An electric power company dams a river for
hydropower purposes. Spillover benefits to adjacent
landowners include flood control and recreational
opportunities. Unless the power company owns all the
land around the lake, some of the benefits spillover to
others.
 All of the above examples of positive externalities, or
spillover benefits from private consumption or
production activities. If individual makes a decision
about how much to produce or consume without taking
positive spillovers into account, then the result is likely
to be too little of a good thing.

D.1. Subsidies to Expand Output and
Consumption
Figure 2
A Positive Externality
P
Dt
P2 b
P1
P3
a Dp
Ds
Q1 Q2 Q (education)

Consumption
(continued)
 Figure 2 illustrates the supply and demand for
technical education, which is assumed to have
spillover benefits to society. The supply curve effects
increasing marginal costs. The demand curve, labeled
Dp, shows private demand for such education, based
on personal benefits. The spillover benefits to society
from each person educated are shown on Ds. Recall
that the price on the demand curve is a measure of
value or benefits to the user. For each person
educated, just add the private benefits on Ds to the
social benefits on Ds to obtain the total benefits,
shown as the kinked, heavy line Dt. For example, the
education of the tenth person creates private benefits
of $ 1000 and social benefits of $ 150 for a total value
of $ 1150.
Consumption
(continued)
 If the market is left to itself, then equilibrium will occur
where private demand intersects private supply at
P1Q1. The social optimum occurs when all demand –
private plus spillover – is taken into account in
determining the output level, which occurs more, would
invest in technical education. If society wants those
extra units of education to be produced and
consumed, a subsidy must be offered. The subsidy
must be sufficient to reduce the price of Q2 units of
output to the demand price of P3 in order to induce
people to purchase more education. Thus, the
optimum subsidy is the vertical distance between the
supply and demand curves, or job.

Consumption
(continued)
 Positive externalities offer justification for many
types of subsidies, particularly in education. In
higher education suppliers often combine price
discrimination with subsidizing goods and
services that have positive externalities. A
pricing pattern that combines financial aid for
students, scholarships for bright students,
work-study opportunities for hard-working
students, and full price for the rest, provides a
subsidy to students with more elastic demand
while charging the others the full price.

D.2. Private Solution
 In small communities there is more likely to be

public support for parks, arts programs,
beautification efforts, and other activities with
positive spillovers benefits. As communities get
larger, however, there is a tendency to look for a
free rider
 For certain goods, the benefits consist almost
entirely of spillovers. There is no identifiable
primary buyer because everyone within a given
area shares equally in the consumption, with or
without a contribution. It may be more costly to
exclude non-payers than it is worth.

Session – Managerial Economics
The Firm in The International

Marketplace*)
Lectured by B. Yuliarto Nugroho, Ph.D
*) (Summarized from Ulbrich et.al, Managerial Economics

A. Background
 Many firms in advanced countries operate in

an increasingly open and competitive world
marketplace. Many of their competitors,
suppliers, and customers are in other
countries. As a result, they must learn to deal
with foreign exchange markets, tariffs and
customs procedures, and other national
regulations that affect trade across national
borders.

A. Background
(continued)
 Much of what economists have observed

about trade between buyers and sellers in
different countries also applies to trade
between different regions of the same country,
separated not by different currencies and
different governments, but by distance and
lack of information.

B. Objectives of This Session
 To explain the concept of comparative

advantage.
 To see how tariffs and quotas work, and who
gains and who loses from restriction on free
trade
 To explain why a firm might choose to produce
abroad rather than at home.

C. Comparative Advantage and Other
Explanations
 The basis for a free trade policy was laid out in
Adam Smith’s 1776 Wealth of Nations, then
developed and expounded by British economists
(particularly David Ricardo) throughout the 19th
century. They offered two arguments for free trade.
The primary argument was the theory of
comparative advantage. The second one was
based on the benefits for consumers of having
foreign competitors to challenge domestic
monopoly power (closely related argument
emerged in the 20th century based on economies
of scale).

Explanations
(continued)
 The comparative advantage argument has

received the most attention. Comparative
advantage rests on the fairly simple idea that
different countries often have different opportunity
cost for producing the same goods or services.
Figure 1 illustrates a simple model of comparative
advantage for two countries producing two
products, bread and wine. The following points lie
on the respective production possibilities curves of
Countries A and B:

Explanations
(continued)
Country A Country B
Bread Wine Bread Wine

0 100 0 75
5 90 5 70
10 80 10 65
15 70 15 60
20 60 20 55
25 50 25 50
30 40 30 45
35 30 35 40
40 20 40 35
45 10 45 30
50 0 50 25
55 20 55 20
60 15 60 15
65 10 65 10
70 5 70 5
75 0 75 0

Explanations
(continued)
 Before trade, Country A is producing 35 units of

bread and 30 of wine for its own consumption,
and Country B is producing 40 of bread, 35 of
wine (point X and X’ on their respective
production possibilities curves in Figure 1).

