Total Cost= TotaFixedC+TotalVariableC AverageTC= AvgFixedC+AvgVariableC MC=(deltaTC)/(deltaQuantity) (how much the cost goes up for one more unit

prod)

Principles of Microeconomics

Chapter 1: Ten Principles of Economics

The study of economics is centered around the allocation of resources (land, labor, capital, etc.). The management of these resources is challenging due to scarcity. This scarcity means that the limited resources available in the economy are unable to produce all the goods and services that people wish to have. Economics is the study of how society manages its scarce resources. The Economic Problem is allocating scarce resources in the face of unlimited wants. Although we will be covering several topics throughout the courses that are some basic principles which will reoccur throughout the term. These ten principles form the basic understanding of economic ideas.

1.1

Principle 1: People Face Trade-os

The expression There aint no free lunch is has some truth. Every choice has some trade-o whether it be money, time or other things. One common example of a trade-o is the eciency vs equality trade-o. Eciency involves moving resources to the highest valued uses. Equality involves spreading these resources equally across the population. When the government redistributes labor income taxes to nance unemployment is one example of a policy that prefers equality over eciency.

1.2

Principle 2: The Cost of Something Is What You Give Up to Get It

Because of trade-os making decisions involves comparing the costs and benets of alternatives. Economics decisions involve taking the highest valued item. The second highest valued item is called the opportunity cost of the decision. It is what is given up to select a certain item.

1.3

Principle 3: Rational People Think at the Margin

Economists make the general assumption that people are rational. Rational means that people make decisions purposefully to achieve some objective. 1

This simply means people make decisions with their own best interest. This does not imply that people never make mistakes. Information can change, and some decisions can be rational but eventually appear to be a mistake. Economic decisions are made on the margin. A marginal change is a small incremental adjustment to an existing plan of action. Agents make there decisions by comparing the marginal benet and marginal cost of a decision. Consider and airline that has a 200 passenger plane that cost 100,000. In this case the average cost is 500 per person. So should a airline ever sell a ticket below 500?? Yes if the plane has 10 empty seats and some standby passengers are only will to spend 300 for a ticket, should the airline sell the tickets? Yes, because the marginal costs of adding a passenger are low (bag of peanuts, a little extra fuel) as long as these costs are below 300, the airline will make a prot by selling the seats.

1.4

Principle 4: People Respond to Incentives

An incentive is something that induces a person to act. These things can come in the form of a punishment or a reward. This mechanism is the key as to why the price works as such a powerful tool in markets. As the price of a good goes up, people tend to buy less of the item. Many tax policies are structured in the form of incentives, just look at recent moves during the nancial crisis: cash for clunks, 8000 home buyer credit, payroll tax reduction. Sometimes incentives has direct and indirect eects: seat belts.

1.5

Principle 5: Trade Can Make Everyone Better O

Trade between people, households, or countries allows all parts to specialize in there best activities while still satisfying their wants by trading with others. Competition and specialization allows for lower costs and thus allows everyone to buy goods at lower prices and have more resources available for other things.

1.6

Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

Many countries have chosen to solve the Economic Problem by organizing into a market economy. A market economy is made up of a the individual decisions of millions or individuals and rms. The rms decide who to hire 2

and what to make. Individuals decide which rms to work for and what to buy with their income. The seemingly unorganized system gain structure through the invisible hand. The market price serves as a signal where buyer use the price to decide how much to buy and the sellers use the price to decide how much to sell.

1.7

Principle 7: Governments Can Sometimes Improve Market Outcomes

Although government is not needed in most situations to allocate resources in the best way. In some cases government action can improve market outcomes. The invisible hand works if the government enforces the rules and maintains the institutions that are key in a market economy. On of the key provisions is protected property rights. Property rights are the ability of an individual to own and control scarce resources. There are also situations where we see a market failure where the market fails to allocate resources eciently. One possible cause is an externality where the action of one party inuences the well being of another and this situation is not captured in the market price. Another failure situation is when market power becomes concentrated in one or a few individuals who can dictate market prices.

1.8

Principle 8: A Countrys Standard of Living Depends on Its Ability to Produce Goods and Services

In 2008, the average US citizen had an income of 47,000. In the same year, the average Mexican earned 10,000 while the average Nigerian earned about 1400. Not surprisingly high income countries also tend to have high quality of life. What explains these dierences? Productivity. Productivity is the quantity of goods and services produced from each unit of labor input. To boost the standard of living policymakers need to raise productivity by ensuring workers are well educated and equipped.

1.9

Principle 9: Prices Rise When the Government Prints Too Much Money

Ination is the increase in the overall price level of the economy. There is a large tie between the an increase in the quantity of money and ination.

1.10

Principle 10: Society Faces a Short-Run Trade-o between Ination and Unemployment

Beyond the link between the money supply and ination, there also appears to be a short-run tie between ination and unemployment. The general chain of events goes as: 1. Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services. 2. Higher demand may over time causes rms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services. 3. More hiring means lower unemployment.

Chapter 2: Thinking Like an Economist

We can now proceed to discuss how an economists approaches the world and the methodology used to address questions about it.

2.1

The Economist as Scientist

The rst thing to observe is that an economists is a social scientist. As a scientist they tend to take a very systematic approach to questions, ideas, and theories. Many of the same techniques in style of thinking as biologists, chemist, etc, also apply to economists. 2.1.1 The Scientic Method: Observation, Theory, and More Observation

Economics is a social science, and as a science there is a certain approach most economists tend to use. The nal objective of most economic endeavors is 4

policy analysis. The approach to studying policy goes through the following steps: 1. Know the data: Gather available data about the question of interest. 2. Proposes a theory: Uses a graph, words, or mathematical model of the economy. 3. Test the theory: Make sure that the proposed theory does a reasonable job of matching the characteristics of the economy 4. Update theory if necessary and repeat steps 2 and 3. 5. Conduct the policy experiment: Send the policy through your model and see the implied outcomes. 2.1.2 The Role of Assumptions

The role of assumptions is to simplify the complexities of the real world. Assumptions are typically made about side issues that are not directly tied to the question that is being studied. Many times assumptions are built o of some empirically visible features taken from data from the real world. 2.1.3 Economic Models

Economists use model to learn about the world. The typical modeling approach of economists is to use equations and diagrams. In this class we will focus on graphical models. Just like any other eld, economic models will describe only those details that are thought to be important to the current analysis. Other complications from the real world are omitted to keep the focus on the main area of study. 2.1.4 Our First Model: The Circular-Flow Diagram

One simple way to get a visual of the entire economy is to build a circular ow diagram. We simplify the world into two decision makers: households and rms. Firms produce goods and services using inputs from the households (factors of production). Households own the factors of production and consume all the goods produced by the rms. Households and rms interact into two types of markets: goods markets and resource markets. In the 5

goods market rms are the sellers and the households are the buyers. In the resource markets households are the sellers and the rms are the buyers. The circular ow simple tracks all pathways between households and rms. 2.1.5 Our Second Model: The Production Possibilities Frontier(PPF)

The production possibilities frontier is a graph that shows the combination of outputs that the economy can possibly produce given the available factors of production and the available production technology. This 2 dimensional graph has quantity of a good on each axis. Any combination outside of the PPF is deemed to be infeasible and not a possible allocation for the current economy. An combination of goods on the PPF is an ecient allocation. Another useful tool of the PPF is it allows us to visual the opportunity cost associated with the trade-o between making dierence amounts of goods. Suppose there are two ecient allocations of Cars and Computers such that A = (600, 2200) and B = (700, 2000) are both ecient. In this situation the tradeo for producing 100 additional cars is an opportunity cost of 200 computers. The opportunity cost of cars varies across the PPF. For higher number of cars each additional car would have a growing opportunity cost (i.e. you have to give up more and more computers on the margin). Improvements in technology or additional resources can be shown as an outward shift in the PPF. This makes some infeasible allocation now feasible and currently ecient allocations now become inecient. 2.1.6 Microeconomics and Macroeconomics

We generally break economics into two broad subelds: microeconomics and macroeconomics. Microeconomics is the study of how individual rms and households make decisions and interact in specic markets. Macroeconomics is the study of economywide phenomena.

2.2

The Economist as Policy Adviser

The nal objective of most economic endeavors is policy analysis. Lets take an introductory look are the economists role as a policy advisor.

2.2.1

Positive versus Normative Statements

Positive economics what is; testable statements price x goes up people buy x less Normative economicswhat should be; statements that cannot be tested. Alcohol ads should not be allowed. Value judgements. 2.2.2 Economists in Washington

There are many economists who work in Washington D.C. The President has his own Council of Economic Advisors. There are also several economists work in other DC based organizations: Oce of Management and Budget, Department of the Treasury, Department of Labor, Department of Justice. In addition we have the Congressional Budget Oce, the Federal Reserve, the Bureau of Economic Analysis, the Bureau of Labor Statistics. This does not include other agencies like the IMF, the World Bank, the NIH, the FCC, and other. All of this organizations give economists a potential voice in steering policy. 2.2.3 Why Economists Advice is not Always Followed

Political realities and economic realities are dierent. Sometimes policy that may be economically attractive can involve a tradeo that is undesirable to a majority of the population. In political environment, 51 percent of the vote wins.

2.3

Why Economists Disagree

Although they agree on many things, there are several areas of disagreement among economists. Sometimes they disagree about positive theories about the way the world works. Sometime they disagree in values and have dierent normative views about what policy should try to accomplish. 2.3.1 Dierences in Scientic Judgements

Sometimes economists disagree about the validity of alternative theories or about important parameters in a model. Example: business cycles.

2.3.2

Dierences in Values

Sometimes economists have dierent values on what a policy should try and accomplish: equality versus eciency. 2.3.3 Perception versus Reality

This being said there are many things which economists generally agree Table 1 on page 36 gives a list of many things.

2.4

Lets Get Going

We have gone through the basic ideas of economic thinking, lets now get into the details started with thinking like an economist. Appendix on Graphing, if uncomfortable with graphs please review.

Chapter 3: Interdependence and the Gains from Trade

As you go through your day you are using goods and services which were produced from people and rms all over the country if not all over the world. All of these benets you are enjoying come from the gains from trade.

3.1

A Parable for the Modern Economy

Lets set up a simple world to get at the gains from trade and related issues. There are two people in the world: a cattle rancher and a potato farmer. Suppose the cattle farmer and potato farmer can both produce some beef and some potatoes. They just specialize in their obvious good, but can produce some of the other. 3.1.1 Production Possibilities

Suppose both the farmer and the rancher can work 8 hours per day and can devote time to raising cattle, growing potatoes, or a combination of the two. For the farmer if he spends all 8 hours raising cattle he can produce 8 ounces of beef, on the other hand if he devotes all his time to Potatoes he can produce 32 ounces of potatoes. If he evenly splits his time he makes 4 8

ounces of beef and 16 ounces of potatoes. In other the farmer can make 1 ounce of beef per hour and 4 ounces of potatoes per hour. For the rancher if he spends all 8 hours raising cattle he can produce 24 ounces of beef, on the other hand if he devotes all his time to Potatoes he can produce 48 ounces of potatoes. If he evenly splits his time he makes 12 ounces of beef and 24 ounces of potatoes. In other the rancher can make 3 ounce of beef per hour and 6 ounces of potatoes per hour. 3.1.2 Specialization and Trade

Now consider the situation where both agent split their time evenly. This would have world output of 16 ounces of beef and 40 ounces of potatoes. Now suppose the rancher approaches the farmer with an idea. Suppose the rancher suggests that the farmer devote all of his time to potatoes and he spends his time producing 18 ounces of meat and 12 ounces of potatoes. If this occurs, we should have 18 ounces of meat and 44 ounces of potatoes. We could both gain an extra unit of both goods in the form of consumption. Seems impossible, but it does happen the world PPF moves out in both goods if these agents move towards their specializations.

3.2

Comparative Advantage: The Driving Force of Specialization

How if the rancher is better at both raising cattle and growing potatoes, does the world improve he trades with the smaller farmer. The key is the concept of comparative advantage. The question is about costs, who produces what goods at lowest costs. 3.2.1 Absolute Advantage

An agent has an absolute advantage if it has the ability to produce a good using fewer inputs than any other producer. In this case the rancher has the absolute advantage he needs only 20 minutes to produce an ounce of meat while the farmer needs 60 minutes. In the case of potatoes, the rancher needs 10 minutes for an ounce of potatoes while the farmer needs 15 minutes per ounce.

