• What is economics?

• A way of understanding behavior

• Based on a simple assumption

• Rationality:

• Meaning that people have purposes and tend to take those actions...

• Not a statement about how people think

• But about the consequences

• True of cats and babies

• Not entirely true, but ...

• A lot human behavior fits that pattern, and ...

• We don't have a good theory for the rest, so ...

• Treat it as random error.

• In some contexts, truer than it ought to be

• Firms maximizing profits

• Large markets where random effects cancel out

• What does it apply to?

• All behavior in all times and places

• My size of nations

• Economic Analysis of Law:

• Armed Robbery

• Contracts under duress

• Mugger--argument for enforcing

• Parole system in warfare--argument against

• Pinochet--argument in both directions.

• Politics, marriage, war, ... .

• Rational ignorance. Name of congressman?

• Armies running away. Njalsaga.

• Silent student problem

• Divorce rate?

• We find out by trying

• Conventional area of applications

• Explicit markets, prices, inflation, unemployment, etc.

• Ideas best worked out in those areas, so we will spend most of our time there, but ...

• With detours to apply the ideas elsewhere.

• Questions about economics?

• Structure of the course

• Read before, be ready to ask questions.

• Homework due next Monday.

• On web page.

• Rtf version available too

• If you need hardcopy, tell me

• One midterm, one final

• Grades 25/25/50

• Outline

• Basics of economics

• Assumptions

• Consumer and demand

• Producer and supply

• Combine for a market

• All in a world without firms, change, uncertainty, monopoly, ...

• French six year old.

• Midterm covering that

• Add in the complications

• firms

• monopoly

• game theory--strategic behavior

• Time

• Chance

• Who gets what?

• Judging

• Idea of economic efficiency

• What is efficient?

• Political failure

• Market failure

• Applications

• politics

• crime and law

• love and marriage

• Macro

 Review

 What is economics?

 A way of understanding behavior

 Applied to all behavior in all times and places

 We will mostly cover conventional, but ...

 Final chapters are broader.

 Mechanics

 Syllabus, web page.

 Homework, midterm, final

 Read chapters before the lecture

 Structure

 First half develops economics in a very simple world

• Individuals produce, consume, trade

• In an unchanging and known world

 Then introduce complications

• Firms, monopoly, strategic behavior

• Time and chance

 Apply to issues of when it produces results we want

 Apply to understanding love and marriage, politics, crime and law.

 Equimarginal principle

 Supermarket example

 Highway example

 Efficient markets

 Why the easy ways of making money on the stock market don’t work

 “If you are so smart, why aren’t you rich?”

 Jobs: Equal net advantage

 Back to the supermarket—fine points

 Search costs limit how equal things are

 Differences in information

 Differences in costs.

• Lane with the tabloids

• Shopping combined with flirting

• Margaret’s dented car

• Warren Buffet

 Jobs

• All equal the right first approximation, but ...

• You have different abilities than other people

• And different tastes.

• More precise version later in the quarter.

 Value

 We are using "value" to predict behavior

 Rationality= correctly act to achieve objectives, and value is

 a summary of objectives

 So what you want is revealed by behavior, not words.

 In that sense, all values appear to be commensurable

 How do you behave?

 How would you behave if life were infinitely valuable—yours or other people’s?

 What does “enough” mean?

 Is that morally relevant? You decide

 Is the society that best gives people what they want the best society?

 If not, what better criterion can you operationalize?

 Non-satiation

 Price Theory

 Why we are all dead

 The impossibility of a pencil

 More generally, how do you coordinate?

 Obvious solution doesn’t scale

 And isn’t happening

• President Bush doesn’t tell the timber company how many trees to plant

• The copper company how much copper to mine

• Nor does anyone else

 Solution is a decentralized one

• Prices are simultaneously determined by value to user and cost of production

• Production and consumption are determined by prices

• If a new need appears, price goes up, creating

 New supplies and

 Less consumption by existing uses

• If a new supply appears, price goes up, creating

 New uses now profitable, and

 Greater amount in existing uses

 How that works

 It’s an interacting system, so you can’t

• Change one part and expect everything else to stay fixed

• Make a law requiring every car to have a CD changer, for instance

• Timed ink

• To figure out the consequence of changing one part, you need to understand how it all fits together.

• Which is what a good deal of the course will deal with.

 Solving hard problems x 2

 Break it up into a lot of small problems

 How much of what does an individual consume, given an income and prices. Sum.

 How much does an individual produce of what, given productive abilities and prices. Sum.

 Add trade, combine the two, and find the set of prices consistent with both sides of the market

 Simplify as much as possible, but not more.

