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Present Value and the Time Value of Money
The time value of money is the principle that a certain amount of money today has a different buying power (value) than in the future.
learning objectives
• Calculate the present and future value of money
The time value of money is the principle that a certain amount of money today has a different buying power (value) than the same currency amount of money in the future. The value of money at a future point of time would take account of interest earned or inflation accrued over a given period of time. This notion exists both because there is an opportunity to earn interest on the money and because inflation will drive prices up, thus changing the “value” of the money.
For example, assume that an investor has $100 today and can invest this money at a 5% return for one year. A year from now the original investment will equal$105, $(100) \times (1.05)$. The return of $5 represents the time value of money over the one year interval. Money: Assuming a 5% interest rate,$100 invested today will be worth $105 in one year ($100 multiplied by 1.05). Conversely, $100 received one year from now is only worth$95.24 today ($100 divided by 1.05), assuming a 5% interest rate. Time value of money:$(1+r)^t x \; (\text{the value of the initial investment})=\text{future value}$; where $r$ is the annual interest rate and $t$ is the number of years. Alternatively, if an investment is valued at$125 and this value includes the 7% return generated over a one year time horizon, the original value of the investment or its present value is equal to $\frac{(125)}{(1.07)}$ or 117.
Present value: $\frac{(\text{the value of the investment at a future time})}{(1+r)^n}$; where $r$ is the annual interest rate and $n$ is the number of years the investment has occurred.
The time value of money is the central concept in finance theory. However, the explanation of the concept typically looks at the impact of interest and assumes, for simplicity, that inflation is neutral.
Measuring and Managing Risk
Risk is pervasive in the economy and is an essential component in the derivation of an asset’s investment return.
learning objectives
• Explain the relationship between time, money, and risk
Assets can have varying maturity dates and potential for default, the attribution of time to maturity and timely payments involve an assessment of risk. Risk is pervasive in the economy and is an essential component in the derivation of an asset’s investment return.
Time and Risk
Time is a component of risk for varying reasons; however, the two most common are related to the increase in general uncertainty rising with the time horizon and reinvestment risk.
In our everyday lives, we are faced with momentary uncertainties that become increasingly harder to predict as we move from a five minute horizon to a five day, five month, or even five year period. This same phenomenon is true of financial assets. Though the attribution of acceptable inflation can be incorporated into an investment return, the actual pricing and resulting purchasing power of the investment at maturity is unknown and the uncertainty increases with time. Therefore, investment returns compensate holders for the time to maturity via a risk premium.
Return expectations are based on risk analysis: In finance and economics, as depicted in the graph above of the capital asset pricing model, risk is evaluated to set the boundary for acceptable return.
Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment. For example, if asset A and asset B both pay a 5% coupon on an annual basis, but asset B matures in 5 years and asset A matures in 1 year, all else equal (asset quality and issuer solvency), we would expect asset A to trade at a higher price than asset B. Remembering that yield and price are inversely related, the higher price on A implies that it has a lower yield than B. The differential in yield can be attributed to a risk premium for time to maturity.
Another aspect of time horizon is reinvestment risk. For some investments, there is a potential for an issuer to call or redeem a security prior to maturity. Given that at the time that the investment is called prevailing rates may be lower than at the purchase of the asset, the holder is taking a reinvestment risk at the time of purchase. To compensate investors for taking on this type of risk, the issuer will provide a risk premium to incentivize the investor to purchase the investment.
The Value of Diversification
The compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.
learning objectives
• Explain the rationale for diversification
Each asset class has specific investment objectives; these are typically stated in a prospectus or investment description. However, all investments have some degree of risk in meeting the stated investment objectives or return.
The risks that are inherent to a specific investment can be compensated for by a market-assessed risk premium, whereby market participants adjust the price of an asset, impacting its overall return, based on the risk characteristics of the asset. However, the compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.
The Value of Diversification
Diversification strategies can be as simple as not “placing all your eggs in one basket.” It can also be as complex as a routine evaluation of investment correlation and risk, and dynamic rebalancing of investment holdings. However, whether a common sense or a highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return.
By holding varying investments, even if they are within the same company or sector, an investor still has the benefit of reducing risk inherent from the default of one asset. For example, stock and bonds provide different returns; while a stock may exhibit no growth for a period of time, the bond may continue to pay its coupon and provide a return. Through diversification, an investor’s entire portfolio can perform better than its worst-performing asset.
In general, most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class. In some cases where the return on investment needs to be met, managers may advocate for the use of hedging instruments to transfer risk of return objectives being met to another party in lieu of a consistent return.
Hedging strategies can be relatively complex but, in general, they serve the role of insuring that an investor is able to meet investment performance objectives. Typically, an investor pays a fee and enters into the hedging strategy, which transfer the risk inherent in an investment for a constant return. The party on the opposite side of the hedge absorbs both the upside and downside return potential of the asset, along with the fee for taking on the risk of uncertainty, and pays the first party a constant return as part of the agreement.
Systematic Risk
It’s important to note that diversification does not remove all of the risk from the portfolio. Diversification can reduce the risk of any single asset, but there will still be systematic risk (or undiversifiable risk). Systematic risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market. For example, government policy, international economic forces, or acts of nature can shock the entire market. Systematic risk will affect the portfolio, regardless of how diversified it is.
The Relationship Between Risk and Return and the Security Market Line
The security market line is useful to determine if an asset being considered for a portfolio offers a reasonable expected return for risk.
learning objectives
• Explain how the security market line relates risk and return
Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non- systematic risk. Systematic risk arises from market structure or dynamics, which produce shocks or uncertainty faced by all agents in the market. Non-systematic risk is unique to a specific company and can be reduced through diversification.
Capital Asset Pricing Model (CAPM)
In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset’s sensitivity to non-diversifiable or systematic risk. Non-diversifiable risk is noted by the variable beta (β), where beta is greater than one if the asset’s price sensitivity is greater than the market; equal to one when the asset’s sensitivity is equal to the market; and less than one if the asset exhibits less pricing volatility than the market.
The CAPM is a model for pricing an individual security or portfolio. The expected return of an asset is equal to the risk free rate plus the excess return of the market above the risk-free rate, adjusted for the asset’s overall sensitivity to market fluctuations or its beta. Mathematically, the capital asset pricing model can be written as: $E(R_i)=R_f+β(E(R_m)–R_f)$, where $R$ is the return, $E(R)$ is the expected return, $i$ denotes any asset, $f$ is the risk-free asset, and $m$ is the market.
Security Market Line (SML)
For individual securities, the security market line (SML) and its relation to expected return and systematic risk (beta) depicts an individual security in relation to their security risk class. The SML essentially graphs the results from the capital asset pricing model formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between β and required return is plotted on the SML, which shows expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, $E(R_m)−R_f$.
Security market line: The security market line depicts the the return on a security relative to its own risk.
The SML is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security’s expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued since the investor would be accepting a smaller return for the amount of risk assumed.
Key Points
• Time value of money: $(1+r)^t x \; (\text{the value of the initial investment})=\text{future value}$; where $r$ is the annual interest rate and $t$ is the number of years.
• The time value of money is the central concept in finance theory. However, the explanation of the concept typically looks at the impact of interest and assumes, for simplicity, that inflation is neutral.
• The time value of money is the principle that a certain amount of money today has a different buying power (value) than the same currency amount of money in the future.
• Investment returns compensate holders for the time to maturity via a risk premium.
• Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment.
• To compensate investors for taking on reinvestment risk, issuers will provide a risk premium to incentivize the investor to purchase the investment.
• Diversification strategies can be as simple as not “placing all your eggs in one basket” or be as complex as routine evaluation of investment correlation and risk and dynamic rebalancing of investment holdings.
• Whether a common sense or highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return. A diversified portfolio will earn a return that is always higher than its lowest performing asset.
• Most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class.
• Investors may enter into hedging strategies in order to ensure a constant return over market volatility. For a fee, a hedging strategy offers a constant return on an investment. The party on the other side of the hedge absorbs the volatility of the investment and pays out a consistent return.
• In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset taking into account an asset’s sensitivity to non-diversifiable risk.
• The security market line essentially graphs the results from the capital asset pricing model formula. The intercept of the SML is the nominal risk-free rate available for the market, while the slope is the market premium.
• If the security’s expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed.
Key Terms
• time value of money: The principle that a certain currency amount of money today has a different buying power (value) than the same currency amount of money in the future.
• present value: The value of an asset in today’s dollars after adjusting for an increase in the asset values as a result of interest earned during the period.
• risk premium: The minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset
• time horizon: A fixed point of time in the future where certain processes will be evaluated or assumed to end.
• prospectus: A document, distributed to prospective members, investors, buyers, or participants, which describes an institution (such as a university), a publication, or a business and what it has to offer.
• asset class: A group of economic resources sharing similar characteristics, such as riskiness and return.
• systematic risk: The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as its beta.
• non-systematic risk: Risk that is unique to a specific company; can be reduced through diversification.
• capital asset pricing model: Used to determine the required rate of return of an asset taking into account an asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk).
• security market line: A line representing the relationship between expected return and systematic risk; thus a graphical representation of the capital asset pricing model.
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• 3.1: Demand
In general, the law of demand states that the quantity demanded and the price of a good or service is inversely related, other things remaining constant.
• 3.2: Supply
The law of supply states that there is a positive relationship between the quantity that suppliers are willing to sell and the price level.
• 3.3: Market Equilibrium
When a market achieves perfect equilibrium there is no excess supply or demand, which theoretically results in a market clearing.
• 3.4: Government Intervention and Disequilibrium
Governments intervene in markets when they inefficiently allocate resources.
3: Introducing Supply and Demand
The Law of Demand
In general, the law of demand states that the quantity demanded and the price of a good or service is inversely related, other things remaining constant.
Learning objectives
Explain the concept of demand and discuss the factors that affect it
In economics, the law of demand states that the quantity demanded and the price of a good or service is inversely related, other things remaining constant. Therefore, the demand curve will generally be downward sloping, indicating the negative relationship between the price of a good or service and the quantity demanded.
Movement along the Demand Curve
If the income of the consumer, prices of the related goods, and preferences of the consumer remain unchanged, then the change in quantity of good demanded by the consumer will be negatively correlated to the change in the price of the good or service. The change in price will be reflected as a move along the demand curve.
Shift in the Demand Curve
The demand curve will shift, move either inward or outward as a result of non-price factors. A shift in demand can be related to the following factors (non-exhaustive list):
• Consumer preferences
• Consumer income
• Change in the price of related goods (i.e. compliments)
• Change in the number of buyers
• Consumer expectations
Law of Demand: A demand curve, shown in red and shifting to the right, demonstrating the inverse relationship between price and quantity demanded (the curve slopes downwards from left to right; higher prices reduce the quantity demanded).
Though in general terms and specific to normal goods, demand will exhibit a downward slope, there are exceptions: Giffen goods and Veblen goods
Giffen Goods
A Giffen good describes an extreme case for an inferior good. In theory, a Giffen good would display the characteristic that as price increases, demand for the product increases. In the real world application, there has not been a true example of a Giffen good, though a popular albeit historically inaccurate example is the purchase of potatoes (an inferior good) as prices continued to increase during the Irish potato famine.
Veblen Goods
Some expensive commodities like diamonds, expensive cars, designer clothing and other high-price limited items, are used as status symbols to display wealth. The more expensive these commodities become, the higher their value as a status symbol and the greater the demand for them. The amount demanded of these commodities increase with an increase in their price and decrease with a decrease in their price. These goods are known as a Veblen goods.
Demand Schedules and Demand Curves
A demand curve depicts the price and quantity combinations listed in a demand schedule.
Learning objectives
Describe the relationship between demand curves and demand schedules
The demand curve is a graphical representation depicting the relationship between a commodity’s different price levels and quantities which consumers are willing to buy. The curve can be derived from a demand schedule, which is essentially a table view of the price and quantity pairings that comprise the demand curve.
Demand Schedule and Curve: The demand curve is the graphical representation of the economic entity’s willingness to pay for a good or service. It is derived from a demand schedule, which is the table view of the price and quantity pairs that comprise the demand curve.
Given that in most cases, as the price of a good increases, agents will likely decrease consumption and substitute away to another good or service, the demand curve embodies a negative price to quantity relationship. The curve typically slopes downward from left to right; though there are some goods and services that exhibit an upward sloping demand, these goods and services are characterized as abnormal.