Explanations
(continued)
Figure 1
Specialization Based on Comparative Advantage
Wine Wine
100
75
50 C 50 C’
30 X 35 X’
0 35 50 Bread 0 40 75 Bread
(a) Country A (b) Country B

Explanations
(continued)
 The theory of comparative advantage says that each
country should specialize in that products in which its
opportunity cost is lower. A’s opportunity cost for bread in
terms of wine forgone is given by the schedule above, or
by the slope of the production possibilities curve in
Figure 1(a). Each extra loaf of bread means giving up
production of two units of wine. For B, the opportunity
cost is 1 for 1. B’s bread is cheaper than A’s in terms of
wine forgone, but this means that A’s wine is cheaper
than B’s in terms of bread forgone (½ bread vs. 1
bread). A should specialize in wine and B in bread; A will
produce 100 units of wine and B will produce 75 units of
bread (points Y and Y’) on their production possibilities
curves).
Explanations
(continued)
Note that at this point world output has risen. Before

specialization, total wine production was 65 (A
produced 30 and B produced 35) and total bread
production was 75 (A produced 35 and B produced
40). Specialization has increased wine production by
35 units with no reduction in bread production. If
these two countries can agree on a rate at which to
trade these goods – such as 1.5 units of wine per
loaf of bread – both can consume more of one or
both products because there is more available.

Explanations
(continued)
 Points C and C’ in Figure 1 show how much bread

and wine each country can consume in a good trade
environment. At C, Country A is consuming 50 units
of wine and 35 of bread, for a gain of 20 wines.
Country B is consuming 50 units of wine and 40 of
bread, for a gain of 15 wines. Other combinations
are also possible. The point is that real output
increases and consumers enjoy more real goods
and services when specialization takes place on the
basis of comparative advantages.

Explanations
(continued)
 Twentieth-century economists have tried to identify

what the sources of competitive advantage are. One
important source of differences in opportunity costs,
on which comparative advantage is based, is
resource endowments. One country may be rich in
capital, a second in labor, a third in land, while in
each case the other two broad groups of resources
are in short supply. It would make sense for the first
country to be highly specialized in producing those
products that use large amounts of capital and
relatively less labor and land, the second to
specialize in labor-intensive products, and the third
in land-intensive (usually agricultural) production.

D. Competition and Economies of
Scale
 Foreign competition fills an important gap,
forcing these firms to be efficient, price-
competitive, and attuned to the needs and
concerns of consumers. Foreign competition can
convert a domestic monopoly into an
international oligopoly, or a domestic oligopoly
into an international industry that is more nearly
monopolistically competitive

D. Competition and Economies of
Scale (continued)
 Economies of scale are a second benefit from

international trade. Industries that enjoy substantial
economies of scale must serve a large market in order
to attain the minimum average cost. If they are limited
to serving the domestic market, the industry will be
likely to have only one or just a few firms. In small
countries even a single firm may not be able to
generate enough sales to get to the most efficient
output level, where average coats are at minimum.
Serving a world market allows firms to achieve
economies of scale while at the same time ensuring
some competition for firms that would otherwise be
operating in conditions of monopoly or oligopoly.

E. Other Explanations of Trade
Patterns
 A significant part of the patterns of trade between
countries can be explained by comparative
advantage, supplemented by the development of
economies of scale. As for this, a nation may
begin with a very small comparative advantage (a
slight price edge). If that nation uses that slight
price advantage to increase market share, and if
the product involved in which they are economies
of scale, then the expansion in output will mean
that average costs will fall. The nation’s cost
advantage thus becomes larger, and its
comparative advantage is strengthened.

Patterns
(continued)
 Other explanations of the patterns of trade have also been

offered by Raymond Vernon of Harvard University. He
points to the product life cycle as an additional explanation
of trading patterns in some types of products. When a
product is new, it is produced in (and exported by) the
country where it was first developed. As the nation’s
producers continue to experiment with, develop, and
standardize the product, they will continue to export. Once
the technology is known and the product is standardized,
however, other countries are likely to jump in and try to
develop its production, first for the home market and
eventually for exports. Over time the production of the
newly standardized product will migrate to those countries
whose resource endowment is best suited for that product,
enabling them to produce at least cost.

Patterns (continued)
 Swedish economist, Stassan Linder points out yet

another determinant of trading patterns. He
observes that the bulk of trade takes place between
the developed, industrial countries, whose resource
endowment are similar, rather than between nations
at different stages of development, whose resources
are very different. Linder argues that production of
certain goods develop in response to home demand.
As producers develop and refine the product and
start looking for other market opportunities, they
begin to export. Markets for such products are most
likely to be found in countries with similar tastes
based on similar income levels.

Patterns
(continued)
 A final contributing factor to trade patterns is

the transportation requirements of the
product. As for this, resource-oriented
plants should be located near the raw
materials. Market-oriented production
should be scattered among many countries.

F. Tariffs, Quotes, and Commercial
Policy
 Firms that must compete with foreign
producers often seek protection and
assistance from the government. The
primary tools of protection are tariffs and
quotas. A tariff is a tax on imported goods. A
quota is a physical limitation on the number
of units of a good that can be imported
during a year. The effects are quite similar.
Figure 2 analyzes the impact of a tariff on
televisions sets.