 Reduce it to the simplest case that still contains the guts of the problem

 Solve that case. Now you understand the logic

 Now see what happens if you add back in complications

 How we are doing the economy in the first half of the course, but also

 How a physics class copes with dynamics: Frictionless vacuum.

 And what we will be doing, repeatedly, for pieces of the problem

 Thinking on paper—Indifference curves

 Simplest consumption problem: Fixed income, two goods, choosing between them.

 Need some way of representing the alternatives you face

 Some way of representing your preferences

 Once we can do both, we find the most preferred alternative available to you. Boom.

 And we can do it on paper because two dimensions will let us show two goods.

 You might think something that simplified is useless, but we will use it to

 Explain the advertising paradox

 Explain the problem with measuring the inflation rate.

 Extra bits

 Fisher sex ratio

 Forgetting meetings

 Light bulbs that last a long time.

 Review

 Equimarginal principle

 First approximation—all lines equally long, all stocks and jobs equally attractive

 Second approximation—just enough difference to make it worth someone checking

 And individuals differ, so how good it is for you isn’t the same as for me

 Value

 To an individual

 As reflected in his choices

 Price Theory

 How do we coordinate millions of people to produce something?

 Centralized solution doesn’t scale

 Decentralized solution uses prices as signals

 Solving hard problems

 Break them up and solve a piece at a time

 Simplify as much as possible

• but not more

• which means the simplest version that still contains the essential problem

 Indifference curves

 Thinking on paper: Using math, whether figures, algebra, or numbers, to clarify our thought.

 Which store is cheaper?

 If all prices higher in one, easy question--but why would anyone shop there?

 If some higher, some lower, how do you average them?

 This is really a much more general issue

 Living in different countries

 Measuring inflation.

 First cut: weight by quantities consumed

 Store: Would my weekly shopping on net cost more at one or the other?

 Country: Would it cost me more or less to buy the bundle of goods I buy there?

 Inflation: How much more does it cost this year to buy what I bought last year?

 Why that is wrong: What you buy depends in part on prices

 Obvious for new products, which get left out entirely

 Less obvious but true for grocery stores--what's on sale.

 Simplify the problem down until we can actually get it on paper

 For choice, we need two goods, one period.

 Consider two grocery stores, selling the same two goods, one cheaper in one, one in the other.

 You have a fixed amount of money, and this is all there is, so nothing else to do with it.

 Solve that problem, then understand the more general problem.

 Geometry of choice: Constraints and preferences

 Constraints--what alternatives are available to you

 Preferences--some description of what you prefer.

 Constraints: The budget line: I=$20

 meat, milk, $1 each

 meat at $2

 Both at $2

 Slope of the line is the ratio of the prices.

 Preferences: Indifference curves.

 Start with 5 lbs of each.

 How much more flour to give up a lb of hamburger? Say 2 lbs.

 Another lb? 3 lbs.

 Indifference curve

 A second is preferred if up and to the right.

 Note that they are dense.

 Combine constraints and preferences.

 Choose the most preferred bundle of those available.

 Hence the tangent

 Solve our problem:

 Same customer, same indifference curves

 Different budget line. Same income, different prices.

 Demonstrate the paradox for two stores that are equally attractive

 Show how, given I curves, you can decide which store is more attractive.

 Comparing countries

 How much it costs in NZ to buy the same goods I buy here overstates the cost of living there

 Because books are more expensive, so would buy fewer, use library

 But housing is less expensive, so would have a bigger apartment or house

 After adjusting the bundle to NZ prices, you would be better off

 So that amount of money makes you better off

 So overstates the cost of living there

 How much it costs in the U.S. to buy what someone would be buying in NZ

 Overstates cost of living here, for the same reason

 You wouldn’t be renting that apartment in Silicon Valley

 So the true measure of relative cost of living is somewhere between the two figures

 Measuring inflation: Same argument

 How much it costs to buy this year what you bought last year overstates the inflation rate

 Because at this year’s prices, you wouldn’t buy what you bought last year

 The point is more obvious if we compare this year to a century ago

 When the consumption bundle included horses but not cars or computers

 If you had enough money this year to buy what you bought last year

 You would be better off than last year

 Because you could buy the same things, making you as well off

 But with different relative prices you wouldn’t—making you better off.

 Subsidizing potatoes

 Price of $2 a pound, subsidy of a dollar a pound

 Everyone is identical, so everyone pays as much in taxes as he gets in subsidy

 Is it a wash? No.

 Review: Indifference curves

 The essence of choice

 What are the available alternatives?

 Which one do you prefer

 Do it all the time.

 As geometry: Choice with only two goods, one period.

 Budget line shows alternatives available?