The demand curve of an individual agent can be combined with that of other economic agents to depict a market or aggregate demand curve. Using a demand schedule, the quantity demanded per each individual can be summed by price, resulting in an aggregate demand schedule that provides the total demanded specific to a given price level. The plotting of the aggregated quantity to price pairings is what is referred to as an aggregate demand curve. In this manner, the demand curve for all consumers together follows from the demand curve of every individual consumer.
The demand curve in combination with the supply curve provides the market clearing or equilibrium price and quantity relationship. This is found at the intersection or point at which the supply and demand curves cross each other.
Market Demand
Market demand is the summation of the individual quantities that consumers are willing to purchase at a given price.
Learning objectives
Examine the relationship between market demand and individual demand
The demand schedule represents the amount of some good that a buyer is willing and able to purchase at various prices. The relationship between price and quantity demanded reflected in this schedule assumes the following factors remain constant:
• Income levels;
• Population;Tastes and preferences;
• Price of substitute goods; and
• Price of complementary goods
The demand schedule is depicted graphically as the demand curve. The demand curve is shaped by the law of demand. In general, this means that the demand curve is downward-sloping, which means that as the price of a good decreases, consumers will buy more of that good.
Demand Curve: The demand curve is the graphical depiction of the demand schedule. For most goods and services, the demand curve exhibits a negative relationship between price and quantity and is as a result downward sloping.
A market demand schedule is a table that lists the quantity of a good all consumers in a market will buy at every different price. A market demand schedule for a product indicates that there is an inverse relationship between price and quantity demanded. The graphical representation of a market demand schedule is called the market demand curve.
Market Demand Schedule: A market demand schedule is a table that lists the quantity of a good all consumers in a market will buy at every different price.
The determinants of demand are:
• Income
• Tastes and preferences
• Prices of related (AKA complimentary) goods and services
• Prices of substitutes
• Number of potential consumers
The market demand is the summation of the individual quantities that consumers are willing to purchase at a given price.
As noted, both individual demand curves and market demand are typically expressed as downward shaping curves. However, special cases exist where the preference for the good or service may be perverse. Two different hypothetical types of goods with upward-sloping demand curves are Giffen goods (an inferior but staple good) and Veblen goods (goods characterized as being more desirable the higher the price; luxury or status items).
Ceteris Paribus
Ceteris paribus is defined as “all else being equal,” or “holding all else constant”.
Learning objectives
Explain the rationale for the assumption of ceteris paribus
Economics seeks to interpret, analyze and or evaluate situations that occur between individuals, firms and other entities. Due to the potential for multiple agents and other known and unknown external activities to be involved or present but not relevant to an analysis, economics employs the assumption of “all else constant,” which is the English translation of the Latin phrase “ceteris paribus”.
When the ceteris paribus assumption is employed in economics, all other variables – with the exception of the variables under evaluation – are held constant.
A Macroeconomic Example
What would happen to the demand for labor by firms if a minimum wage was imposed at a level above the prevailing wage rate, ceteris paribus? As depicted in below, the supply and demand curve are held constant, as are labor and leisure preferences for workers, and output considerations for firms, in addition to all other variables and characteristics embedded within the shape of the supply and demand curves. Thus, what is being evaluated is the impact of a constraint on market equilibrium.
Macroeconomics: Binding price floor: E is the equilibrium wage level when there is no binding minimum wage. When a minimum wage is imposed, ceteris paribus, suppliers of labor are willing to provide more labor than firms (demand for labor) are willing to purchase at the binding minimum wage rate. There is no shifting of either curve related to behavior influenced by the higher wage rate because ceteris paribus is holding labor-leisure trade-off (of workers) and substitution of labor (by firms) constant, along with other potential influencing variables.
A Microeconomic Example
What would happen for the demand for a normal good when income increases, ceteris paribus? In this case, as depicted in, a consumer’s preferences for the good and his demand for complements and substitutes are being held constant along with other attributes that could potentially impact his demand for a good, such as the good’s price. The supply of the good and the market and firm characteristics implicit in the shape of the supply curve are also held constant. This allows for an analysis of the increase in income, on the consumer’s demand for the single good alone.
Microeconomics: Income and Demand: A consumer is able to purchase a normal good and has a demand curve, D1, which provides the relationship between price and quantity given his preferences, income and other consumption attributes. Assuming an increase in his income, ceteris paribus, his demand curve would shift outward to D2, corresponding to a higher quantity for each purchase price. The consumer would then move his consumption for the good from Q1 to Q2, increasing his purchase of the good.
Changes in Demand and Shifts in the Demand Curve
Demand is the relationship between the willingness to purchase a quantity of a good or service at a specific price.
Learning objectives
Distinguish between shifts in the demand curve and movement along the demand curve
The demand curve is a graphical representation of an economic agent’s willingness to purchase a given quantity of a good or service at a specific price based on preferences, income, and other prevailing factors at a given point in time. Demand curves in combination with supply curves, which depict the price to quantity relationship of producers, are a representation of the goods and services market. Where the two curves intersect is market equilibrium, the price to quantity relationship where demand and supply are equal.
Movements in demand are specific to either movements along a given demand curve or shifts of the entire demand curve.
Movements along the demand curve are due to a change in the price of a good, holding constant other variables, such as the price of a substitute. If the price of a good or service changes the consumer will adjust the quantity demanded based on the preferences, income and prices of other factors embedded within a given curve for the time period under consideration.
Shifts in the demand curve are related to non-price events that include income, preferences and the price of substitutes and complements. An increase in income will cause an outward shift in demand (to the right) if the good or service assessed is a normal good or a good that is desirable and is therefore positively correlated with income. Alternatively, an increase in income could result in an inward shift of demand (to the left) if the good or service assessed is an inferior good or a good that is not desirable but is acceptable when the consumer is constrained by income.
Demand Curve: A demand curve provides an economic agent’s price to quantity relationship related to a specific good or service. Movements along a demand curve are related to a change in price, resulting in a change in quantity; shifts is demand (D1 to D2) are specific to changes in income, preferences, availability of substitutes and other factors.
A change in preferences could result in an increase (outward shift) or decrease (inward shift) in the quantity level desired for a specific price; while a change in the price of a substitute, could result in an outward shift if the price of the substitute increases and an inward shift if the substitute’s price decreases. The demand curve for a good will shift in parallel with a shift in the demand for a complement.
Key Points
• The demand curve is downward sloping, indicating the negative relationship between the price of a product and the quantity demanded.
• For normal goods, a change in price will be reflected as a move along the demand curve while a non-price change will result in a shift of the demand curve.
• Two exceptions to the law of demand are Giffen goods and Veblen goods.
• Demand curves are a graphical representation of a demand schedule, which is the table view of an economic agents’ price to quantity relationship.
• Demand curves embody preferences, substitution potential and income, as well as other characteristics that influence an economic agent’s ability to assess willingness to pay at a specific point in time for goods and services.
• Demand curves may be linear or curved.
• Aggregate demand is the sum of the quantity demanded for a specific price over a group of economic agents.
• The graphical representation of a market demand schedule is called the market demand curve.
• Following the law of demand, the demand curve is almost always represented as downward-sloping. This means that as price decreases, consumers will buy more of the good.
• Two different hypothetical types of goods with upward-sloping demand curves are Giffen goods and Veblen goods.
• When ceteris paribus is employed in economics, all other variables with the exception of the variables under evaluation are held constant.
• An example of the use of ceteris paribus in macroeconomics is: what would happen to the demand for labor by firms if a minimum wage was imposed at a level above the prevailing wage rate, ceteris paribus.
• An example of the use of ceteris paribus in microeconomics is: what would happen for the demand for a normal good when income increases, ceteris paribus.
• A change in price will result in a movement along a demand curve.
• A change in a non-price variable will result in a shift in the demand curve.
• An outward shift in demand will occur if income increases, in the case of a normal good; however, for an inferior good, the demand curve will shift inward noting that the consumer only purchases the good as a result of an income constraint on the purchase of a preferred good.
Key Terms
• Giffen good: A good which people consume more of as only the price rises; Having a positive price elasticity of demand.
• Veblen good: A good for which people’s preference for buying them increases as a direct function of their price, as greater price confers greater status.
• normal good: A good for which demand increases when income increases and falls when income decreases but price remains constant.
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• Market demand: The summation of the individual quantities that consumers are willing to purchase at a given price.
• ceteris paribus: all else equal; holding everything else constant
• normal good: A good for which demand increases when income increases and falls when income decreases but price remains constant.
• inferior good: a good that decreases in demand when consumer income rises; having a negative income elasticity of demand.
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The Law of Supply
The law of supply states that there is a positive relationship between the quantity that suppliers are willing to sell and the price level.
Learning objectives
Explain the Law of Supply
The law of supply is a fundamental principle of economic theory. It states that an increase in price will result in an increase in the quantity supplied, all else held constant.
An upward sloping supply curve, which is also the standard depiction of the supply curve, is the graphical representation of the law of supply. As the price of a good or service increases, the quantity that suppliers are willing to produce increases and this relationship is captured as a movement along the supply curve to a higher price and quantity combination.
The Law of Supply: Supply has a positive correlation with price. As the market price of a good increases, suppliers of the good will typically seek to increase the quantity supplied to the market.
The rationale for the positive correlation between price and quantity supplied is based on the potential increase in profitability that occurs with an increase in price.
All else held constant, including the costs of production inputs, the supplier will be able to increase his return per unit of a good or service as the price for the item increases. Therefore, the net return to the supplier increases as the spread or difference between the price and the cost of the good or service being sold increases.
The law of supply in conjunction with the law of demand forms the basis for market conditions resulting in a price and quantity relationship at which both the price to quantity relationship of suppliers and demanders (consumers) are equal. This is also referred to as the equilibrium price and quantity and is depicted graphically at the point at which the demand and supply curve intersect or cross one another. It is the point where there is no surplus or shortage in the market.
Law of Supply and Law of Demand: Equilibrium: The law of supply and the law of demand form the foundation for the establishment of an equilibrium–where the price to quantity combination for both suppliers and demanders are the same.
Supply Schedules and Supply Curves
A supply schedule is a tabular depiction of the relationship between price and quantity supplied, represented graphically as a supply curve.
Learning objectives
Explain the price to quantity relationship exhibited in the supply curve
Supply is the amount of some product that producers are willing and able to sell at a given price, all other factors being held constant. In general, supply depicts a positive relationship between the price of a good or service and the quantity that the producer is willing to supply: if a supplier believes it can sell the product for more, it will want to make more of the product. As a result, as the price of a good or service increases, suppliers increase the quantity available for purchase.
A supply schedule is a table that shows the relationship between the price of a good and the quantity supplied. The supply curve is a graphical depiction of the supply schedule that illustrates that relationship between the price of a good and the quantity supplied.
The Supply Schedule and Supply Curve: The supply curve is a graphical depiction of the price to quantity pairings presented in a supply schedule. The supply schedule is a table view of the relationship between the price suppliers are willing to sell a specific quantity of a good or service.
The supply curves of individual suppliers can be summed to determine aggregate supply. One can use the supply schedule to do this: for a given price, find the corresponding quantity supplied for each individual supply schedule and then sum these quantities to provide a group or aggregate supply. Plotting the summation of individual quantities per each price will produce an aggregate supply curve.
In theory, in the long run the aggregate supply curve will not be upward sloping but will instead be vertical, consistent with a fixed supply level. This is due to the underlying assumption that in the long run, supply of a good only depends on the fixed level of capital, technology, and natural resources available.
The supply curve provides one side of the price-to-quantity relationship that ensures a functional market. The other component is demand. When the supply and demand curves are graphed together they will intersect at a point that represents the market equilibrium – the point where supply equals demand and the market clears.
Market Supply
Market supply is the summation of the individual supply curves within a specific market where the market is characterized as being perfectly competitive.
Learning objectives
Identify the market conditions that yield a market supply curve.
A supply curve is the graphical representation of the supplier’s positive correlation between the price and quantity of a good or service. As a result, the supply curve is upward sloping. Market supply is the summation of the individual supply curves within a specific market.
Market Supply: The market supply curve is an upward sloping curve depicting the positive relationship between price and quantity supplied.