3.2.2

Opportunity Cost and Comparative Advantage

There is a second way to look ate the cost of producing potatoes. Rather than looking at inputs we can look at the opportunity cost. In this situation we look explicit at the trade-o involved with producing individual items. In the case of the Farmer the production of an additional unit of beef involves giving up 4 ounces of potatoes, for the rancher this additional production involves giving up 2 ounces of potatoes. Thus the cost of producing beef are lower for the rancher, thus he has a comparative advantage in beef production. If we switch the analysis, if the farmer produces and additional unit of potatoes he must give up 1/4 ounce of beef, for the rancher and additional unit of potatoes costs 1/2 unit of beef. So the cost of potato production are lower for the rancher and he has comparative advantage in potato production. A comparative advantage is the ability to produce an item at the lowest opportunity cost. 3.2.3 Comparative Advantage and Trade

Gains from trade are made from comparative advantage, not absolute advantage. When each agent specializes in there comparative advantage, the total production of the economy increases. Increasing the size of the economy leads to the potential for all parties being made better o. In this case when the rancher went to more meat production and the farmer went to more potato production we saw an increase in the production and consumption of both goods. 3.2.4 The Price of Trade

Both parties can be made better o from trade, but what sets the price of trade (ie how much of the benet each party receives). The important thing to notice is that the gain need not be split equally.

3.3

Conclusion

We now have a basic understanding of the interdependence and gains from trade. Now we can begin to look at how parties negotiate their actions and how prices are determined. We thus can move on to looking at market behavior.

10

Chapter 4: The Market Forces of Supply and Demand

This chapter introduces the key ideas behind the forces of Supply and Demand and how these forces help to determine Market prices and quantities.

4.1

Markets and Competition

Supply and demand are the behavior of people as they interact with each other in competitive markets. 4.1.1 What is a Market?

A market is a group of buyers and sellers of a particular good or service. Market take on many dierent forms. Some are highly organized where buyers and sellers all meet at a specic time and place. So are less organized whether agents meet in many dierent locations. 4.1.2 What is Competition?

Competition is a situation the buyers know there are several sellers from which to choose and each seller is aware that its product is similar to that oered by other sellers. No one seller or buyer has the power to determine the market price. A competitive market is a market in which there are many buyers and many sellers so that each has a negligible impact on the market price. A seller has little reason to oer a below market price and oering more would simply drive consumers away. In this chapter we will assume markets are perfectly competitive which means that (1) the goods oered by the sellers are all identical and (2) the buyers and sellers are so numerous that no single buyer or seller has any inuence on the market price: they are what is called price takers. At the market price buyers can buy all they want and sellers can sell all they want.

4.2

Demand

We begin by looking at the behavior of buyers.

11

4.2.1

The Demand Curve: The Relationship between Price and Quantity Demanded

The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. As the price of a good changes so does the quantity demanded. If the market price increase the quantity demanded decreases and vice versa if the market price decreases. This relationship is governed by the law of demand which is the claim that, other things constant, the quantity demanded of a good falls when the price of the good rises. This relationship can be summarized in table and graph form. A demand schedule is a table that shows the relationship between the price of a good and the quantity demanded. The information from this table can be graphed into a demand curve. 4.2.2 Market Demand versus Individual Demand

Market Demand is simply the summation of Individual Demands. You simply horizontally sum the demand curves of the individual curves to get the market demand. 4.2.3 Shifts in the Demand Curve

Because the demand curve holds other things constant, it need not be stable over time. As things change overtime, the demand curve can shift in or out. A rightward shift in the demand curve represents an increase in market demand. 1. Income an increase in income increases Market Demand: if the demand for a good moves with income it is a normal good, if an income increase, decreases demand the good is inferior. 2. Price of Related Goods if the drop in the price of a related good increases demand for the current good: these two goods are complements (peanut butter and jelly). if a drop of the price of a related good decreases the demand for the current good: theses two goods are substitutes (Coke vs Pepsi). 3. Tastes increased tastes for a good increases demand

12

4. Expectations if you expect the price of the good to rise in the future, your demand for the good today will increase. 5. Number of Buyers more buyers means an increase in demand.

4.3

Supply

Now we can look at the behavior of the sellers. 4.3.1 The Supply Curve: The Relationship between Price and Quantity Supplied

The quantity supplied of any good or service is the amount that sellers are willing and able to sell. As the price of a good changes so does the quantity supplied. If the market price increase the quantity supplied increases and vice versa if the market price decreases. This relationship is governed by the law of supply which is the claim that, other things constant, the quantity supplied of a good rises when the price of the good rises. This relationship can be summarized in table and graph form. A supply schedule is a table that shows the relationship between the price of a good and the quantity supplied. The information from this table can be graphed into a supply curve. 4.3.2 Market Supply versus Individual Supply

Market Supply is simply the summation of Individual Supply curves. You simply horizontally sum the supply curves of the individual curves to get the market supply. 4.3.3 Shifts in Supply

Because the supply curve holds other things constant, it need not be stable over time. As things change overtime, the supply curve can shift in or out. A rightward shift in the supply curve represents an increase in market supply. 1. Input Prices: An increase in input prices, decreases the supply curve (leftward shift) 2. Technology: An improvement in technology decreases the costs of production and increase the supply curve.

13

3. Expectations: if the rm expects the price of the good to rise in the future they will decrease supply today when the price is low. 4. Number of Sellers: the higher the number of suppliers the greater is the supply

4.4

Supply and Demand Together

We can now combine the behaviors to see how market price and quantity are determined. 4.4.1 Equilibrium

Market equilibrium is at the position where market supply and market demand intersect. The price at this point is the equilibrium price and the quantity at this point is the equilibrium quantity. At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly matches the quantity that sellers are willing and able to sell. This is also called the market clearing price. If you are at a price greater than equilibrium the quantity supplied of the good will exceed the quantity demanded for the good thus giving us a surplus of the good. If you are at a price less than equilibrium the quantity supplied of the good will be less than the quantity demanded for the good thus giving us a shortage of the good. 4.4.2 Three Steps to Analyzing Changes in Equilibrium

There are three steps to understanding a change in market equilibrium. 1. Decide whether the event shifts the supply or demand or both. 2. Decide in which direction the curve shifts. 3. Use the Supply-and-Demand diagram to see how the shift changes the equilibrium price and quantity. 4.4.3 Examples of Changes in Market Equilibrium

1. A Change in Market Equilibrium due to a change in Market Demand 2. Shifts in Curves versus Movements along Curves 14

3. A Change in Market Equilibrium due to a change in Market Supply 4. Shifts in Both Supply and Demand

Chapter 5: Elasticity and Its Application

Thus far the Law of Demand tells us if a shock increases the price of the good, consumers are going to buy less. But suppose you wanted to know exactly how much less. This is answered by a concept called elasticity. This measures how much buyers and sellers respond to changes in market conditions. We will nd the concept useful in several applications.

5.1

The Elasticity of Demand

We know that we the price of a good decreases the quantity demanded for the good increases. To get a sense on the quantitative size of the eect we need to calculate the Price Elasticity of Demand for this good. 5.1.1 The Price Elasticity of Demand and Its Determinants

The Price Elasticity of Demand measures how much the quantity demanded of a good responds to a change in the price of that good. Demand is said to be elastic if the quantity demanded changes signicantly with price changes. Demand is said to be inelastic if the quantity demanded changes slightly with price changes. Several dierent factors can inuence the price elasticity of demand. Availability of Close Substitutes: Goods that tend to have close substitutes tend to be more elastic than those that do not. Butter is more elastic than eggs. Necessities versus Luxuries: Necessities tend to be inelastic and luxuries tend to be elastic. Gasoline versus vacations. Denition of the Market: Narrowly dened markets tend to be more elastic than broad markets. Food is a broad category is inelastic, Yellow Duck Peeps would be very elastic because of the ease of nding a substitute.

15

 Time Horizon: Things are more elastic in the long run. Gasoline short run versus gasoline long run. The long run has more substitutes. 5.1.2 Computing the Price Elasticity of Demand

Now that we have a basic understanding of elasticity, lets now discuss how we actually compute elasticity. It is all about calculating percentage change. Price Elasticity of Demand = (Percent Change in quantity demanded)/(Percent Change in price) Suppose as the price of coee increases from 2 to 2.50 the quantity demanded for coee drops from 50 to 40. In this case the Price Elasticity of Demand for Coee would be ((2.50-2)/2)*100 /(40-50)/50))*100 which equals 25/-20 = -1.25. Given law of demand, price moves inversely with quantity demanded, the price elasticity of demand should be a negative number. Warning: the book drops the negative sign, I would not recommend that. 5.1.3 The Variety of Demand Curves

We typically describe demand curves by their elasticity. Demand is considered elastic if the elasticity is greater than 1 in absolute value. Demand is considered inelastic when its absolute value is less than 1. If elasticity happens to be 1 then demand is unit elastic. As elasticity rises the demand curve becomes more horizontal. See Figure 1 on page 93. Inelastic curves are vertical in nature and elastic curves tend to be more horizontal in nature. 5.1.4 Total Revenue and the Price Elasticity of Demand

Total revenue is the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold. If demand is inelastic, then an increase in price would lead to a small decrease in quantity demanded. Overall total revenue would increase. In increased revenue from the higher price more than osets the drop in quantity. The story is reversed for elastic demand curves. With elastic demand total revenue is increased by lowering the price of the good. 5.1.5 Elasticity and Total Revenue along a Linear Demand Curve

With a linear demand curve, the demand curve has a constant slope, it does not have constant elasticity. Price elasticity drops with the price of the good. 16

This clearly shows elasticity is not the slope of the demand curve. 5.1.6 Other Demand Elasticities

In addition to price elasticity, we can use other elasticities to describe buyer behavior. The Income Elasticity of Demand: Income Elasticity of Demand is a measure of how much the quantity demanded of a good responds to a change in a buyers income, computed as percentage change in quantity demanded divided by percentage change in income. Most goods have a positive income elasticity (normal goods). The Cross-Price Elasticity of Demand: Cross-price Elasticity of Demand is a measure of how much quantity demanded of a good responds to a change in the price of another good, computed as percentage change in quantity demanded divided by percentage change in the price of the other good. Complements have a negative cross-price elasticity, substitutes have a positive cross-price elasticity.

5.2

The Elasticity of Supply

We know that we the price of a good decreases the quantity supplied for the good decreases. To get a sense on the quantitative size of the eect we need to calculate the Price Elasticity of Supply for this good. 5.2.1 The Price Elasticity of Supply and Its Determinants

The Price Elasticity of Supply measures how much the quantity supplied of a good responds to a change in the price of that good. Supply is said to be elastic if the quantity supplied changes signicantly with price changes. Supply is said to be inelastic if the quantity supplied changes slightly with price changes. Several dierent factors can inuence the price elasticity of supply. The key determinant is the length of time, in the short run supply is inelastic as suppliers have very limited ways to adjust production. 5.2.2 Computing the Price Elasticity of Supply

Now that we have a basic understanding of elasticity, lets now discuss how we actually compute elasticity. It is all about calculating percentage change. 17

Price Elasticity of Supply = (Percent Change in quantity supplied)/(Percent Change in price). Given law of supply, price moves directly with quantity supplied, the price elasticity of supply should be a positive number. 5.2.3 The Variety of Supply Curves

We typically describe supply curves by their elasticity. Supply is considered elastic if the elasticity is greater than 1 in absolute value. Supply is considered inelastic when its absolute value is less than 1. If elasticity happens to be 1 then supply is unit elastic. As elasticity rises the supply curve becomes more horizontal. See Figure 5 on page 100. Inelastic curves are vertical in nature and elastic curves tend to be more horizontal in nature.

5.3

Applications of Supply, Demand, and Elasticity

Lets now look at a variety of applications using elasticity. 5.3.1 Can Good News for Farming Be Bad News for Farmers

Consider an improvement in farmer technology which leads to an increase in the Supply of wheat. The supply and demand for wheat are both inelastic. This increase in supply causes a large drop in the market price with a relatively small increase in quantity. This would lead to a drop in total revenue. 5.3.2 Does Drug Interdiction Increase or Decrease Drug-Related Crime

Suppose the government institutes tougher penalties on illegal drugs, reduces supply of drugs. Suppose the government institutes drug education on illegal drugs, reduces demand of drugs. Now the eect on illegal drug market depends on the elasticity of demand, if inelastic, tougher penalties would actually increase total revenue in this market.

Chapter 21: The Theory of Consumer Choice

Thus far we have summarized consumer behavior with demand curves. But there is more to what lies a demand curve what set the height of the de18

mand curve. The theory of consumer choice will allow us to gain a deeper understanding of buyers decisions.

6.1

The Budget Constraint: What the Consumer can aord

As stated in the beginning of the course, consumers have unlimited wants they always want more goods and services. The main limitation to these wants is typically their nancial resources (income). Consider a situation where a consumer has 20 dollars in their wallet and wants to order food through a fast-food restaurant. In this case hamburgers cost 4 dollars and French Fries cost 2 dollars. If the consumer spends their entire income on hamburgers they can buy at most 5 hamburgers. If they choose only French Fries they could order 10 orders of fries. They could also aord any combination in between as long as the total costs is no more than 20 dollars. The line that traces out these combinations is called the consumers budget constraint. The slope of this line represents the trade-o between goods which in this case is 1 hamburger for every 2 orders of fries.

