The Economic The Economic Point of ViewPoint of View

Glen WhitmanGlen Whitman

Dept. of EconomicsDept. of Economics

CSUNCSUN

The Economic Model ofThe Economic Model ofPretty Much EverythingPretty Much Everything

Goals

Constraints

Choices

Example: The ConsumerExample: The Consumer

Satisfaction of Preferences

Income, Prices

Buying Decisions

Example: The FirmExample: The FirmProfit Maximization

Technology, Factor Prices, Consumer Demand

Prices, Product Characteristics,Store Location, Hours...

The Basic Lesson of All Economics:The Basic Lesson of All Economics:

Incentives MatterIncentives Matter

Alter constraints to alter choices.Alter constraints to alter choices.

What you reward, you get more of.What you reward, you get more of.

What you punish, you get less of.What you punish, you get less of.

Thinking About Thinking About IncentivesIncentives

Non-economist: “People are like Non-economist: “People are like robots; they follow their programs.”robots; they follow their programs.”

Lousy economist: “People respond Lousy economist: “People respond to incentives in foreseeable ways.”to incentives in foreseeable ways.”

Good economist: “People respond to Good economist: “People respond to incentives, often in unforeseeable incentives, often in unforeseeable ways.”ways.”

Incentives: Getting It Incentives: Getting It WrongWrong

Vipers in an Italian townVipers in an Italian town

Socialized healthcare in CanadaSocialized healthcare in Canada

The Soviet nail quotaThe Soviet nail quota

Incentive pay for welders and Incentive pay for welders and secretariessecretaries

The Soviet Nail QuotaThe Soviet Nail Quota

“Who needs a nail as big as that?”

“Who cares? The important thing is we fulfilled the plan for nails in one fell swoop.”

Incentives: Getting It Incentives: Getting It RightRight

Think about the goals of those you’re Think about the goals of those you’re trying to influence.trying to influence.

Check for compatibility between Check for compatibility between what you want and what you’re what you want and what you’re rewarding/punishing.rewarding/punishing.

Beware of substitution effects.Beware of substitution effects.

Opportunity Cost Preview:Opportunity Cost Preview:

Is This a Profitable Is This a Profitable Business?Business?

You are the sole proprietor and You are the sole proprietor and manager of a massage parlor.manager of a massage parlor.

Weekly revenue: $7000Weekly revenue: $7000 Weekly expenditures: $6200Weekly expenditures: $6200 What is your profit? What is your profit?

Is This a Profitable Is This a Profitable Business?Business?continuedcontinued

You could have worked somewhere You could have worked somewhere else instead of being self-employed. else instead of being self-employed. Forgone salary: $1000/weekForgone salary: $1000/week

Accounting profitAccounting profit= $7000 - $6200 = $800/week= $7000 - $6200 = $800/week

Economic profitEconomic profit= $7000 - $6200 - $1000 = -$200/week= $7000 - $6200 - $1000 = -$200/week

Opportunity Cost Preview:Opportunity Cost Preview:

Is This a Profitable Is This a Profitable Investment?Investment?

You are given $1,000,000 to You are given $1,000,000 to manage.manage.

You spend all year managing the You spend all year managing the money.money.

By the end of the year, you have By the end of the year, you have gained $60,000.gained $60,000.

Was this a wise investment?Was this a wise investment?

Is This a Profitable Is This a Profitable Investment? continuedInvestment? continued

You could have had another job.You could have had another job.Forgone income: $45,000Forgone income: $45,000

You could have put the money in the You could have put the money in the bank.bank.Forgone interest (at 5%): $50,000Forgone interest (at 5%): $50,000

Economic ProfitEconomic Profit= $60,000 - $45,000 - $50,000 = -$35,000= $60,000 - $45,000 - $50,000 = -$35,000

Opportunity CostOpportunity Cost

Opportunity cost = the value of the Opportunity cost = the value of the next best opportunity forgone in next best opportunity forgone in making a choicemaking a choice

Includes explicit costs: wages, rent Includes explicit costs: wages, rent payments, etc.payments, etc.

Also includes implicit costs: Also includes implicit costs: forgone income from owner’s timeforgone income from owner’s time forgone income from firm-owned assetsforgone income from firm-owned assets forgone interest on capitalforgone interest on capital

The Economic The Economic Telecommunications Telecommunications

SystemSystem A market economy relies on people A market economy relies on people

to use information they don’t have.to use information they don’t have.

Two features of the market make Two features of the market make this possible: this possible: The price mechanismThe price mechanism The profit/loss mechanismThe profit/loss mechanism

The Price MechanismThe Price Mechanism

Prices are signals of scarcity.Prices are signals of scarcity. Scarcity: the relationship between how Scarcity: the relationship between how

much people want of something and much people want of something and how much there ishow much there is

Higher prices imply greater scarcity.Higher prices imply greater scarcity. People consume less, economize morePeople consume less, economize more

Lower prices imply lower scarcity.Lower prices imply lower scarcity. People consume more, economize lessPeople consume more, economize less

The Profit/Loss The Profit/Loss MechanismMechanism

Above-normal profits in an industry Above-normal profits in an industry attract entry of more firms.attract entry of more firms. More resources allocated to this useMore resources allocated to this use

Below-normal profits in an industry Below-normal profits in an industry force the exit of existing firms.force the exit of existing firms. More resources allocated to other usesMore resources allocated to other uses

The Price-Profit ProcessThe Price-Profit Process

Increased demand for a good/service Increased demand for a good/service leads to higher prices.leads to higher prices.

Higher prices lead to higher profits.Higher prices lead to higher profits. Higher profits attract more firms.Higher profits attract more firms. Greater competition drives prices Greater competition drives prices

and profits back down.and profits back down. Net effect: more resources pulled Net effect: more resources pulled

into production of this good/service.into production of this good/service.

Seeking Profit in a Dynamic Seeking Profit in a Dynamic MarketplaceMarketplace

Profits are usually transitory: in the Profits are usually transitory: in the long run, they tend to disappear.long run, they tend to disappear.

But the transition time is crucial. But the transition time is crucial. Various factors can speed up or slow Various factors can speed up or slow

down the transition time, including down the transition time, including barriers to entry.barriers to entry.

Some of these factors may be under Some of these factors may be under your control.your control.

Summary:Summary:

Thinking Like an EconomistThinking Like an Economist Always think about the incentives you Always think about the incentives you

have and the incentives you create.have and the incentives you create.

Take into account all costs of your Take into account all costs of your choices, not just the explicit ones.choices, not just the explicit ones.

Maintain a dynamic perspective to Maintain a dynamic perspective to keep up with the market.keep up with the market.