The market supply curve is derived by summing the quantity suppliers are willing to produce when the product can be sold for a given price. As a result, it depicts the price to quantity combinations available to consumers of the good or service. In combination with market demand, the market supply curve is requisite for determining the market equilibrium price and quantity.
By its very nature, conceptualizing a supply curve requires the firm to be a perfect competitor, namely requires the firm to have no influence over the market price. This is true because each point on the supply curve is the answer to the question “If this firm is faced with this potential price, how much output will it be able to and willing to sell? ” If a firm has market power, its decision of how much output to provide to the market influences the market price, then the firm is not “faced with” any price, and the question is meaningless.
The attributes of a competitive market signal that the price is set external to any firm. Therefore, production in the market is a sliding scale dependent on price. As price increases, quantity increases due to low barriers to entry, and as the price falls, quantity decreases as some firms may even opt out of the market.
The supply curve can be derived by compiling the price-to-quantity relationship of a seller. A seller could set the price of a good or service equal to zero and then incrementally increase the price; at each price he could calculate the hypothetical quantity he would be willing to supply. Following this process the seller would be able to trace out its complete individual supply function. The market supply curve is simply the sum of every seller’s individual supply curve.
Determinants of Supply
Supply levels are determined by price, which increases or decreases supply along the price curve, and non-price factors, which shifts the entire curve.
Learning objectives
Identify the factors that affect the supply of a good
Supply is the quantity of a good or service that a supplier provides to the market. Innumerable factors and circumstances could affect a seller’s willingness or ability to produce and sell a good. Some of the more common factors are:
• Good’s own price: An increase in price will induce an increase in the quantity supplied.
• Prices of related goods: For purposes of supply analysis, related goods refer to goods from which inputs are derived to be used in the production of the primary good.
• Conditions of production: The most significant factor here is the state of technology. If there is a technological advancement related to the production of the good, the supply increases.
• Expectations: Sellers’ expectations concerning future market conditions can directly affect supply.
• Price of inputs: If the price of inputs increases the supply curve will shift left as sellers are less willing or able to sell goods at any given price. Inputs include land, labor, energy and raw materials.
• Number of suppliers: As more firms enter the industry the market supply curve will shift out driving down prices. The market supply curve is the horizontal summation of the individual supply curves.
• Government policies and regulations: Government intervention can take many forms including environmental and health regulations, hour and wage laws, taxes, electrical and natural gas rates and zoning and land use regulations. These regulations can affect a good’s supply.
Suppliers will change their production levels along the supply curve in response to a price change, so that their production level is equal to demand. However, some factors unrelated to price can shift the production level. For example, a technological improvement that reduces the input cost of a product will shift the supply curve outward, allowing suppliers to provide a greater supply at the same price level.
Determinants of Supply: If the price of a good changes, there will be movement along the supply curve. However, the supply curve itself may shift outward or inward in response to non-price related factors that affect the supply of a good, such as technological advances or increased cost of materials.
Changes in Supply and Shifts in the Supply Curve
The supply curve depicts the supplier’s positive relationship between price and quantity.
Learning objectives
Distinguish between shifts in the supply curve and movement along the supply curve
Price changes and movement along supply curve
If the price of the good or service changes, all else held constant such as price of substitutes, the supplier will adjust the quantity supplied to the level that is consistent with its willingness to accept the prevailing price. The change in price will result in a movement along the supply curve, called a change in quantity supplied, but not a shift in the supply curve. Changes in supply are due to non-price changes.
Non-price changes and shifts of the supply curve
If production costs increase, the supplier will face increasing costs for each quantity level. Holding all else the same, the supply curve would shift inward (to the left), reflecting the increased cost of production. The supplier will supply less at each quantity level.
If production costs declined, the opposite would be true. Lower costs would result in an increase in output, shifting the supply curve outward (to the right) and the supplier will be willing sell a larger quantity at each price level. The supply curve will shift in relation to technological improvements and expectations of market behavior in very much the same way described for production costs.
Technological improvements that result in an increase in production for a set amount of inputs would result in an outward shift in supply.
Supply will shift outward in response to indications of heightened consumer enthusiasm or preference and will respond by shifting inward if there is an assessment of a negative impact to production costs or demand.
Supply Shifts: A shift in supply from S1 to S2 affects the equilibrium point, and could be caused by shocks such as changes in consumer preferences or technological improvements.
Key Points
• Quantity supplied moves in the same direction as price.
• The supply curve is an upward sloping curve.
• Producers are willing to increase production at higher prices to increase profit.
• The supply curve plots the quantity that is willingly supplied at any given price.
• The individual supply curves can be summed by quantity provided at a specific price to achieve an aggregate supply curve.
• The supply curve is upward sloping in the short run.
• A supply curve is the graphical representation of the supplier’s positive correlation between the price and quantity of a good or service.
• The supply curve can only be attributed to a depiction of a perfectly competitive market due to the unique attributes of perfect competition: firms are price takers, no single firm’s actions can influence the market price, and ease of exit and entry.
• The market supply curve is derived by summing the quantity for a given price across all market participants (suppliers). It depicts the price-to-quantity combinations available to consumers of the good or service.
• Supply is the quantity of a good or service that a supplier provides to the market.
• Suppliers will shift production for non- price changes related to the determinants of supply and will slide production levels across the supply curve for price related movements.
• Innumerable factors and circumstances could affect a seller’s willingness or ability to produce and sell a good.
• A change in the price of a good or service, holding all else constant, will result in a movement along the supply curve.
• A change in the cost of an input will impact the cost of producing a good and will result in a shift in supply; supply will shift outward if costs decrease and will shift inward if they increase.
• A change in the expected demand for a good or service will result in a shift in supply; supply will shift outward if enthusiasm is expected to increase and will shift inward if there is an expectation for consumers preferences to change in favor of an alternate good or service.
Key Terms
• surplus: That which remains when use or need is satisfied, or when a limit is reached; excess; overplus.
• shortage: a lack or deficiency
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• aggregate: A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• Supply curve: A graphical representation of the quantity producers are willing to make when the product can be sold at a given price.
• intervention: The action of interfering in some course of events.
• incentive: Something that motivates, rouses, or encourages.
• Non-price changes: Shocks, either exogenous or endogenous, that affect the positioning of the supply curve.
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Clearing the Market at Equilibrium Price and Quantity
When a market achieves perfect equilibrium there is no excess supply or demand, which theoretically results in a market clearing.
Learning objectives
Define market equilibrium
The interdependent relationship between supply and demand in the field of economics is inherently designed to identify the ideal price and quantity of a given product or service in a marketplace. This equilibrium point is represented by the intersection of a downward sloping demand line and an upward sloping supply line, with price as the y-axis and quantity as the x-axis. At perfect equilibrium there is no excess demand (represented by ‘A’ in the figure) or excess supply (represented by ‘B’ in the figure), which theoretically results in a market clearing.
Equilibrium Pricing: This chart effectively highlights the various basic implications of a simple supply and demand chart. The equilibrium point is where market clearing will theoretically occur.
Market Clearing Assumptions
A market clearing, by definition, is the economic assumption that the quantity supplied will consistently align with the quantity demanded. This definition requires a variety of assumptions which simplify the complexities of real markets to coincide with a more theoretical framework, most centrally the assumptions of perfect competition and Say’s Law:
• Perfect competition is a market where the price determined for a given good or service is not affected by external forces or competition in a way that allows incumbents (companies) to attain market influence.
• Say’s Law hinges on the concept that capital loses value over time, or that money is essentially perishable. The simplest way to view this law is interest rates. When you invest or owe money, that capital accrues interest due to the fact that there is an opportunity cost in not investing that money elsewhere. This opportunity cost creates the assumption that money will not go unused.
Combining these two assumptions, in a perfectly competitive market the amount of a product or service that is supplied at a given price will equate to the amount demanded, clearing the market of all goods/services at a given equilibrium point.
Theory and Practice
While this concept of market clearing resonates well in theory, the actual execution of markets is very rarely perfect. Markets demonstrate consistent shifts of supply and shifts of demand based on a wide spectrum of externalities. Even in static markets there is competitive consolidation that allows companies to charge differing price points than that of the equilibrium. The concept of monopolies provides a good example for this experience, as monopolies (see example) can control price and quantity simultaneously.
Another classic criticism of market clearing is the way in which the labor market functions. In the 1930’s, during the worst depression recorded in the United States, the labor market did not clear the way economic theories of market clearing would assume it would. Instead, there seemed to be what John Maynard-Keynes (father of Keynesian Economics) called ‘stickiness,’ which preventing the market from normalizing. The importance of raising these concerns is the understanding that while the concept of market clearing, equilibrium and supply/demand charts are highly useful in understanding the basic functioning of markets, reality does not always conform with these models.
Impacts of Surpluses and Shortages on Market Equilibrium
The existence of surpluses or shortages in supply will result in disequilibrium, or a lack of balance between supply and demand levels.
Learning objectives
Infer the outcomes of departures from equilibrium using the model of supply and demand
In the analysis of market equilibrium, specifically for pricing and volume determinations, a thorough understanding of the supply and demand inputs is critical to economics. Surpluses and shortages on the supply end can have substantial impacts on both the pricing of a specific product or service, alongside the overall quantity sold over time. Shifts such as these in the supply availability results in disequilibrium, or essentially a lack of balance between current supply and demand levels. Surpluses and shortages often result in market inefficiencies due to a shifting market equilibrium.
Surpluses
Surpluses, or excess supply, indicate that the quantity of a good or service exceeds the demand for that particular good at the price in which the producers would wish to sell (equilibrium level). This inefficiency is heavily correlated in circumstances where the price of a good is set too high, resulting in a diminished demand while the quantity available gains excess. There are substantial business risks inherently built into the concept of surpluses, as the general outcome will be either selling off inventory at sub-par prices or leftover unsold inventory. In both scenarios businesses will be forced to minimize margins or incorporate losses on that particular good. Governmental intervention can often create surplus as well, particularly through the utilization of a price floor if it is set at a price above the market equilibrium.
Price Floor: A price floor ensures a minimum price is charged for a specific good, often higher than that what the previous market equilibrium determined. This can result in a surplus.
In a perfectly competitive market, particularly pertaining to goods that are not perishable, excess supply is equivalent to the quantity available in the market beyond the equilibrium point of intersection between supply and demand. In this theoretical scenario the equilibrium point will transition towards a lower price point due to the increased supply, which will in turn motivate consumers to purchase a higher quantity as a result. This allows the economic model of the market to correct itself.
Shortages
Inversely, shortage is a term used to indicate that the supply produced is below that of the quantity being demanded by the consumers. This disparity implies that the current market equilibrium at a given price is unfit for the current supply and demand relationship, noting that the price is set too low. It could also indicate that the desired good has a low level of affordability by the general public, and can be a dangerous societal risk for necessary commodities. Indeed, Garrett Hardin emphasized that a shortage of supply could also be perceived as a ‘longage’ of demand, as the two are inversely related. From this vantage point shortages can be attributed to population growth as much as resource scarcity.
In a perfectly competitive market, a shortage in supply will ultimately result in a shift in the equilibrium point, transitioning towards a higher price point due to the limited supply availability. This will prioritize who receives the good or service based upon their willingness and ability to pay a premium for the specific item in demand, leveraging those along the demand curve who are at higher levels with higher ability and willingness to pay.
Changes in Demand and Supply and Impacts on Equilibrium
Alterations to overall supply or demand dictate the cross-section or equilibrium, ascertaining price and volume for a product or service.
Learning objectives
Illustrate how changes in supply or demand impact the market equilibrium
The interdependent relationship between the supply of a given product or service and the overall demand exercised by interested parties generates a theoretical equilibrium point, dictating the average market price and purchased volume relative to that price. In a static market it would be reasonable to assume that prices and volumes would remain fairly predictable and consistent relative to the population, but realistic markets are not static. Instead, markets are in constant flux as demands and supplies are subjected to varying driving forces and influences. These shifts play a critical role in altering market equilibrium price points and volumes for products and services, requiring constant vigilance and adaptation by providers and consumers. To better understand market variations, it is useful to examine how changes in supply and demand may occur, as well as the impacts and implications of these changes.