Policy
(continued)
Figure 2
P Effects Of Tariff Sd
$300= PT G C
H F E B
$250= P0
Impor
D
1000 1200 2000 2500 Q

Policy
(continued)
 In Figure 2, Sd represents the domestic supply
curve, and D is the domestic demand curve. For
simplicity, assume that the importing country is small
relative to the world market, so that its citizens can
buy all the foreign TV sets they like at the going
price of $ 250. Before the tariff, the price of a TV set
was $ 250. Domestic producers were producing
1,000 sets a month, and consumers were buying
2,500 sets a month; thus, 1,500 sets were being
imported each month. Now domestic TV producers
persuade the government to impose a tariff of $ 50
per set on imported TV sets.

Policy
(continued)
The price paid by consumers rises to $ 300.

Domestic producers are better able to compete
at this price; their output rises to 1,200 sets a
month. Consumers, faced with higher prices, cut
back their purchases to 2,000 sets a month.
Imports fall from 1,500 a month to 800 a month.
Domestic producers have gained, while foreign
producers and domestic consumers have lost. A
third loser, not shown on this diagram, is likely to
be domestic firms that export other products,
because other countries are likely to retaliate
with tariffs of their own.

Policy
(continued)
 Using the concept of consumer surplus, it is
possible to measure the loss to consumers and
to see where it went. Triangle ABP0 measures
the original consumer surplus before the tariff.
The tariff shrinks consumer surplus to triangle
ACPT. The loss of consumer surplus is
measured by the quadrilateral P0PTCB. Part of
that loss to consumers, who are now consuming
fewer units at a higher price, goes to the
government in tariff revenue. Tariff revenue is
equal to the volume of imports multiplied by the
tariff PT – P0, or triangle CEFG, which is known
as the revenue effect.
Policy
(continued)
Another part of that loss became producer surplus in

the amount of quadrilateral P0PTGH (called the
protective effect). Producer surplus measures the
earnings over and above the sum of marginal costs of
production, which goes to benefit the owners and
workers in the protected industry in the form of higher
wages and/ or profit. A third part of the loss to
consumers goes to pay for the increasing marginal
cost of shifting purchases away from more efficient
foreign suppliers by triangle FGH (the efficiency
effect). Finally, there is a component of consumer
surplus that is lost (not transferred to anyone),
measured by triangle BCE. This is called the
deadweight loss.

Policy
Figure 2 (continued)
P
Effects Of Tariff Sd
Revenue
Effect
$300= PT G C
Deadweight
Protective Loss
Effect
H F E B
$250= P0
Impor
D
Efficiency
Effect
1000 1200 2000 2500 Q

Exercise
1. Does vaccinating against Covid 19 or other diseases
create any externalities? If the private sector is left
alone, will too many or too few vaccinations be
administered?
2. How do externalities cause process to convey the
wrong information to demanders and suppliers?
Construct an example where the consumption of a
good creates a positive externality, and then discuss
how the market price is “wrong.”
3. “Everyone knows that a tariff on foreign imports and
only foreign imports. Tariffs do not tax domestic
producers. Thus, as long as the nation has domestic
firms willing to produce the item, a tariff cannot change
the domestic market and so a tariff cannot harm the
nation.” Comment on these statements.

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Session – Managerial Economics

Firms As Neighbors: External Effects*)

Lectured by B. Yuliarto Nugroho, Ph.D

*) (Summarized from Ulbrich et.al, Managerial Economics

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 1

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 2

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 3

 To identify the effects of positive and negative

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 4

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 7

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 8

 Imposing the social marginal cost on the

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 9

 Regulation Of Forcing the Firm to Reduce Negative

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 11

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 12

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 13

 Without government intervention, private

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 14

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 15

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 16

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 17

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 18

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 20

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 21

 In small communities there is more likely to be

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 22

The Firm in The International

Lectured by B. Yuliarto Nugroho, Ph.D

*) (Summarized from Ulbrich et.al, Managerial Economics

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 23

 Many firms in advanced countries operate in

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 24

 Much of what economists have observed

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 25

 To explain the concept of comparative

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 26

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 27

 The comparative advantage argument has

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 28

Bread Wine Bread Wine

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 29

 Before trade, Country A is producing 35 units of

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 30

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 31

Note that at this point world output has risen. Before

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 33

 Points C and C’ in Figure 1 show how much bread

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 34

 Twentieth-century economists have tried to identify

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 35

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 36

 Economies of scale are a second benefit from

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 37

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 38

 Other explanations of the patterns of trade have also been

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 39

 Swedish economist, Stassan Linder points out yet

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 40

 A final contributing factor to trade patterns is

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 41

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 42

1000 1200 2000 2500 Q

Managerial Economics, by B.Y. Nugroho. Ph.D © 2020 43

Session 13A&B-BYN-Firms As Neighbors & Firm in Intl Market

Session 13A&B-BYN-Firms As Neighbors & Firm in Intl Market