6.2

Preferences: What the Consumer Wants

We know what combinations the consumer can select. The next questions is how do they choose the best one? That choice depends on consumer preferences. 6.2.1 Representing Preferences with Indierence Curves

An indierence curve represents various consumption bundles that give the consumer equal levels of satisfaction. We can draw an indierence curve which shows combinations of hamburgers and fries which yield equal satisfaction. The slope along the indierence curve equals the rate at which the consumer is willing to substitute one good for another. The rate is called the marginal rate of substitution (MRS). In this case the MRS measures how many hamburgers the consumer will have to be compensated for giving up an order of fries. The consumer is equally satised along the indierence curve. However, the consumer would be more satised with higher indierence curves which are combinations of higher satisfaction. There are some general properties for indierence curves. 19

6.2.2

Four Properties of Indierence Curves

Indierence curves represent preferences and follow four standard rules. Higher indierence curves are preferred to lower ones. Indierence curves are downward sloping. Indierence curves do not cross. Indierence curves are bowed inward.

6.3

Optimization: What the Consumer Chooses

We have seen the budget constraint and consumer preferences. We can now combine them together to see the optimization problem that consumers are completing. 6.3.1 The Consumers Optimal Choices

The optimization of the consumer is to attain the highest indierence curve which intersects the budget constraint. In the standard situations this will occur with an indierence curve which is just tangent to the budget constraint. At the point of tangency, the slope of the budget constraint will be equal to the slope of the indierence curve (MRS). Given the slope of the budget constraint is equal the relative price between the two goods, at the optimal decision the relative price of the goods equates the MRS which is the consumers valuation of the tradeo between the two goods. 6.3.2 How Changes in Income Aect the Consumers Choices

An increase in income would be represented as an outward shift in the budget constraint, suppose income increases from 20 to 22 dollars. The consumer can now achieve a higher indierence curve and a higher consumer of both goods. 6.3.3 How Changes in Prices Aect the Consumers Choices

A change in the price of a good will rotate the budget constraint. If the price of hamburger drops from 4 dollars to two dollars, the feasible number 20

of hamburger that the consumer could possibly consume increases from 5 to 10, the budget constrain would rotate in the direction of the cheaper good. This outward rotation of the budget constraint will increase the consumption of the cheaper good, the eect on the other good depends on preferences. 6.3.4 Deriving the Demand Curve

We can use this framework to derive demand curves. This is done by simply nding the optimal consumption of a good under several dierence prices. As this is done we can use the implied decisions with the prices to map out a demand curve.

Chapter 6: Supply, Demand, and Government Policies

In chapter 5 we studied how markets used Supply and Demand to determine market prices and quantities. In this chapter we look at how policy can be used to manipulate these prices and quantities. There are two basic types of policies we will be addressing: price controls, and taxes.

7.1

Controls on Prices

In some markets, the government can impose certain rules on how prices behave. The most common types of controls and price ceilings and price oors which place upper and lower bounds on the price of a good. There are also controls which limit how fast a price may change. These policies can have important implications on market allocations and lead to shortages or surpluses depending on the policy in place. 7.1.1 How Price Ceilings Aect Market Outcomes

A price ceiling is a legal maximum on a price at which a good can be sold. If the price ceiling is set below the equilibrium price, the nal outcome will be that the good will be sold at the price ceiling. However, at this price quantity demanded exceeds quantity supplied and thus we face a shortage of the good and the quantity supplied determines how much of the good is actually sold. If the price ceiling is set above the equilibrium price, then is 21

it non-binding and the market will move the equilibrium price and quantity. Common side-eects of price ceilings include: queueing, discrimination based rationing, low turnover, poor maintenance, etc. 7.1.2 How Price Floors Aect Market Outcomes

A price oor is a legal minimum on a price at which a good can be sold. If the price oor is set above the equilibrium price, the nal outcome will be that the good will be sold at the price oor. However, at this price quantity supplied exceeds quantity demanded and thus we face a surplus of the good and the quantity demanded determines how much of the good is actually sold. If the price oor is set below the equilibrium price, then is it non-binding and the market will move the equilibrium price and quantity. 7.1.3 Evaluating Price Controls

Price controls do reduce market quantities, but for those still in the market there are measurable benets that leads to a tradeo between these benets and the lower quantities.

7.2

Taxes

Another common policy is the government to tax certain goods to generate revenue. The government tends to use a variety of dierent taxes that can be typically broken down into two categories: a sellers tax or a buyers tax. These tax can have large implications on markets. 7.2.1 How Taxes on Sellers Aect Market Outcomes

To study the inuence of a sellers tax on a market, think of the same basic steps as with any other shock to a market. If the tax is imposed on sellers that should, holding all else constant, increase the costs for the seller and thus lead to a drop in the Supply of the good by the amount of the tax. Given this shock, we can study some implications on taxes. First, the market quantity of the good will decrease with the introduction of a tax. Second, the equilibrium price of the good will increase. Third, the increase in the price will not be equal to the total amount of the tax. Although the tax bill from the government is collected from the sellers, the actual tax incidence,

22

who really pays the tax, is shared between the buyers and sellers. Finally, we can measure the amount of tax revenue is collected by the tax. 7.2.2 How Taxes on Buyers Aect Market Outcomes

To study the inuence of a buyers tax on a market, think of the same basic steps as with any other shock to a market. If the tax is imposed on buyers that should, holding all else constant, decrease the desire for the buyer to purchase the good and thus lead to a drop in the Demand of the good by the amount of the tax. Many of the implications of a buyers tax are the same as a sellers tax. First, the market quantity of the good will decrease with the introduction of a tax. Second, the equilibrium price of the good will increase. Third, the increase in the price will not be equal to the total amount of the tax. Although the tax bill from the government is collected from the buyers, the actual tax incidence, who really pays the tax, is shared between the buyers and sellers. Finally, we can measure the amount of tax revenue is collected by the tax. 7.2.3 Elasticity and Tax Incidence

The general rule of thumb is whoever is more inelastic will face the larger burden of taxes.

Chapter 7: Consumers, Producers, and the Eciency of Markets

We have studied how supply and demand determine market prices and quantities. We have a sense of how the market allocates goods, but we have yet to discuss whether these allocations are desirable. To get at this we need to study welfare economics. This is the study of how the allocation of resources aects economics well-being. We will nd that market equilibrium will indeed maximize the total benets received by buyers and sellers.

8.1

Consumer Surplus

We begin by looking at the benets receive from participating in markets.

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8.1.1

Willingness to Pay

Consider the possibility of purchasing a laptop. Four students A, B, C, and D are looking into purchasing the laptop. Before considering the price of the tickets each student has a maximum price at which they would be willing to spend on the laptop. This price represents their willingness to pay and shows how much each buyer values the good. Every student would buy the good for any price up to a equal to their willingness to pay. Suppose that student A is willing to spend 2000 for a laptop and the current price of the laptops is 1250. In this case if A buys the laptop they are earning a consumer surplus of 2000 - 1250 = 750. The consumer surplus is the amount a buyer is willing to pay for the good minus the amount the buyer actually pays for the good. Suppose B values a laptop at 1500, student C values it at 1300, and student D values it at 1000. In this case the 3 students would buy a laptop and student D would not. Student B has a consumer surplus of 250 and consumer C has surplus of 50. 8.1.2 Using the Demand Curve to Measure Consumer Surplus

We can use the willingness to pay to line up the students demand for laptops. Graphically, consumer surplus is the vertical distance between the demand curve and the market price. If smoothed out the total consumer surplus is the triangle area between the demand curve, y axis, and the market price. 8.1.3 How a Lower Price Raises Consumer Surplus

If the market price drops the triangle gets bigger because the consumer surplus for each buyer goes up and thus total consumer surplus goes up. 8.1.4 What Does Consumer Surplus Measure

Consumer surplus measures the perceived benet that consumer gets from engaging in the market. The total consumer surplus gives some sense of the buyers well-being in the market.

8.2

Producer Surplus

This concept measures the benets for the sellers from participating in a market. This is similar to consumer surplus. 24

8.2.1

Cost and the Willingness to Sell

Consider the possibility of selling a laptop. Four sellers A, B, C, and D are looking into selling a laptop. Before considering the price of a laptop each student has a minimum price at which they would be willing to sell the laptop. This price represents their willingness to sell and shows how much is costs each seller to produce the good. Every seller would sell the good for any price above their willingness to sell. Suppose that it cost seller A 600 to build a laptop and the current price of the laptops is 1250. In this case if A sells the laptop they are earning a producer surplus of 1250 - 600 = 650. The producer surplus is the amount a seller sells the good minus his willing to sell (costs) for the good. Suppose B has a cost of laptops for 750, seller C has a costs of 1200, and student D has a cost of 1500. In this case the 3 sellers would sell laptops and seller D would not. Seller B has a producer surplus of 500 and seller C has surplus of 50. 8.2.2 Using the Supply Curve to Measure Producer Surplus

We can use the willingness to sell to line up the sellers supply for laptops. Graphically, producer surplus is the vertical distance between the supply curve and the market price. If smoothed out the total producer surplus is the triangle area between the supply curve, y axis, and the market price. 8.2.3 How a Higher Price Raises Producer Surplus

If the market price rises the triangle gets bigger because the producer surplus for each seller goes up and thus total producer surplus goes up.

8.3

Market Eciency

So, given these measurements of benets, is the market allocation of resources desirable? 8.3.1 The Benevolent Social Planner

Suppose you could step back and allocate the market. You could chose who receives and sells the goods in the market. The benevolent social planner is an all-knowing, well-intentioned planner who allocates the market is such a way that he wants to maximize the economic well-being of everyone in 25

society. How should the planner allocate the market. First he must measure well-being. One possible measure is to calculate the sum of consumer and produce surplus which is called total surplus. So, Total Surplus = Consumer Surplus + Producer Surplus Total Surplus = (Value to Buyers - Price Paid by Buyers) + (Amount Received by Sellers - Cost to Sellers) or Total Surplus = Value to Buyers - Cost to Sellers The planner could strive to maximize total surplus, and if achieved the market is considered ecient. Given that the planner knows every sellers costs and buyers value he can always arrange an ecient allocation. 8.3.2 Evaluating the Market Equilibrium

So, how about the market allocation where the price allocates goods and not the planner. We can simply draw a market in equilibrium. When this happens we can see consumer and producer surplus which forms the area to the left of the equilibrium. Is the allocation of goods ecient? Is total surplus maximized? Well every buyer to the left of equilibrium has a value at or greater than the price and every seller has a costs at or below the prices so what we rst see is that market allocated goods to those with the highest value and lowest cost. Also, note that every quantity to the right of equilibrium is in the opposite position. The cost to the seller exceed the price and the value to the buyer is below the price. Thus any quantity to the right would decrease total surplus and should not be allocated. Thus, yes the market outcome is ecient every positive contribution toward total surplus receives the good.

8.4

Conclusion: Market Eciency and Market Failure

In this situation we found that market do generate an ecient allocation, that does not mean that every market will generate an ecient solution. We had to use a few assumptions in this situation. First, we used perfect competition where no one seller has power over the market price. In some markets a single or small group of sellers could have market power and potentially distort the allocation. Second, we assumed that the outcome in the market only inuenced the buyers and sellers in the market. In some real-world markets, the decision of buyers and sellers can aect people who are not participating in the market. Think about pollution as a classic example. These two ideas 26

can lead to the possibility of a market failure where the market is unable to allocate resources eciently. We will study this idea in more depth starting in chapter 10.

Chapter 8: Application: The Costs of Taxation

In this chapter we study how tax inuence the welfare of buyers and seller in a market. In this cost benet type analysis we need to weigh the lost quantities and drop of total surplus against the amount the tax revenue which is collected and used in other, potential welfare improving, ways. We begin by considering the cost of taxation.

9.1

The Deadweight Loss of Taxation

Recall from our previous work that given a tax of a particular size, the total quantity of the good allocated in the market will drop. The amount of the drop is not dependent on who is taxed (buyer or seller). The tax generates a wedge the price buyers pay for the good and the amount sellers receive for the good. This wedge creates the drop in quantity. 9.1.1 How a Tax Aects Market Participants

We can now apply our tools of welfare economics to measure the gains and losses from the introduction of a tax. To get this correct we need to see how the tax inuences the buyers, sellers, and the government. Total surplus measures the overall benet across all three types. For the government we consider the tax revenue generate as public surplus which goes towards government goods. So, Total Surplus = Consumer Surplus + Producer Surplus + Tax Revenue Welfare without a tax: Without a tax Total Surplus is simply the triangle area to the left of equilibrium. Welfare with a tax: With a tax the Total Surplus is the total area to the left of the newly reduced quantity and between the Supply and Demand Curves. The middle section in tax wedge is the tax revenue. The 27

area above the tax revenue and below the demand curve is consumer surplus and the area below the tax revenue and above the supply curve is producer surplus. Changes in Welfare: We do nd the some of the total surplus is lost with a tax. The triangle area between the original equilibrium and tax revenue is no longer included and these good are no longer traded. This are is called the deadweight loss of the tax and is the fall in total surplus that results from a market distortion, such as a tax. 9.1.2 Deadweight Losses and the Gains from Trade

Taxes generate deadweight losses because the tax prevents buyers and seller from realizing some of their gains from trade. For some buyers and sellers, these lost gains actually drive them out of the market and thus the market quantity falls. For everyone else, the total gain from trade is reduced.

