Chapter 1 – Economics and Economic Reasoning 12/2/15 7:48 PM What Economics Is

• Economics is the study of how humans coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society

o Coordination § What (and how much) to produce § How to produce it § For whom to produce it

• In our economy there is a problem of scarcity o The goods available are too few to satisfy individuals’ desires

• Economies deal with scarcity with coercion – limiting wants and increasing the amount of work people do to fulfill them

o This leads to the alternative definition of economics: the study of how to get people to do things they’re not wild about doing and not to do things they are wild about doing, so that the things some people want to do are consistent with the things other people want to do

A Guide to Economic Reasoning • Cost/Benefit Analysis

o Abstraction from the ‘unimportant’ elements of a question and focus on the ‘important’ elements

Marginal Costs and Marginal Benefits • The relevant costs and benefits to economic reasoning are the expected incremental

costs and the expected incremental benefits that result from a decision. o Marginal costs vs. marginal benefits

• Marginal cost is the additional costs to you over and above the cost you have already incurred

o This means not counting sunk costs – costs that have already been incurred and cannot be recovered

• Marginal benefit is the additional benefit above what you’ve already derived • These two concepts yield the economic decision rule: If the marginal benefits of

doing something exceed the marginal costs, do it. If the marginal costs of doing something exceed the marginal benefits, don’t do it.

Opportunity Cost • Opportunity cost is the benefit that you might have gained from choosing the next-

best alternative.

o To obtain the benefit of something, you must forgo something else. The value of this alternative is the opportunity cost.

Economic and Market Forces • All scarce goods must be rationed in some fashion. These rationing mechanisms are

economic forces, the necessary reactions to scarcity. • A market force is an economic force that is given relatively free rein by society to

work through the market. These forces ration by affecting prices. o When there’s a shortage, price rises; when there’s a surplus, price falls. o The invisible hand is the price mechanism, the rise and fall of prices that

guide our actions in a market. • What happens in a society can be seen as the reaction to, and interaction of, these

three forces: economic, political/legal, and social/historical forces. Economic Insights

• An economic model is a framework that places the generalized insights of the theory in a more specific contextual setting

• An economic principle is a commonly held economic insight stated as a law or general assumption

• Economics is an observational science, not a laboratory science. Thus, models are tested not in controlled experiments, but rather in the actual economy. Economists observe and try to figure out what is affecting what in natural experiments, where something has changed in one instance but not another and then compare results.

o Theories, models, and principles must be combined with a knowledge of real-world economic institutions to arrive at specific policy recommendations

The Invisible Hand Theory • Much of economic theory deals with the pricing mechanism and how the market

operates to coordinate individuals’ decisions. o When the quantity supplied is greater than the quantity demanded, the price

has a tendency to fall. o When the quantity demanded is greater than the quantity supplied, price has

a tendency to rise. • Efficiency means achieving a goal as cheaply as possible. Economists call this

insight the invisible hand theory – a market economy, through the price mechanism, will tend to allocate resources efficiently.

Economic Theory and Stories

• Economic institutions sometimes act differently than expected, this is because a) economics abstracts from many issues that may account for the differences and b) economic principles often affect decisions from behind the scenes

Economic Policy Options • Economic policies are (in)actions taken by government to influence economic

actions. Objective Policy Analysis

• Good economic policy analysis is objective – it keeps the analyst’s value judgments separate from the analysis.

o “This is the way the economy works, and if society wants to achieve a particular goal, this is how it might go about doing so.”

o NOT like, “This is the way things should be…” • Positive economics is the study of what is, and how the economy works.

o E.g. How does the market for hog bellies work? How do price restrictions affect market forces?

• Normative economics is the study of what the goals of the economy should be. o E.g. What should the distribution of income be? What should tax policy be

designed to achieve? • The art of economics (a.k.a. political economy) is the application of the knowledge

learned in positive economics to the achievement of the goals one has determined in normative economics.

o E.g. To achieve a certain distribution of income, how would you go about it, given the way the economy works?

• Maintaining objectivity is easiest in positive economics and harder in normative economics. It’s hardest to maintain objectivity in the art of economics, the judgments of made in political economy are likely to reflect our own value judgments.

Policy and Social and Political Forces • Economics focuses analysis on the invisible hand and how the economy would act if

only the invisible hand were present.

Chapter 2 – The Production Possibility Model, Trade, and Globalization 12/2/15 7:48 PM

The Production Possibilities Model • A production possibility table is a table that lists a choice’s opportunity costs by

summarizing what alternative outputs you can achieve with your inputs. o An output is a result of an activity o An input is what you put into a production process to achieve an output

A Production Possibility Curve for an Individual • A production possibility curve (PPC) is a curve measuring the maximum

combination of outputs that can be obtained from a given number of inputs. o A graphical representation of the opportunity cost concept o It also measures opportunity cost

• A PPC demonstrates that: o there is a limit to what you can achieve, given the existing institutions,

resources, and technology. o Every choice you make has an opportunity cost. You can get more of

something only by giving up something else. Increasing Marginal Opportunity Cost

• PPCs are rarely ever straight lines o Opportunity costs tend to rise as we choose more and more of an item

• The principle of increasing marginal opportunity cost says that in order to get more of something, one must give up ever-increasing quantities of something else

o Essentially, marginal costs are increasing • PPC of increasing marginal costs bellow outwards

Comparative Advantage • A comparative advantage is the ability to be better suited to the production of one

good than to the production of another good Efficiency

• Productive efficiency is achieving as much output as possible from a given amount of inputs or resources.

• Inefficiency is getting less output from inputs that, if devoted to some other activity, would produce more output.

• Efficiency is achieving a goal using as few inputs as possible. • Graphically, the concept of efficiency is demonstrated by only moving one’s

production on to a point on the PPC. Distribution and Productive Efficiency

• Assume that the distributional effects that accompany policy are acceptable, and that we, as a society, prefer more input

Trade and Comparative Advantage • A society wants to be on the frontier of its PPC

o Individuals must produce those goods for which they have a comparative advantage

• How to direct individuals toward those activities in which they have a comparative advantage?

o Adam Smith argued that it is humankind’s proclivity to trade that leads to individuals using their comparative advantage. As people act in their best interest, the invisible hand guides the economy as a whole.

Markets, Specialization, and Growth • Markets allow specialization and encourage trade

o Individuals compete and specialize, they learn by doing, becoming even better at what they do.

The Benefits of Trade • When people freely enter into a trade, both parties can be expected to benefit from

the trade; otherwise, they wouldn’t have entered the transaction. o When there is competition in trade, so individuals can pick the best

transaction available to them, each individual can achieve the best bargain he can.

• Laissez-faire is an economic policy of leaving coordination of individuals’ actions to the market.

• Trade allows countries to consume past the limitations of their individual PPCs Comparative Advantage and the Combined PPC

• The slope of the combined PPC is determined by the country with the lowest opportunity cost

Outsourcing Trade and Comparative Advantage • Outsourcing

o Outsourcing is the relocation of production once done in the US to foreign countries

o Insourcing is the relocation of production done abroad to the US § Outsourcing is only a problem when it significantly exceeds insourcing

o These two concepts are basically comparative advantage demonstrated in the real world

• Globalization

o Globalization is the increasing integration of economies, cultures, and institutions across the world

§ A globalized world is one where the economics of the world are highly integrated

§ 2 effects ú The rewards for winning globally are much larger than the

rewards for winning domestically • Positive

ú It is much harder to win or even stay in business when competing globally

• Negative o Globalization increases competition due to greater specialization/division of

labor § Adam Smith: Increases growth and improves standard of living for

everyone § Allows for implementation of comparative advantage

o Increased productivity • Law of One Price

o The law of one price states that the wages of workers in one country will not differ significantly from the wages of equal workers in another institutionally similar country

Chapter 3 – Economic Institutions 12/2/15 7:48 PM

The U.S. Economy in Historical Perspective • The U.S. economy is a market economy, an economic system based on private

property and the market in which, in principle, individuals decide how, what, and for whom to produce.

o Individuals follow their self-interest; supply and demand coordinate those individual pursuits

• The government must allocate and defend private property rights in order for a market to exist

o Private property rights are the control a private individual or firm has over an asset

§ Private ownership must be accepted as a concept by society How Markets Work

• System of rewards and payments o How much you get is determined by how much you give; fairness

§ “Them that works, gets; them that don’t, starve.” Capitalism and Socialism

• Markets are not universally accepted as the most reasonable way to organize society o Arguments against markets say they bring out the worst in people

• Socialism is an economic system based on individuals’ goodwill toward others, not on their own self-interest, and in which, in principle, society decides what, how, and for whom to produce

o People contribute what they can and get what they need • Capitalism is an economic system based on the market in which ownership of the

means of production resides with a small group of individual called capitalists • Most economies today are distinguished by the degree to which their economies rely

on markets, not whether they are a market, capitalist, or socialist economy The U.S. Economy

• The American economy can be divided into three sectors: businesses, households, and government.

o Households supply labor and other factors of production to businesses and are paid by businesses for doing so. This is called the factor market.

o Businesses produce goods and services and sell them to households and government. This is called the goods market.

Business • Business is the name given to private producing units in our society

o Businesses in the U.S. decide what to produce, how much to produce, and for whom to produce it

• Some businesses are easy to start, some require licenses, permits, etc. o Entrepreneurship is the ability to organize and get something done

• What Do U.S. Firms Produce? o Firms produce both physical goods and intangible services o Distribution, or getting goods where you want them when you want them, is

as important as production and is a central component of a service economy o Services compose about 85% of the American economy, compared to 20% in

1947 • Consumer Sovereignty and Business

o Consumer sovereignty is the power of the consumer’s wishes to determine what’s produced

§ Businesses decide what to produce based on what they believe will sell

o Profit is what’s left over from total revenues after all the appropriate costs have been subtracted

§ Businesses that guess correctly about what consumers want generally make profit; businesses that don’t often operate at a loss

• Forms of Business o The three main forms of business are sole proprietorships, partnerships, and

corporations § 71% of American businesses are sole proprietorships, 10% are

partnerships, and 19% are corporations o Sole proprietorships are businesses that have only one owner

§ Easiest to start, few bureaucratic hassles o Partnerships are businesses with two or more owners

§ These create possibilities for sharing the burden, but they also create unlimited liability for each of the partners

o Corporations are businesses that are treated as a person, and are legally owned by their stockholders, who are not liable for the actions of the corporate “person”

§ Largest form of business when measured in terms of receipts § When a corporation is formed, it issues stock (certificates of

ownership in a company), which is sold/given to individuals

ú Proceeds from the sale of that stock compose the equity capital of a company

§ A corporation provides the owners with limited liability – the stockholder’s liability is limited to the amount the stockholder has invested in the company.

ú Owners of the other two forms of business can lose everything they possess even if they have only invested a small amount in the business

Households • Households are groups of individuals living together and making joint decisions,

they are the most powerful economic institution o Households ultimately control government and business through voting in the

political arena and supplying labor/capital to businesses through spending decisions or expenditures

• Suppliers of Labor o The largest source of household income is wages/salaries from labor o The fastest-growing jobs are in the service industries and the fastest-

declining are in manufacturing and agriculture • Other Roles of Households

o Households make a significant number of decisions in the economy besides being suppliers of labor.

§ They control how much schooling to get, what to buy, housing investment, and the housing stock – which is half the capital stock of the country.