 Indifference curves show your preferences--higher is better.

 Choose the point on the budget line that touches the highest I curve

 Supermarket paradox

 What does "equally cheap" mean?

 If they are equally cheap, first one always seems cheaper

 Because you are choosing the bundle of goods that is the best you can do with your money in that supermarket.

 What we have done

 Taken a problem where thinking it through in words is inadequate

 Reduced it to the simplest possible version that retains the problem

 Treated that formally, in mathematics

 Seen a clear answer there

 Intuit the bigger problem. Could do some of it with harder mathematics.

 Apply to

 Why the first supermarket appears the cheaper

 Defining the inflation rate

 Why potato tax plus demogrant makes everyone worse off.

 If that isn't obvious, how about a potato ban?

 Doesn't cost you a cent?

 Yet you are worse off.

 The puzzle raised by the potato ban

 How much is it worth to you to be able to buy all the potatoes you want at a dollar a pound?

 The value of an opportunity set.

 How much is it worth to get off of a desert island?

 Marginal value of potatoes

 The idea

 Why D=MV

 The diamond/water paradox

 Water is much more important to us than diamonds, but the price per gram is considerably lower.

 The marginal value of water is low—because it is available at a low cost

 And so we use it for all important purposes, all not so important purposes, and lots of trivial purposes.

 Total value in all uses is high, but value of a little more is low.

 How big is total value? Consumer surplus

 Summing the gain on each drop of water—marginal value minus price

 Or on each potato

 Showing the excess burden of a potato subsidy financed by a head tax

 The popcorn puzzle

 Costs them .50/bag to produce

 Your demand curve

 What determines what you will pay for a ticket?

 Value of film plus consumer surplus from popcorn

 Implies that they should charge .50/bag!

 But they don't. Stay tuned.

 Popcorn analysis: Maximize total gain, then transfer it, so ...

 Very much like question: What policies make us all better off

 A central political question.

 Review consumer surplus

 Question: How much better off am I being able to buy at price P than not buy

 Note that the answer gives P vs P’ too

 And is relevant to questions such as who pays taxes, tariffs, etc.

 Marginal value to Demand curve

 Marginal value to Consumer surplus

 Hence Demand curve to consumer surplus

 Review Monday

 Homework: Mean about 14.6—not surprising

 I don’t use a “90%=A etc.” scale

 A few people got almost all of it, most got some, a few got almost none

 Which is about normal

 Marginal value curve to demand curve

 If you can buy as many potatoes as you want at $1/lb

 You keep buying until the additional value of one more pound is down to $1

 So your demand curve equals your marginal value curve

• MV curve shows the value of an additional potato as a function of how many you are consuming per month

• Demand curve shows how many you will choose to consume per month as a function of their price

 MV curve to consumer surplus

 How much better off are you buying as many potatoes as you want at $1/lb?

 You are better off by the sum of

• The value of one pound instead of zero, minus its price, plus

• The value of two instead of one, minus the price of the second pound, plus

• ... all the way up to the last pound, which is worth just about a dollar to you

• So the area under the MV curve and above the price

 Labor

 Simple world—only input to production is undifferentiated labor

 So I don’t care what I do, aside from pay, but ...

 People are different from each other in their productive abilities.

 First choice: What to produce

 Calculate dollars per hour for each option

 Pick the highest one—since there is only one input, all you care about is how much you get per hour

 The answer will be different for different people, because their abilities are different—some are better at one thing, worse at another.

 Note that if prices changed, so might your choice.

 Hence as prices change, quantities change for two reasons

• Individuals produce more or less, and ...

• Some switch from producing one thing to producing another.

 Second choice: How many hours to work

 Marginal disvalue of labor

 Work until it is down to the wage

 So it is the supply curve for labor

• Just as the MV curve for potatoes is the demand curve

• For the same reason

 Producer surplus from working is the area above the line

 Rubber ruler problem

• If this represents your only source of income and

• A decision made for your entire lifetime

• Working zero hours at $5/hour you are going to get very hungry

• Or in other words, we have been implicitly assuming the value of a dollar is fixed for you

• But in fact, if you have very few dollars, each additional one is worth a lot more than if you have lots of them

• The same problem arises with a demand curve, if we are doing things precisely, since increasing the price of something makes us poorer, which makes dollars more valuable to us.

 Solution for the moment

• Assume this is someone who is making the decision for only one day

• Or who has some additional source of income, savings, etc.

 Supply curve for mowed lawns isn’t just the supply curve for labor

• You have to scale for how many lawns I can mow per hour

• If the answer is two, then four hours corresponds to eight lawns

• But you also have to take account of other things I could do with my time

• If the price for mowing lawns drops too low, I switch to doing something else

• And my output of mowed lawns goes to zero.