9.2

The Determinants of the Deadweight Loss

What makes the deadweight loss of a tax large or small. Once obvious thing is the size of the tax. Holding all else constant, the larger the tax, the larger the deadweight loss. The second important determinant is the elasticity of demand and supply. Generally, as the market becomes more elastic, sensitive to price changes, the deadweight loss from a tax get larger. This is mostly because more elastic markets will face larger drops in quantity with the introduction of a tax.

9.3

Deadweight Loss and Tax Revenue as Taxes Vary

As stated before the size of the deadweight loss of a tax partially depends on the size of the tax. Doubling the size of a tax will double the base and height of the triangle which measures deadweight loss so the area of deadweight loss would increase by a factor of 4. This is not the only area which varies by the size of the tax, revenues also change and do not always go up with the size of the tax. In most situations as the size of the tax increases, so will revenues up to some point. After this point, if taxes increase again the increases in deadweight loss and the loss in quantity actually reduces tax revenues. This type of behavior is summarized in a Ladder Curve. This curves biggest claim

28

to fame is the whole Supply-Side economics of the 1980s. If you believe we are on the downward side of the Laer curve, then a reduction in tax rates can actually generate increases in tax revenues through a large increase in quantity.

10

Chapter 10: Externalities

In this chapter we study situations where government action may improve market allocations. In this chapter we will explicit look at the market failure know as externalities. An externality is the uncompensated impact of one persons actions on the well-being of a bystander. If the impact on the bystander is adverse it is a negative externality. Is the impact on the bystander is benecial it is a positive externality. Because buyers and sellers neglect the external eects of their actions when deciding how much to demand or supply, the market equilibrium is not ecient. The total surplus in the market is not maximized. Some examples of externalities include: car exhaust, restored historic buildings, barking dogs, research.

10.1

Externalities and Market Ineciency

We can use the tools of welfare economics to examine how externalities aect economic well-being. We can see how market allocations are changed in the presence of externalities. 10.1.1 Negative Externalities

Consider a situation of pollution, for each unit produced a certain amount of smoke enters the air. Because this smoke create a health risk for others, it is a negative externality for this market. This smoke implies that the societys true cost of production are higher than those implied by the seller. This would make the true cost higher and the supply curve decreased when compared to that the seller is using. Thus the optimal output is lower than the market quantity and the optimal price is higher than the market price. Thus the market allocation is inecient. How could the market reach the ecient outcome? The common strategy is to internalize the externality. Internalizing the externality is altering incentives so that people take account of the external eects of their actions. In this case one possibility would be to tax the seller to push the supply curve up to match the social cost. 29

10.1.2

Positive Externalities

Some externalities are actually positive. Consider education which leads to other things such as: more informed voters, lower crime rates, development of technology. All of these are in addition to the higher income one receives from education. These extra benets of education to society are not normally consider in the market for education. The true, society, demand for education is actually higher than what the buyer perceives. This implies that the market quantity and price for education is actually lower than what is optimal. How to line up demand curve? Subsidies could do it.

10.2

Public Policies toward Externalities

We have seen how externalities alter allocations, now we can consider how government and private policies could be used to move the market towards the ecient allocation. 10.2.1 Command-and-Control Policies: Regulation

These type of policies directly regulate market behavior. One possible strategy is to simply eradicate the externality causing activity. You could attempt to remove certain types of pollution to eliminate these types of costs, however, this can be dicult and remove all pollution is practically impossible. Thus the best we can do most of the time is to regulate and inform about the behavior. 10.2.2 Market-Based Policy 1: Corrective Taxes and Subsidies

Market policies provide incentives so that decision makers choose to solve the problem on their own. The general strategy is to tax, through whats called a corrective tax, negative externalities and subsidized positive externalities to simply try and line up the market supply and demand with the optimal supply and demand. Consider two possible solutions to pollution. One: regulation to cap pollution at some level. Corrective tax which taxes the rm for each ton of pollution. Which way should work better? Most economist argue that the tax is the way to go. While both policies should indeed reduce pollution, only the tax creates the incentive to continually lower pollution to lower

30

costs. Those rm who could easily reduce will have a larger incentive to reduce pollution. 10.2.3 Market-Based Policy 2: Tradable Pollution Permits

Another possible solution to the pollution problem is to allow rms to trade amount of pollution for a price. The benet of this approach is that the government can set the cap on pollution versus trying to guess size of a tax that would generate the same amount of pollution.

10.3

Private Solutions to Externalities

Government need not be to only solution maker for externalities, people can also develop private solutions. 10.3.1 The Types of Private Solutions

Moral code and social sanctions most people dont litter. Charities used to reallocate markets. There can also be contracts between parties to directly internalize the externality. 10.3.2 The Coase Theorem

The Coase Theorem reinforces the idea that private solutions can solve externalities. The Coase Theorem states that if private parties can bargain without cost over allocation of resources, they can solve the problem of externalities on their own. 10.3.3 Why Private Solutions Do Not Always Work

The Coase Theorem only works if parties have no trouble in reaching an agreement that is enforceable. Sometimes due to transaction costs bargaining is costly and can cause the Coase Theorem to fail. If the number of people is large or if the cost are not clear the bargaining gets really dicult to complete.

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11

Chapter 11: Public Goods and Common Resources

Not all good have price, things like rivers, beaches, roads, and other items have some value but buyers do not have to pay a price to use them. When goods are available free of charge, the market forces which normally determine ecient allocations are no longer present. This chapter talks about these types of goods.

11.1

The Dierent Kind of Goods

Goods do vary by types. There are two basic characteristics which generally dictate what type a good is described as. The rst trait is whether the good is excludable. A good is said to be excludable if a person can be prevented from using it. The second trait is whether the good is rival in consumption. A good is rival in consumption if one person using a good diminishing another persons ability to use the good. Private Goods: are both excludable and rival in consumption. Ice cream and other basic consumption goods. Public Goods: are neither excludable or rival in consumption. tornado siren. Common Resources: are rival in consumption but are not excludable. Fish in the ocean, roads to a degree,. Club Goods: are excludable but not rival in consumption. Cable TV, toll road (not congested). This chapter will focus on non-excludable goods: public and common. Both of these types of goods face externalities both positive for public goods or negative for common goods.

11.2

Public Goods

Public goods are those that are neither excludable or rival in consumption. These goods have their own complications.

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11.2.1

The Free-Rider Problem

One of the main allocation issues with public goods is that they could face a free-rider problem. This is a problem someone can receive the benet of a good, but avoids paying for it. Suppose a town wants to put on a reworks display. The display will cost 10,000 dollars and the citizen put a value of 25,000 on the display, so the show should happen as the benets exceed the costs. Suppose the town tries to use a private rm to setup the display. Would this arrangement create an ecient allocation? Probably not, how would the rm collect the 10,000 dollars? Selling ticket wont really work because someone can still see the show without buying a ticket, which would be a classic free-rider problem. The solution to the problem, let the government use public funds for the show and eliminate any free-riders. Ever done group work? 11.2.2 Some Important Public Goods

There are several common examples of public goods in our everyday life. National Defense Basic Research: General knowledge cannot be patented. We have institution like NIH and NSF the subsidize basic research. Public Roads Not Congested: 11.2.3 The Dicult Job of Cost-Benet Analysis

Economist often use cost-benet analysis to justify whether or not a program should be introduced or maintained. When analyzing public goods, estimating benets can become tricky as there is no price to judge the value of the good. Using other means to estimate the benets of the good will often lead to bias estimate of the value: user would have an incentive to exaggerate their benets, and non-user would have the same incentive to overstate their costs. In other situation morals can cloud the benets of a good if it is for public safety.

33

11.3

Common Resources

Common resources, like public goods are not excludable, but are rival in consumption. One persons use of the good can limit another persons use of the good. 11.3.1 The Tragedy of the Commons

The Tragedy of the Commons is that common resources are used more than is desirable from the standpoint of society as a whole. Since these goods are rival in consumption there is an incentive to want to use it rst. This leads to either over use of the good or early use of the good before it is ready. Think about a public garden if you dont get the crop early there may be none for you later. So their is an incentive to harvest early before fully ripe. 11.3.2 Some Important Common Resources

There are several common resources we use everyday. Clean air and water: Congested Roads: Fish, Whales, and Other Wildlife:

11.4

Conclusion: The Importance of Property Rights

What the chapter shows is how important it is to have a well established system of private property and right in place to create the proper incentives on both the benets and cost of goods. Without these rights, the government can attempt to provide goods (public and common) but as we have discussed there is a potential for large allocation issues with these goods which were not present in private markets.

12

Chapter 12: The Design of the Tax System

In 1789 Ben Franklins coined the famous phrase that in this world nothing is certain but death and taxes. At the time of this quote the average American 34

paid less than 5 percent of their income in taxes. This stayed true for about the next 100 years. In the 20th century the role of taxes in the typical lives of citizens has changes greatly. Today, once all taxes are counted, taxes make up about 1/3 of the average Americans income. In Europe taxes are even higher in many countries. Taxes come about by the fact that we expect our government to provide goods and services. Taxes pay for these items. In this chapter we will discuss the design of the US tax system. We begin by looking at the basic nances of taxes and then consider some of the basic principles which guide the design of the tax code. Most people agree that taxes should be both ecient, low deadweight loss, and equitable. However, these two goals sometimes behave as a tradeo.

12.1

A Financial Overview of the US Government

Since 1900 government revenues have increased substantially. Around 1900 federal tax was around 2.5 percent of GDP and state and local tax was around 3 percent of GDP. By World War II, the federal share had increased to 17 percent and the state and local was 5 percent. The federal share has remained in the range of 15 to 18 percent. Today the state and local share is about 10 percent. The current US burden of taxation is roughly 30 percent. Lets look more closely and the receipts and spending of both the federal and state and local governments. 12.1.1 The Federal Government

The federal government collects about 2/3 of their money through taxes in our economy. Here are the dierent ways the federal government raises money and spends it. Receipts: In 2009 the federal government collect 2.105 trillion dollars in taxes. Individual income taxes made up 43 percent of the total, social insurance tax was 42 percent, corporate income tax was 7 percent, and other taxes were 8 percent. Average amount per person was 6846 dollars. The largest piece, income tax, is a sort of a proportional tax. The actual calculation of tax liability depends on an individuals tax bracket, marginal tax rate, and deductions. Other taxes like social security and medicare are proportional at a single rate up to a cap. Corporations also pay taxes on their prots. These prots are 35

actually taxed twice, once at the corporate level, and then again at the individual level depending on who gets the prots. Spending: In 2009 the federal government spent at total of 3.518 trillion dollars or 11441 dollars per person. The largest piece was Social Security which was 19 percent of the total or 683 billion dollars, defense was second at 661 billion. This number was higher than usual due to Iraq and Afghanistan. Income security was 533 billion and was once again higher because of the recession. Medicare and other health spending, including Medicaid, totaled 764 billion. Net interest payments totaled 187 billion and other spending, including federal courts, the space program, highways, housing credits, and federal salaries, totalled 690 billion. In this year spending was 1413 billion more than receipts, that would imply a budget decit. This was nanced by government bonds. Future Fiscal Challenges: Although the budget decit in 2009 was large, it is the future which is really concerning. As a percentage of GDP tax collection is forecast to stay relatively constant. However, many federal programs are not. Spending is forecast to grow as a percentage of GDP mainly due to liabilities tied to Social Security and Medicare. The population is getting older. Today the 21 percent of the population is 65+, by 2060 that number should be around 40 percent. This would imply that government spending on just Social Security, Medicare, and Medicaid would be about 15 percent of GDP which is roughly equal to the amount of taxes gathered by the federal government. 12.1.2 State and Local Government

State and local governments collect nearly as much tax as the federal government. However, they tend to collect and spend their money in dierent ways. Receipts: Total revenues in 2009 were 2.329 trillion dollars or 7574 per person. State and locals tend to get most of their taxes from a combination of property taxes, sales taxes, and income tax. They also receive substantial funds from the federal government.

36

 Spending: Total spending in 2009 totaled 2.265 trillion dollars or 7367 per person. Education is the big ticket item accounting for over 1/3 of all spending. Contrary to the federal government, the state and local level primarily buys goods and does little in the way or transfer programs. You will also notice that due to many balance budget rules the total spending is basically equal to receipts.