§ They are the driving force for much of the economy Government

• Two general roles in the economy: o A referee setting the rules that determine relations between business and

households o An actor collecting money in taxes and spending that money on projects such

as defense and education • Government as an Actor

o The entire United States government (federal/state/local) consume about 15% of the country’s total output and employ over 22 million people

o They also redistribute income through taxes and social welfare and assistance programs

o State and Local Governments § Employ over 19 million people and spend over $2.5 trillion a year § Receive most of their income from taxes and spend their revenues on

public welfare, administration, education, and roads o Federal Government

§ Income and Social Security taxes compose 80% of their revenue. § They spend it on income security, health and education, and national

defense. • Government as a Referee

o Government sets the rules of interaction between households and businesses, and acts as a referee, changing the rules when it sees fit.

o What referee role should the government play in an economy? o Government plays a variety of specific roles in the economy

§ 1. Providing a stable set of institutions and rules § 2. Promoting effective and workable competition § 3. Correcting for externalities § 4. Ensuring economic stability and growth § 5. Providing public goods § 6. Adjusting for undesirable market results

o Provide a Stable Set of Institutions and Rules § A basic role of government is to provide a stable institutional

framework that includes the set of laws specifying what can and cannot be done as well as a mechanism to enforce those laws

ú The modern market economy necessitates complicated contractual agreements between different parties

o Promote Effective and Workable Competition § Monopolization and competition are always at conflict in market

economies; the government must decide to what extent it protects competition

§ The U.S. is often adverse to monopoly power – the ability of individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business

ú The government’s job is to promote competition and prevent excessive monopoly powers

o Correct for Externalities

§ An externality is the effect of a decision on a third party not taken into account by the decision maker

ú Externalities can be positive (society benefits from the trade between two parties) or negative (society is harmed by the trade)

§ When externalities are presented, there is potential for the government to adjust the market result

ú Actions with positive externalities are promoted and those with negative externalities should be discouraged

§ The role of government is a potential role because ú 1. Government often has difficulty dealing with externalities in

such a way that society gains. ú 2. Government is an institution that reflects, and is often

guided by, politics and vested interests o Ensure Economic Stability and Growth

§ Government has the potential role of providing economic stability ú The government should prevent 1.) large fluctuations in the

level of economic activity, 2.) maintain a relatively constant price level, and 3.) provide an economic environment conducive to growth

§ These aims became the U.S. government’s goals in the 1946 Employment Act

ú They are justified as appropriate government aims because they involve macroeconomic externalities – externalities that affect the levels of unemployment, inflation, or growth in the economy as a whole

o Provide Public Goods § A public good is a good that if supplied to one person must be

supplied to all and whose consumption by one individual does not prevent its consumption by another individual

§ A private good is a good that, when consumed by one individual, cannot be consumed by another individual

§ A free rider is a person who gets a benefit but does not contribute to paying for the cost of that benefit

o Adjust for Undesirable Market Results

§ A controversial role for government is to adjust the results of the market when those market results are seen as socially undesirable

ú E.g. redistribution of income § Demerit goods or activities are goods or activities that government

believes are bad for people even though they choose to use the goods or engage in the activities.

ú E.g. How addictive drugs are illegal or highly taxed. § Merit goods or activities are goods and activities that government

believes are good for you even though you may not choose to engage in the activities or to consume the goods

ú E.g. Government support for contributing to charities, etc. through subsidies or tax benefits.

• Market Failures and Government Failures o Market Failures are situations in which the market does not lead to a desired

result o Government failures are situations in which the government intervenes and

makes things works Global Institutions

• It is impossible to talk about the U.S. economic institutions without considering how they integrate with the world economy

Global Corporations • Global corporations are corporations with substantial operations on both the

production and sales sides in more than one country o Global corporations provide significant benefits for countries by creating jobs,

bringing ideas/technology to a country, providing competition for domestic companies

o They also pose a problem by evading policy through shifting its operations between different countries

Coordinating Global Issues • Governments have developed international institutions to promote negotiations and

coordinate economic relations on the global stage o These include the UN, World Bank, World Court, and IMF

• Countries have developed global/regional organizations to coordinate trade and reduce trade barriers

o These include the WTO, EU, and NAFTA • These international organizations is voluntary, thus they have limited power

Chapter 4 – Supply and Demand 12/2/15 7:48 PM

Demand • Demand is the ability and willingness to pay

The Law of Demand • The law of demand states that ‘Quantity demanded rises as price falls, other things

constant.’ Or alternatively, ‘Quantity demanded falls as price rises, other things constant.’

• If the price of something goes up, people will tend to buy less and buy a substitute instead

The Demand Curve • The demand curve is the graphical representation of the relationship between price

and quantity demanded. o It slopes downward

• ‘…other things constant.’ o This qualifier places a limitation on the application of the law of demand. If the

fall in demand is a result of decreased income or some other factor, then adjustments must be made to hold income constant.

o These ‘other things’ include individuals’ tastes, prices of other goods (substitutes), and even the weather. These other factors must remain constant if a valid study is to be made of the effect of an increase in the price of a good on the quantity demanded.

Shifts in Demands versus Movements along a Demand Curve • Demand v. Quantity Demanded

o Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant. I.e. how much will be bought at various prices

§ Graphically, demand refers to the entire demand curve o Quantity demanded refers to a specific amount that will be demanded per

unit of time at a specific price, other things constant. I.e. how much will be bought at a specific price.

§ Graphically, quantity demanded refers to a point on the demand curve • A change in price changes the quantity demanded. It refers to a movement along a

demand curve – the graphical representation of the effect of a change in price on the quantity demanded.

• A shift in demand is the graphical representation of the effect of anything other than price on demand.

Shift Factors of Demand

• Important shift factors of demand are o 1. Society’s income o 2. The prices of other goods o 3. Tastes o 4. Expectations o 5. Taxes on and subsidies to consumers

• Income o A rise in income increases the demand for normal goods. For other goods,

called inferior goods, an increase in income reduces demand. § E.g. Normal good: steak; Inferior good: hot dog.

• Price of Other Goods o When the price of a substitute rises, demand for the good whose price has

remained the same will rise. o When the price of a good declines, the demand for its complement rises.

• Tastes o Changes in taste can affect the demand for a good without a change in price.

• Expectations o If one expects his income to rise in the future, he will start spending some of it

now. • Taxes and Subsidies

o Taxes levied on consumers or subsidies given to consumers either raise or reduce the cost of the goods to consumers, thus reducing or increasing demand for those goods

Individual and Market Demand Curves • A market demand curve is the horizontal sum of all individual demand curves

o Firms don’t care who buys their goods; they only care that someone buys them

• Even if individuals don’t respond to small changes in price, the market demand curve can still be smooth and downward sloping

o 1. At lower prices, existing demanders buy more o 2. At lower prices, new demanders enter the market

Six Things to Remember about a Demand Curve • 1. A demand curve follows the law of demand: When price rises, quantity falls, and

vice versa • 2. The horizontal axis – quantity – has a time dimension • 3. The quality of each unit is the same

• 4. The vertical axis – price – assumes all other prices remain the same • 5. The curve assumes everything else is held constant • 6. Effects of price changes are shown by movements along the demand curve.

Effects of anything else on demand (shift factors) are shown by shifts of the entire demand curve

Supply • In a sense, supply is the mirror image of demand

o The supply process of produced goods is generally complicated § Many layers of firms involved § Thus, the analysis of the supply of produced goods has two parts

ú Analysis of the supply of factors of production to households and firms

ú Analysis of the process by which firms transform those factors of production into usable goods/services

o The supply of nonproduced goods is more direct The Law of Supply

• The law of supply states that ‘Quantity supplied rises as price rises, other things constant.’ Or alternatively, ‘Quantity supplied falls as price falls, other things constant.’

The Supply Curve • A supply curve is the graphical representation of the relationship between price and

quantity supplied. o It slopes upward

• ‘…other things constant.’ o This qualifier also applies to the law of supply.

Shifts in Supply versus Movements along a Supply Curve • Supply v. Quantity Supplied

o Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant.

§ Graphically, supply refers to the entire curve o Quantity supplied refers to a specific amount that will be supplied at a

specific price. § Graphically, quantity supplied refers to a point on a supply curve

• Changes in price cause changes in quantity supplied, these are represented by a movement along a supply curve – the graphical representation of the effect of a change in price on the quantity supplied.

• If the amount supplied is affected by anything other than price, that is, by a shift factor of supply, there will be a shift in supply – the graphical representation of the effects of a change in a factor other than price on supply.

Shift Factors of Supply • Price of Inputs

o If a firm’s costs rise, profits will decline, and a firm has less incentive to supply. Thus, supply falls when the price of inputs rises.

• Technology o Advances in technology allow for improvements in the production process,

reducing production costs to a firm. Thus, suppliers can increase production. • Expectations

o Supplier expectations are an important factor in the production decision. If a supplier expects the price of their good to rise, they may withhold some of today’s output in order to sell it later for higher profits; decreasing supply now and increasing it later.

• Taxes and Subsidies o Taxes on suppliers increase the cost of production by requiring a firm to pay

the government a portion of the income from products or services sold. Thus, suppliers reduce supply because of the increased cost of production and reduced profit.

o The opposite occurs for subsidies. Individual and Market Supply Curves

• The market supply curve is the horizontal sum of all the individual supply curves The Interaction of Supply and Demand Equilibrium

• When a market exists where neither suppliers nor consumers collude and where prices are free to move up and down, the forces of supply and demand arrive at an equilibrium

o Equilibrium is a concept in which opposing dynamic forces cancel each other out

o Equilibrium quantity is the amount bought and sold at the equilibrium price o Equilibrium price is the price toward which the invisible hand drives the

market • Excess Supply

o Excess supply, or a surplus, is when quantity supplied is greater than the quantity demanded

o Price in the market falls to allow quantity demanded to meet quantity supplied • Excess Demand

o Excess demand, or a shortage, is when quantity demanded is greater than the quantity supplied

o Market price will rise to allow quantity supplied to meet quantity demanded • Price Adjusts

o When quantity demanded is greater than quantity supplied, prices tend to rise o When quantity supplied is greater than quantity demanded, prices tend to fall

§ The greater the difference between quantity demanded and quantity supplied, the more pressure there is for prices to rise or fall

§ When quantity demanded equals quantity supplied, the market’s in equilibrium

What Equilibrium Isn’t • It is not a state of the world, it’s a characteristic of the model – the framework you

use to look at the world. • Equilibrium is not inherently good or bad

o It’s simply a state in which dynamic pressures offset each other o Some equilibria are good – a market in competitive equilibrium is one in

which people can buy the goods they really want at the best possible price o Some equilibria aren’t good at all – nuclear war and resulting mutually

assured destruction Political and Social Forces and Equilibrium

• In the real world, political and social forces are acting and pushing the price away from the supply/demand equilibrium

The Limitations of Supply/Demand Analysis • Supply and demand are tools that help only when used appropriately

o When used incorrectly, they can be misleading • In supply/demand analysis, other things are assumed constant. If other things

change, then once cannot directly apply supply/demand analysis. • Micro v. Macro

o The fallacy of composition is the false assumption that what is true for a part will also be true for the whole

o An understanding of the fallacy of composition is of central relevance to macroeconomics.

§ In the aggregate, whenever firms produce (whenever they supply), they create income (demand for their goods). So in macro, when supply changes, demand changes.

§ In macroeconomics, the other-things-constant assumption central to microeconomics cannot hold

o To account for all these interdependencies is why macro analysis is separated from micro analysis.

§ In macro, curves are used whose underlying foundations are much more complicated than the supply and demand curves that are used in micro.