Demand Shifts
Demand shifts are defined by more or less of a given product or service being required at a fixed price, resulting in a shift of both price and quantity. As would be assumed, an increase in demand will shift price upwards and volume to the right, increasing the overall value of both metrics relative to the prior equilibrium point. Alternately, a decrease in demand will shift price downwards and volume to the left, decreasing both measurements to realign equilibrium with a reduced demand.
Demand Shifts: In this graph, the demand curve (red) has been affected by an increase in demand. This consequently increases price at a given volume.
Demand shifts can be caused by a wide variety of factors, but largely revolve around drivers of consumer behavior and circumstances. Demand shifts can therefore often be affected by economic factors such as average spending power per person in a given economy or overall average income. Demand can also be affected by cultural changes, demographic shifts, availability of substitutes, environmental factors and concerns (e.g. climate change), politics, and advances in science (e.g. declining demand for unhealthy foods). Demand is particularly malleable in respect to goods that are not necessities, thus are desired or not based upon sociological norms.
Supply Shifts
Supply shifts are defined by more or less of a particular product/service being available to fulfill a given demand, affecting the equilibrium point by shifting the supply curve upwards or downwards. A supply shift to the right, indicating more availability of the specified product or service, will create a lower price point and a higher volume assuming a fixed demand. Alternately, a decrease in supply with a consistent given demand will see an increase in price and a decrease in quantity. This is an intuitive theory underlining the fact that scarcity is relevant to the willingness to pay.
Supply Shifts: In this supply and demand chart we see an increase in the supply provided, shifting quantity to the right and price down. More of a given product, assuming the same demand, will result in lower price points at the equilibrium.
Supply shifts, similar to demand shifts, can ultimately be a result of a wide variety of external factors. As discussed above, scarcity plays a critical role in pricing and thus controlling supply is often even considered a strategic play by companies in specific industries (most notably industries like precious stones, rare earth metals, etc.). Supply shifts can also be a result of technological advances, over-utilization or consumption, globalization, supply-chain efficiency, and economics. For example, the discovery of a new gold deposit, acts as a shock to the supply of gold, shifting the curve right.
Equilibrium
In combining these two potential shifts, equilibrium is constantly subjected to both factors resulting in supply shifts and factors resulting in demand shifts. Due to the demand curve sloping downward and the supply curve sloping upwards, they inadvertently will cross at some given point on any supply/demand chart. This cross-section, or equilibrium, serves as a price and quantity tracking point based upon the consistent inputs of overall demand and supply availability. Any change in either factor will result in immediate impact on equilibrium, balancing the new demand or supply with a corresponding volume and appropriate average price point.
Key Points
• The interdependent relationship between supply and demand in the field of economics is inherently designed to identify the ideal price and quantity of a given product or service in a marketplace.
• A market clearing, by definition, is the economic assumption that the quantity supplied will consistently align with the quantity demanded.
• Market clearing requires a variety of assumptions which simplify the complexities of real markets to coincide with a more theoretical framework, most centrally the assumptions of perfect competition and Say’s Law.
• While this concept of market clearing resonates well in theory, the actual execution of markets is very rarely perfect. The concepts of consolidated markets and ‘sticky’ markets reduces the accuracy of these models.
• Surpluses, or excess supply, essentially indicates that the quantity of a good or service exceeds the demand for that particular good at the price in which the producers would wish to sell ( equilibrium level).
• In a perfectly competitive market, excess supply is equivalent to the quantity available in the market beyond the equilibrium point of intersection between supply and demand. This will result in a shift in market equilibrium towards lower price points.
• Shortage is a term used to indicate that the supply produced is below that of the quantity being demanded by the consumers. This disparity implies that the current market equilibrium at a given price is unfit for the current supply and demand relationship.
• In a perfectly competitive market, a shortage in supply will ultimately result in a shift in the equilibrium point, transitioning towards a higher price point due to the limited supply availability.
• The interdependent relationship between the supply of a given product or service and the overall demand exercised by interested parties generates a theoretical equilibrium point, dictating the average market price and purchase volume relative to that price.
• Markets are in constant flux as demands and supplies are subjected to varying driving forces and influences. These shifts play a critical role, altering market equilibrium price points and volumes for products and services.
• Demand shifts can be caused by a wide variety of factors, but largely revolve around drivers of consumer behavior and circumstances.
• Supply shifts, similar to demand shifts, can ultimately be a result of a wide variety of externalities. Scarcity, or the lack of availability for a particular material, is a core driving force for overall supply.
• Due to a demand curve ‘s sloping downward and a supply curve ‘s sloping upwards, the curves will eventually cross at some point on any supply/demand chart. This point of equilibrium serves as a price and quantity tracking point.
Key Terms
• Say’s Law: The idea that money is perishable.
• Incumbents: A holder of a position as supplier to a market or market segment that allows the holder to earn above-normal profits.
• Opportunity cost: The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.
• Disequilibrium: The loss of equilibrium or stability, especially due to an imbalance of forces.
• surplus: That which remains when use or need is satisfied, or when a limit is reached.
• shortage: Not enough or not sufficient for a given demand.
• scarcity: An insufficiency or lack of availability; a shortage.
• equilibrium: A condition in which competing forces are in balance.
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Why Governments Intervene In Markets
Governments intervene in markets when they inefficiently allocate resources.
Learning objectives
Identify reasons why the government might choose to intervene in markets
Governments intervene in markets to address inefficiency. In an optimally efficient market, resources are perfectly allocated to those that need them in the amounts they need. In inefficient markets that is not the case; some may have too much of a resource while others do not have enough. Inefficiency can take many different forms. The government tries to combat these inequities through regulation, taxation, and subsidies. Most governments have any combination of four different objectives when they intervene in the market.
Maximizing Social Welfare
In an unregulated inefficient market, cartels and other types of organizations can wield monopolistic power, raising entry costs and limiting the development of infrastructure. Without regulation, businesses can produce negative externalities without consequence. This all leads to diminished resources, stifled innovation, and minimized trade and its corresponding benefits. Government intervention through regulation can directly address these issues.
Another example of intervention to promote social welfare involves public goods. Certain depletable goods, like public parks, aren’t owned by an individual. This means that no price is assigned to the use of that good and everyone can use it. As a result, it is very easy for these assets to be depleted. Governments intervene to ensure those resources are not depleted.
Macro-Economic Factors
Governments also intervene to minimize the damage caused by naturally occurring economic events. Recessions and inflation are part of the natural business cycle but can have a devastating effect on citizens. In these cases, governments intervene through subsidies and manipulation of the money supply to minimize the harsh impact of economic forces on its constituents.
Socio-Economic Factors
Governments may also intervene in markets to promote general economic fairness. Government often try, through taxation and welfare programs, to reallocate financial resources from the wealthy to those that are most in need. Other examples of market intervention for socio-economic reasons include employment laws to protect certain segments of the population and the regulation of the manufacture of certain products to ensure the health and well-being of consumers.
Former President Bill Clinton signing welfare reform: Former President signing a welfare reform bill. Welfare programs are one way governments intervene in markets.
Other Objectives
Governments can sometimes intervene in markets to promote other goals, such as national unity and advancement. Most people agree that governments should provide a military for the protection of its citizens, and this can be seen as a type of intervention. Growing a large and impressive military not only increases a country’s security, but may also be a source of pride. Intervening in a way that promotes national unity and pride can be an extremely valuable goal for government officials.
Price Ceilings
A price ceiling is a price control that limits how high a price can be charged for a good or service.
Learning objectives
Define price ceilings
A price ceiling is a price control that limits the maximum price that can be charged for a product or service. Generally ceilings are set by governments, although groups that manage exchanges can set ceilings as well. The purpose of a price ceiling is to protect consumers of a certain good or service. By establishing a minimum price, a government wants to ensure the good is affordable for as many consumers as possible.
US Poster for Price Ceilings: Governments often impose price ceilings in times of war to ensure goods are available to as many people as possible.
An example of a price ceiling is rent control. These regulations require a more gradual increase in rent prices than what the market may demand. This regulation is meant to protect current tenants. Without rent control, there could be situations where the demand for housing in an area could cause rent prices to make a substantial jump. Unable to afford the new, significantly higher rent, a majority of the neighborhood’s tenants may be forced to move out of the neighborhood. Rent controls limit the possibility of tenant displacement by minimizing the amount by which rent can be increased.
By definition, however, price ceilings disrupt the market. By setting a maximum price, any market in which the equilibrium price is above the price ceiling is inefficient. There will be excess demand because the price cannot increase enough to clear the excess.
For a price ceiling to be effective, it must be less than the free-market equilibrium price. This is the price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. It is also the price that the market will naturally set for a given good or service. If the price ceiling is higher than what the market would already charge, the regulation would not be effective. As a result, a government will do significant research into the current market conditions for a good before setting a price ceiling.
Price Ceiling Impact on Market Outcome
A binding price ceiling will create a surplus of supply and will lead to a decrease in economic surplus.
Learning objectives
Explain how price controls lead to economic inefficiency
A price ceiling will only impact the market if the ceiling is set below the free-market equilibrium price. This is because a price ceiling above the equilibrium price will lead to the product being sold at the equilibrium price.If the ceiling is less than the economic price, the immediate result will be a supply shortage. As you can see from the chart below, a lower base price means less of a good will be produced. The quantity demanded will increase because more people will be willing to pay the lower price to get the good while producers will be willing to supply less, leading to a shortage.
Price Ceiling Chart: If a price ceiling is set below the free-market equilibrium price (as shown where the supply and demand curves intersect), the result will be a shortage of the good in the market. The dead weight loss, represented in yellow, is the minimum dead weight loss in such a scenario. If individuals who value the good most are not capable of purchasing it, there is a potential for a higher amount of dead weight loss.
A price ceiling will also lead to a more inefficient market and a decreased total economic surplus. Economic surplus, or total welfare, is the sum of consumer and producer surplus. Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest that they are willing pay. Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least they would be willing to sell for. An effective price ceiling will lower the price of a good, which means that the the producer surplus will decrease. While the effective price ceiling will also decrease the price for consumers, any benefit gained from that will be minimized by decreased sales caused by decreased available supply for sale from producers due to the decrease in price. This translates into a net decrease total economic surplus, otherwise known as deadweight loss. This loss is signified in the attached chart as the yellow triangle.
Rationing
If a ceiling is to be imposed for a long period of time, a government may need to ration the good to ensure availability for the greatest number of consumers. One way the government may ration the good is to issue ticket to consumers. A government will only allow as much of good to be out in the marketplace as there are available tickets. To obtain the good, the consumer must present the ticket and the money to the vendor when making the purchase. This is generally considered a fair way to minimize the impact of a shortage caused by a ceiling, but is generally reserved for times of war or severe economic distress.
Black Market
Prolonged shortages caused by price ceilings can create black markets for that good. A black market is an underground network of producers that will sell consumers as much of a controlled good as they want, but at a price higher than the price ceiling. Black markets are generally illegal. However these markets provide higher profits for producers and more of a good for a consumers, so many are willing to take the risk of fines or imprisonment.
Price Floors
A binding price floor is a price control that limits how low a price can be charged for a product or service.
Learning objectives
Define price floors
A price floor is a price control that limits how low a price can be charged for a product or service. Generally floors are set by governments, although groups that manage exchanges can set price floors as well. The purpose of a price floor is to protect producers of a certain good or service. By establishing a minimum price, a government seeks to promote the production of the good or service and ensure that the producers have sufficient resources to go about their work.
For a price floor to be effective, it must be greater than the free-market equilibrium price. This is the price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. It is also the price that the market will naturally set for a given good or service. If the price floor is lower than what the market would already charge, the regulation would serve no purpose. Since the price is set artificially high, there will be a surplus: there will be a higher quantity supplied and a lower quantity demanded than in a free market. As a result, a government will generally do significant research into the current market conditions for a good or service before setting a price floor.
Price Floor: If a price floor is set above the equilibrium price, consumers will demand less and producers will supply more.
An example of a price floor is the federal minimum wage. In this case the suppliers are employees and employers are the consumers. The federal government has established a price that all employers must pay their workers. Obviously employers can pay more than that amount, but they cannot pay less. The purpose of setting this floor is to ensure that all employees make enough money from their jobs to provide for their basic needs.
History of the Federal Minimum Wage: History of the federal minimum wage in real and nominal dollars. The federal minimum wage is one example of a price floor.
Price Floor Impact on Market Outcome
Binding price floors typically cause excess supply and decreased total economic surplus.