12.2

Taxes and Eciency

We have now seen how the government raises and spends its money. How do we evaluate tax policy and the design of the tax system? The primary goal of the system is to raise revenue. However there are also two important secondary issues to thinking about with a tax design: eciency and equity. We start by looking at eciency. By eciency we mean to minimize the deadweight loss that result when taxes distort decisions and minimize the administrative burden that results from the taxpayers trying to comply with tax laws. 12.2.1 Deadweight Losses

Because taxes distort supply or demand, they create a deadweight loss. Deadweight loss is smaller in inelastic markets, so many taxes tend to show up in these markets. Income versus consumption debate. Taxing interest income can create a distortion against saving as it reduces the interest rate. Some economist call for a consumption tax that has no such distortion. 12.2.2 Administrative Burden

How costly is it to ll out tax forms? Between the time associated with lling out the forms and the time needed to keep the records for those forms, there appears to be a substantial cost of just complying with tax laws. The resources used to comply with the tax code represent a deadweight loss. 12.2.3 Marginal Tax Rates vs Average Tax Rates

Marginal tax rate measure the taxes gathered on the next dollar earned. The average tax rate is the total taxes paid divided by total income. Suppose the tax code is 20 percent tax on the rst 50,000 and 50 percent of all income over 50,000. Suppose the person makes 60,000. His total tax bill is = .20*50000 37

+ .5*(60000-5000)= 15000. So his average tax rate is 15000/60000 = 25 percent. His marginal tax rate is 50 percent as the next dollar earned would be taxed at that rate. The average tax rate measure the sacrice of the taxpayer. The marginal tax rate does more to measure the distortion of taxes on decisions. 12.2.4 Lump-Sum Taxes

These are taxes where everyone pays the same amount. It is the most ecient tax possible as it does not distort decisions. The next dollar is taxed at zero marginal tax rate. So why dont we use them? Eciency is not the only goal in tax design. Equity is another big player. Consider a situation where the at tax rate is 5000. Now look at two people, one makes 20,000 and one makes 100,000. Both face a zero marginal tax rate, but their average tax rates are dierent. The rst person has an average rate of 5000/20000= 25 percent. The second person has an average rate of 5000/100000 = 5 percent.

12.3

Taxes and Equity

Now lets consider the equity of the tax system. How should the burden of taxes be spread across the population? Most people agree in some of equity, but there is much disagreement over what equity means. 12.3.1 The Benets Principle

The benets principle is the idea that people should pay taxes based on their benets they receive from government services. In private markets, the more you buy the more you pay. This idea would seem like is should also apply to public goods, and in some cases in does (excise taxes, toll roads, etc...) Those you use the public good are being charged for using that good. This could even be used to argue why the wealthy citizens should pay higher taxes. They receive more benets from government (police protection, the social value of lower poverty, etc.). 12.3.2 The Ability to Pay Principle

The ability to pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden of the taxation. The idea is that those who are wealthier are better able to deal with the 38

burden of taxation and thus should pay more than those who cannot. There are two other related items which spin o of this topic. Vertical Equity: This is the idea that taxpayers with greater ability to pay taxes should pay larger amounts. How much more is the big debate. Is is an amount, average rate, or percentage, marginal rate? This leads dierent styles of tax systems. Proportional taxes are represented as xed fractions. A regressive tax is one where the rich pay a lower percentage. A progressive tax is one where the rich pay a higher percentage. This is typically a huge issue in politics. 2006 numbers are presented on page 248, any way you slice it the tax code is progressive and this does not include government transfers which will make the system even more progressive. If someone receives more in transfers than it pays in taxes, that person is paying a negative tax rate. Horizontal Equity: This is the idea that taxpayers with similar abilities to pay taxes should pay the same amount. 12.3.3 Tax Incidence and Tax Equity

We also have to think about tax incidence when evaluating a tax system. The burden of tax is not always the person who gets the tax bill from the government. Taxes move supply and demand and thus change equilibrium prices. Most discusses of tax equity leave out this discussion. Does an excise tax on fur coats stay on the wealthy? It seems to be vertically equitable as most buyers are probably rich. However, there are lots of substitutes for fur coats. The demand for furs coats is probably more elastic than the supply, so most of the tax incidence will be passed on to the suppliers of fur coats who are probably not a wealthy as the buyers.

12.4

Conclusion: Tradeo between Equity and Eciency

Equity and eciency are the two most important goals of the tax system. Political parties often dier on there relative importance and denition of these goals. Recent political history shows many examples of shifting tax rates which show each partys beliefs. Issues beyond economics help to determine the best way to balance these goals. 39

13

Chapter 13: The Costs of Production

Up until this point we have simplied the actions of the rm to a supply curve. How is the supply curve determined? That is the topic of this chapter. Now we turn our attention to rm behavior. This behavior centers around the concepts of cost minimizations and prot maximization. This behavior is determined by the type of market and length of time in which the rm is engaged in. We start with an understanding of a rms costs.

13.1

What Are Costs?

We begin by looking at what we can call basic cost and revenue accounting for a rm and understanding certain denitions which will be used in the next several chapters. 13.1.1 Total Revenue, Total Cost, and Prot

Total revenue is the amount a rm receives for the sale of its output. Total cost is the market value of the inputs a rm uses in production. Prot is simply total revenue minus total costs. The objective of most rms is to maximize prot. 13.1.2 Costs as Opportunity Costs

It should be noted that the costs facing the rm are measured as opportunity costs. Opportunity cost of an item refers to all those things that must be forgone to acquire that item. Some costs for the rm involve direct money payouts, these are considered explicit costs. Other items, workers skills, do not require direct payments and are considered implicit costs of production. These costs turn out to be important when thinking about a rm economically vs accounting. Accounting costs are only explicit. Economic costs are the sum of explicit and implicit costs. 13.1.3 The Cost of Capital as an Opportunity Cost

One of the largest implicit costs facing every rm is the opportunity cost of the capital used for the rm. Suppose a rm used one million dollars to buy a building. If that money were left in a bank that is thousands of dollars of

40

interest income that is being given up for this rm. Accountants would not count this as a cost for the rm and economist would. 13.1.4 Economics Prot vs Accounting Prot

Given the dierence in measuring costs, it should be obvious that economic and accounting prot would be dierent. Economic prot is total revenue minus total costs which include both explicit and implicit costs. Accounting prot is total revenue minus explicit costs. Accounting prot will always be larger than economic prot. Firms which make a positive economic prot will have the incentive to stat in business. If not, and those conditions persist, the rm will eventually close.

13.2

Production and Costs

Firms incur costs when they buy inputs for production. Some of these costs, over the short run, are xed no matter how much quantity is produced (factory). Others vary with quantity (ingredients). Lets look at the tie between production and costs. 13.2.1 The Production Function

The production function describes the relationship between quantity of inputs used to make a good and the quantity of output of that good. The following describes the production function of a hypothetical rm.
Workers 0 1 2 3 4 5 6 Output 0 50 90 120 140 150 155 Marginal Product of Labor 50 40 30 20 10 5 Cost of Factory 30 30 30 30 30 30 30 Cost of Workers 0 10 20 30 40 50 60 Total Cost 30 40 50 60 70 80 90

The only unknown column here is the marginal product of labor. Marginal product measures the increase of output that arise from an additional unit of input. The typical pattern of marginal product is that it is high for low numbers of inputs, however eventually, as the number inputs rises, marginal product will decrease. The basic idea here is that the most productive inputs are used rst and less productive ones will be used as the amount of production increases. This concept is called diminishing marginal product. We can use the columns of this table to display both the production function and total cost curve of this rm. The production function increases as inputs

41

increase, however, because of diminishing marginal product, the function is increases at a decreasing rate. On the ip side as quantity increases, total cost increase at an increasing rate. 13.2.2 From the Production Function to the Total-Cost Curve

These two curves are basically two sides of the same coin. As the production function attens out the total costs curve gets steep.

13.3

The Various Measures of Cost

We can further breakdown a rms costs into important components which will greatly help us understand rm behavior. Consider the following table of costs for a hypothetical rm.
Quantity 0 1 2 3 4 5 6 7 8 9 10 Total Cost 3.00 3.30 3.80 4.50 5.40 6.50 7.80 9.30 11.00 12.90 15.00 Fixed Cost 3 3 3 3 3 3 3 3 3 3 3 Variable Cost 0 0.30 0.80 1.50 2.40 3.50 4.80 6.30 8.00 9.90 12.00 AFC 3.00 1.50 1.00 0.75 0.60 0.50 0.43 0.38 0.33 0.30 AVC 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20 ATC 3.30 1.90 1.50 1.35 1.30 1.30 1.33 1.38 1.43 1.50 MC 0.30 0.50 0.70 0.90 1.10 1.30 1.50 1.70 1.90 2.10

13.3.1

Fixed and Variable Costs

The costs of a rm can be broken down into two basic types. Fixed costs which do not vary with output, things like rent, property taxes, some wages. Variable costs which do vary with output like the basic inputs needed for producing goods and some wages. A rms total costs are the sum of xed and variable costs. Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC) In this table Total Costs, column 2, is the sum of columns 3 and 4. 13.3.2 Average and Marginal Cost

When it comes to deciding how much to produce, costs are going to be a key component of that decision. How much does a typical unit of the good cost to produce? How much will it cost the rm to produce another unit of the good?

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These two dierent, yet both important questions, will go a long way to explaining production decisions. The rst question is asking about the average cost of production To measure average cost we simply need to divide total cost by quantity to get average total cost (ATC). We can also get the average of each of the components by performing similar calculations. Average variable cost (AVC) is total variable cost divided by quantity. Average xed cost (AFC) is total xed cost divided by quantity. These costs measures tell us the cost of the typical unit of the good or service, but it does not tell us how much the next unit will cost. To measure the cost of the next unit we need to calculate marginal cost (MC). Marginal cost is the increase in total cost that arise from an extra unit of production. To calculate Marginal Cost we simply need to measure the change in total cost and divide that by the change in quantity. 13.3.3 Cost Curves and Their Shapes

All of these average and marginal costs curves have standard patterns which we will become accustomed to over time. The graph to plot these curves should be quantity on the horizontal axis and cost on the vertical axis. Here are some of the typical patterns you will nd in a complete cost curve graph of a rm. Rising Marginal Cost: Because the most productive units of inputs are typically employed rst, as a rm increases its quantity the required use of less productive inputs implies that marginal cost must eventually rise with quantity. U-Shaped Total Cost: The typical ATC curve is U-shaped. For low quantities AFC are high keeping ATC high, for high quantities AVC are high keeping ATC high. The region of lowest ATC is somewhere in the middle. There is a rm level trade-o between Variable and Fixed Cost. The bottom of the ATC curve is sometimes called the ecient scale. Relationship between Marginal Cost and Average Total Cost: There is a relationship between MC and ATC. If MC is below ATC then ATC will be decreasing, if MC exceeds ATC, ATC will be increasing. The MC of a rm pulls on the ATC of the rm.

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13.3.4

Typical Cost Curves

This picture of cost curves is the typical patten exhibited by most rms. There will be special cases in which we will discuss, but this is the standard graph that should be thought of when discussing the costs of a rm.

13.4

Costs in the Short Run and in the Long Run

Lets see how time horizon inuences a rms cost considerations. 13.4.1 The Relationship between Short-Run and Long-Run Average Total Cost

The key thing about the long run is that there are no xed costs. Since the rm can change anything over the a long enough period of time all costs are considered variable and the costs of the rm can simply be summarized by a long run average total cost curve (LRATC) which is simply the bottom of all the short run ATC curves. The denition of the long run is simply the time needed to make everything variable and will vary by rm type and industry. 13.4.2 Economies and Dis-economies of Scale

We can summarize the basic cost/quantity relationship of a rm by looking at the LRATC curve. We say that a rm is exhibiting economies of scale if it has the property where is LRATC is falling at quantity is increasing. In this case it is better to be a bigger rm. If the LRATC is upward sloping the rm is displaying diseconomies of scale and costs are lower if the rm is smaller. If the LRATC is at that is considered constant returns to scale and a rms long run cost are not inuenced by change the size of the rm. Just like the ATC in the short run, the LRATC also tends to be U-shaped for most rms.

13.5

Conclusions

This chapter has set up the tools to understand the costs that rms face. We can now turn to how these costs are use to a rms decisions on quantity and entry/exit into a market. We will start by looking at rms in competitive environment.

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14

Chapter 14: Firms in a Competitive Markets

In this chapter we will analyze the prot maximization and market entry/exit behavior in an environment of heavy competition. This environment has the characteristic of one where the rms in the market have little to no ability to change prices in such a way that deviates from the general price of the other rms. If they raise there price about the group norm, the rm would basically loss all sales and generate no revenue. In this environment each rm is small and had no power over the market price.

14.1

What Is a Competitive Market?