Chapter 5 – Using Supply and Demand 12/2/15 7:48 PM

Real-World Supply and Demand Applications The Price of Foreign Currency

• The forex (foreign exchange) market determines exchange rates, or the price of one country’s currency in terms of another’s currency

o Whenever a foreign good is bought, someone must trade currencies o Currency acts as a good in forex markets

Government Intervention in the Market Price Ceilings

• A price ceiling is a government-imposed limit on how high a price can be charged o This limit is generally below the equilibrium price o E.g. rent control – a price ceiling on rents, set by government

• With price ceilings, existing goods are no longer rationed entirely by price. Other methods of rationing existing goods arise called non-price rationing

Price Floors • A price floor is a government-imposed limits on how low a price can be charged

o This limit is generally above the equilibrium price o E.g. minimum wage laws – laws specifying the lowest wage a firm can

legally pay an employee Excise Taxes

• An excise tax is a tax that is levied on a specific good. • A tariff is an excise tax on an imported good

Quantity Restrictions • Governments often regulate markets with licenses that limit entry into a market • Quantity restrictions tend to raise price because with quantity restrictions, increases

in demand lead only to price increases Third-Party-Payer Markets

• A third-party-payer market is one where the person who receives the good differs from the person paying for the good

o E.g. The healthcare industry with insurance/HMOs • In third-party-payer markets, equilibrium quantity and total spending are much higher

o Because the co-payment faced by the consumer is much lower, quantity demanded is much greater

Chapter 6 – Thinking Like a Modern Economist 12/2/15 7:48 PM

The Nature of Economists’ Models • A model is a simplified representation of the problem or question that captures the

essential issues o Economic models differ from others. What does differentiate economists are:

§ 1. The building blocks that economists use in their models and § 2. The structure of formal models that economists find acceptable

• Models don’t have to be mathematical o Heuristic models are models that are expressed informally in words o The building blocks and structures of models that economists use have

evolved. Early economists used only a highly restricted set of building blocks and a narrow set of simple formal models.

§ Modern economists are economists who are willing to use a wider range of models than did earlier economists. Modern economists use a more inductive approach to modeling. Earlier economists used a much more deductive approach.

ú An inductive approach is an approach to understanding a problem in which understanding is developed empirically from statistically analyzing what is observed in the data

ú A deductive approach is one that begins with certain self-evident principles from which implications are logically determined.

Behavioral and Traditional Building Blocks • Traditional building blocks of microeconomics are the assumptions that people are

rational and self-interested • Traditional economists are economists who study the logical implications of

rationality and self-interest in relatively simple algebraic or graphical models such as the supply and demand model

Behavioral Economic Models • Behavioral economics is microeconomic analysis that uses a broader set of

building blocks than rationality and self-interest used in traditional economics. o Inductive study of people’s behavior that argues that rationality and self-

interest should be broadened § Rationality should be broadened to purposeful behavior – behavior

reflecting reasoned but not necessarily rational judgment § Self-interest should be broadened to enlightened self-interest in

which people care about other people as well as themselves

• These differing assumptions affect the patterns economists see in the results of their models’ analysis

• Predictable Irrationality o Behavioral economists argue that what might be deemed irrational behavior

by a traditional economist might not be so irrational if the context is evaluated o For behavioral economists, universality is less important than the fact that the

model captures how people actually behave § An example of this is precommitment strategy, a strategy in which

people consciously place limitations on their future actions, thereby limiting their choices

The Advantages and Disadvantages of Modern Traditional and Behavioral Models • The Difficulty with Behavioral Building Blocks: Testing

o Traditional economists argue against moving away from traditional building blocks is difficult because it leads to much less clear-cut models and results

o Behavioral economists respond by using experimental economics, i.e. lab and field experiments to test alternative building blocks and find those that best describe how people actually act

o Endowment effects is the concept that people value something more just because they have it

• Traditional Models Provide Simplicity and Insight o Traditional models provide simple and clear results, which can highlight

issues that behavioral models cannot • Behavioral Economic Models Reflect Observed Behavior

Types of Models Behavioral and Traditional Informal (Heuristic Models)

• The Armchair Economist: Heuristic Models Using Traditional Building Blocks o ‘Armchair Economist’ o More Sex Is Safer Sex

§ Martin wants to hook up with Joan. Joan wants to hook up with Martin. Martin is prudent and he is scared of STDs so he does not attend a party where Joan and him expected to hook up. In his stead, Joan hooks up with not-so-prudent Maxwell. Maxwell gives Joan AIDS all because Martin was virtuous and did not have safe sex with Joan.

§ Decisions about sex may have externalities and therefore what is best for the individuals involved may not be best for society.

o Why Car Insurance Costs More Some Places Than Others

§ Insurance rates in Ithaca, NY cost a third of what they cost in Philadelphia, PA even though theft/accident rates are similar. There is a feedback effect of the initial choices people make of whether to buy insurance that affects the cost of insurance. If a few people decide not to get insurance, the costs of insurance to who buy it will be higher because their accidents will be more likely to be with an uninsured driver and, thus, their insurance would have to pay. Which is what happened in Philadelphia. The opposite occurred in Ithaca.

§ A “path-dependent tripping point model” is used in this case. It is a type of a path-dependent model – a model in which the path to equilibrium affects the equilibrium.

• The Economic Naturalist: Heuristic Models Using Behavioral Building Blocks o Why Are People More Likely to Return Cash Than a Lampshade?

§ That people return a $20 lampshade that was mistakenly not scanned less often than they will return an overpayment of $20 in change supports the assumption of purposeful behavior.

o Why Don’t More People Wear Velcro Shoes? § Behavioral models take social considerations into account; traditional

models do not. • The Limits of Heuristic Models

o Heuristic models are very easy to modify and come to different conclusions. Empirical Models

• The Importance of Empirical Work in Modern Economics o Econometrics – the statistical analysis of economic data – developed in the

late 20th century because computers allowed for the lack of data and computing power to be overcome. Thus, economics started making its way from deductive reasoning to inductive reasoning.

o Modern economics relies on experiments and statistical analysis of real-world observations

o Empirical models are models that statistically discover a pattern in the data • Regression Models

o A regression model is an empirical model in which one statistically relates one set of variables to another

o ‘Running a regression’ finds the line of best fit between the points plotted on a graph of the two sets of variables

§ The ‘goodness of fit’ between the two variables is described by the coefficient of determination, which is a measure of the proportion of the variability in the data that is accounted for by the statistical model

o Regression models can reveal all sorts of relationships. They have been called ‘data-mining models’ but a better term for them is ‘pattern-finding models’

The Role of Formal Models • Data alone has no meaning • Framing is an important concept in empirical modeling

o Two economists can draw different conclusions from the same empirical model

o Economists rely on theoretical models to help them interpret data • In economics, controlled experiments are generally impossible. Thus, natural

experiments – an event created by nature that can serve as an experiment – are used instead

• Different Types of Formal Models That Economists Use o Models with many equilibria, so it’s difficult to know what an equilibrium is o Models in which not only are the variable related, but also are the changes in

variables and the changes in changes in variables o Models in which systemic equilibrium involves enormous continual change in

the parts so that even though the system is in equilibrium, the individual parts are not

o Models in which relationships are non linear on various levels, and in which an infinitely small change can lead to drastically different results

• The Trade-off between Simplicity and Completeness o Complexity in models provides the broadest approach, however it also yields

results that make it difficult to arrive at a conclusion o A self-confirming equilibrium is an equilibrium in a model in which people’s

beliefs become self-fulfilling o A ‘strange attractor model’ or a butterfly effect model is a model in which a

small change causes a large effect • Other Formal Models

o Game theory models are models in which one analyzes the strategic interaction of individuals when they take into account the likely response of other people to their actions

o More complicated models often yield no analytic solution

§ The agent-based computational (ACE) model is a culture dish approach to the study of economic phenomena in which agents (encapsulated collections of data and methods representing an entity residing in that environment on the computer) are allowed to interact in a computationally constructed environment and the researcher observes the results of that interaction

• Empirically Testing Formal Models o ‘Bringing the model to the data’

§ Formal model where all the relationships are specified What Difference Does All This Make to Policy?

• Modern economists, with their various frames, are less sure of the conclusion that the market will solve every problem

o For a modern economist, policy does not follow directly from a model o Models provide theorems – results that follow logically from a model – not

precepts – general rules for public policy.

Chapter 7 – Describing Supply and Demand: Elasticities12/2/15 7:48 PM

Price Elasticity • The price elasticity of demand is the percent change in quantity demanded

divided by the percentage change in price

o

€

ED =Percentage change in quantity demanded

Percentage change in price

• The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price

o

€

ES =Percentage change in quantity supplied

Percentage change in price

What Information Price Elasticity Provides • How quantity responds to a change in price

Classifying Demand and Supply as Elastic or Inelastic • Demand or supply is classified as elastic if the percentage change in quantity is

greater than the percentage change in price. Oppositely, demand or supply is inelastic if the percentage change in quantity is less than the percentage change in price.

o Elastic: E > 1 o Inelastic: E < 1

• An inelastic supply means that the quantity supplied doesn’t change much with a change in price.

• An elastic supply means that quantity supplied changes by a larger percentage than the percentage change in price

Elasticity Is Independent of Units • Percentages allow us to have a measure of responsiveness that is independent of

units, making comparisons of responsiveness among different goods easier. Calculating Elasticities

• In 2005, the city of London raised the daily toll motorists pay to drive in central London by 46%. The increase reduced the number of motorists driving in central London by 3%.

o E = 3/46 = .07 • The endpoint problem arises because the percentage change differs depending on

whether you view the change as a rise or a decline. o Economists use the average of the two end values to get around the endpoint

problem. Elasticity and Supply and Demand Curves Elasticity Is Not The Same as Slope

• The relationship between elasticity and slope is the following: The steeper the curve becomes at a given point, the less elastic is supply or demand.

• A vertical demand curve is described by economists as perfectly inelastic – quantity does not respond at all to changes in price (E = 0)

• A horizontal demand curve is described by economists as perfectly elastic – quantity responds enormously to changes in price (E = ∞)

Elasticity Changes along Straight-Line Curves • On straight-line supply and demand curves, slope remains constant, but elasticity

does not. • At one point along the demand curve, between an elasticity of infinity and zero,

demand is unit elastic – the percentage change in quantity equals the percentage change in price (E = 1)

Review • Perfectly elastic

o E = ∞ • Elastic

o E > 1 • Unit elastic

o E = 1 • Inelastic

o E < 1 • Perfectly inelastic

o E = 0 Substitution and Elasticity

• The most important determinant of price elasticity of demand is the number of substitutes for the good. The more substitutes a good has, the more elastic is its supply or demand.

Substitution and Demand • The number of substitutes a good has affected by various factors. Several important

ones are listed. o 1. The time period being considered o 2. The degree to which a good is a luxury o 3. The market definition o 4. The importance of the good in one’s budget

• The more substitutes, the more elastic the demand and the more elastic the supply • 1. The time period being considered

o The larger the time interval considered, the more elastic is the good’s demand. There are more substitutes in the long run than the short run.

• 2. The degree to which a good is a luxury o The less a good is a necessity, the more elastic is its demand

• 3. The market definition o As the definition of a good becomes more specific, demand becomes more

elastic. o Substitutes for transportation are more difficult to find, than substitutes for

unicycle transportation. • 4. The importance of the good in one’s budget

o Demand for goods that represent a large proportion of one’s budget is more elastic than demand for goods that represent a small proportion of one’s budget.

o Goods that cost very little relative to one’s total expenditures aren’t worth spending a lot of time figuring out whether there’s a good substitute.

Substitution and Supply • The same general issues involving substitution are relevant when considering

determinants of the elasticity of supply. But when it comes to supply, economists focus on time rather than on other factors because time plays such a central role in determining supply elasticity.

• The longer the time period considered, the more elastic is supply. • Economists distinguish 3 time periods relevant to supply

o 1. In the instantaneous period, quantity supplied is fixed, so supply is perfectly inelastic. This supply is sometimes called the momentary supply.

o 2. In the short run, some substitution is possible, so short-run supply is somewhat elastic.

o 3. In the long run, significant substitution is possible; supply becomes very elastic.

Elasticity, Total Revenue, and Demand • Knowing elasticity of demand is useful to firms when they want to know whether total

revenue will rise or fall when they change their pries. o If demand is elastic (ED > 1), a rise in price lowers total revenue o If demand is unit elastic (ED = 1), a rise in price leaves total revenue

unchanged o If demand is inelastic (ED < 1), a rise in price increases total revenue

Total Revenue along a Demand Curve

• With elastic demands, a rise in price decreases total revenue. With inelastic demands, a rise in price increases total revenue.