 Producer surplus for mowing lawns at that rate.

 Combining people.

 Add up two supply curves.

 Why it is a horizontal sum

 Same would be true for demand curves

• Production vs consumption

• The basic logic is the same

• You can think of the individual as starting with 24 hours/day of leisure

• Consuming some of it (i.e. not working)

• Selling the rest (i.e. working)

• One difference is that most of us specialize in production, diversify our consumption

• Giffen good is unlikely x 2

• The idea

• Must be an inferior good

• And use a lot of your budget

• A backward bending supply curve for labor is much more likely

• Because leisure only has to be a normal good

• and we specialize in production

•

 Chapter 6: Trade

 When can you gain from trade, how?

 Individual or ...

 Nation.

 Can I be better at everything than you? Japan than the U.S.?

 What does it mean--measured how?

 Prices require exchange rate--where does it come from?

 Theory of comparative advantage.

 Two people

• I wash dishes cheaper, you cook cheaper, we gain by trade

• You do both cheaper, we still gain by trade

 Two countries

 Trade balance and exchange rates

 Arbitrage and consistent prices

 Trade

 Simplest case. 100 apples, 100 oranges.

 Exchange some of my apples for your oranges

• Because the last apple is worth less to me than the first is to you?

• More precisely, worth fewer oranges worth more oranges.

 Trade with production--roommates.

 Easy case--I am "better" at one in hours, you at the other.

• Me: 1 hour to cook, 1/2 hour to cleanup, you the reverse.

• Both better off if I clean up, you cook.

 You are better at both: doesn't matter. 1/6 hour to cook, 1/3 hour to clean up

 We aren't trading hours.

• Cost to me of cooking=2 cleanups

• For you = 1/2 cleanup

• Gains from trade if you cook and I clean up

 I gain if you are willing to cook in exchange for fewer than two cleanups

 You gain if I am willing to clean up in exchange for fewer than two meals cooked

 So anywhere between—say one for one—we both gain

• Cannot both be better at everything

 Because better means “better at this relative to that”

 And if I am better at cleaning up relative to cooking than you are

 You must be better at cooking relative to cleanup than I am

 This is the central principle underlying the theory of comparative advantage

 Note that "comparative advantage" doesn't mean

 I am good at producing compared to you, but ...

 I am good at producing X compared to how good I am at producing Y

 Relative to how good you are at producing X compared to how good you are at producing Y

 Hence my having comparative advantage in X means you have it in Y

 Works itself out through the exchange rate in international trade.

 Consider the dollar/yen market

• Start by assuming the only use Japanese have for dollars is to buy U.S. goods and import them

• The only use we have for Yen is to buy Japanese goods and import them

 Suppose everything is cheaper in Japan

 Americans want to buy Yen for dollars, Japanese don’t want dollars, so ...

 Price of the dollar falls—and keeps falling until

 Japanese want to buy as many dollars as we want to sell

 Which means that Japanese want to import as much from us as we do from them.

 Suppose the U.S. imposes a tariff in order to “improve the balance of trade”

 If the exchange rate stays the same, Japanese goods are now more expensive to us, so

 We buy fewer of them

 But that means we want to buy fewer Yen (with which Japanese goods are bought)

 So the demand for Yen falls, so Yen get cheaper in dollars, so ...

 Japanese goods get cheaper to us, U.S. goods more expensive to Japanese

 Until the dollar/yen market

 How can there be an imbalance of trade?

 Capital flow

• Some of the dollars the Japanese buy are used to buy Apple stock instead of Apple computers

• The stock stays in the country, so if you look at imports and exports

• We are importing more than we export—and balancing by “exporting” ownership of U.S. stocks

 So a “trade deficit” means we are importing capital

• Could be good--19th century canals and railroads were built partly with European capital

• Or bad—we are living on credit provided by foreigners.

• But it has nothing to do with the usual explanations of a trade deficit

 Which come down to “it is expensive to produce things here”

 With the reason depending on what people are arguing should change

 And ignoring the fact that “expensive” depends on the exchange rate

 Supply, demand, price, quantity

 The Curves

 Demand curve from the horizontal sum of individual demand curves

 Supply curve from the horizontal sum of individual supply curves

 No reason they should be straight lines

 Putting them together

 If price too high, quantity demanded is less than quantity supplied

• So some sellers cut their price in order to sell

• So the price falls

 Similarly the other way if price is too low

 So the price and quantity are at the intersection of the demand and supply curves

 Which lets us answer questions about how things that change demand or supply

 Change prices, quantities

 Affect us

 Change in demand vs change in quantity demanded

 Change in supply vs change in quantity supplied

 Elasticity—the idea

 Who pays taxes—version 1. Prices

 Tax of $1 on every widget sold

 On every widget bought

 Note the similarity

 Easy way of doing it

 Homework

 Mean 14

 10 and below should be worried

 Review trade

 Idea of gains from trade.