Lets quickly review the idea of a competitive market. 14.1.1 The Meaning of Competition

A competitive market is a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker. Since every seller is a small fraction of the total market and there are many sellers, if a rm raises their price, they will lose all of their sales. Since they can pretty much sell all their product at the given market price, and they are striving for maximum prots, there is no incentive to lower their price. In addition to other characteristics, a competitive market is also denoted as have the quality of free market entry and exit. Given that the rms are small the cost of starting new one are low. 14.1.2 The Revenue of a Competitive Firm

To get a prot maximize we need to look at the total revenue and cost of a rm in this competitive market. There are two basic questions a rm needs to address when analyzing revenue. How much does the rm receive from selling a typical unit of the good? How much will the rm receive from selling the next unit of the good? Consider the following example.

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Quantity Price Total Revenue Average Revenue Marginal Revenue 1 10 10 6 6 2 10 20 6 6 3 10 30 6 6 4 10 40 6 6 5 10 50 6 6 6 10 60 6 6 7 10 70 6 6 8 10 80 6 6 Note that the price set by the rm does not change with quantity, they have no power to change the market price. The rst three columns are straightforward. The fourth column average revenue is simply P*Q/Q which is P, and given the price is constant, the revenue from selling each unit is also equal to the price. For a competitive rm price = marginal revenue.

14.2

Prot Maximization and the Competitive Firms Supply Curve

The goal of this rm is to maximize prot, we can now combine our study of cost from the previous chapter with revenue to determine what optimal supply decision for the rm. 14.2.1 A Simple Example of Prot Maximization
Price 10 10 10 10 10 10 10 10 Total Revenue 0 10 20 30 40 50 60 70 Prot 5 8 13 21 31 43 57 73 Total Cost -5 -2 7 9 9 7 3 -3 Marginal Revenue 10 10 10 10 10 10 10 Marginal Cost 3 5 8 10 11 12 13 Change in Prot 3 9 2 0 -2 -4 -6

Consider the following rm.

Quantity 0 1 2 3 4 5 6 7

This table tracks the cost, revenue, and prot of this rm by varying amounts of output. From the table we see that to maximize prot this rm should produce 3 or 4 units for a prot of 9. All the unit before 3 generate increasing prot as they have the condition of MR MC. That is the revenue generated from the selling of the unit was greater than the cost of producing the unit. All the unit after 4 generate decreasing prot as they have the condition of MR MC. That is the revenue generated from the selling of the unit was less than the cost of producing the unit. The relationship between

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MR and MC is critical for prot maximization which will always occur at the point MR = MC. 14.2.2 The Marginal Cost Curve and the Firms Supply Decision

Now consider the cost curves from the previous chapter. This time we will simply impose P=AR=MR onto the cost curve graph which is simply a horizontal line at the market price. Given we know prot maximization occurs at MR = MC we can graphically see the prot maximizing quantity for the rm. A few very simple rules also apply If MR MC, the rm should increase output. IF MR MC, the rm should decrease output. IF MR = MC, the rm should maintain output at the prot maximizing level. These rules will apply to all rms regardless of market conditions. Note that the prot maximizing output level is at the intersection of MR = MC = P, if I were to change the price the new optimal quantity would simple slide along the MC curve accordingly. The MC tracks the supply decisions of the rm for any given market price. Thus, the Marginal Cost curve is the rms supply curve. 14.2.3 The Firms Short-Run Decision to Shut Down

Now lets look into a rms decision to shutdown. Shutdown implies to a short-run decision to produce no output. This is dierent from exit which is a long-run decision to shutdown. A rm that shuts down must still cover their xed costs, whereas a rm that exits does not pay any costs. In the short run that rm considers its xed costs as sunk costs. A sunk cost is a cost that has already been committed and cannot be recovered. A rm will shutdown if the revenue generated would earn less that the variable cost of production. Thus competitive rms will remain open as long as P = AVC. If price drops below variable costs, then the rm can not even pay for its inputs of production and must shut down. So the region below the AVC curve is a region where the rm decides not to produce. So the rms supply curve is really the MC curve that lies above average variable cost.

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14.2.4

The Firms Long-Run Decision to Exit or Enter a Market

In the long-run the rm has another decision and that is about exit or entry into the market. Remember in the long run there are no xed cost, so everything is variable. The same rules that apply to shutdown in the shortrun, apply to exit in the long-run. IF the price average variable cost then the rm will exit. However in the long run average variable cost equal average total cost. So in the long run the rm will exit if P ATC and the long run supply curve for the rm is the marginal costs curve at and above the ATC curve. The decision to enter the market is just the ip side of the same story. If entering the market would be protable, and sense it is inexpensive to do so, then rms will enter. This entry will occur is P ATC. 14.2.5 Measuring Prot in Our Graph for the Competitive Firm

Prot is easy to see on the graph Prot = Total Revenue - Total Cost = P*Q - ATC * Q = (P-ATC)*Q. Prot is the box between price and ATC and between the vertical axis and quantity.

14.3

The Supply Curve in a Competitive Market

Now that we have seen the rm level supply curve, we can turn our attention to the supply curve in the competitive market. 14.3.1 The Short Run: Market Supply with a Fixed Number of Firms

Since rms are pretty much identical in the competitive market, the market Supply is simply represented as the rms supply curve with quantity scaled up by the number of rms. 14.3.2 The Long Run: Market Supply with Entry and Exit

In the long run, market entry/exit can lead to a changing number of rms. If rms are currently making a prot, then new rms will enter the market. This leads to an increase in supply and drives down the market price and prots. If rms are currently making a loss, then rms will exit the market. This leads to a decrease in supply and drives up the market price and prots. 48

The only long run stable situation is where the rm are making zero prot. At this point we see that P = min ATC = MR = MC. Thus rms are making zero prot and they are producing at their ecient scale (minimum cost). The long run supply curve for the competitive market is a horizontal line at the same price. 14.3.3 Why Do Competitive Firms Stay in Business If They Earn Zero Prot?

Remember this is economic prot. This rm is covering all of its explicit and implicit (opportunity cost) of production. This zero prot condition just says that the rm is making a typical market rate of return on the its production. 14.3.4 A Shift in Demand in the Short Run and the Long Run

Consider a positive shock to demand. How will this inuence rms in the short run and the long run. In the short run the increase in demand will drive up the market price thus driving up prots for the rms and increasing their output. In the long run, these positive prots will signal entry of new rms which would increase market supply until the price is driven back down to the long run supply curve. At the end of the process we see the same market prices but a higher quantity because of the entry of new rms.

14.4

Conclusion: Behind the Supply Curve

In this chapter we learned a great deal about how a rms supply curve is constructed. In the competitive environment where no one rm has much market power and cheap entry/exit. The threat of new competition keeps prots close to zero and cost at their minimum. As consumers we should expect to pay prices that are pretty close to the cost of production in these industries. This may not be the case when we shut o competitive forces as we will see in the next chapter.

15

Chapter 15: Monopoly

In this chapter we will analyze a completely dierent market, a monopoly. Whereas the previous chapter dealt in situations where there were many rms, no of which had any power over the market price, this chapter takes 49

the opposite stance. In monopoly markets, one rm controls the price and quantity of goods available in the market. This will lead to substantially dierent rm behavior than we saw in the perfectly competitive situation.

15.1

Why Monopolies Arise?

A rm is a monopoly if it is a rm that is the sole seller of a product without a close substitute. The main reason we see monopolies is due to barrier to entry which makes entry of new rms into the market very costly/dicult. These barriers exists because of several dierent situations: monopoly resources, government regulation, the production process. Lets look at each of these. 15.1.1 Monopoly Resources

The simplest way for a monopoly to form is if a the single rm controls a resource that is necessary for production of the goods in the market. In this case it is obvious that the rm would have substantial power over market quantity and price. The best examples of these types of monopolies are local markets such a power companies, phone companies. These are relatively rare on a macro level scale. 15.1.2 Government-Created Monopolies

Sometimes monopolies arise because they are given exclusive rights over a market by the government. Patent laws and copyrights are two policies which create monopoly situations. The small scale monopolies are induced to mimic the innovation aspects of a competitive market when barrier to entry are high. Drug companies benet greatly by this policy. 15.1.3 Natural Monopolies

Other industries exhibit natural monopolies. A natural monopoly is a monopoly that arises because a single rm can supply a good or service to an entire market at a smaller cost than could two or more rms. These industries are ones that have persistence economies of scale, where in minimum of the ATC curve occurs at a very high quantity or never. In this case a single rm can continually reduce its costs from getting larger.

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15.2

How Monopolies Make Production and Pricing Decisions

Just like other rms, monopolies will make quantity and pricing decisions in attempt to maximize prots. 15.2.1 Monopoly versus Competition

The dierence between a monopoly and the competitive rm is the monopolys ability to inuence the price of its output. This is because of the relative size of the monopoly against the market, it is the market. The main way to see this to look at the demand curves each type of rms face. In the competitive situation the rm faces a perfectly elastic, horizontal, demand curve. In contrast, a monopoly is the market so it faces a typical market demand curve which is downward sloping and more importantly not perfectly elastic. The monopolist can alter is price a only face changes in quantity as dictated by market demand. 15.2.2 A Monopolys Revenue

Given the nature of demand in a monopoly situation, it should come as no surprise that its revenue will also behave dierently. Consider the follow Quantity Price Total Revenue Average Revenue Marginal Revenue 0 11 0 1 10 10 10 10 2 9 18 9 8 3 8 24 8 6 monopoly rm. 4 7 28 7 4 5 6 30 6 2 6 5 30 5 0 7 4 28 4 -2 8 3 24 3 -4 The key dierences between the monopolist and the competitive rm is that monopolist face a dropping price to increase quantity and decreasing marginal revenue as quantity goes up. The monopolist has more control over its prot as it can manipulate total revenue, but the limitation of market demand means that the is a quantity versus price tradeo that the monopolist must deal with. This price eect did not exist in the competitive situation.

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Graphically, demand and marginal revenue have a simple pattern. The two curves will start on the same point on the vertical axis as the marginal revenue of the rst unit must generate marginal revenue that must equal average revenue. For all future quantities the marginal revenue curve lies strictly below the demand curve. The is due to the price eect, lower, for increasing quantity. 15.2.3 Prot Maximization

The point of prot maximization of the monopolist is the same as the competitive rm, that the quantity where MR=MC. The cost curves are the same as in the competitive situation, the only dierence is that the demand curve and marginal revenue are downward sloping. In the competitive situation we had P = MR = MC. In the monopoly situation we have P MR = MC. The key dierence is that the monopolist will set price above MR and MC. 15.2.4 A Monopolys Prot

How much money does a monopolist make? Prot = TR - TC = (TR/Q - TC/Q)*Q = (P - ATC) * Q. This is exactly the same result as in the competitive situation.

15.3

The Welfare Cost of Monopolies

Given what we have seen, is a monopoly a good way to arrange a market? Given that the monopolist can set a price above marginal cost, consumers view, this higher price should make the monopoly an undesirable allocation. From the prospective of the owners however, the high price makes the monopoly a desirable allocation. Which one wins? For this we return to our previous work with welfare economics. Remember total surplus is equal to the sum of consumer surplus and producer surplus. We already know that the competitive market yields a standard market equilibrium which maximizes total surplus. How about a monopoly? 15.3.1 The Deadweight Loss

The monopolists optimal decision occurs at the point where its MR = MC, this is not the same point as S=D. The monopolist generates a market quantity that is below the socially optimal. In addition is charges a price based 52

o of the demand curve at that point. Thus the monopolist creates a deadweight loss that would not be there if this were a socially optimal market. Because the monopolist has market power through a P MC, it creates a wedge between buyer and sellers much like a tax collector, where the markup in the price is the tax. 15.3.2 The Monopolys Prot: A Social Cost?

The loss of the situation should center more about the lack of quantity versus the markup in the price. The markup simply transfers consumer surplus into producer surplus, there is no loss in gain from trade up to the point of optimal quantity. It is the lost quantity that generates the loss.

15.4

Price Discrimination

Some monopolist have enough power that they can practice price discrimination. Price discrimination is the business practice of selling the same good at dierent prices to dierent customers. With a monopoly, as long as the price of the good is below the buyers willingness to pay, they will buy the good from the monopolist, there are no other lower price substitutes available. 15.4.1 The Analytics of Price Discrimination

The key aspect of a rm to successfully price discriminate is that it needs to identify where on a specic types of consumers are on the demand curve. If this group can be identied, the monopolist with his market power can charge a price close to the willingness to pay. In this situation the monopolist is able to extract consumer surplus into the rms prots. If the monopolist were able to nd each consumers willingness to pay, hypothetical the monopolist could extract all of consumer surplus into prot. The are some basic conclusion we can draw from price discrimination: 1) The decision of price is discrimination is perfectly rational for a prot-maximizing rm. 2) The rm needs to be able to identify consumer types. 3) Price discrimination can actually increase social welfare. Some consumers, those with the lowest willingness to pay, we see a lower monopoly price and return to the market as they were in the competitive market.