Elasticity of Individual and Market Demand • Firms have a strong incentive to separate out people with less elastic demand and

charge them a higher price o Price discrimination

Other Elasticity Concepts • The income elasticity of demand is the percentage change in demand divided by

the percentage change in income. It shows responsiveness of demand to changes in income.

o

€

Income elasticity of demand =Percentage change in demandPercentage change in income

• the cross-price elasticity of demand is the percentage change in demand divided by the percentage change in the price of a related good. It shows responsiveness of demand to changes in prices of related goods.

o

€

Cross − price elasticity of demand =Percentage change in demand

Percentage change in price of a related good

Income Elasticity of Demand • Normal goods are goods whose consumption increases with an increase in income. • Luxuries are goods that have an income elasticity of greater than 1 • A necessity is a good that has an income elasticity between 0 and 1. • An inferior good is a good whose consumption decreases when income increases

Cross-Price Elasticity of Demand • Substitutes are goods that can be used in place of another. When the price of a

good goes up, the demand for the substitute goes up. o Most goods have substitutes, so most cross-price elasticities are positive.

• Complements are goods that are used in consumption with other goods. A fall in the price of a good will increase the demand for its complement.

o The cross-price elasticity of complements is negative The Power of Supply/Demand Analysis Elasticity and Shifting Supply and Demand

• When demand shifts

o

€

Percentage change in price =Percentage change in demand

ED + ES

• When supply shifts

o

€

Percentage change in price =Percentage change in supply

ED +ES

Chapter 10 – The Logic of Individual Choice: The Foundation of Supply and Demand 12/2/15 7:48 PM

Utility Theory and Individual Choice • Economists agree that there is an underlying psychological foundation of why people

make certain choices and execute certain actions: self-interest. o Much of what people do reflects their rational self-interest.

• Using the theory of self-interest, two things determine what people do: o Utility – the pleasure or satisfaction people get from doing or consuming

something o Price – the tool the market uses to bring the quantity supplied equal to the

quantity demanded • Economists’ theory of rational choice is simple, it shows how pleasure and price are

related Total Utility and Marginal Utility

• Total utility refers to the total satisfaction one gets from consuming a product o Total utility is the sum of marginal utilities

• Marginal utility refers to the satisfaction one gets from consuming one additional unit of a product above and beyond what one has consumed up to that point.

o Marginal utility tends to decrease as a consumption of a good increases Diminishing Marginal Utility

• When graphed, the marginal utility curve slopes downward, this is due to the principle of diminishing marginal utility – as you consume more of a good, after some point, the marginal utility received from each additional unit of a good decreases with each additional unit consumed, other things equal.

o At some point, marginal utility can become negative Rational Choice and Marginal Utility

• The analysis of rational choice is the analysis of how individuals choose goods within their budget to maximize total utility

o Premise that rational individuals want as much satisfaction as possible from their available resources

• The term ‘rational’ in economics means that people prefer more to less and will make choices that give them as much satisfaction as possible

The Principle of Rational Choice • The principle of rational choice is as follows: Spend your money on those goods

that give you the most marginal utility (MU) per dollar

o Thus, if

€

MUx

Px<MUy

Py, choice y would be the more rational choice in terms of

marginal utility Simultaneous Decisions

• Choices are not always so neatly separated in real life Maximizing Utility and Equilibrium

• The principle of rational choice says you should keep adjusting your spending within

your budget if the marginal utility per dollar (

€

MUP

) of two goods differs

• The utility-maximizing rule says that when the ratios of the marginal utility to price of the two goods are equal, you’re maximizing utility

o

€

MUx

Px=MUy

Py

• When you are maximizing utility, you’re in equilibrium o As we consume more of an item, the marginal utility we get from the last unit

consumed decreases. Conversely, as we consume less of an item, the marginal utility we get form the last unit consumed increases.

§ The principle of diminishing marginal utility operates in reverse Extending the Principle of Rational Choice

• The general principle of rational choice is to consume more of the good that provides a higher marginal utility per dollar.

o When

€

MUx

Px>MUz

Pz, consume more of good x

o When

€

MUy

Py>MUz

Pz, consume more of good y

o When

€

MUx

Px=MUy

Py=MUz

Pz, you are maximizing utility

• When this rule is met, the consumer is in equilibrium; the cost per additional unit of utility is equal for all goods and he consumer is as well off as it is possible to be

• This rule does not say that the rational consumer should consume a good until its marginal utility reaches zero because consumers don’t have enough money to buy all they want

o Consumers have budgets and they do the best they can under that constraint Rational Choice and the Laws of Demand and Supply The Law of Demand

• The law of demand in relation to the principle of rational choice: when the price of a good goes up, the marginal utility per dollar goes down. Thus, if we are initially in equilibrium as a consumer and the price of a good goes up, we no longer are and we choose to consume less of that good.

o If

€

MUx

Px=MUy

Py and the price of good x goes up, then

€

MUx

Px<MUy

Py

• To satisfy our utility-maximizing rule so that our choice will be rational, we must somehow raise the MU we get from the good whose price has risen. According the principle of diminishing marginal utility we can increase MU only by decreasing consumption of the good whose price has risen.

o If the price of a good rises, you’ll increase your total utility by consuming less of it.

Income and Substitution Effects • There is a certain ambiguity with the changes in nominal prices and their precise

effects on how much quantity demand will change. o The income effect is the reduction/increase in quantity demanded because

we’re poorer/richer o Second, a substitution effect is the reduction/increase in quantity

demanded because relative price has risen/fallen § When the relative price of a good goes up, the quantity purchased of

that good decreases (even when you’re given money to compensate for the price increase)

The Law of Supply • According to the principle of rational choice, if there is diminishing marginal utility and

the price of supplying a good goes up, you supply more of that good. Opportunity Cost

• Opportunity cost is essentially the marginal utility per dollar you forgo from the consumption of the next-best alternative.

o To say

€

MUx

Px>MUy

Py, is to say that the opportunity cost of not consuming

good x is greater than the opportunity cost of not consuming good y Applying Economists’ Theory of Choice to the Real World Given Tastes

• Some behavioral economists are questioning whether tastes are given or shaped by society.

• Conspicuous Consumption

o Conspicuous consumption – the consumption of goods not for one’s direct pleasure, but simply to show off to others

• Tastes and Individual Choice o Somehow, whenever a need is met, it’s replaced by a want, which soon

becomes another need Utility Maximization

• The ultimatum game is a game where the first person only gets the money if the other person accepts the offer. If the second person does not accept, they both get nothing

o Reveals that people have a sense of fairness in their decisions • A status quo bias is where an individual’s actions are very much influenced by the

current situation, even when that reasonably does not seem to be very important to the decision

Chapter 11 – Game Theory, Strategic Decision Making, and Behavioral Economics 12/2/15 7:48 PM

Game Theory and the Economic Way of Thinking • John Nash was a large figure in the development of game theory

o Nash’s realization was that each person, acting in his or her own best interest, will not necessarily arrive at the best of all possible outcomes; Adam Smith is wrong.

• The central element of the modern economic way of thinking is strategic thinking o Whenever the decisions being analyzed involve interdependent decisions,

the decision makers’ strategy needs to be considered • Game theory is formal economic reasoning applied to situations in which decisions

are interdependent Game Theory and Economic Modeling

• Where does game theory fit into the modern economist’s modeling method? o Bob Solow: “You look at a problem; you create a simple model that captures

its essence’ you empirically test how well that model fits the data, and if it fits, you use that model as a guide to understanding the problem and devising a solution.”

• Game theory offers a new set of models with which to approach economic issues. o They can be better tailored to fit the actual problem and are more flexible than

the standard models of economics o A different game theory model must be developed for each different situation

and each different set of assumptions o Rather than one model with one equilibrium solution, game theory had many

models with multiple equilibrium solutions The Game Theory Framework

• A screening question is a question structured in a way to reveal strategic information about the person who answers

The Prisoner’s Dilemma • The prisoner’s dilemma is a well-known two-person game that demonstrates the

difficulty of cooperative behavior in certain circumstances • A payoff matrix is a table that shows the outcome of every choice by every player,

given the possible choices of all the other players. • The prisoner’s dilemma is an example of a noncooperative game – a game in

which each player is out for himself and agreements are either not possible or not enforceable

• Cheap talk is communication tat occurs before the game is played that carries no cost and is backed up only by trust, and not any enforceable agreement

o Economists find, through empirical findings, that people do have interdependent utility functions and cheap talk does influence the outcome of a game

Informal Game Theory and Modern Behavioral Economics Informal Game Theory

• Informal game theory (often called behavioral game theory) relies on empirical observation, not deductive logic alone, to determine the likely choices of individuals. It looks at how people actually think and behave and is thus empirically based.

• Informal game theory proves a framework for approaching questions rather than providing definite answers

Real-World Applications of Informal Game Theory • Survivor example – pg. 267 • Warren Buffet example – pg. 267

An Application of Game Theory: Auction Markets • William Vickrey was a Nobel Prize-winning economist that developed an example of

game theory: the Vickrey auction – a sealed-bid auction where the highest bidder wins but pays the price bid by the next-highest bidder

o This second-price auction changes the strategy of the bidders Behavioral Economics and Game Theory

• Informal game theory is used to explore what rationality is and the nature of individuals’ utility functions.

o Behavioral economists use experiments in which people actually play the formal games to explore the validity of the assumptions in formal game theory

Games and Perceptions of Fairness • If people feel someone is being unfair, people will reduce their own income to make

that person pay Loss Aversion and Incorrect Inference

• Ownership increases the value of a good Framing Effects

• Framing effects are the tendency of people to base their choices on how the choice is presented

Behavioral Economics and the Traditional Model • Behavioral economics provides a more nuanced view of human behavior than does

standard economics

o People are purposeful, rather than fully rational; they demonstrate enlightened self-interest rather than greed; and they are boundedly rational rather than fully “Nash-style” rational

The Importance of the Traditional Model: Money Is Not Left on the Table • Just because people don’t act as the traditional economic model predicts doesn’t

mean that the traditional assumption and model are irrelevant o People acting differently than they would if the standard rationality

assumptions hold true creates potential profit opportunities for individuals to take advantage of people’s actual behavior

Chapter 12 – Production and Cost Analysis I 12/2/15 7:48 PM

The Role of the Firm • Production is the transformation of factors into goods and services • A firm is an economic institution that transforms factors of production into goods and

services. Firms: o 1) organize factors of production and/or o 2) produce goods and/or o 3) sell produced goods to individuals, businesses, or government

• Some firms are virtual firms, which don’t ‘produce’ anything but they simply subcontract out all production

Firms Maximize Profit • The firm plays the same role in the theory of supply that the individual does in the

theory of demand o The difference is that whereas individuals maximize utility, firms maximize

profit. § Profit = Total revenue – Total cost

o In accounting, Total revenue = Total sales x Price o When determining that to include in total revenue and total costs, accountants

focus on explicit revenues and explicit costs because they must have quantifiable measures to go into a firm’s income statement.

§ Thus, Accounting profit = Explicit revenue – Explicit costs • Economists include both explicit and implicit costs and revenues into their analysis

o Implicit costs include opportunity costs of the factors of production § For economists, total cost is explicit payments to the factors of

production plus the opportunity cost of the factors provided by the owners of the firm

o Implicit revenues include the increase in the value of assets § Total revenue is the amount a firm receives for selling its product or

service plus any increase in the value of the assets owned by the firm o Economic profit = (Explicit/implicit revenue) – (Explicit/implicit cost)

The Production Process The Long Run and the Short Run

• The production process is conventionally divided into the a long-run planning decision and a short-run adjustment decision

o Long-run planning decisions choose the least expensive method of producing from among all possible methods. A firm chooses among all possible production techniques.

o Short-run adjustment decisions adjust a firm’s long-run planning decision to reflect new information. The firm is constrained in regard to what production decisions it can make.