Learning objectives
Show how price floors contribute to market inefficiency
A price floor will only impact the market if it is greater than the free-market equilibrium price. If the floor is greater than the economic price, the immediate result will be a supply surplus. As you can see from, a higher base price will lead to a higher quantity supplied. However, quantity demand will decrease because fewer people will be willing to pay the higher price. This will lead to a surplus of supply.
Surplus from a price floor: If a price floor is set above the free-market equilibrium price (as shown where the supply and demand curves intersect), the result will be a surplus of the good in the market.
A price floor will also lead to a more inefficient market and a decreased total economic surplus. Economic surplus, or total welfare, is the sum of consumer and producer surplus. Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest that they are willing pay. Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least they would be willing to sell for. An effective price floor will raise the price of a good, which means that the the consumer surplus will decrease. While the effective price floor will also increase the price for producers, any benefit gained from that will be minimized by decreased sales caused by decreased demand from consumers due to the increase in price. This translates into a net decrease total economic surplus, otherwise known as deadweight loss.
Since well designed price floors create surpluses, the big issue is what to do with the excess supply. The first option is to let inventories grow and have the private producers bear the cost of storing it. The other option is for the government that set the price floor to purchase the excess supply and store it on its own. The government could then sell the surplus off at a loss in times of a food shortage.
Introduction to Deadweight Loss
Deadweight loss is the decrease in economic efficiency that occurs when a good or service is not priced at its pareto optimal level.
Learning objectives
Define deadweight loss
Deadweight loss is the decrease in economic efficiency that occurs when a good or service is not priced and produced at its pareto optimal level. When output is at its pareto optimal point, the price, production, and consumption of a good cannot be altered for one person’s benefit without making at least one other worse off. In a perfectly competitive market, products are priced at the pareto optimal point.
When deadweight loss occurs, it comes at the expense of either the consumer economic surplus or the producer’s economic surplus. Consumer surplus is the gain that consumers receive when they are able to purchase a product for less than the price they are willing to pay; producer surplus is the benefit producers receive when the sell a product for more than they are willing to sell for. While price controls, subsidies and other forms of market intervention might increase consumer or producer surplus, economic theory states that any gain would be outweighed by the losses sustained by the other side. This net harm is what causes deadweight loss.
Deadweight loss can be visually represented on supply and demand graphs. Known as Harberger’s triangle, the deadweight loss equals the area within the following three points:
Deadweight loss: This chart illustrates the deadweight loss created when a price floor is instituted on the market for a good. The amount of deadweight loss is shown by the triangle highlighted in yellow. This area is known as Harberger’s triangle.
• where the supply and demand curve intersect, otherwise known as the free market equilibrium;
• the point on the supply curve where the y-coordinate equals the non-pareto optimal price;
• the point on the demand curve where the y-coordinate equals the non-pareto optimal price.
Example – Price Ceilings and Deadweight Loss
The chart above shows what happens when a market has a binding price ceiling below the free market price. Without the price ceiling, the producer surplus on the chart would be everything to the left of the supply curve and below the horizontal line where y equals the free market equilibrium price. The consumer surplus would equal everything to the left of the demand curve and above the free market equilibrium price line.
With the price ceiling, instead of the producer’s surplus going all the way to the pareto optimal price line, it only goes as high as the price ceiling.The consumer surplus extends down to the price ceiling, but it is limited on the right by Harberger’s triangle. In this case, the reason for that limitation is due to quantity produced. The consumer would purchaser more of the product at the ceiling price, but the producers are unwilling to supply enough to meet that demand because it is not profitable. As a result all of the goods that might have been produced and consumed if the good was priced optimally are not, representing a net loss for society.
Arguments for and Against Government Price Controls
Many argue that price controls ensure resource availability, but most economists agree that these controls should be used sparingly.
Learning objectives
Justify the use of price controls when certain conditions are met
When unemployment is especially high or when there is a shortage of goods, it can be difficult for people to get what they need at an affordable price. The main appeal of government imposed price controls is that they can ensure that citizens can purchase what they need in times of national economic hardship.
USFA Depression Price Fixing Poster: During the depression the US government fixed prices on basic staples, such as food, to ensure people would be able to obtain their basic necessities.
Well designed price controls can do three things. First, these regulations can ensure that a basic staple, such as food, remains affordable to most of a country’s citizens. Second, regulation can protect the producers of a good and ensure that they get sufficient revenue. This in turn limits the possibility of shortages, which benefits consumer. Finally, when shortages occur, price controls can prevent producers from gouging their customers on price.
Generally price controls are used in combination with other forms of government economic intervention, such as wage controls and other regulatory elements.
While price controls may appear to be a sound decision in theory, most economists believe these controls should be used sparingly. By keeping prices artificially low through price ceilings, consumers demand a higher quantity than producers are willing to supply, leading to a shortage in the controlled product. As Nobel Prize winner Milton Friedman said, “We economists do not know much, but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers can’t sell tomatoes for more than two cents per pound. Instantly you’ll have a tomato shortage. ”
Price floors often lead to surpluses, which can be just as detrimental as a shortage. One of the best known price floors in the minimum wage, which establishes a base line per hour wage that must be paid for work. As a result, employers hire fewer employees than they would if they could pay workers lower than the minimum wage. As a result the supply of workers is greater than the amount of work, which creates higher unemployment.
Taxes
Governments use its tax systems to raise funds for its programs and influence its citizens’ economic actions.
Learning objectives
Categorize types of taxes into ad valorem taxes and excise taxes
Taxes are the primary means for governments to raise funds for its programs and to pay off its debts. It can also be used to influence its citizens’ financial behavior.. Choosing the right set of rules that have all of the elements of a good tax system can be a challenge for any government.
Tax: Taxes are a tool used by governments to raise money and influence their citizens’ economic choices.
Elements of a Good Tax System
• Efficient: A tax system should raise the necessary revenues without unduly burdening the taxpayer.
• Understandable: A tax system should be easily understandable by the average citizen who has to pay the tax.
• Equitable: The tax burden should be distributed equitably among a nation’s citizens. Generally, this means that those that are wealthier should pay more.
• Benefit Principle: Generally, the people who use public services should pay for them with higher taxes. However this principle is difficult to enforce in practice.
Two Types of Tax Systems
1. Direct Taxation: A direct tax is assessed on the income of the taxpayer and is generally collected before the taxpayer collects his wages.
2. Indirect Taxation: An indirect tax is an avoidable tax assessed on certain activities, such as purchasing goods or services. Examples of an indirect tax include sales tax and VAT (value added tax).
Types of Tax Structures
• Proportional Tax: Otherwise known as a flat tax, a flat tax rate is applied to all earned income regardless of how much the taxpayer earns. So a person making \$20,000 would pay the same rate as a person making \$120,000, but would pay significantly less in real dollars.
• Progressive Tax: The more a person earns, the higher the tax rate. Generally in a progressive tax system, income is divided into “brackets. ” For example, assume a tax system divides earners into people two groups. Those who earn less than \$100,000 pay 10% and people who earn \$100,000 or more pay 20%. A person earning \$20,000 would have to pay 10%, or \$2,000, while a person who earns \$120,000 would have to pay 20%, or \$24,000.
• Regressive Tax: In a regressive tax system, poorer families pay a higher tax rate. Although a regressive tax system is never explicitly used, some claim a sales tax is a type of regressive tax. Since high income earners spend a lower proportion of their income on goods and services in comparison to low income earners, the rich tend to pay proportionally less sales tax.
Ad Valorem vs Excise Tax
Ad Valorem (or Value Added) and Excise Taxes are types of indirect taxes. Both are generally assessed on the sale of goods. These two taxes differ in three ways:
1. An excise tax typically applies to a narrower range of products, such as gasoline, tobacco, and alcohol.
2. An excise tax is typically heavier than an ad valorem, accounting for a higher fraction of a product’s retail price.
3. Excise taxes are typically a fixed fee per unit, meaning that the government earns its revenue based on volume sold. Ad valorem taxes are proportional to the price of the good, so the government earns revenue based on the value of the good or service being sold.
Taxation Impact on Economic Output
Tax incidence falls mostly upon the group that responds least to price, or has the most inelastic price-quantity curve.
Learning objectives
Analyze how changes in taxes affect the price of a good for sellers and buyers
Tax incidence is the effect a particular tax has on the two parties of a transaction; the producer that makes the good and the consumer that buys it. The burden of the tax is not dependent on whether the state collects the revenue from the producer or consumer, but on the price elasticity of supply and the price elasticity of demand. To understand how elasticities influence tax incidence, its important to consider the two extreme scenarios and how the tax burden is distributed between the two parties.
Inelastic supply, elastic demand
Because supply is inelastic, the firm will produce the same quantity no matter what the price. Because demand is elastic, the consumer is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. The imposition of the tax causes the market price to increase and the quantity demanded to decrease. Because consumption is elastic, the price consumers pay doesn’t change very much. Because production is inelastic, the amount sold changes significantly. The producer is unable to pass the tax onto the consumer and the tax incidence falls on the producer.
Tax Incidence of Producer: When supply is inelastic but demand is elastic, the majority of the tax is paid for by the consumer. Since quantity demanded drops significantly in this scenario, the producer is forced to sell less.
Elastic supply, inelastic demand
Consumption is inelastic, so the consumer will consume the same quantity no matter the price. The producer will be able to produce the same amount of the good, but will be able to increase the price by the amount of the tax. As a result, the entirety of the tax will be borne by the consumer.
Similarly elastic supply and demand
Generally consumers and producers are neither perfectly elastic or inelastic, so the tax burden is shared between the two parties in varying proportions. If one party is comparatively more inelastic than the other, they will pay the majority of the tax.
Increasing tax
If the government increases the tax on a good, that shifts the supply curve to the left, the consumer price increases, and sellers’ price decreases. A tax increase does not affect the demand curve, nor does it make supply or demand more or less elastic. This potential increase in tax could be called marginal, because it is a tax in addition to existing levies.
Key Points
• The government tries to combat market inequities through regulation, taxation, and subsidies.
• Governments may also intervene in markets to promote general economic fairness.
• Maximizing social welfare is one of the most common and best understood reasons for government intervention. Examples of this include breaking up monopolies and regulating negative externalities like pollution.
• Governments may sometimes intervene in markets to promote other goals, such as national unity and advancement.
• For a price ceiling to be effective, it must be less than the free-market equilibrium price.
• The purpose of a price ceiling is to protect consumers of a certain good or service. By establishing a maximum price, a government wants to ensure the good is affordable for as many consumers as possible.
• Rent control is an example of a price ceiling.
• A price ceiling has an economic impact only if it is less than the free-market equilibrium price.
• An effective price ceiling will lower the price of a good, which decreases the producer surplus. The effective price ceiling will also decrease the price for consumers, but any benefit gained from that will be minimized by the decreased sales due to the drop in supply caused by the lower price.
• If a ceiling is to be imposed for a long period of time, a government may need to ration the good to ensure availability for the greatest number of consumers.
• Prolonged shortages caused by price ceilings can create black markets for that good.
• A price floor is economically consequential if it is greater than the free-market equilibrium price.
• Price floors lead to a surplus of the product.
• Supply surpluses created by price floors are generally added to producer’s inventory or are purchased by governments.
• Consumer surplus is the gain obtained by consumers because they can obtain a product for a lower price than they would be willing to pay.
• Producer surplus is the benefit producers get by selling at a price higher than the lowest price they would sell for.
• Deadweight loss can be caused by monopolies, binding price controls, taxes, subsidies, and externalities.
• When deadweight loss occurs, it comes at the expense of consumer surplus and/or producer surplus.
• Deadweight loss can be visually represented on supply and demand graphs as a figure known as Harberger’s triangle.
• The main appeal of governmental imposed price controls is that they can ensure that citizens can purchase what they need in times of national economic hardship.
• Well designed price controls can ensure that basic staples are affordable, minimize the possibility of shortages, and prevent price gouging when shortages occur.
• By keeping prices artificially low through price ceilings, economists argue that demand is increased to a point where supply cannot keep up, leading to a shortage in the controlled product.
• Price floors often lead to surpluses, which can be just as detrimental as a shortage.
• A good tax system should be efficient, understandable and equitable. It should also allocate the costs of public services to those who use it, although that principle is hard to execute in practice.