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15.4.2

Examples of Price Discrimination

There are various common examples of situations where a rm charges different prices to dierent customers. Movie Tickets: Airline Prices: Discount Coupons: Financial Aid: Quantity Discounts:

15.5

Public Policy toward Monopolies

In general monopolies tend to generate socially suboptimal amounts of goods. To deal with this problem the government attempts several dierent strategies. 15.5.1 Increasing Competition with Antitrust Laws

The rst policy is to simply prevent monopolies from coming together. Antitrust laws basically prevent two or more potential large rms from coming together to make up a monopoly. The government can use antitrust laws in a couple of ways. First, they could simply prevent mergers. Second, the government can also has the power to breakup a rm if it is deemed to be a monopoly (ATT). Of course there are potential risks in antitrust, especially if the industry is of the natural monopoly variety where the economies of scale are large. The key industry in the situation right now is the banking industry where size is a benet to the rm. 15.5.2 Regulation

The government can try and come in and prevent the monopolist from charging the monopoly price. This can be done with regulations on price as in the case of many utilities companies. The question become what price to allow? From the socially optimal situation we know P = MC, should that be applied here? That can be dangerous for the rm if this is a natural monopoly. In 54

this case inducing P = MC would force a loss for the rm. In this case the government can either come back in a subsidize the rm to oset the loss. A secondary problem with this pricing is that the monopoly has no incentive to lower their costs. 15.5.3 Public Ownership

The third option for the government is for the government to come in a be the monopoly. This occurs with things like the Postal Service. 15.5.4 Doing Nothing

Another possibility is to just do nothing, having the monopoly in place may be the best option, the cost of the government policy or the simple lack of market could be costlier than the drawbacks of a monopolist.

15.6

Conclusion: The Prevalence of Monopolies

The case of the monopolistic a drastic dierence from the environment of perfect competition. Table 2 on page 324 does a good job of summarizing these two market situations.

16

Chapter 16: Monopolistic Competition

What about markets that carry characteristics of both competitive markets, yet show signs of monopolistic behaviors. The coee shop market appears to be very competitive in some regards, there are many small rms, where no one appears to have too much control over the price. However, once inside the coee shop, only certain brands are sold. Each shop tends to have their own blends where they would appear to have some market power over the particular items in their store. This is a situation where you are working in a market monopolistic competition.

16.1

Between Monopoly and Perfect Competition

We are going to talk about two types of markets which fall between the situations of monopoly and perfect competition. In this chapter we will learn about monopolistic competition. These markets are characterized as 55

having many sellers, however, the sellers sell products that are similar, but not identical. In the next chapter we will discuss an oligopoly. This market is one where there are only a few sellers who can oer similar or identical products. Monopolistic competition describes a market with the following conditions. Many Sellers: Product Dierentiation: Free Entry and Exit: One could argue that monopolistic competition is the most common market type in the economy. Lets look at the decision making process of rms in this style of market.

16.2

Competition with Dierentiated Products

Lets begin by looking as the decisions facing a rm in this market in the short-run. We will than proceed to the long run equilibrium and compare this with the perfectly competitive solution. 16.2.1 The Monopolistically Competitive Firm in the Short Run

Firms in this environment look in many ways like a monopolist. The demand for their specialized product is like a small market. So in some ways the rms see demand and marginal revenue conditions just like a monopolist. Just like a monopolist this rm will choose output such that MR = MC and the price charged will be set o of demand curve at that output. In the short-run we are just looking at the monopolist again. 16.2.2 The Long-Run Equilibrium

The dierence appear over the long run. If there is a short run prot in this market, free entry will lead to addition rms entering the market. The increase in the number of rms will reduce the demand that each current rm has access too. This will cause a drop in the demand and marginal revenue curve for each existing rm. This process would continue until the prot is driven to zero. The equilibrium of this market occurs where the output 56

at MR = MC is also the point where P = ATC. Note: because demand is downward sloping this tangency does not occur at the minimum of ATC. 16.2.3 Monopolistic versus Perfect Competition

The are really two main dierences between the equilibria for monopolistic an perfect competition. They are excess capacity and a price markup. Excess Capacity: In this situation, the quantity produced is less than what is found in perfect competition. And this placing the rms on a downward sloping part of the ATC curve. The rms are note reaching the lowest possible cost and do not achieve their ecient scale. Because the rms should actually get larger, when compared to perfect competition, we say this market holds excess capacity. It needs no additional sellers, the existing sellers should just be larger. Markup over Marginal Cost: A second dierence is that at equilibrium P MC. This does not contradict the idea of zero prot which only gives us the condition P = ATC. Because we nd that rms are on the downward sloping portion of ATC, we know at this point ATC MC. 16.2.4 Monopolistic Competition and the Welfare of Society

Typical welfare analysis approach to determining the welfare cost of the monopolistic competition is a bit tricky in this market. We do see that even though the rms will make zero prot in the long run, they are still an the downward slope of the ATC and have a markup of the price greater than MC. This will lead to the same deadweight loss we saw in the case of monopolies. Attempts at using regulations to solve this allocation issue prove to be dicult as the rms in this market are making dierentiated products and each would have to individually regulated. Plus, since these rms already earn zero prot in the long run any regulation which lowers price will pass along losses to these rms.

16.3

Advertising

Given the dierentiated products of this market and the charging of a price above marginal cost, there is an incentive for rms to advertise their products.

57

There is a tendency for the degree of dierentiation in products is directly related to the amount of advertising rms use to market their products. 16.3.1 The Debate over Advertising

Does advertising serve a valuable service or is it a waste of resources? Lets discuss this debate. The Critique of Advertising: Critics of advertising argue that rms are trying to manipulate tastes because they argue that advertising is more psychological than informational. They also argue that advertising is anti-competition try to prove the goods are more dierent than they really are. If they can make demand curves less elastic they can increase the markup on their goods. The Defense of Advertising: Defenders of advertising argue that advertising are providing information: sale prices, new products, locations, etc. The information enhances consumers decisions allowing them to gain an accurate measure of their true willingness to buy the good. Some say that advertising enhances competition because customers can more easily take advantage of price dierences thus making demand more elastic. 16.3.2 Advertising as a Signal of Quality

Another defense of advertising is in the idea that even money on advertising that has very little information sends signals to the market. The signal is that of quality. The company is so condent in the quality of the good, the rm is willing to more or less throw away money just for entertainment. If the money for advertising is not oset by increased sales, the prot maximizing rm would never choose this strategy for spending money. 16.3.3 Brand Names

One other aspect of advertising is the use of brand names. Brand name often spend more on advertising and charge a higher price than do generic brands. Some argue that brand names lead to misconceptions about quality dierences that do not really exist. On the other hand it could be the case that branding passes on information about quality when it is dicult to 58

measure. Branding can also generate an incentive to keep quality high to defend the name. This can be very important for companies with several locations spread across a large distance.

16.4

Conclusion

Table 1 on page 345 summarizes the behaviors of the three market types we have addressed thus far. We can now move on to the nal type oligopoly which is made up of a few large sellers.

17

Chapter 17: Oligopoly

This chapter continues our analysis in the area between perfect competition and monopoly. This chapter deals with markets that are called oligopolies. An oligopoly is a market where only a few sellers oer similar or identical goods. Every seller makes up a signicant piece of the market and thus any change in behavior from one rm can inuence the decisions made by all other rms in the market. We will also have chance to study strategic decision making using game theory. Strategic jut means the process of when someone makes a decision they consider the responses of others before making their decision. This strategic thinking can help us understand why some oligopolies look like monopolies and why others look more like competitive markets.

17.1

Markets with Only a Few Sellers

Given the small number of sellers in this type of market there will be a built in tension between the rms for cooperation versus self-interest. Cooperation makes the rms act as a monopolist. However they only get a percent cut of the monopolist prots. There is also an incentive to not cooperate and attempt to drive out your competitors to become a true monopoly and get all the monopoly prots. 17.1.1 Duopoly Example

Lets consider an oligopoly with only two sellers called a duopoly. Two sellers Jack and Jill own a well on a hill and each day they must decide how much water to pump, bring it to town, and sell it for whatever price the market

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will allow. Suppose the pumping water is free (marginal cost = 0 ). The following table shows the market condition. Quantity Price Total Revenue 0 120 0 10 110 1100 20 100 2000 30 90 2700 40 80 3200 50 70 3500 60 60 3600 70 50 3500 80 40 3200 90 30 2700 100 20 2000 110 10 1100 120 0 0 Since costs are zero in this example, the total revenue equals prot. Lets now consider how the organization of the towns water industry aects the price and quantity of water. 17.1.2 Competition, Monopolies, and Cartels

Lets rst consider the extreme examples of perfect competition and monopoly. If the market were perfectly competitive the production decisions of each rm would drive the price to equal marginal cost. Thus in this example the equilibrium price would be zero and the equilibrium quantity would be 120. Now consider how a monopoly would behave. The maximum prot occurs at quantity and price of 60. This result would generate a much higher price and lower quantity well below the socially optimal level of 120. How would Jack and Jill behave as a duopoly? The answer depends on the behavior of the duopoly. They could get together and agree on a price and quantity for water. Such an agreement is called collusion and the rms are acting in tandem to form a cartel. Once a cartel is form the market eectively breaks down into a monopoly allocation. Thus in this case if collusion is reached we would expect 60 units of water at a price of 60. For the the collusion to complete their agreement they two rms must agree on their cut. Each side will want a larger cut, but if Jack and Jill split the market we would have each one producing 30 units at a price of 60 for a prot of 1800. 60

17.1.3

The Equilibrium of an Oligopoly

Now is this the only possibility, probably not. The agents have an incentive to change the arrangement of the even split. At this point they each earn 1800. However one could decide to increase my output to 40 which would make a total output of 70 which decreases the price to 50. However, at a quantity of 40, my prot is 2000. Of course both parties will see this incentive. An what would happen is both would go to 40 quantity and thus we see a total of 80 at a price of 40. Thus, each party gets a prot of 1600. The sequence would stop here as any further increases in production will decrease prot. We have migrated o of the monopoly allocation, but we will not get to the competitive solution. The outcome comes out to be that both Jack and Jill choose 40 and a price of 50 to earn prot of 1600. This forms an equilibrium in this market. A Nash Equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. Neither agent has any incentive to move from output of 40 given the other agents actions. So, when rms independently choose output to maximize prot, they will produce a quantity of output that is greater than the monopoly allocation, but less than competition. The oligopoly price will also lie between monopoly and perfect competition. 17.1.4 How the Size of an Oligopoly Aects the Market Outcome

As the oligopoly increases in the number of rms, the chance of a successful cartel shrinks. All it takes is one rm to break the cartel to lead into the situation the mimics a Nash equilibrium for multiple rms. As the number of rms grows the eect each one has on the price shrinks, so the demand is becoming more and more elastic. Breaking the cartel and raise revenue freely by raising quantity. Once the number of rms gets large we should expect to head toward the competitive equilibrium.

17.2

The Economics of Cooperation

As we have seen oligopolies would like to reach the monopoly outcome, but doing so requires cooperation. In this section we look into the issues that make cooperation dicult. We can analyze this by doing a little game theory. We will focus on a particular game called the prisoners dilemma which

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shows why cooperation can be dicult to maintain even when it is mutually benecial. This works for basically any group trying to maintain cooperation. 17.2.1 The Prisoners Dilemma

The prisoners dilemma is about two criminals who have been captured by the police. Let them be Bonnie and Clyde. The police have enough evidence to convict both criminals of a minor crime that would bring about a 1 year prison sentence. The police also suspect the two of bank robberies, but lack the hard evidence to convict them of the major crime. If one of the two criminals confesses to the crime, the criminal who confesses will get immunity and the other will get 20 years, if you both confess we wont need any testimony and you will both get 8 years. Bonnie Confess Dont Confess Clyde Confess C(8) B(8) C(0) B(20) Dont Confess C(20) B(0) C(1) B(1) What will the criminals do? Consider Bonnies decision. She doesnt know what Clyde is going to do if he remains silent, my best strategy is to confess, since I would rather go free than spend a year in jail. if he confesses, my best strategy is to still confess since I would rather spend 8 years in prison instead of 20. In either case I should confess regardless of what Clyde does. In terms of game theory, the strategy to confess is a dominant strategy since it is not conditional on what the other party does. Clyde faces a similar decision process and would nd that confession is once again the dominant strategy. In the end both end up confessing and spend 8 years in prison even though if both would have been silent they would have gotten only 1 year. 17.2.2 Oligopolies as a Prisoners Dilemma

Consider the situation of Jack and Jill as a Prisoners Dilemma, in this situation the payo are the prots at the monopoly output of 30 and the Nash Equilibrium of 40. Jack High Production (40) Low Production (30) Jill High Production (40) Jack(1600) Jill(1600) Jack(1500) Jill(2000) Low Production (30) Jack(2000) Jill(1500) Jack(1800) Jill(1800) Like the earlier example the choice of 40 for output is a dominant strategy.