• In the long run, all inputs are variable; in the short run, some inputs are fixed. Production Tables and Production Functions

• A production table is a table showing the output resulting from various combinations of factors of production or inputs.

• Marginal product is the additional output that will be forthcoming from an additional worker, other inputs constant. Marginal product is how much additional output will be forthcoming if the number of workers changes.

• Average product is output per worker. Workers’ average product is the total output divided by the number of workers.

• A production function is the relationship between the inputs and outputs The Law of Diminishing Marginal Productivity

• Both marginal and average productivities initially increase with the number of workers, but eventually they both decrease

• The law of diminishing marginal productivity states that as more and more of a variable input is added to an existing fixed input, eventually the additional output one gets from that additional input is going to fall.

o Sometimes called the flowerpot law The Costs of Production Fixed Costs, Variable Costs, and Total Costs

• Fixed costs are costs that are spent and cannot be changed in the period of time under consideration

• Variable costs are costs that change as output changes • These two sum to total cost (TC = FC + VC)

Average Total Cost, Average Fixed Cost, and Average Variable Cost • Average total cost (average cost) equals total cost divided by the quantity

produced

o

€

ATC =TCQ

o Also,

€

ATC = AFC + AVC • Average fixed cost equals fixed cost divided by quantity produced

o

€

AFC =FCQ

• Average variable cost equals variable cost divided by quantity produced

o

€

AVC =VCQ

Marginal Cost • Marginal cost is the most important cost a firm considers when deciding how much to

produce • Marginal cost is the increase (decrease) in total cost from increasing (decreasing)

the level of output by one unit Graphing Cost Curves

• Total Cost Curves

• Average and Marginal Cost Curves

o The MC curve goes through the minimum point of the ATC curve and AVC curve. Each of these curves is U-shaped. The AFC curve slopes down continuously

o Downward-Sloping Shape of the Average Fixed Cost Curve

§ As output increases, the same fixed cost can be spread over a wider range of output, so average fixed cost falls

o The U Shape of the Average Cost Curves § In the short run, output can be raised only by increasing the variable

input. But as increasing variable inputs are added to a fixed input, the law of diminishing marginal productivity enters in. Marginal and average productivities fall and marginal and average costs rise.

§ Thus, if eventually the law of diminishing marginal productivity holds true, then eventually both the marginal cost curve and the average cost curve must be upward sloping.

§ Average total cost initially falls faster and then rises more slowly than average variable cost.

o The Relationship between the Marginal Productivity and Marginal Cost Curves

§ When MC exceeds AC, AC must be rising. When MC is less than AC, AC must be falling. This relationship explains why MC curves always intersect the AC curve at the minimum of the AC curve.

§ When the productivity curves are falling, the corresponding cost curves are rising

o The Relationship between the Marginal Cost and Average Cost Curves § The positioning of the MC curve is indicative of the ATC curve

ú If MC > ATC, then ATC is rising ú If MC = ATC, then ATC is at its minimum ú If MC < ATC, then ATC if falling

§ Marginal and average reflect a general relationship that also holds for MC and AVC

ú If MC > AVC, then AVC is rising ú If MC = AVC, then AVC is at its minimum ú If MC < AVC, then AVC is falling

o This part is best understood by reading pages 285-289 in the text book Review Costs

• Marginal cost o The additional cost resulting from a one-unit increase in output o

€

MC = ΔTC • Total cost

o The sum of all costs of inputs used by a firm in production o

€

TC = FC +VC

• Average total cost o Total cost per unit of production

o

€

ATC = AFC + AVC =TCQ

• Fixed cost o Cost that is already spent and cannot be recovered. It exists only in the short

run. o

€

FC • Averaged fixed cost

o Fixed costs per unit of production

o

€

AFC =FCQ

• Variable cost o Costs that vary with production o

€

VC • Average variable cost

o Variable costs per unit of production

o

€

AVC =VCQ

Chapter 13 – Production and Cost Analysis II 12/2/15 7:48 PM

Making Long-Run Production Decisions • Firms have many more options in the long run than in the short run

o They can change any input they want o Plant size is not given

• To make their long-run decisions, firms look at the costs of the various inputs and the technologies available for combining those inputs and seeing which has the lowest cost

Technical Efficiency and Economic Efficiency • Technical efficiency in production means that as few inputs as possible are used to

produce a given output o Many production processes can have equal technical efficiencies, but their

economic efficiencies distinguish some from others • An economically efficient method of production is the method that produces a

given level of output at the lowest possible cost o In long-run production decisions, firms look at all production technologies and

choose the most economically efficient method of producing Determinants of the Shape of the Long-Run Cost Curve

• The shape of the long-run cost curve is due to the existence of economies and diseconomies of scale

o In the long run, all inputs are variable Economies of Scale

• Economies of scale is when long-run average total costs decrease as output increases

• In real-world production, low levels of production are greatly affected by economies of scale because many production techniques require a certain minimum level of output to be useful

o An indivisible setup cost is the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use

§ E.g. Books: buying a printing press is a cost that must be incurred if any production is to take place, but not a cost that increases with the number of books produced

• The minimum efficient level of production is the amount of production that spreads setup costs out sufficiently for a firm to undertake production profitably

Diseconomies of Scale

• Diseconomies of scale is when long-run average total costs increase as output increases

o Diseconomies of scale sometimes, but not always, start occurring as firms get large.

• Diseconomies of scale could not occur if production relationships were only technical relationships

o The same technical process could be used over and over again at the same per-unit cost.

• In reality, production relationships have social dimensions that effect the production process:

o 1) As the size of the firm increases, monitoring costs generally rise § Monitoring costs are the costs incurred by the organizer of

production in seeing to it that the employees do what they’re supposed to do

§ Larger firms have to have more and more people devoted to simply monitoring employees

o 2) As the size of the firm increases, team spirit/morale generally declines § Team spirit is the feelings of friendship and being part of a team that

bring out people’s best efforts § Most types of production are highly dependent on team spirit

Constant Returns to Scale • Constant returns to scale are where long-run average total costs do not change

with an increase in output • Together, economies of, constant returns to, and diseconomies of scale contribute to

the U-shaped curve of long-run average total costs The Importance of Economies and Diseconomies of Scale

• If firms can make and sell more at lower per-unit costs they can make more profits Envelope Relationship

• Since long-run costs are variable and short-run costs aren’t, long-run costs will always be less than or equal to short-run cost at the same level of output

o In the short run, all expansion must be done by increasing only the variable input. This constraint must increase average cost (or at least not decrease it) compared to what the average cost would have been if the firm had planned to initially produce that level.

• This envelope relationship comes from the fact that the long-run average total cost curve is an envelope of short-run average total cost curves

o The more options you have to choose from, the lower the costs of production. § I.e. constraints always raise costs

• When there are economies of scale and you have chosen an efficient plant size for a given output, your short-run average costs will fall as you increase production.

o Pg 302 Entrepreneurial Activity and the Supply Decision

• The expected price of a good must exceed the opportunity cost of supplying the good for a good to be supplied

• An entrepreneur is a person who sees an opportunity to sell an item at a price higher than the average cost of producing it

Using Cost Analysis in the Real World Economies of Scope

• Economies of scope are when the costs of producing products are interdependent so that it’s less costly for a firm to produce one good when it’s already producing another

Learning by Doing and Technological Change • Learning by doing means that as we do something, we learn what works and what

doesn’t, and over time we become more proficient at it o Many firms estimate that worker productivity grows 1-2% p.a. due to learning

by doing • Technological change is an increase in the range of production techniques that

leads to more efficient ways of producing goods as well as the production of new and better goods

o Tech changes can fundamentally alter the nature of production costs • Technological change and learning by doing are intricately related.

Many Dimensions • Real-world economic decisions have many dimensions besides the single dimension

of output in the standard model Unmeasured Costs

• Economists Include Opportunity Cost o Accountants’ calculations don’t take into account the time and effort that the

owner inputs • Economic Depreciation versus Accounting Depreciation

o Depreciation is a measure of the decline in value of an asset that occurs over time

Chapter 14 – Perfect Competition 12/2/15 7:48 PM

Perfect Competition • Competition as a process is a rivalry among firms • Competition is also a perfectly competitive market structure

A Perfectly Competitive Market • A perfectly competitive market is a market in which economic forces operate

unimpeded • A market in perfect competition must meet certain stringent requirements

o 1. Both buyers and sellers are price takers o 2. The number of firms is large o 3. There are no barriers to entry o 4. Firms’ products are identical o 5. There is complete information o 6. Selling firms are profit-maximizing entrepreneurial firms

• These requirements are needed to ensure that economic forces operate instantaneously and aren’t hindered by social and political forces

The Necessary Conditions for Perfect Competition • Both Buyers and Sellers are Price Takers

o A price taker is a firm or individual who takes the price determined by market supply and demand as given

• The Number of Firms is Large o The term large means sufficiently large so that any one firm’s output

compared to the market output is imperceptible and what one firm does has no influence on what other firms do

• There are No Barriers to Entry o Barriers to entry are social, political, or economic impediments that prevent

firms from entering a market § Legal barriers, technological barriers

• Firms’ Products are Identical o Each firm’s output is indistinguishable from any other’s

• Complete Information o Firms and consumers know all there is to know about the market – prices,

products, and available technology o No firm/consumer has a competitive edge

• Selling Firms are Profit-maximizing Entrepreneurial Firms

o Firms can have many goals, but for perfect competition, firms must seek maximum profit and only profit. The people who make the decisions must receive only profits and no other form of income from the firms.

The Definition of Supply and Perfect Competition • The stated conditions are enormously strong and rarely meet simultaneously,

however they’re necessary for a perfectly competitive market to exist. When they do meet, they create an environment in which each firm, following its own self-interest, will offer goods to the market in a predictable way.

• Recall the definition of supply: a schedule of quantities of goods that will be offered to the market at various prices.

o This definition requires the supplier to be a price taker o In almost all other market structures, firms aren’t price takers; they are price

makers. § Market structure – frameworks within which firms interact

economically • The second condition – the number of firms is large – is necessary so that firms have

no ability to collude (operate in concert to reap more benefits) • Conditions 3-5 are closely related to the first two; they make it impossible for any firm

to forget about the hundreds of other firms • Condition 6 tells a firm’s goals; without these, we wouldn’t knowhow firms would

react when faced with the given price • Marginal Cost

o If the conditions for perfect competition hold, then a firm’s supply curve will be that portion of the firm’s short-run marginal cost curve above the AVC curve

Demand Curves for the Firm and the Industry • The demand curve for an industry is downward-sloping, but the demand curve for the

firm is horizontal (perfectly elastic) • The difference is explained by perception. Each firm in a competitive industry is so

small that it perceives that its actions will not affect the price it can get for its product. Price is the same no matter how much the firm produces.

o The price a firm can get is determined by the market supply and demand curve

• Firms will increase their output in response to an increase in market demand, even though that increase in output will cause price to fall and can make all firms collectively worse off. But in perfect competition firms don’t act collectively.