 A lot of people think of exchanges as a zero sum game

 Bill Gates “giving back” ... .

 But voluntary exchange only occurs if both parties think they gain

 And they can both be right.

 Mistake of absolute advantage

 You should produce what you are better at in terms of some natural unit

 Such as hours of labor

 Hence if I am better at everything, I buy nothing from you.

 Comparative advantage

 “Better” at one thing is measured in terms of the other thing, since we trade things.

 At the individual level,

• we can both gain in hours worked if I do the job I have comparative advantage in, and ...

• Unless relative costs are identical there is always something

 At the national level this works itself out through exchange rates

• If everything is cheaper in Japan, Americans want to trade dollars for yen, Japanese don’t, so price of dollar falls measured in yen

• Until enough things are cheaper in America so that the $/Y market balances.

• Old mechanism was flows of gold

 Balance of trade

• So far, should always be zero

• With many countries, should sum to zero

• Doesn’t because of capital flows.

 Review Monday

 Where demand and supply curves come from

 Why their intersection is equilibrium price and quantity

 How a tax on producers shifts the supply curve

 How a tax on consumers shifts the demand curve

 The easy way of doing it

 Use the Demand curve to show quantity demanded as a function of price paid

 Supply curve to show quantity supplied as a function of price received

 Tax is the difference between price paid and price received

• Whether the money is actually handed over by the consumer

• Or the producer

 So find the quantity where the difference between the supply price and the demand price is the amount of the tax.

 Who pays taxes 1: What determines the division between increased cost to consumer and decreased payment to the producer?

 Graphical

 Verbal

• If quantity supplied is very sensitive to price, then

 a small drop in price receives by producers causes a large drop in quantity

 Which causes a large increase in price paid

 So most of the price effect is on the consumers

• If quantity demanded is very sensitive to price, the same logic means that most of the price effect is on producers

• More generally, the division of the tax between increase in price paid and decrease in price consumed, depends on the relative elasticity of the two curves.

 Who pays taxes—version 2.

 Does change in price tell you how much worse off you are?

 No.

 Change in price doesn’t affect you much (for instance) if you aren’t buying much.

 Does the change in what you spend tell you how much worse off you are?

 No

 Because how well off you are also depends on what you get for it

 Change in your surplus is the answer.

 Excess burden

 What it means

 The difference between the amount of money collected and the cost to consumers and producers

 To see why there is a difference, consider a tax of $1000/potato

 No money is collected—does that mean consumers and producers are no worse off?

 More generally, the tax is collected on what is still produced and consumed given that the tax is there

 The dead weight burden is the loss of the benefit from producing and consuming goods that are no longer being produced and consumed because of the tax.

 Finding it on the graph

 Minimizing it.

 Tax things with very inelastic supply and/or demand

 Land a standard example of one

 Cigarettes? Heads? For the other.

 Review Wednesday

 Demand and supply curves, market equilibrium where they cross

 At the price where

 Quantity demanded equals quantity supplied

 Taxes shift one curve or the other, changing the equilibrium, so we can use these tools to figure out what the effect of taxes is

 A tax on the consumer shifts the demand curve down by the amount of the tax because

• Paying $9 to the seller and an additional $1 to the government

• Means you have to give up $10 for each unit bought

• Just as if the price had been $10 with no tax

 A tax on the producer shifts the supply curve up by the amount of the tax because

• Being paid $11 and having to give $1 of it to the government

• Means you end up with $10 for each unit sold

• Just as if the price had been $10 with no tax

 If you shift the curves and look at the result, you notice that

• A $1 tax on either producer or consumer has the same effect on quantity and

• The same effect on what each actually pays and receives

• The only difference being at what point in the transaction the government takes its $1

 And we can make that clearer if instead of shifting the curves, we merely note

• That quantity supplied depends on what the seller gets, net of taxes

• Quantity demanded depends on what the buyer pays, including taxes

• So equilibrium is where price paid is greater than price received by the amount of the tax.

 Who actually pays a tax?

 It isn’t determined by who hands over the money—see above

 How much of the tax ends up

• as increased cost per unit to the consumer

• And how much as decreased revenue to the seller per unit

• Depends on the relative slope of the supply and demand curves, but ...