• A direct tax is assessed on a person’s income. Indirect taxes are assessed on an individual’s participation in certain activities, such as making a purchase.
• The three types of tax systems are proportional, progressive, and regressive.
• Ad valorem and excise taxes are two types of indirect taxes.
• When supply is inelastic and demand is elastic, the tax incidence falls on the producer.
• When supply is elastic and demand is inelastic, the tax incidence falls on the consumer.
• Tax incidence is the analysis of the effect a particular tax has on the two parties of a transaction; the producer that makes the good and the consumer that buys it.
• A marginal tax is an increase in a tax on a good that shifts the supply curve to the left, increases the consumer price, and decreases the price for the sellers.
Key Terms
• inefficient market: An economy where social optimality is not acheived; an economy where resources are not optimally allocated
• free-market equilibrium price: The price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers
• Price ceiling: An artificially set maximum price in a market.
• black market: trade that is in violation of restrictions, rationing or price controls
• free-market equilibrium price: The price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers
• price floor: A mandated minimum price for a product in a market.
• Pareto optimal: Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.
• deadweight loss: A loss of economic efficiency that can occur when an equilibrium is not Pareto optimal.
• Price control: A law that sets the maximum or minimum amount for which a good may be sold.
• staple: A basic or essential supply.
• progressive: Increasing in rate as the taxable amount increases
• regressive: Whose rate decreases as the amount increases.
• elastic: Sensitive to changes in price.
• Tax incidence: The effect a particular tax has on the two parties of a transaction. | textbooks/socialsci/Economics/Economics_(Boundless)/3%3A_Introducing_Supply_and_Demand/3.4%3A_Government_Intervention_and_Disequilibrium.txt |
Arguments For and Against Discretionary Monetary Policy
Discretionary policies refer to subjective actions taken in response to changes in the economy.
learning objectives
• Contrast discretionary and rules-based monetary policy.
Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; instead, they use subjective judgment to treat each situation in a unique manner. For much of the 20th century, governments adopted discretionary policies to correct the business cycle. These typically used fiscal and monetary policy to adjust inflation, output, and unemployment. However, following the stagflation of the 1970s, policymakers were attracted to policy rules.
Discretionary Policy
A discretionary policy is supported because it allows policymakers to respond quickly to events. However, discretionary policy can be subject to dynamic inconsistency: a government may say it intends to raise interest rates indefinitely to bring inflation under control, but then relax its stance later. This could make the policy noncredible and ultimately ineffective.
Rules-based Policy
A rule-based policy can be more credible, because it is more transparent and easier to anticipate, unlike discretionary policy. Policy is implemented based on indicator events in the economy and the policy is expected and carried out in a timely manner. Further, as commented by Milton Friedman who argued in favor of a rules-based approach, the dynamics of discretionary policy present a lag between observation and implementation. This can create compounding issues related to the discretionary policy enacted. However, a strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain circumstances.
Milton Friedman: Milton Friedman was a Nobel Prize (1976) recipient in the field of Economics and was a supporter of rules-based monetary policy.
Compromise
A compromise between strict discretionary and strict rule-based policy is to grant discretionary power to an independent body. For instance, the Federal Reserve Bank, European Central Bank, Bank of England, and Reserve Bank of Australia all set interest rates without government interference, but do not adopt a strict rules-based policy stance. In this case the central banking authorities have autonomy and are able to use monetary policy to enable their mandate of economic growth and full employment. The policies they enact cannot be destabilized by government fiscal policy.
Arguments For and Against Fighting Recession with Expansionary Monetary Policy
Expansionary monetary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates.
learning objectives
• Assess the value of discretionary expansionary monetary policy and the associated shortcomings.
Expansionary monetary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into investing, leading to overall economic growth. Monetary policy, to a great extent, is the management of expectations between interest rates, the price of the use of money, and the total supply of money. Monetary policy uses a variety of discretionary tools to control one or both of these to influence outcomes like economic growth, inflation, exchange rates with other currencies, and unemployment. When the central bank is in complete control of the money supply, the monetary authority has the ability to alter the money supply and influence the interest rate to achieve policy goals.
Money supply: The increase in the money supply is the primary conduit for expansionary monetary policy.
However, the success of monetary policy intervention rests on the credibility of the central bank on one hand and the understanding of central bank operations related to interest rates and money supply effects on the part of the public, in general. For example, if the central bank is implementing expansionary policy but is committed to keeping interest rates low, the central bank needs to convey this policy with credibility, otherwise economic agents may assume that expansionary policy will lead to inflation and begin augmenting behavior to initiate the outcome expected, higher inflation.
Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body.
Arguments For and Against Fighting Recession with Expansionary Fiscal Policy
Expansionary fiscal policies, which are usually implemented during recessions, attempt to increase economic demand.
learning objectives
• Evaluate the pros and cons of fiscal policy intervention during recession
Fiscal policy is a broad term, describing the policies enacted around government revenue and expenditure in order to influence the economy. Governments can increase their revenue by increasing taxes, or increase their expenditure by spending money on programs.
Fiscal policy: Taxes: Taxes have not only been a way to initiate fiscal policy intervention, but have also been used to solidify popular approval. In the picture above former President George W. Bush is signing into effect the Tax Relief Reconciliation Act of 2001.
Expansionary fiscal policies are usually implemented during recessions because they attempt to increase economic demand, and as a result, increase economic output which is reduced during a recession. Expansionary fiscal policies involve reducing taxes or increasing government expenditure.
Remember that government revenue is based on collected taxes. When taxes exceed government spending, the government is characterized as having a surplus. When taxes equal government expenditures, the government has a balanced budget. When the government spends more than the revenue it collects, it has a deficit. Increasing government spending, creating a budget deficit, and financing the shortfall through debt issuance are typical policy actions in an expansionary fiscal policy scenario.
Due to the funding process of expansionary policy, there is a lack of consensus among economists with respect to the merits of fiscal stimulus. The discord mostly centers on crowding out, defined as government borrowing leading to higher interest rates that in turn may offset the stimulative impact of government spending. When the government runs a budget deficit, funds will need to come from public or foreign borrowing. As a result, the government issues bonds. This raises interest rates across the economy because government borrowing increases demand for credit in the financial markets. This may in turn reduce aggregate demand for goods and services, which defeats the purpose of a fiscal stimulus.
Fiscal stimulus is implemented with the view that tax relief through a reduction in tax rate and or direct government spending through investment (infrastructure, repair, construction) will provide stimulus to increase economic growth by directly influencing consumption or the government expenditure component of GDP.
Arguments For and Against Inflation Targeting Policy Interventions
Inflation targeting often succeeds in controlling inflation and anchoring expectations, but may limit a central bank’s flexibility.
learning objectives
• Argue that central banks should maintain inflation targets, Argue that central banks should not maintain inflation targets
Inflation targeting is an economic policy in which a central bank publicly determines a target inflation rate and then attempts to steer actual inflation towards the target. For example, in the United States, the Federal Reserve implicitly maintains a target inflation range of 1.7%-2.0%. When inflation falls below this range, the Fed would lower interest rates and raising the money supply in order to push inflation up. Likewise, when inflation rises above the target range, the Fed would raise interest rates and decrease the money supply in order to suppress the high level of inflation. While the inflation rate and the interest rate generally have an inverse relationship, these tools are not always successful in affecting inflation – for example, in response to the 2008 financial crisis and ensuing recession, the Fed raised its target inflation level to 2% and lowered interest rates to nearly zero. This did not, however, succeed in raising inflation to 2%.
Inflation Targeting: The relationship between the money supply and the inflation rate is not exact, but it suggests that a central bank can often affect inflation by adjusting the money supply through higher or lower interest rates.
Argument in Favor of Inflation Targeting
Proponents of inflation targeting argue that a volatile inflation rate has negative effects for an economy. High levels of inflation eat away at savings, increase menu costs and shoe-leather costs, discourage lending, and may create an inflationary spiral that leads to hyperinflation. Inflation targeting has been successful in keeping inflation levels low and avoiding many of these negative effects.
Further, inflation targeting is a transparent way to explain interest rate policy and to anchor consumers’ expectations about future inflation. When the central bank announces an inflation target of 2%, the public knows that if inflation goes too far above or below that level, the central bank will take action. This certainty stimulates economic activity. Further, the public’s expectations about inflation tend to be a self-fulfilling prophecy. When consumers expect high inflation they spend their money immediately, attempting to avoid higher future prices. This increase in demand leads to higher prices, causing more inflation. Likewise, when consumers expect deflation they tend to save their money, delaying consumption until prices fall. This decrease in demand causes producers to sell their goods at lower prices, and the cycle continues. Inflation targeting sets consumers’ expectations, making a certain inflation level easier to maintain.
Arguments Against Inflation Targeting
On the other hand, some argue that the costs of inflation targeting exceed the benefits. If the rule is implemented very strictly, an inflation target could severely limit the central bank’s flexibility in responding to changing economic conditions. During a recession, for example, central banks shouldn’t raise the interest rate even if inflation is above the target level. Further, sometimes higher inflation is a good thing because it stimulates spending. A central bank with a strict inflation targeting rule, however, would not allow that higher inflation rate even if it were otherwise beneficial.
Others argue that, since inflation isn’t necessarily coupled to any factor internal to a country’s economy, inflation isn’t the best variable to target. Adherents of market monetarism, for example, argue that targeting a nominal national income (nominal GDP) would be more effective than targeting inflation. Others suggest targeting long-run inflation, which takes the exchange rate into account, rather than the short-term inflation rate.
Key Points
• A discretionary policy allows policymakers to respond quickly to events.
• A rule-based policy can be more credible because it is more transparent and easier to anticipate, unlike discretionary policy.
• A strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain circumstances, creating a need for a compromise between discretionary and rules-based policy.
• The success of monetary policy intervention rests on the credibility of the central bank on one hand and the understanding of central bank operations related to interest rates and money supply effects on the part of the public, in general.
• Without central bank credibility with respect to low interest rate targets, economic agents may assume that expansionary policy will lead to inflation and begin augmenting behavior to initiate the outcome expected, higher inflation.
• Announcements can be made credible in various ways. One method would be to establish an independent central bank with low inflation targets (but no output targets).
• Government can enact changes in fiscal policy by changing taxes and government spending levels in various sectors.
• Fiscal stimulus through the debt creation channel, may result in reducing the availability of loanable funds, increasing interest rate which may in turn cause a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.
• Fiscal stimulus is implemented with the view that tax relief through a reduction in tax rate and or direct government spending through investment will provide stimulus to increase economic growth by directly influencing consumption or the government expenditure component of GDP.
• Inflation targeting is an economic policy in which a central bank publicly determines a target inflation rate and then attempts to steer actual inflation towards the target.
• Inflation targeting has often been successful in keeping inflation levels low and avoiding many of its negative effects.
• Inflation targeting is a transparent way to explain interest rate policy and to anchor consumers’ expectations about future inflation.
• On the other hand, if the rule is implemented very strictly, an inflation target could severely limit the central bank’s flexibility in responding to changing economic conditions.
• Others argue that, since inflation isn’t necessarily coupled to any factor internal to a country’s economy, inflation isn’t the best variable to target.
Key Terms
• discretionary policy: Actions taken in response to changes in the economy. These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner.
• expansionary monetary policy: Traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.
• discretionary: Available at one’s discretion; able to be used as one chooses; left to or regulated by one’s own discretion or judgment.
• fiscal stimulus: Involves government spending exceeding tax revenue, and is usually undertaken during recessions.
• crowding out: A drop in private investment caused by increase in government investment.
• inflation: An increase in the general level of prices or in the cost of living.
• central bank: The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.
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Reasons for Trade
Countries benefit when they specialize in producing goods for which they have a comparative advantage and engage in trade for other goods.
learning objectives
• Discuss the reasons that international trade may take place
International trade is the exchange of capital, goods, and services across international borders or territories. Trading-partners reap mutual gains when each nation specializes in goods for which it holds a comparative advantage and then engages in trade for other products. In other words, each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.
International Trade: Countries benefit from producing goods in which they have comparative advantage and trading them for goods in which other countries have the comparative advantage.