The Profit-Maximizing Level of Output

• The goal of a firm is to maximize profits • Since profit is the difference between total revenue and total cost, the effect of

change in output on profit is determined by marginal revenue and marginal cost. o Marginal revenue (MR) – the change in total revenue associated with a

change in quantity o Marginal cost (MC) – the change in total cost associated with a change in

quantity • A firm maximizes profit when MC=MR

Marginal Revenue • Since a perfect competitor accepts the market price as a given, marginal revenue is

simply the market price. • For a competitive firm, MR=P

o The Marginal revenue curve and demand curve are the same for a perfect competitor

Profit Maximization: MC = MR • To maximize profit, a firm should produce where MC=MR • Since MR is market price, the profit-maximizing condition of a competitive firm is

MC=MR=P • If marginal revenue does not equal marginal cost, a firm can increase profit by

changing output The Marginal Cost Curve is the Supply Curve

• Consider the definition of the supply curve as a schedule of quantities of goods that will be offered on the market at various prices.

o The upward-sloping portion of the marginal cost curve fits this definition • Because the marginal cost curve tells us how much of a produced good a firm will

supply at a given price, the marginal cost curve is the firm’s supply curve; MC=S Firms Maximize Total Profit

• Maximizing profit means maximizing total profit, not profit per unit • As long as increase in output will increase total profits, a profit-maximizing should

increase output Profit Maximization Using Total Revenue and Total Cost

• Total revenue and total cost curves can also be used to determine the profit-maximizing level of output

o Total profit is maximized where the vertical distance between total revenue and total cost is greatest. At that output, marginal revenue (the slope of the

total revenue curve) and marginal cost (the slope of the total cost curve) are equal

Total Profit at the Profit-Maximizing Level of Output • Marginal cost is all that is needed to determine a competitive firm’s supply curve

Determining Profit from a Table of Costs and Revenue • The P=MR=MC demonstrates how much output a competitive firm should produce to

maximize profit, however it does not tell us how much profit the firm makes • Profit is determined by total revenue minus total cost at the point where MR=MC

Determining Profit from a Graph • The profit-maximizing output can be determined in a table or in a graph • Find Output Where MC=MR

o Find point where MC=MR, this point marks the quantity that the firm will produce

• Find Profit per Unit Where MC=MR o After finding the profit-maximizing quantity, drop a vertical line down to the

horizontal axis. Find the ATC at that output level and extend a line from the ATC to the Y-axis (price).

o This rectangle is the amount of profit the firm earns o To determine maximum profit, you must first determine what output the firm

will choose to produce by seeing where MC equals MR and then determine the ATC at that quantity by dropping a line down to the ATC curve

• Zero Profit or Loss Where MC=MR o ATC at the profit-maximizing position is below the price, thus making profit

§ When the ATC is below the marginal revenue curve, the firm makes a profit

§ When the ATC is above the marginal revenue curve, the firm incurs a loss

o To determine maximum profit, first determine what output the firm will choose to produce by seeing where MC=MR, and then extending a line to the ATC curve

o MC=MR=P is both a profit-maximizing and a loss-minimizing condition The Shutdown Point

• The supply curve of a competitive firm is the MC curve where it is above the AVC curve. If a firm is operating above AVC, there is no point of shutting down. The fixed costs are sunk costs and the firm must pay them regardless of whether it produces

or not. The firm only considers the variable costs, as long as it covers its variable costs, it pays to keep on producing.

• The shutdown point is the point below which the firm will be better off if it temporarily shuts down than it will if it stays in business

Short-Run Market Supply and Demand • In the short run when the number of firms in the market is fixed, the market supply

curve is the horizontal sum of all the firm’s marginal cost curves, taking account of any changes input prices that might occur

o All firms in a competitive market have identical MCs • As the short run evolves into the long run, the number of firms in the market is

variable and the market supply curve shifts to the right because more firms are supplying the quantity indicated by the representative marginal cost curve

Long-Run Competitive Equilibrium • In the long run, firms can enter and exit the market

o Thus, in the long run only the zero profit equilibrium (shown on pg 329) can exist

o Firms can’t make economic profit or economic loss in the long run because of the entry and exit of firms

§ If there are economic profits, firms will enter the market, shifting the market supply curve to the right. As market supply increases, the market price will decline and reduce profits for each firm. Firms will continue to enter the market until economic profit is eliminated

§ Only at zero profit will entry and exit stop • Normal profit is the amount the owners of business would have received in the

next-best alternative o The zero-profit condition is enormously powerful; it makes the analysis of

competitive markets far more applicable to the real world than would otherwise be the case

Adjustment from the Short Run to the Long Run An Increase in Demand

• A market in equilibrium that experiences an increase demand. Firms are making zero profit because they’re in long-run equilibrium. If demand increases, firms will see the market price increasing and will increase their output until they’re once again at a position where MC=P.

• As new firms enter

Chapter 15 - Monopoly 12/2/15 7:48 PM Monopoly is a market structure in which one firm makes up the entire market

• Opposite of perfect competition • Exist due to barriers to entry into a market that prevent competition

o Legal barriers (i.e. patents) o Sociological barriers - custom or tradition o Natural barriers - unique ability to produce what other firms can’t duplicate o Technological barriers – the size market can support only one firm

The Key difference between a monopolist and a Perfect Competitor • A competitive firm is too small to affect price so it does not take into account the

effect of its output decision on the price it receives (“price taker”) o MR=Market price

• A monopolistic firm takes into account that its output decision can affect price; it’s marginal revenue is not its price

• In competitive markets the firms do not act in the interest of the firms collectively o Each firm is pitted against another; consumers benefit o Monopolists see to it that they, not the consumer, benefit

A Model of Monopoly • Pricing

o Profit-Maximizing output at MC=MR § MR is not equal to market price § MR changes as output changes

o Demand curve downward sloping (more inelastic demand) § MR curve lies below demand curve

o If MR>MC the monopolist gains profit by increasing output o If MR<MC the monopolist gains profit by decreasing output o If MR=MC the monopolist is maximizing profit o Equilibrium output for the monopolist, like equilibrium output for the

competitor is determined by the MC=MR condition, but because the monopolist’s marginal revenue is below its price, its equilibrium output is different from the competitive market

Profits and Monopoly • Profit is determined by subtracting ATC from average revenue (P) at that level of

output and multiplying by the chosen output o If Price>ATC the monopolist will make a profit o If Price=ATC the monopolist will make no profit (only a normal return) o If Price<ATC the monopolist will incur a loss

• Price is given by the demand curve (at the Quantity where MR=MC) • Monopolist are not guaranteed a profit

The Welfare Loss from Monopoly • Because monopolies charge a price that is higher than marginal cost, people’s

decisions don’t reflect the true cost to society. Price exceeds marginal cost. Because price exceeds marginal cost, people’s choices are distorted, they choose to consume less of the monopolist’s output and more of some other output than they would if markets were competitive.

o The marginal cost of increasing output is lower than the marginal benefit of increasing output, so there’s a welfare loss

The Price-Discriminating Monopolist • Price-discriminate – to charge different prices to different individuals or groups of

individuals o If monopolies can identify groups of customers who have different elasticities

of demand, separate them in some way, and limit their ability to resell its product between groups, it can charge each group a different price

§ It could charge consumers with less elastic demands a higher price and vice versa

o Examples § Movie theaters give discounts to senior citizens and children § Automobiles are seldom sold at list price

Barriers to entry and Monopoly • Natural Ability

o A firm might have unique abilities that make it more efficient than all other firms

• Economies of Scale o If sufficiently large economies of scale exist, it would be inefficient to have two

producers o Referred to as Natural Monopolies

§ An industry in which a single firm can produce at a lower cost than can two or more firms

§ Occurs when the technology is such that indivisible set up costs are so large that average total costs fall within the range of possible outputs

§ Results in a welfare gain • Government Created Monopolies

Normative Views of Monopoly • Monopolies are unfair and inconsistent with liberty (entrance barriers) • The public does not like the income distributional effects of monopoly • Government-created monopoly encourages people to spend a lot of their time in

political pursuits trying to get the government to favor them with a monopoly rather than doing “productive things”

Chapter 16 – Monopolistic Competition and Oligopoly12/2/15 7:48 PM Market structure is the physical characteristics of the market within which firms interact

• Monopolistic competition is a market structure in which there are many firms selling differentiated products and few barriers to entry

• Oligopoly is a market structure in which there are only a few firms and firms explicitly take other firms’ likely response into account

Characteristics of Monopolistic Competition • Many sellers

o There is no need to take competitors’ responses to price changes into account

• Differentiated products o The goods sold aren’t homogenous, each firm has a monopoly on the good it

sells o This monopoly is based on advertising to convince people that one firm’s

good is different from the goods of competitors o Advertising to increase monopoly power makes sense as long as the

marginal benefit exceeds marginal cost • Multiple dimensions of competition

o Such as advertising or service and distribution outlets. They follow two general decision rules

§ Compare marginal costs and marginal benefits § Change that dimension of competition until marginal costs equal

marginal benefits • Easy entry of new firms in the long run

Output, Price and Profit of a Monopolistic Competitor • Downward sloping demand curve • Profit maximization occurs at MC=MR • Competition implies zero economic profit in the long run

o Due to new suppliers entering the market in search of profit • Comparing Monopolistic Competition with Perfect Competition

o In perfect competition demand is perfectly elastic so firms produce where MC=P=ATC (minimum)

o In Monopolistic Competition the demand curve is downward sloping. Price exceeds marginal cost. Produces at MC=MR

o This means that for monopolistic competitors market share is a valid concern § Since increasing output lowers average cost, increasing market share

would allow the firm to do better

§ For perfect competitors increasing output offers no benefit • Monopolies can make long-term economic profit though monopolistic competitors

cannot • Advertising and Monopolistic Competition

o Goals of Advertising § Shifting the demand curve to the right and making it more inelastic

o Does advertising help or hurt society? § Joan Robinson believed that the difference between the cost of a

perfect competitor and the cost of a monopolistic competitor was the cost of what he called “differentness”. If consumers are willing to pay this cost it’s not a waste but, rather, a benefit.

Characteristics of Oligopoly • There are a small number of firms in the industry, so that, in any decision a firm

makes, it must take into account the expected reaction of other firms o Can be collusive or noncollusive o Mutual interdependence

§ Fosters strategic decision making- taking explicit account of a rival’s expected response to a decision you are making

Models of Oligopoly Behavior • There is no single model because an oligopolist can decide on pricing and output

strategy in many possible ways • The Cartel Model

o A cartel is a combination of firms that acts as if it were a single firm, a shared monopoly

o The Cartel model of oligopoly is a model that assumes that oligopolies act as if they were monopolists that have assigned output quotas to individual member firms of the oligopoly so that total output is consistent with joint profit maximization

§ Explicit formal collusion is illegal in the United States § Dominant firm cartel model- a single large firm makes pricing and

output decisions and smaller, fringe firms follow o Implicit price collusion

§ Implicit collusion – multiple firms make the same pricing decisions even though they have not explicitly consulted with one another

§ Social pressures play an important role in stabilizing prices

o Since other firms can enter the market, cartels encourage technological advances to retain their monopoly

o Why are prices sticky? § They don’t change frequently, due to informal collusion as well as the

kinked demand curve ú If a firm increases its price and the firm believes that other

firms won’t go along, it’s perceived demand curve is very elastic. It will lose a lot of business

ú If a firm decreases its price, the firm assumes that its competitors would immediately match that price so it would gain very few, if any, additional sales. Thus its demand curve is here very inelastic

ú Thus the demand curve has a kink and MR curve has a gap • The Contestable Market Model

o A model of oligopoly in which barriers to entry and barriers to exit, not the structure of the market, determine a firm’s price and output decisions.