• That isn’t really the cost of the tax either

 The cost is how much worse off you are as a result of the tax

• Loss of consumer surplus for the consumer

• Loss of producer surplus for the producer

 If we graph it and look at it, we see

• The total loss of surplus is a rectangle, representing the amount of tax collected

• Plus a triangle, representing the loss of surplus on goods no longer produced and consumed due to the tax

• We call the latter the deadweight loss of the tax

 One could try to minimize the deadweight loss per dollar collected either by

• Taxing goods with a very inelastic demand—so quantity doesn’t change much

• Or taxing goods with a very inelastic supply—ditto

• Or spreading taxes over many goods, because

 The smaller the tax is

 The lower the ratio of excess burden to amount collected.

 Application to regulation

 Fifty dollar a month ceremony: Landlord hands a fifty dollar bill to tenant each month. What happens?

 Graphically:

• Like a $50 tax on landlord—supply curve shifts up

• Like a -$50 tax on tenant—demand curve shifts up

• So price (rent) goes up by $50—so no effect on either.

 Verbally

 A regulation requiring the landlord to provide hot water (or some other desirable feature of the apartment) to the tenant

 Suppose it costs the landlord $100 and is worth $50 to the tenant

 Like a $100 tax and a $50 subsidy

 Which shifts the rent up by some amount between $50 and $100

 Making both landlord and tenant worse off!

 What if instead it costs $50, worth $100?

 Conclusion? Freedom of contract.

 But ... note simplifying assumption

 I have assumed that the requirement

• Costs all landlords the same amount per apartment

• And is worth the same amount per apartment to all tenants

• Like a tax or subsidy

 Could have a landlord with a hot spring

• Making everyone provide hot water when it isn’t worth the cost for other landlords

• Requiring everyone else to do it raises their costs, which reduces the competition he faces

• Before the requirement he could charge $50 for his hot water, now he can charge the increase in rent—which is between $50 and $100.

 Tenant who values hot water at $90 when others value it at $50 and it costs $100.

 So this shows that the simple argument for regulation benefiting tenants is wrong

• The regulation can lead to hurting both—and in the simple case does

• But it does not show that nobody can be benefited by restrictions on freedom of contract

• And to figure out whether people on net are benefited or harmed requires things we won’t do until later in the quarter.

 Odds and Ends

 Shortage and surplus

 People think of “there is a shortage” as a fact about how much there is and how much people need

• But how much of something is produced depends on the price

• And so does how much of something is demanded

• If gold were as cheap as iron, we would use enormously more of it

• And if water cost a dollar a gallon, we would use enormously less.

 A shortage means people want to buy more than other people want to pay

 Which tells us what about the price?

 And similarly for a surplus

 How to create either ... .

 Demand or supply—which determines the price?

 Neither by itself, both together

 The price is that price at which quantity demanded equals quantity supplied

 So changing either demand or supply curve changes equilibrium price and quantity

 By moving along the other curve

 So a change in demand (the demand curve) changes quantity demanded and quantity supplied

 As does a change in supply

 One could change both demand and supply in a way that left quantity demanded and quantity supplied the same!

 As we saw a little while ago.

 Not bargaining.

 We are used to thinking of prices as determined by one to one bargaining

• But for most of what we buy, that isn’t what happens

• You don’t bargain with the grocery store, the gas station, the restaurant

 So our intuition is that when costs go up, the seller uses that as an argument for raising his price. But that isn’t what is happening here.

• When cost goes up, if price stays the same, some sellers leave the market or reduce their output

• Which means quantity demanded is now larger than supplied

• So the price goes up

• Even if no seller every spoke to any buyer

 One example of a more general point: It’s risky to assume you already understand this stuff, so as long as what I say sounds vaguely right you don’t actually have to pay attention.

• The problem appears in other fields as well—in part because words sound familiar, but have special meaning in particular fields

• “I understand the theory of relativity. It’s that everything is relative. I just don’t know the details.”

• Similarly for comparative advantage, economic inefficiency, supply and demand, and much else.

 Homework

 Review:

 The equilibrium price is the price at which

 The amount producers want to sell equals

 The amount consumers want to buy

 Which is the intersection of the market supply and market demand curves

 Each of which is the sum of individual supply and demand curves.

 That lets us see what the effect of a tax is

 Because the existence of the tax on consumers shifts the demand curve

 On producers shifts the supply curve

 Either way giving us a new equilibrium price and quantity

 Who pays a tax?

 The cost to a consumer of a tax is the amount he is worse off because of it

• Which is not the increase in what he pays per unit

• Nor the change in the total amount he pays, but ...