In addition to comparative advantage, other reasons for trade include:
• Differences in factor endowments: Countries have different amounts of land, labor, and capital. Saudi Arabia may have a lot of oil, but perhaps not enough lumber. It will thus have to trade for lumber. Japan may be able to produce technological goods of superior quality, but it may lack many natural resources. It may trade with Indonesia for inputs.
• Gains from specialization: Countries may gain economies of scale from specialization, experiencing long run average cost declines as output increases.
• Political benefits: Countries can leverage trade to forge closer cultural and political bonds. International connections also help promote diplomatic (rather than military) solutions to international problems.
• Efficiency gains: Domestic firms will be forced to become more efficient in order to be competitive in the global market.
• Benefits of increased competition: A greater degree of competition leads to lower prices for consumers, greater responsiveness to consumer wants and needs, and a wider variety of products.
To summarize, international trade benefits mostly all incumbents and generates substantial value for the global economy.
Understanding Production Possibilities
The production possibility frontier shows the combinations of output that could be produced using available inputs.
learning objectives
• Explain the benefits of trade and exchange using the production possibilities frontier (PPF)
In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two commodities that could be produced using the same total amount of the factors of production. It shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.
PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight line. An economy that is operating on the PPF is productively efficient, meaning that it would be impossible to produce more of one good without decreasing the production of the other good. For example, if an economy that produces only guns and butter is operating on the PPF, the production of guns would need to be sacrificed in order to produce more butter. If production is efficient, the economy can choose between combinations (i.e., points) on the PPF: B if guns are of interest, C if more butter is needed, or D if an equal mix of butter and guns is required.
Production Possibilities Frontier: If production is efficient, the economy can choose between combinations on the PPF. Point X, however, is unattaible with existing resources and technology if trade does not occur.
If the economy is operating below the curve, it is operating inefficiently, because resources could be reallocated in order to produce more of one or both goods without decreasing the quantity of either. Points outside the curve are unattainable with existing resources and technology if trade does not occur with an outside producer.
The PPF will shift outwards if more inputs (such as capital or labor ) become available or if technological progress makes it possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital.
Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier is also the consumption possibilities frontier. Trade enables consumption outside the production possibility frontier. The world PPF is made up by combining countries’ PPFs. When countries’ autarkic productions are added (when there is no trade), the total quantity of each good produced and consumed is less than the world’s PPF under free trade (when nations specialize according to their comparative advantage). This shows that in a free trade system, the absolute quantity of goods available for consumption is higher than the quantity available under autarky.
Defining Absolute Advantage
A country has an absolute advantage in the production of a good when it can produce it more efficiently than other countries.
learning objectives
• Relate absolute advantage, productivity, and marginal cost
Absolute advantage refers to the ability of a country to produce a good more efficiently than other countries. In other words, a country that has an absolute advantage can produce a good with lower marginal cost (fewer materials, cheaper materials, in less time, with fewer workers, with cheaper workers, etc.). Absolute advantage differs from comparative advantage, which refers to the ability of a country to produce specific goods at a lower opportunity cost.
A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For example, the Canadian economy, which is rich in low cost land, has an absolute advantage in agricultural production relative to some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much lower unit labor costs.
China and Consumer Electronics: Many consumer electronics are manufactured in China. China can produce such goods more efficiently, which gives it an absolute advantage relative to many countries.
Imagine that Economy A can produce 5 widgets per hour with 3 workers. Economy B can produce 10 widgets per hour with 3 workers. Assuming that the workers of both economies are paid equally, Economy B has an absolute advantage over Economy A in producing widgets per hour. This is because Economy B can produce twice as many widgets as Economy B with the same number of workers.
Absolute Advantage: Party B has an absolute advantage in producing widgets. It can produce more widgets with the same amount of resources than Party A.
If there is no trade, then each country will consume what it produces. Adam Smith said that countries should specialize in the goods and services in which they have an absolute advantage. When countries specialize and trade, they can move beyond their production possibilities frontiers, and are thus able to consume more goods as a result.
Defining Comparative Advantage
A country has a comparative advantage over another when it can produce a good or service at a lower opportunity cost.
learning objectives
• Analyze the relationship between opportunity cost and comparative advantage
Comparative Advantage
In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (has an absolute advantage in all goods) than another, both countries will still gain by trading with each other. More specifically, countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.
Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having more and/or better resources or discovering improved production techniques.
Determining Comparative Advantage
Imagine that there are two nations, Chiplandia and Entertainia, that currently produce their own computer chips and CD players. Chiplandia uses less time to produce both products, while Entertainia uses more time to produce both products. Chiplandia enjoys and absolute advantage, an ability to produce an item with fewer resources. However, the accompanying table shows that Chiplandia has a comparative advantage in computer chip production, while Entertainia has a comparative advantage in the production of CD players. The nations can benefit from specialization and trade, which would make the allocation of resources more efficient across both countries.
Comparative Advantage: Chiplandia has a comparative advantage in producing computer chips, while Entertainia has a comparative advantage in producing CD players. Both nations can benefit from trade.
For another example, if the opportunity cost of producing one more unit of coffee in Brazil is 2/3 units of wheat, while the opportunity cost of producing one more unit of coffee in the United States is 1/3 wheat, then the U.S. should produce coffee, while Brazil should produce wheat (assuming Brazil has the lower opportunity cost of producing wheat).
Comparative vs Competitive Advantage
It is important to distinguish between comparative advantage and competitive advantage. Though they sound similar, they are different concepts. Unlike comparative advantage, competitive advantage refers to a distinguishing attribute of a company or a product. It may or may not have anything to do with opportunity cost or efficiency. For example, having good brand recognition or relationships with suppliers is a competitive advantage, but not a comparative advantage. In the context of international trade, we more often discuss comparative advantage.
Absolute Advantage Versus Comparative Advantage
Absolute advantage refers to differences in productivity of nations, while comparative advantage refers to differences in opportunity costs.
learning objectives
• Differentiate between absolute advantage and comparative advantage
Absolute advantage compares the productivity of different producers or economies. The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good.
The accompanying figure shows the amount of output Country A and Country B can produce in a given period of time. Country A uses less time than Country B to make either food or clothing. Country A makes 6 units of food while Country B makes one unit, and Country A makes three units of clothing while Country B makes two. In other words, Country A has an absolute advantage in making both food and clothing.
Absolute Advantage: Country A has an absolute advantage in making both food and clothing, but a comparative advantage only in food.
Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to increased productivity.
For example, consider again Country A and Country B in. The opportunity cost of producing 1 unit of clothing is 2 units of food in Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than in Country A, Country B has a comparative advantage in clothing.
Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B specializes clothing. The countries will then trade, and each will gain.
Absolute advantage is important, but comparative advantage is what determines what a country will specialize in.
Benefits of Specialization
Specialization leads to greater economic efficiency and consumer benefits.
learning objectives
• Discuss the effects of specialization on production
Whenever a country has a comparative advantage in production it can benefit from specialization and trade. However, specialization can have both positive and negative effects on a nation’s economy. The effects of specialization (and trade) include:
• Greater efficiency: Countries specialize in areas that they are naturally good at and also benefit from increasing returns to scale for the production of these goods. They benefit from economies of scale , which means that the average cost of producing the good falls (to a certain point) because more goods are being produced. Similarly, countries can benefit from increased learning. They simply are more skilled at making the product because they have specialized in it. These effects both contribute to increased overall efficiency for countries. Countries become better at making the product they specialize in.
• Consumer benefits: Specialization means that the opportunity cost of production is lower, which means that globally more goods are produced and prices are lower. Consumers benefit from these lower prices and greater quantity of goods.
• Opportunities for competitive sectors: Firms gain access to the whole world market, which allows them to grow bigger and to benefit further from economies of scale.
• Gains from trade: Suppose that Britain and Portugal each produce wine and cloth. Britain has a comparative advantage in cloth and Portugal in wine. By specializing and then trading, Britain can get a unit of wine for only 100 units of labor by trading cloth for labor instead of taking 110 units of labor to produce the wine itself (assuming the price of Cloth to Wine is 1). Similarly, Portugal can specialize in wine and get a unit of cloth for only 80 units of labor by trading, instead of the 90 units of labor it would take to produce the cloth domestically. Each country will continue to trade until the price equals the opportunity cost, at which point it will decide to just produce the other good domestically instead of trading. Thus (in this example with no trade costs) both countries benefit from specializing and then trading.
Of course, there are also some potential downsides to specialization:
• Threats to uncompetitive sectors: Some parts of the economy may not be able to compete with cheaper or better imports. For example, firms in United States may see demand for their products fall due to cheaper imports from China. This may lead to structural unemployment.
• Risk of over-specialization: Global demand may shift, so that there is no longer demand for the good or service produced by a country. For example, the global demand for rubber has fallen due the the availability of synthetic substitutes. Countries may experience high levels of persistent structural unemployment and low GPD because demand for their products has fallen.
• Strategic vulnerability: Relying on another country for vital resources makes a country dependent on that country. Political or economic changes in the second country may impact the supply of goods or services available to the first.
As a whole, economists generally support specialization and trade between nations.
Relationship Between Specialization and Trade
Comparative advantage is the driving force of specialization and trade.
learning objectives
• Discuss how countries determine which goods to produce and trade
Specialization refers to the tendency of countries to specialize in certain products which they trade for other goods, rather than producing all consumption goods on their own. Countries produce a surplus of the product in which they specialize and trade it for a different surplus good of another country. The traders decide on whether they should export or import goods depending on comparative advantages.
Imagine that there are two countries and both countries produce only two products. They can both choose to be self-sufficient, because they have the ability to produce both products. However, specializing in the product for which they have a comparative advantage and then trading would allow both countries to consume more than they would on their own.
One might assume that the country that is most efficient at the production of a good would choose to specialize in that good, but this isn’t always the case. Rather than absolute advantage, comparative advantage is the driving force of specialization. When countries decide what products to specialize in, the essential question becomes who could produce the product at a lower opportunity cost. Opportunity cost refers to what must be given up in order to obtain some item. It requires calculating what one could have gotten if one produced another product instead of one unit of the given product.
For example, the opportunity cost to Bob of 1 bottle of ketchup is 1/2 bottle of mustard. This means that in the same amount of time that Bob could produce one bottle of ketchup, he could have produced 1/2 bottle of mustard. Tom could have produced 1/3 bottle of mustard during the time that he was making one bottle of ketchup. Tom will have the comparative advantage in producing ketchup because he has to give up less mustard for the same amount of ketchup. In sum, the producer that has a smaller opportunity cost will have the comparative advantage. It follows that Bob will have a comparative advantage in the production of mustard.
Comparative Advantage: Tom has the comparative advantage in producing ketchup, while Bob has the comparative advantage in producing mustard.
There is one case in which countries are not better off trading: when both face the same opportunity costs of production. This doesn’t mean that both countries have the same production function – one could still be absolutely more productive than the other – but neither has a comparative advantage over the other. In this case, specialization and trade will result in exactly the same level of consumption as producing all goods domestically.
Key Points
• International trade is the exchange of capital, goods, and services across international borders or territories.
• Each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.
• Benefits of trade include lower prices and better products for consumers, improved political ties among nations, and efficiency gains for domestic producers.
• The production possibilities curve shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.
• Points outside the production possibilities curve are unattainable with existing resources and technology if trade does not occur with an external producer.
• Without trade, each country consumes only what it produces. However, because of specialization and trade, the absolute quantity of goods available for consumption is higher than the quantity that would be available under national economic self-sufficiency.
• A country that has an absolute advantage can produce a good at lower marginal cost.
• A country with an absolute advantage can sell the good for less than the country that does not have the absolute advantage.
• Absolute advantage differs from comparative advantage, which refers to the ability to produce specific goods at a lower opportunity cost.
• Even if one country has an absolute advantage in the production of all goods, it can still benefit from trade.
• Countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.
• Specialization according to comparative advantage results in a more efficient allocation of world resources. A larger quantity of outputs becomes available to the trading nations.
• Competitive advantage is distinct from comparative advantage because it has to do with distinguishing attributes which are not necessarily related to a lower opportunity cost.
• The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good.
• Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another.
• The existence of a comparative advantage allows both parties to benefit from trading, because each party will receive a good at a price that is lower than its opportunity cost of producing that good.
• Whenever countries have different opportunity costs in production they can benefit from specialization and trade.
• Benefits of specialization include greater economic efficiency, consumer benefits, and opportunities for growth for competitive sectors.