• Comparison of the Contestable Market Model and the Cartel Model o New Entry limits the Cartelization Strategy o Price Wars

§ Firms utilize the strategy of pushing down price to drive the other firm out of business

Classifying Industries and Markets in Practice • See the table on page 372 of Collander • Problems with classification

o Choosing the relevant market (whole U.S or town?) o Deciding what is to be included in an industry (Transportation industry vs

urban transit industry) § The narrower the definition, the fewer firms

o Economists classify using cross-price elasticities • The North American Industry Classification System (NAICS)

o An industry classification that categorizes industries by type of economic activity and groups firms with like production processes

o Consists of six digits with each successive digit specifying a subgroup of the initial two digit sector

• Empirical Measures of Industry Structure

o Concentration Ratio – the value of sales by the top firms of an industry stated as a percentage of total industry sales

§ The higher the ratio, the closer the industry is to an oligopolistic or monopolistic type of market structure

o Herfindahl index – an index of market concentration calculated by adding the squared value of the individual market shares of all the firms in the industry

• Conglomerate firms and bigness o Bigness is not measured by either the Concentration Ratio or Herfindahl

index. o This is due to Conglomerates- companies that span a variety of unrelated

industries • Oligopoly models and Empirical Estimates of Market Structure

o The Cartel model fits best with these empirical measurements because it assumes that the structure of the market (the number of firms) is directly related to the price a firm charges

o The Contestable market model gives less weight to the empirical estimates because a market structure that looks highly oligopolistic could actually be highly competitive

§ Barriers to entry and exit are what matter

Chapter 17 – Real-World Competition and Technology12/2/15 7:48 PM The Goals of Real-World Firms and the monitoring Problem

• Short-run versus Long-run profit o If firms are profit maximizers they aren’t just concerned with short-run profit;

most are concerned with long-run profit. Expenditures on reputation and goodwill (to be perceived as good citizens) can increase long-run profit,

even if they reduce short-run profit

• The Problem with Profit Maximization o In the real world the decision makers’ income is often a cost of the firm

Managers’ incentives

• Self-interested decision makers have little incentive to hold down their pay, which is a cost of the firm.

o Increased pay results in decreased profit § Monitoring problem- the need to oversee employees to ensure that

their actions are in the best interest of the firm o Need for monitoring

§ Employee’s incentives differ from the owner’s incentives Incentive-Compatible Contract- the incentives of each of the two parties to the contract are made to

correspond as closely as possible

Self-interested managers are interested in maximizing the firm’s profit only if the structure of the firm

requires them to do so

• What do Real-World Firms Maximize o Profit is one of the goals of firms

Often other intermediate goals become the focus of the firm (ex: growth of sales)

The Lazy Monopolist and X-Inefficiency • Lazy monopolist- firms that do not push for efficiency, but merely enjoy the position

they are already in o Not profit maximizers, they perform as efficiently as is consistent with keeping

their jobs Results in X-Inefficiency- firms operating far less efficiently than they could technically

These firms are in monopoly positions

The standard model avoids dealing with monitoring problems by assuming the owner of the firm makes all

the decisions

• How Competition Limits the Lazy Monopolist o All economic institutions must have sufficient revenue coming in to cover

costs, so all economic institutions have a limit to how lazy they can get – imposed by their monopoly position

§ Profit can be translated into inefficiency but no more o The degree of competition determines the limit on laziness

Competitive pressure can be generated by a Corporate takeover- in which a firm or group of individuals

issues a tender offer (that is, offers to buy up the stock of a company) to gain control and install its own

manager

• Managers lose perks or even their jobs with takeovers so they will often preventively restructure the company

Restructuring incurs debt so even more pressure is placed on the management to operate efficiently

• Motivations for Efficiency other than the Profit Incentive o Some individuals derive pleasure from efficiently-run organizations. In such

cases monitoring increases costs and is inefficient § Rare

The Fight Between Competitive and Monopolistic Forces • Self-interest-seeking individuals don’t like competition for themselves (though they do

like it for others) and when competitive pressures grow strong, they push back with social or political forces

How monopolistic Forces Affect Perfect Competition

• Our laws and social values and customs simply do not allow perfect competition to work because government emphasizes other goals besides efficiency

• Economic Insights and Real-World Competition o The movement away from perfectly competitive markets can be predicted by

economic theory § Firms collude and restrict entry into the market in order to increase

profits (in self interest) • How Competitive Forces Affect Monopoly

o For a Monopoly to exist it must prevent other firms from entering the market, which is nearly impossible

§ Breaking Down Monopoly ú To get some of the profit firms will break down monopolies

through political or economic means § Reverse Engineering

ú The process of a firm buying other firms’ products, disassembling them, figuring out what’s special about them, and then copying them within the limits of the law

• Competition and Natural Monopoly

o Natural monopolies often have high profits, which gives other firms an incentive to research alternate ways (new technologies) of supplying the product

Political Pressure is also used to regulate or break up the monopoly

Regulating Natural Monopolies

• Given the exclusive right to operate in an industry in return to submission to pricing regulation

They are allowed to make a normal return but no economic profit and thus have no incentive to keep

costs down, resulting in X-Inefficiency

• Deregulating Natural Monopolies o In order to prevent X-inefficiency, more and more outside oversight is needed

to determine appropriate and inappropriate costs, resulting in high costs to the board overseeing the firm

How Firms Protect their Monopolies • Cost/Benefit Analysis of Creating and Maintaining Monopolies

o Monopolies are expensive to create and maintain, thus firms will buy monopoly power until the marginal cost of such power equals the marginal benefit.

Establishing Market Position

• Similar to a Winner-take-all competition. The winner (established because of brand loyalty, patent protection, or simply consumer laziness) achieves monopoly and can charge significantly higher prices than its costs without facing competition.

o Technology § Technological development – the discovery of new or improved

products or methods of production ú Technological advance lowers costs and improves efficiency

Natural outcome of specialization due to the increased knowledge gained in specialization that allows a

breakthrough

Technology, Efficiency, and Market Structure • Some market structures are more conducive to growth than others (they provide

more incentives) Dynamic Efficiency- a market’s ability to promote cost-reducing or product-enhancing technological

change

Perfect Competition and Technology

• Perfect Competitors have no incentive to develop new technologies

They also make no economic profit and thus may not be able to acquire the funds needed to devote to

R&D

• Monopolistic Competition and Technology o The promise of gaining market power provides the incentive to fund research

in new technologies However, in Monopolistic competition, long-term economic profit is zero so the gained market power will

eventually deteriorate

• Monopoly and technology o Monopolies seldom have the incentive to innovate because their market is

protected from entry. This results in a lazy monopoly • Oligopoly and Technology

o Oligopoly is the market structure most conducive to technological change Typical oligopolistic firms have continual economic profit and can thus fund R&D

• Also spurred on by the belief their competitors are doing so, and the desire to gain an edge on said competitors

• Network Externalities, Standards, and Technological Lock-In o Network externality- occurs when greater use of a product increases the

benefit of that product to everyone (ex: telephones) Network Externalities lead to the development of Industry standards (such as AC vs. DC)

Standards and Winner-take-all industries

• Network externalities increase the likelihood that the industry becomes a winner-take-all industry.

Network externalities increase the need for an industry standard, benefitting the firm whose standard is

accepted.

• First-Mover Advantage o Firms will be willing to incur large losses in order to set the industry standard o Technological Lock-In

§ The market might not gravitate toward the most efficient standard, yet be maintained by the First –mover advantage.

Technological lock-in – when prior use of a technology makes the adoption of subsequent technologies

difficult

This does not, however, merit government interference because this would slow or stop the competitive

process and make society worse off

Chapter 19 – Work and the Labor Market 12/2/15 7:48 PM

The Supply of Labor • The labor market is a factor market in which individuals supply labor services for

wages to other individuals and to firms that demand labor services o If the invisible hand were the only force operating in the labor market, wages

would be determined entirely by supply and demand; this is not the case • The incentive effect is how much a person will change his or her hours worked in

response to a change in the wage rate o Economists focus on the incentive effect when considering an individual’s

choice of whether and how much to work o Normal relationship: The higher the wage, the higher the quantity of labor

supplied § As per the rational choice theory

Real Wages and the Opportunity Cost of Work • Over the last century, real wages in the U.S. rose significantly, but average number

of house worked per person fell. o This is counter to the logic that opportunity cost of leisure rises as wages rise

• Higher incomes, however, make people richer and richer people can afford more to choose more leisure

Income Taxation, Work, and Leisure • After-tax income is what determines how much people work

o Taxes reduce people’s incentives to work • Societal and political programs reward the needy with less expenses/taxes

o This ironically increases people’s incentives to be needy The Elasticity of the Supply of Labor

• Elasticity of Market Supply depends on o 1. Individuals’ opportunity cost of working o 2. The type of market being discussed o 3. The elasticity of individuals’ supply curve o 4. Individuals entering and leaving the labor market

• Individuals’ opportunity cost of working determine individuals’ supply curves and the amounts of people entering and leaving the labor force

Immigration and the International Supply of Labor • International limitations on immigration play an important role in elasticities of labor

supply The Derived Demand for Labor

• The demand for labor follows the basic law of demand:

o The higher the wage, the lower the quantity of labor demanded • When people are self-employed, the demand for the labor is the demand for the

product or service they supply • When a person isn’t self-employed, determining the demand for labor isn’t as direct

o There’s 2 steps: Consumers demand products from firms; firms then demand labor

• Labor is a derived demand – the demand for factors of production by firms, which depends on consumers’ demands

Factors Influencing the Elasticity of Demand for Labor • Factors that influence the elasticity of demand for labor are

o 1. The elasticity of demand for the firm’s good o 2. The relative importance of labor in the production process o 3. The possibility, and cost, of substitution in production o 4. The degree to which marginal productivity falls with an increase in labor

Labor as a Factor of Production • Land, labor, and capital are the traditional factors of production along with

entrepreneurship – labor that involves high degrees of organizational skills, concern, oversight responsibility, and creativity

o Labor and entrepreneurship are differentiated in the sense that an hour of work is not an hour work if organizational skills/creativity/etc are exerted

• Should a firm try to higher high-wage entrepreneurial labor or low-wage nonentrepreneurial labor?

Shift Factors of Demand • Factors that shift the demand curve for labor will put pressure on the equilibrium

price to change o If the price of a machine that is used in production rises, then demand for

labor (a substitute) would shift right and the wage would rise • Technology and the Demand for Labor

o “Technology makes it possible to replace workers with machines, so it will decrease the demand for labor”

§ This Luddite reasoning is incorrect o Technology increases output, however its affect on demand of labor is

ambiguous; technology decreases the demand for certain types of labor but increases demand for other types.

§ E.g. Computers decreased demand for calligraphers and increased demand for computer programmers

• International Competitiveness and a Country’s Demand for Labor o A central determinant of a country’s competitiveness is the relative wage rate

of labor in that country § Hence why MNCs often establish manufacturing plants in the third

world o The focal point phenomenon is when a company chooses to move, or

expand, production to another country because other companies have already moved there

The Role of Other Forces in Wage Determination • Supply and demand forces greatly influence wages, but do not determine them

o Real-world labor markets are filled with individuals/firms that resist market forces of supply and demand

Imperfect Competition and the Labor Market Monopsony

• A monopsony is a market in which a single firm is the only buyer o It buys less and pays less

• When there’s only one buyer of labor, with each worker hired, the equilibrium wages of the next one rise

o The marginal factor cost – the additional cost to a firm of hiring another worker – is above the supply curve

Union Monopoly Power • A union monopoly is where workers organized together that allows them to act as if

there were only a single seller • The union will have the incentive to act like a monopoly and increase its members’

wages o To do so, it must be able to restrict supply and union membership

• The wage that the union sets wouldn’t be below the competitive wage, it would be above it

Bilateral Monopoly • A bilateral monopoly is a market with only a single seller and single buyer • The equilibrium wage will between that of the monopsonist wage and the union

monopoly power wage; the equilibrium quantity will be between the monopsonist quantity and union monopoly power quantity

Political and Social Forces and the Labor Market • To understand real-world labor markets, one must broaden the analysis

Fairness and the Labor Market

• Efficiency Wages o Efficiency wages are wages paid above the going market wage to keep

workers happy and productive • Comparable Worth Laws

o Comparable worth laws are laws mandating comparable pay for comparable work

Job Discrimination and the Labor Market • On average women are paid les than men and blacks are often directed into lower-

paying jobs • Three Types of Direct Demand-Side Discrimination

o 1. Discrimination based on individual characteristics that will affect job performance

o 2. Discrimination based on correctly perceived statistical characteristics of the group

o 3. Discrimination based on individual characteristics that don’t affect job performance or are incorrectly perceived

o Discrimination based on characteristics that affect job performance is hard to eliminate, while discrimination based on characteristics that do affect job performance is easy to eliminate as there are no economic motivations causing such discrimination.