• The decrease in his consumer surplus—his net benefit from being able to buy the good at the price it sells for

 And similarly, the cost to the producer is the decrease in his producer surplus

 And the sum of those two costs is

• the amount collected by the tax (rectangle—tax per unit times number of units sold) plus

• the dead weight loss of the tax (triangle—lost of the surplus on the units no longer produced and consumed

• this ignores, for simplicity, other costs such as paying the people who collect the tax, etc.

 The same tools can be used to analyze the effect of regulations

 A regulation requiring a product to have some characteristic

• Changes the cost of producing it, which shifts the supply curve

• Changes its value to the consumer, which shifts the demand curve

• And so changes price and quantity

 In the simple case we analyzed, where both effects are equivalent to per unit taxes

• Either the result is to make both consumers and producers worse off, or ...

• To force people to do something they would have done anyway

 Odds and ends

 “Surplus” means the price is above the market equilibrium, “shortage” means it is below.

 Price is jointly determined by supply and demand, as we have seen

• with supply ultimately reflecting cost of production and

• demand ultimately reflecting value to consumer

• where both cost and value are marginal, varying with quantity

 demand curve comes from marginal value curve, which shows how the value to the consumer of one more unit depends on how many units he is consuming

 and supply similarly from marginal disavalue of labor curve.

 The big picture

 So far, we are solving the economy one good at a time

 Referred to as partial equilibrium theory

 Look at the effect of a tax or regulation on the market being taxed or regulated

 And ignore most further effects on other markets

 In practice, that often works

 Looking at a tax on one good

 Or regulation of one good

 But in principle it’s too simple because

 When the market changes for one good

 People spend more or less on that good

 Leaving less or more for other goods

 Hence changing everything else.

 The reason we still get mostly the right answer is

 Spend more on this good, spend a tiny bit less on each other

 So that costs us the marginal unit

 On which we get almost no surplus.

 If the money was all being shifted from buying one good, there would be a big effect.

 If it is from a thousand goods, as it usually is, there is only a tiny effect.

• Because both the quantity reduced and the lost surplus per unit go down by a thousand, meaning that the lost surplus goes down by a million

• And when we multiply that by a thousand goods, lost surplus is still down by a thousand

• Relative to the case of taking all the money from one good

 How, in principle, would you solve the whole system?

 Because it is an interdependent system, you can’t solve it one piece at a time

• To calculate the demand curve for one good you need prices of all other goods

• And income

• To calculate the supply curve for one good, you need prices of all other goods the individual might produce instead

• And prices of all goods he might consume, since that determines the value to him of the money he gets in exchange for his leisure

 But you could, in principle, solve the problem by:

 Picking a set of prices

 Calculating all supply curves from that—which gives you all incomes

 With incomes and prices you can calculate all demand curves

 With supply and demand curves and prices you can calculate all quantities supplied and demanded

 See if they match for every good

 If not, try again.

 Doing it that way would take a very long time, but is an “in principle” solution.

 And that’s enough, not to solve a real world economy—which we never do—but to use mathematics to prove things about what the solution would look like.

 20% rule

 Homework: Average about 17

 Your questions

 Ideas you should know

 What is economics

 Budget line indifference curve diagrams

 What each means and

 How it can be used to understand choice

 In the very simple world of only two goods

 Marginal value to demand curve

 What each means

 Why they are the same line

 Demand curve to consumer surplus

 What consumer surplus means

 Why it is the area on the figure that it is

 The same logic applied to production

 Marginal disvalue of labor to labor supply curve

 Add in productive abilities and get

• The decision of what to produce—depending on the price it sells for and how much you can produce in an hour

• Which gives you a supply curve for goods

 And producer surplus

 Individual demand and supply curves to market supply and demand curves

 Add them up horizontally—why?

 Surplus adds too (in book, not discussed in class)

 Using these tools to analyze the effect of a tax

 How to do it—shifting demand or supply curve, and why it shifts that way.

 Conclusions you should be able to show yourself

• It doesn’t matter which side “pays” the tax

• How the amount of the tax divides between price paid and price received depends on the relative slopes of the curves

 The burden of a tax on consumers and producers

• Is the loss of surplus to each

• Which is the sum of the amount collected by the tax

• Plus the deadweight loss—lost surplus on goods not produced and consumed, due to the tax.

 How one might design taxes to minimize deadweight loss

 Using the same tools in the same way to analyze the effect of a regulation

 The logic of trade

 Reasons why both parties can benefit

 Comparative advantage as an explanation of under what circumstances both parties can benefit by trading goods, and which goods it is in their interest to trade in which direction

• As it works itself out between individuals trading

• And between nations, via exchange rates.