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17.2.3

Other Examples of the Prisoners Dilemma

There are other examples of Prisoners Dilemma type problems in nonoligopoly situations. Arms Race: Consider the US and USSR build up disarm vs arm. In this situation arm is the dominant strategy. Common Resources: Use heavily versus not to use heavily. The dominant strategy is to use the resource heavily which repeats the tragedy of the commons. 17.2.4 The Prisoners Dilemma and the Welfare of Society

In this situation the prisoners dilemma is actually a benet to society as the solution to the prisoners dilemma tends to promote competitive solutions. 17.2.5 Why People Sometimes Cooperate

This dilemma shows that cooperation is dicult, but it is not impossible. Some cartels do exist and can persist for long periods of time. This happens often in situations where the dilemma is played multiple times. Given a repeated natural of the game, the monopoly allocation can actually become a learned strategy. There also way to rig contracts in such a way that any attempt to break the collusion yields no incentive to break the collusion.

17.3

Public Policy toward Oligopolies

Just as with monopolies there is often a public policy attempt to push the oligopoly allocation toward the competitive solution. In these situations the policy is a attempt to guide rms to compete rather than collude. 17.3.1 Restraint of Trade and the Antitrust Laws

There are antitrust laws on the books which make collusive sorts of behaviors between parties as a criminal act. Thus laws attempt to keep oligopolies from acting as a single monopoly.

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17.3.2

Controversies over Antitrust Policy

There has been many questions over what kind of behavior the antitrust laws should prohibit. Price xing policies in a competitive environment should be deemed illegal. Yet it is not entirely clear what the total eects of these practices are. Resale Price Maintenance: Forcing of certain retail prices, is setting the price anti-competitive. Depends, in some sense it could, but it could increase competition between the resale rms who must compete in other aspects. Predatory Pricing: Using pricing to drive out competitors. Tying: Using goods to tie themselves into future monopoly power on other goods,

17.4

Conclusion

This concludes our analysis of dierent types of markets. Each market has its own unique attributes which are important to understand many of the rm behaviors we see in the economy.

18

Chapter 18: The Markets for the Factors of Production

Income is a large part of the economy. That income comes from the productive resources in the economy. Labor makes up about 3/4 of the total income in the economy. Capital income in the form of rents and other returns in the form of prots and interest. How are wages determined? Why do some workers earn more than others? These answers depends on the fundamentals of Supply and Demand. This chapter provides the basic theory of the analysis of factor markets. Factors of production are the inputs used to produce goods and services. The markets for the factors of production are similar to that of goods markets. The main dierence is that the demand for a factor of production is a derived demand. The rms demand for a resource is derived from its decision to supply a good in another market.

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18.1

Demand for Labor

Labor markets are governed by the laws of supply and demand. The demand for labor is derived from the supply (production) of the good the labor is utilized for. As production increases so does the demand for resources used to build the goods. The labor market will help us determine the equilibrium quantity and wage for labor. 18.1.1 The Competitive Prot-Maximizing Firm

Lets consider the decisions of the competitive rm. For this rm we will consider the rm competitive both in terms of nal goods and the resources used to produce those goods. The competitive rm is a price taker in the price of the nal good and the wages used for labor to build the good. Additionally, the rm is prot maximizing. All decisions are made with this goal in mind. 18.1.2 The Production Function and the Marginal Product of Labor

When hiring, a rm must consider how the size of its workforce aects the amount of output produced. Consider the following example. Labor Output MP Labor Value MP Labor Wage Marginal Prot 0 0 1 100 100 1000 500 500 2 180 80 800 500 300 3 240 60 600 500 100 4 280 40 400 500 -100 5 300 20 200 500 -300 The rst columns of this table describe the production function to describe the relationship between the quantity of the inputs used in production and the quantity of output from production. Third column described the marginal product of labor. The marginal product of labor measures the increase in additional output from an additional unit of labor. As stated way earlier in the course, factors of production exhibit diminishing marginal product. As you add units of a resources, additional unit increase output by a diminishing amount.

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18.1.3

The Value of the Marginal Product and the Demand for Labor

The prot maximizing rm is considered more about money than output. The rm will continue to add workers to production as long as those workers add to prot. This will occur as long as the value of the marginal product of labor exceeds the wage paid for labor. The value of marginal product is measured as the marginal product of labor multiplied by the price of the good. The prot maximizing rm hires workers up to the point where the value of the marginal product of labor equals the wage. Given we know that the equilibrium price will be found on the demand curve as MR=d for a competitive rm, and since wage = marginal cost of labor, we know demand for labor = mc of labor = wage = value of marginal product of labor. Thus, the value of marginal product curve is the labor demand curve for a competitive prot maximizing rm. 18.1.4 What causes the Labor-Demand Curve to Shift

The labor demand curve reects the value of the marginal product of labor, lets look at some things that might shift labor demand. 1. The Output Price: The value of marginal product is marginal product times the price of the output. Thus, when output price changes, the value of marginal product changes. 2. Technological Change: Technological innovations typically raise the marginal product of labor which in turn increases the demand for labor. This would be considered labor augmenting technology. It is also possible for an innovation to reduce labor demand. This labor-saving technological change when it replaces labor. 3. The Supply of Other Factors: There are linkages between factors of production. It is possible for shortages in certain resources to reduce the demand or increase the demand for others.

18.2

The Supply of Labor

We will now briey discuss the decisions that make-up the labor supply curve.

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18.2.1

The Trade-o between Work and Leisure

The fundamental trade-o for labor is between work and leisure. When a worker decides to spend an additional hour working they are giving up an hour of leisure and vice versa. The labor-supply curve reects how workers decisions about labor-leisure trade-o respond to a change in opportunity cost. An upward sloping curve implies than in increase in the wage induces workers to increase their supply of labor. 18.2.2 What Causes the Labor-Supply Curve to Shift

The labor supply curve shifts whenever people change the amount they want to work given a wage. Lets look at some things that can shift this curve. 1. Changes in Tastes: There has been a large increase in female labor force participation in the last 50 years, this increased taste for female labor increases the supply for labor. 2. Changes in Alternative Opportunities: The supply of labor in any market depends on the opportunities in other labor markets. If those opportunities improve that will decrease the supply of labor. 3. Immigration: An inow of workers will increase the supply of labor.

18.3

Equilibrium in the Labor Market

Thus far we have determined that in a competitive market. The wage will adjust to balance the supply and demand for labor and the wage will equal the value of the marginal product of labor. This occurs because of the derived nature of labor demand which is equal to the value of marginal product of labor and equilibrium must occur at supply equals demand. 18.3.1 Shifts in Labor Supply

Increases in labor supply lead to increases in labor and decreases in wages. Decreases in labor supply lead to decreases in labor and increases in wages. 18.3.2 Shifts in Labor Demand

Increases in labor demand lead to increases in labor and increases in wages. Decreases in labor demand lead to decreases in labor and decreases in wages. 67

18.4

The Other Factors of Production: Land and Capital

Labor is not the only factor of production used for production. Firms have to utilize other factors including capital and land. These factor behave in supply and demand markets similar to that of labor. These markets work as competitive markets as with labor, and many of the same features we discussed for labor apply to these markets. 18.4.1 Equilibrium in the Markets for Land and Capital

The equilibrium price of land and rental price of capital are determined in a very similar nature as the equilibrium wage in the labor market. The interpretation of demand for these other resources works the same, the demand for the resource is derived from the supply of production of output of nal goods. This derived demand is equal to the value of the marginal product of the resource and follows similar patterns to that seen in the labor market. All factors of production will each have there own equilibrium price and at the price each factor of production will earn its value of marginal product. 18.4.2 Linkages among Factors of Production

So for any factor of production the price of that factor is equal to value of the marginal product of that factor. In several ways the factors of production are linked together. It typically takes a mix of factors to produce goods and services. The availability of any one factor can inuence the marginal product of any of the other factors of production.

18.5

Conclusion

This chapter explain how the prices for resources: labor, land, and capital are determined. The amount of each resources depends on the supply and demand for each factor of production. And each factor earns a return equal to its value in production. We now turn our attention to wage dierentials across workers and the issue of wage discrimination.

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19

Chapter 19: Earnings and Discrimination

Why are you college? One of the main reasons is the belief that the increase in education should lead to a higher wage. Why is it with pretty high certainty we have condence in this belief? Wage dierentials are a topic of this chapter. When are these dierentials economically justied versus when do we see wage discrimination? That is another topic for this chapter.

19.1

Some Determinants of Equilibrium Wages

Workers dier from one another in many ways. Jobs also have diering characteristics. Lets see how these dierences aect labor supply, labor demand, and equilibrium wages. 19.1.1 Compensating Dierentials

When workers decide to take on a job the wage is only one of several factors which are used to make this decision. Some jobs have more fun in them, some are risky, late-night, or other things. These characteristic create wage dierences due to whether workers see the characteristic as a cost or a benet. If a cost the wage should increase, if a benet then the wage should be reduced. These types of things are called compensating dierentials. These are common in many jobs. 1. Miners receive a wage bonus for risk 2. Night shift workers have a bonus due to their undesirable lifestyle. 3. Professors make lower wages than the private sector as they get the benet of person satisfaction and other benets (summer vacation). 19.1.2 Human Capital

Human capital is the accumulation of investments in people, such as education and on the job training that enhances a workers ability to produce. Since there is a direct link between human capital and productivity there is also a direct link between a workers wage and productivity, as increase marginal productivity means higher demand and thus a higher wage. So once again, why are you all in college?

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19.1.3

Ability, Eort, Chance

Along the lines of human capital, ability can also generate a wage dierential, major league versus minor league player. Along those line eort and chance can also explain some of the wage dierences we see in the economy. These traits are hard to quantify so the size of their impact is unclear. 19.1.4 An Alternative View of Education: Signaling

Another view of education argues that education can serve as a form of advertising which signals commitment and other things to the labor market which can generate potential wage dierentials. If some just says they graduated from Harvard, that advertising can generate a wage dierentials as we know through signaling what they have been through to get their degree. 19.1.5 The Superstar Phenomenon

Do superstars generate a social benet that brings about a large wage? The evidence seems to say that they do, why else would a select number of athletes and movies stars earn so much more than average. The only reasonable explanation is some sort of social benet. 19.1.6 Above-Equilibrium Wages: Minimum Wage Laws, Unions, and Eciency Wages

They are other, beyond market forces which may push a wage above its equilibrium level. These things include minimum wages laws, unions, and eciency wages. We have already discussed the implications of the minimum wage laws which only have an impact if set above equilibrium levels. These laws do generate above equilibrium wages but generate a shortage of labor and excess unemployment. In addition unions can use the threat of strikes against rms to build market power in setting wages. Just as with goods markets, whenever market power is achieved the market price (wage) moves above marginal costs. Another feature we see is the use of eciency wages which are above equilibrium wages paid by rms to increase worker productivity and reduce job turnover. These things all generate the same types of eects as the minimum wage laws.

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19.2

The Economics of Discrimination

Another source of dierences in wages is discrimination. Discrimination is oering of dierent opportunities to similar individuals who dier only by race, ethnic group, sex, age, or other personal characteristic. The tough parts about looking at discrimination is getting around the emotions of the issue and separate legitimate wage dierentials from discrimination. 19.2.1 Measuring Labor-Market Discrimination

Look at general characteristics we see that minorities and women tend to general lower wages than do white male workers. The next question to ask is why? How much of these is compensating wage dierentials and how much of this is actual discrimination? Human capital is based mostly o of education? What about school quality? Genders tend to choose dierent types of jobs. There is no clear agreement on how much of the wage dierentials we see are discrimination, most economists agree there is some just not sure how big. 19.2.2 Discrimination by Employers

Now is there really an incentive for a rm to practice discrimination? Part of the goals of a prot maximizing rm involves keeping costs low. Now if I know I can get the same quality labor for a lower wage, why wouldnt the rm hire them? They would to get the cost below their rival rms. Over time the demand for these below cost workers should bid their price up to that of the other workers. So discrimination should not be a long run condition of an ecient market. 19.2.3 Discrimination by Customers and Governments

Prots can be a strong force to eliminate discriminatory wage dierentials, but they can only go so far. Customer preferences and government action can aect wages. Sometimes consumers actually prefer seeing workers of a typically demographic or other type. IF you east in an ethnic restaurant, most people want authentic food. Consumers would like to see the food prepared by a person of the same ethnic background as the food being served. Thus, to maximize prot this restaurant is going to want to hire the appropriate workers. Governments can also impose these type of labor market

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restrictions where if the rm wants to max prots and stay in business it will follow these practices.

19.3

Conclusion

In competitive markets, workers will earn a wage equal to the value of their marginal contribution to the production of goods and services. There are many things which can inuence this contribution. After considering any legitimate reasons for productive dierences, remaining wage dierentials are potential sources of discrimination.

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