• Institutional Discrimination o When the structure of the job makes it difficult/impossible for some groups to

succeed, there is institutional discrimination The Evolution of Labor Markets

• Evolving Labor Laws • Unions and Collective Bargaining

o A closed shop is a firm in which the union controls hiring § These are illegal

o A union shop is a firm in which all workers must join the union § Federal law permits these

Chapter 20 – Who Gets What? The Distribution of Income12/2/15 7:48 PM

Ways of Considering the Distribution of Income • The share distribution of income is the relative division of total income among

income groups • The socioeconomic distribution of income is the allocation of income among

relevant socioeconomic groupings The Lorenz Curve

• A Lorenz curve is a geometric representation of the share distribution of income among families in a given country at a given time

o Real-world Lorenz curves are below the diagonal line U.S. Income Distribution over Time

• Until 1970, income equality rose; it has fallen since • Redistribution measures instated by the U.S. government

o Social Security o Progressive taxation o Improved macroeconomic performance of the economy

Defining Poverty • Poverty can be defined absolutely and relatively

The Official Definition of Poverty • The poverty threshold is the income below which a family is considered to live in

poverty o “A family is in poverty if its income is equal to or less than three times an

average family’s minimum food expenditures as calculated by the U.S. Department of Agriculture.”

Debates about the Definition of Poverty • The poverty line is seen as too high and too low by various groups based on

observations on prices of food, etc. • Like most economic statistics, poverty statistics should be used with care

The Costs of Poverty • Poverty is argued to bring significant costs to society

o General morale o Increases crime (lower opportunity cost)

Social and Economic Mobility • The U.S. was seen as a meritocracy

o Recently, this view is under question International Dimensions of Income Inequality Comparing Income Distribution across Countries

• The U.S. has less income inequality than most developing countries but more income inequality than many developed countries

Income Distribution among Countries • International wealth distribution is incredibly unequal

o Income is highly unequally distributed among countries The Total Amount of Income in Various Countries

• There are enormous differences of income among countries The Distribution of Wealth

• Equality of wealth and equality of income are used measuring equality o Wealth is the value of the things individuals own less the value of what they

owe § A static concept

o Income is payments received plus or minus changes in value in a person’s assets in a specified time period

§ A flow concept A Lorenz Curve of the Distribution of Wealth

• Wealth is significantly more unequally distributed than is income in the U.S. Socioeconomic Dimensions of Income Inequality Income Distribution According to Socioeconomic Characteristics

• Income differs substantially by type of job Income Distribution According to Class

• Class divisions by income source have become blurred o The U.S. has socioeconomic classes with some mobility among classes. This

is not to say such classes should exist, just that they do. • The Importance of the Middle Class

o Economists used to see the class structure as a pyramid, with a large lower class, a smaller middle class, and an even smaller upper class

§ However, now the class structure is more like a pentagon with the middle class being the largest

• Distributional Questions and Tensions in Society o Mainstream economists tend to focus on the share distribution of income,

nonmainstream economists emphasize class and group structures in their analysis

§ Radical economists emphasize the control that the upper class has over the decision process

§ Libertarian economists emphasize the role of special interests of all types in shaping government policy

o People’s acceptance of the U.S. economic system is based not only on what the distribution of income is but also on what people thing it should be and what they consider fair

Income Distribution and Fairness • Value judgments necessarily underlie all policy prescriptions

Philosophical Debates about Equality and Fairness • Different philosophies hold very different normative views on how incomes should be

distributed if at all Fairness and Equality

• Fairness has many dimensions and it is often difficult to say what is fair and what isn’t

• Determining whether an equal income distribution is fair involves 3 things to keep in mind

o 1. People don’t start from equivalent positions o 2. People’s needs differ o 3. People’s efforts differ

Fairness and Equality of Opportunity • Equality of income given that individuals are comparably endowed

The Problems of Redistributing Income The Important Side Effects of Redistributive Programs

• Three main side effects of income redistribution are o 1. A tax may result in a switch from labor to leisure o 2. People may attempt to avoid or evade taxes, leading to a decrease in

measured income o 3. Redistributing money may cause people to make themselves look as if

they’re more needy than they really are • People will change their behavior in response to changes in taxation and income

redistribution programs o Incentive effects of taxation o The importance of incentive effects of taxation is debated by economists to

the point where they’re considered marginal or crucial and taxation should be abandoned

Politics, Income Redistribution, and Fairness

• Often, politics (instead of value judgments) plays a central role in determining what taxes an individual will pay

• Politics/voting is not a socioeconomically fair way to determine taxation practices o Poor people are discouraged from voting feeling one vote can’t make a

difference o Elections require financing o Education levels, etc.

Income Redistribution Policies • The government uses taxation and expenditures for income redistribution

Taxation to Redistribute Income • A progressive tax is one in which the average tax rate increases with income • A proportional tax is one in which the average rate of tax is constant regardless of

income level • A regressive tax is one in which the average tax rate decreases as income

increases • Federal Income Taxes

o In the 1940s, the federal personal income tax was made highly progressive. But since then, the rates have become less progressive.

o The Social Security tax is initially proportional • State and Local Taxes

o State and local governments get most of their income from the following sources:

§ 1. Income taxes (somewhat progressive) § 2. Sales tax, which tend to be proportional or slightly regressive § 3. Property taxes which are roughly proportional

Expenditure Programs to Redistribute Income • Expenditure programs have been more successful in redistributing income than

taxes • Social Security

o The Social Security system is a social insurance program that provides financial benefits to the elderly and disabled and to their eligible dependents and/or survivors

o Medicare is a multibillion-dollar medical insurance system • Public Assistance

o Public assistance programs are means-tested social programs targeted to the poor and providing financial, nutritional, medical, and housing assistance

§ E.g. Medicaid, SNAP (food stamps) • Supplemental Security Income

o Supplemental Security Income (SSI) is a federal program that pays benefits, based on need, to the elderly, blind, and disabled

• Unemployment Compensation o Unemployment compensation is short-term financial assistance,

regardless of need, to eligible individuals who are temporarily out of work • Housing Programs

How Successful Have Income Redistribution Programs Been? • The gain in equality is at the expense of total income of society

Chapter 21 – Market Failure versus Government Failure12/2/15 7:48 PM

Market Failures • There is an ongoing debate between whether or not government intervention is

acceptable in certain markets o The invisible hand framework says that if markets are perectly competitive,

they will lead individuals to make voluntary choices that are in society’s interest

• When conditions aren’t met to ensure that the invisible hand guides private actions towards social good, market failure occurs

o Market failure is a situation in which the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes

o There are three sources of market failures § Externalities § Public goods § Imperfect information

• Any time there’s a market failure, it is possible government intervention could improve the outcome but is not certain as the politics of execution often result in more problems

o These problems of government intervention are called government failures – when the government intervention in the market to improve the market failure actually makes the situation worse

Externalities • Externalities are the effects of a decision on a third party that are not taken into

account by the decision maker o Can be positive and negative o Negative externalities occur when the effects of a decision not taken into

account by the decision maker are detrimental to others o Positive externalities occur when the effects of a decision not taken into

account by the decision maker are beneficial to others A Negative Externality Example

• When there are externalities, the marginal social cost differs from the marginal private cost

o The marginal social cost includes all them marginal costs that society bears – or the marginal private costs of production plus the cost of the negative externalities associated with that production

o The distance between the two marginal cost curves (social vs. private) is the additional marginal cost of the externality

§ The vertical distance between the two (MC [or supply]) curves at a given quantity is the MC of the externality

A Positive Externality Example • Positive externalities make the marginal private benefit below the marginal social

benefit o The marginal social benefit equals the marginal private benefit of

consuming a good plus the benefits of the positive externalities resulting from consuming that good

o The distance between the two marginal benefit curves (social vs. private) is the additional marginal benefit of the externality

§ The vertical distance between the two (demand) curves at a given quantity is the marginal benefit of a decision

Alternative Methods of Dealing with Externalities • 1) Direct Regulation • 2) Incentive Policies • 3) Voluntary Solutions

Direct Regulation • Direct regulation is when the amount of a good people are allowed to use is directly

limited by the government o Can require an equal quantity reduction or an equal percentage reduction

• Direct regulation is not efficient – achieving a goal at the lowest cost in total resources without consideration as to who pays those costs

o Direct regulation does not take into account that the costs of reducing consumption may differ among individuals

o A solution is inefficient when a goal is achieved in amore costly manner than necessary

Incentive Policies • Tax Incentive Policies

o A tax incentive program is a program using a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends

§ More efficient than a regulatory solution as the person for whom the reduction is lest costly cuts consumption the most

o An efficient tax equals the additional cost imposed on society but not taken into account by the decision maker

§ Such taxes on externalities are called effluent fees – charges imposed by government on the level of pollution created

§ With such a tax, the cost the suppliers face is the social cost of supplying the good. With the tax, the invisible hand guides the traders to equate the marginal social cost to the marginal social benefit and the equilibrium is socially optimal

• Market Incentive Policies o A market incentive plan is a plan requiring market participants to certify that

they have reduced total consumption – not necessarily their own individual consumption – by a specific amount

§ Close to the regulatory solution, but different in the fact that if individuals choose to reduce consumption by more than the required amount, they’ll be given a marketable certificate that they can sell to someone who has chosen to reduce consumption by less than the required amount

o Incentive policies are more efficient than direct regulatory policies Voluntary Reductions

• Leaving individuals free to choose whether to follow a socially optimal or a privately optimal path

o The free rider problem is individuals’ unwillingness to share in the cost of a public good

The Optimal Policy • The optimal policy is one in which the marginal cost of undertaking the policy

equals the marginal benefit of that policy o If a policy isn’t optimal, resources are being wasted because the savings from

reducing expenditures on a program will be worth more than the gains that will be lost from reducing the program

• To spend too little on a beneficial program is as inefficient as spending too much on a non beneficial program

Public Goods • A public good is a good that is nonexclusive (no one can be excluded from its

benefits) and nonrival (consumption by one does not preclude consumption by others)

o No such thing as a pure public good in reality • Governments generally provide goods with public aspects as private businesses will

not supply them without transforming them into a mainly private goods

• Supply and demand of public goods o The market demand curve represents the marginal social benefit of a good

§ While the market demand curve for a private goods is the horizontal sum of all the individual demand curves, the market demand curve of a public good is the vertical sum. This is because the quantity of the good supplied is not split up; the full benefit of the total output is received by everyone

Excludability and the Costs of Pricing • Public/private good differentiation is seldom clear-cut

o Goods can be non rival but highly excludable and vice versa Informational Problems

• If a buyer doesn’t have perfect information, then they can be deceived o Real-world markets often involve deception, cheating, and inaccurate

information • Imperfect information can be the source of market failure

o An adverse selection problem is a problem that occurs when buyers and sellers have different amounts of information about the good for sale

• Problems in imperfect information can be solved by signaling – an action taken by an informed party that reveals information to an uninformed party that offsets the false signal that caused the adverse selection problem in the first place

Policies to Deal with Informational Problems • Licenses, regulatory commissions, etc.

o These have a problem of their own; they can slow down the economic process. E.g. FDA

• A Market in Information o Information is valuable, markets will develop to provide the information that

people need and are willing to pay for Government Failure and Market Failures

• Government failures can occur for various reasons o Governments don’t have an incentive to correct the problem

§ Political pressures often dominate over the general good o Governments don’t have enough information to deal with the problem o Intervention in markets is always more complicated than it seems

§ Long-run vs. short-run incentives conflict with government intervention o The bureaucratic nature of government intervention does not allow fine tuning o Government intervention leads to more government intervention

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