 Evaluating

 How to evaluate

 Government failure

 Market failure

 Applications

 Politics

 Crime and Law

 Love and Marriage

 Midterm:

 Mean 35. Over 40 in good shape, under 30 should be worried.

 Indifference curve—most people mostly got it, but ...

 A lot of people, on the last part, said something like ...

 “It depends on your values—if you like milk a lot, then Safeway is better

 But in this problem we know your values.

 Most people understand consumer surplus, comparative advantage

 But not why the demand curve is the marginal value curve.

 The “I already know it” phenomenon?

 “How much I want it” ≠ ”How much of it I want.”

• I very much want a wife

• But one is enough

 Because I best achieve my objectives by buying the quantity for which price=MV

• If I buy less than that, I can make myself better off by buying some more

• If I buy more than that, I can make myself better off by buying less.

 What about a MV curve that goes up and then down?

 Questions?

 The Firm

 One could imagine an agoric economy

• A much more complicated version of Chapters 1-8

• Where one person makes automobiles

• By contracting separately with fifteen other people to buy and assemble parts

• Each of them contracting with ...

• So that nobody works for a salary, nobody is a boss—everyone is just trading with each other

 Elements of that exist now—we call it outsourcing

 The “inside contracting system” of the 19th century was an intermediate case

• Multiple firms rent space in a building

• Firm A makes gun stocks

• Firm B makes barrels

• Firm C makes the action

• Firm D buys from the other three and assembles

 The advantage—Firm D doesn’t have to worry about keeping track of how hard firm A’s workers are working—shorter lines of authority.

 The disadvantage

• If something goes wrong with Firm A, B-C have their output piling up, D has nothing to assemble

• And one firm might try to bargain for better terms by threatening to close down for a while.

• That could be covered by contract—each firm owes damages to the others if it doesn’t deliver on time

• But as the contracts get more complicated, the whole thing starts looking more like a single firm

• And in fact, integrated firms replaced the inside contracting system

• And people who outsource try not to have only a single source.

 More generally, the problem is that there are transaction costs associated with market transactions

 Finding someone who is selling what you want to buy—search costs

 Determining the quality of what he is selling and his reliability—information costs

 Reaching agreement on a price—bargaining costs

 Etc.

 The bigger the firm is, the less it has to worry about the transaction costs associated with dealing with other people on the market, but ...

 The more it has to worry about the costs of centralized control

• Figuring out what everyone should do in order to best maximize firm profits

• And making sure they are actually doing it—instead of maximizing their own welfare at the expense of the firm

 In practice, we observe everything from the one man firm

• Whose owner doesn’t have to worry about watching his employees, because

• His welfare and the firm’s welfare are the same

 To the very large corporation

 And we have a tendency to overestimate the importance of the latter, because ...

• Big firms are newsworthy

• What are the biggest areas of employment and output in the U.S. economy—industries loosely defined?

 In this chapter we will be seeing how to add the firm into the analysis we have already done.

 Owned by the person running it

• His interest and the firm’s are the same

• And he makes sure everyone else serves the firm’s interest

 Owned by the employee hardest to monitor

• Consider a firm built around a talented inventor

• Who could collect a large salary while twiddling his thumbs at work

• Then resign and file for a lot of patents

• So some such firms are owned by the inventor (Ruger, Dolby, ...)

• Who hires a top manager

 Owned by a group of employees who can best monitor each other—law firm

 A joint stock company—owned by lots and lots of stockholders

• At first glance, this is unworkable, because ...

 Each stockholder has almost no incentive to keep track of what the managers are doing, since he owns a tiny bit of the firm and his vote has a tiny effect

 So the managers should be able to enrich themselves, short of clearly criminal acts, at the stockholders’ expense

• One thing that helps solve this problem is the threat of a takeover bid

 If I realize a firm is badly run, and would be worth more with different management

 I accumulate a lot of stock in the firm—enough so that I and my allies can replace the management

 At which point the stock goes up, and I make a lot of money

 And start looking for another badly run firm

 Buying inputs from ultimate producers

 Selling output to ultimate consumer

 Your production function shows all the ways of combining inputs into outputs

 For each quantity, pick the cheapest way

 The cost of the inputs used in that way is the cost of producing that quantity

 Voila—a total cost curve

 MC=change in total cost when you increase quantity produced by one

• Analogous to marginal value curve

• Which was the change in total value to you when you increased quantity consumed by one

• Or to marginal disvalue of labor curve

• Which was the increase in cost to the worker of producing one more hour

 AC=TC/Q

 The firm can sell all it likes at a price P

 It maximizes profit at the quantity where MC=P

 Provided that P is at least as great as AC at that quantity

 Otherwise maximize profit at zero by not existing.