• The disadvantages of specialization include threats to uncompetitive sectors, the risk of over-specialization, and strategic vulnerability.
• Nations decide whether they should export or import goods based on comparative advantages.
• Generally, nations can consume more by specializing in a good and trading it for other goods.
• When countries decide which country will specialize in which product, the essential question becomes who could produce the product at a lower opportunity cost.
Key Terms
• comparative advantage: The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.
• Production possibilities frontier: A graph that shows the combinations of two commodities that could be produced using the same total amount of each of the factors of production.
• Autarky: National economic self-sufficiency.
• Absolute advantage: The capability to produce more of a given product using less of a given resource than a competing entity.
• Opportunity cost: The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.
• competitive advantage: Something that places a company or a person above the competition
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Exports: The Economic Impacts of Selling Goods to Other Countries
Exporting is a form of international trade which allows for specialization, but can be difficult depending on the transaction.
learning objectives
• Evaluate the effects of international trade on exporting countries
Exports
Export is defined as the act of a country shipping goods and services out of the port of a country. In international trade, an export refers to the selling of goods and services produced in the home country to other markets (other countries). The seller of the goods and services is referred to as the “exporter.”
Exports: The map shows the primary exporters for countries around the globe. The colors indicate the leading merchandise export destination for the indicated country (the United States main export destination is the European Union). Exporting is the act of shipping goods and services to other countries.
Protecting Exports
In order to protect exports, commercial goods are subject to customs authorities for both the exporting and importing countries. Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported. When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods and services that are exported to other countries.
Impact of Exports
Exporting goods and services has both advantages and disadvantages for countries involved in international trade.
Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products. It is viewed as a low-risk mode of production and trade. Exporters also experience internationalization advantages which are the benefits of retaining a core competence within a company and threading it through the value chain instead of obtaining a license to outsource or sell the goods or services.
Disadvantages of exporting are mainly the result of manufacturers having to sell their goods to importers. In domestic sales, manufacturers sell directly to wholesalers or even directly to the retailer or customer. For exports, manufacturers face and extra layer in the chain of distribution which squeezes the margins. As a result, manufacturers may have to offer lower prices to the importers than to domestic wholesalers in order to move their product and generate business.
Imports: The Economics Impacts of Buying Goods from Other Countries
Imports are critical for many economies; they are the defining financial transactions of international trade and account for a large portion of the GDP.
learning objectives
• Evaluate the effects of international trade on an importing country
Imports
Imports are defined as purchases of good or services by a domestic economy from a foreign economy. The domestic purchaser of the good or service is called an importer. Imports and exports are critical for many economies and they are the defining financial transactions of international trade.
Protecting Imports
Due to the economic importance of imports, countries enact specific laws, barriers, and policies in order to regulate international trade. Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations. When trade barriers and policies of protectionism are eliminated, consumer surplus increases. The price of a good or service will decrease while the quantity consumed will increase.
Impacts of Buying Imported Goods
On a national level, in most countries international trade and importing goods represents a significant share of the gross domestic product (GDP). International trade has a significant economic, social, and political importance in many countries. Imports provide countries with access to goods and services from other nations. Without imports, a country would be limited to the goods and services within its own borders.
Imports: The map shows the largest importers on an international scale. The color indicates the leading source of merchandise imports for the indicated country (the United States’ imports the largest percentage of its goods from China). Imports account for a significant share in the gross domestic product (GDP) of a country.
International trade is generally less expensive than domestic trade despite additionally imposed costs, taxes, and tariffs. However, the factors of production are usually more mobile domestically than internationally (capital and labor). It is common for countries to import goods rather than a factor of production. For example, the U.S. imports labor-intensive goods from China. Instead of importing Chinese labor, the U.S. imports goods that were produced in China by Chinese labor.
On a business level, companies take part in direct-imports, which occur when a major retailer imports goods that are designed locally from an overseas manufacturer. The direct-import program allows the retailer to bypass the local supplier and purchase the final product directly from the manufacturer. Direct imports save retailers money by eliminating the local supplier.
Costs of Trade
Free trade is a policy where governments do not discriminate against imports and exports; creates a large net gain for society.
learning objectives
• Identify the groups that benefit and the groups that are harmed by free trade policies
Free Trade
Free trade is a policy where governments do not discriminate against exports and imports. There are few or no restrictions on trade and markets are open to both foreign and domestic supply and demand.
Advantages
Free trade is beneficial to society because it eliminates import and export tariffs. Restricted trade affects the welfare of society because although producers experience increases in surplus and additional revenue, the loss faced by consumers is greater than any benefit obtained. When a country trades freely with the rest of the world, it should theoretically produce a net gain for society and increases social welfare. Free trade policies consist of eliminating export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country. With free trade in place, the producers of the exported good in exporting countries and the consumers in importing countries all benefit.
Tariffs: This image shows what happens to societal welfare when free trade is not enacted. Tariffs cause the consumer surplus (green area) to decrease, while the producer surplus (yellow area) and government tax revenue (blue area) increase. The amount of societal loss (pink area) is larger than any benefits experienced by the producers and government. Free trade does not have tariffs and results in net gain for society.
Disadvantages
One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade diversion. It is economically efficient for a good to be produced in the country with the lowest production costs. However, this does not always occur if a high cost producer has a free trade agreement and the low cost producer does not. When free trade is applied to only the high cost producer it can lead to trade diversion to not the most efficient producer, but the one facing the lowest trade barriers, and a net economic loss. Free trade is highly effective and provides society with a net gain, but only if it is applied.
Due to industry specializations, many workers are displaced and do not receive retraining or assistance finding jobs in other sectors. The nature of industries and trade increases economic inequality. As a result of unskilled workers the wages within the various industries may decline.
Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where there is not comparative advantage. Despite this disadvantage, the level of output that is generated by free trade for both the “winner” and the “loser” is increased substantially.
The Results of Free Trade
Economists have studied free trade extensively and although it creates winners and losers, the main consensus is that free trade generates a large net gain for society. In a 2006 survey of American economists, it was found that 85.7% believed that the U.S. should eliminate any remaining tariffs and trade barriers. Economists professor N. Gregory Mankiw explained that, “few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards.”
Key Points
• Export is defined as the act of shipping goods and services out of the port of a country.
• Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported.
• When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods and services that are exported from the country.
• Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products.
• Due to an extra layer in the chain of distribution which squeezes the margins, exporters may have to offer lower prices to the importers than to domestic wholesalers in order to move their product and generate business.
• Imports are defined as purchases of good or services by a domestic economy from a foreign economy.
• Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations.
• In most countries, international trade and importing goods represents a significant share of the gross domestic product ( GDP ).
• International trade is generally more expensive than domestic trade due to additionally imposed costs, taxes, and tariffs.
• On a business level, companies take part in direct-imports; a major retailer imports goods from an overseas manufacturer in order to save money.
• Free trade eliminates export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country.
• With free trade in place the producers in exporting countries and the consumers in importing countries all benefit.
• One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade diversion.
• Trade restricts displaces workers, makes overcoming unemployment challenging, increases economic inequality, and can lower wages.
• When free trade is applied to only the high cost producer it can lead to trade diversion and a net economic loss.
• Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where there is not comparative advantage.
Key Terms
• trade: Buying and selling of goods and services on a market.
• export: Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.
• protectionism: A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.
• import: To bring (something) in from a foreign country, especially for sale or trade.
• tariff: A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.
• welfare: Health, safety, happiness and prosperity; well-being in any respect.
• free trade: International trade free from government interference, especially trade free from tariffs or duties on imports.
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The Importance of Trade
International trade is an integral part of the modern world economy.
learning objectives
• Discuss the reasons of the U.S. increase in international trade participation after World War II
Economists generally support trade because it allows for increased overall utility for both countries. Gains from trade are commonly described as resulting from:
Silk Road Trade: Even in ancient times, people benefited from widespread international trade. The benefits from international trade have increased as costs decline and the international system becomes better integrated.
• specialization in production from division of labor (according to one’s comparative advantage), economies of scale, scope, and agglomeration and relative availability of factor resources in types of output by farms, businesses, location and economies
• a resulting increase in total output possibilities
• trade through markets from sale of one type of output for other, more highly valued goods.
The Rise of International Trade
International trade is important, and, over time, has become more important. There have been three primary reasons for this increase in importance.
First, there have been large reductions in the cost of transportation and communication. It is now much cheaper to not only operate internationally and trade with foreign partners, but also to exchange information between potential buys and sellers.
Second, technological advances have made international production and trade easier to coordinate. More efficient telecommunications, from the first transatlantic telephone cable in 1956 to the popularization of the internet in the 1980s and 1990s, have allowed companies to exchange goods more efficiently and lowered the costs of international integration. Technological advances, from the invention of the jet engine to the development of just-in-time manufacturing, have also contributed to the rise in international trade.
Third, trade barriers between countries have fallen and are likely to continue to fall. In particular, the Bretton Woods system of international monetary management has shaped the relationship between the world’s major industrial states and has resulted in a much more integrated system of international exchange. Established in 1946 to rebuild the international economic system after World War II, the Bretton Woods Conference set up regulations for production of their individual currencies to maintain fixed exchange rates between countries with the aim of more easily facilitating international trade.This was the foundation of the U.S. vision of postwar world free trade, which also involved lowering tariffs and, among other things, maintaining a balance of trade via fixed exchange rates that would be favorable to the capitalist system. Although the world eventually abolished the system of fixed exchange rates, the goal of more open economies and free international trade remained.
The Balance of Trade
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period.
learning objectives
• Explain the relationship between the trade balance of a nation and its economic well-being
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period, measured in the currency of that economy. It is the relationship between a nation’s imports and exports. It is measured by finding the country’s net exports. A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.
Factors that can affect the balance of trade include:
• The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy compared to those in the importing economy
• The cost and availability of raw materials, intermediate goods, and other inputs
• Currency exchange rate
• Multilateral, bilateral, and unilateral taxes or restrictions on trade
• Non-tariff barriers such as environmental, health, or safety standards
• The availability of adequate foreign exchange with which to pay for imports
• Prices of goods manufactured at home
In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.
Twin Deficits Hypothesis
The twin deficits hypothesis is a concept from macroeconomics that contends that there is a strong link between a national economy’s current account balance and its government budget balance. This link can be seen from considering the national accounting model of the economy:
\[Y=C+I+G+(NX)\]
\(Y\) represents national income or GDP, \(C\) is consumption, \(I\) is investment, \(G\) is government spending, and \(NX\) stands for net exports (exports minus imports). This represents GDP because all the production in an economy (the left hand side of the equation) is used as consumption (\(C\)), investment (\(I\)), or government spending (\(G\)), and the leftover production is exported (\(NX\)).
Another equation defining GDP using alternative terms (which in theory results in the same value) is:
\[Y=C+S+T\]
\(Y\) is again GDP, \(C\) is consumption, \(S\) is savings, and \(T\) is taxes. This is because national income is also equal to output, and all individual income either goes to pay for consumption (\(C\)), to pay taxes (\(T\)), or becomes savings (\(S\)).
Since \(Y=C+I+G+NX\), and \(Y−C−T=S\), then \(S=G−T+NX+I\), which simplifies to:
\[(S−I)+(T−G)=(NX)\]
If \((T−G)\) is negative, we have a budget deficit. Assuming that the economy is at potential output (meaning \(Y\) is fixed), if the budget deficit increases and savings and investment remain the same, then net exports must fall, causing a trade deficit. Thus, budget deficits and trade deficits go hand-in-hand.
Twin Deficits in the US: In the U.S., net borrowing has tended to have a direct relationship with net imports. The red line represents net imports, which is equivalent to the negative balance of trade, and the black line represents net borrowing, which is equivalent to the government budget deficit. Although the two are not identical, a rise in one tends to accompany a rise in the other, and vice versa.
The twin deficits hypothesis implies that as the budget deficit grows, net capital outflow from a country falls. This is because the nation is financing its spending by selling assets to foreigners. The total rate of national savings falls, which may lead to an increase in the interest rate as lending to the country (i.e. buying bonds and other financial assets) becomes more risky.
Key Points
• The international market serves as an important place for the exchange of goods and services.
• Economic theory shows that there are gains from trade for both countries involved.
• Advances in transportation has dramatically reduced the costs of moving goods around the globe.
• Technological advances have made international production and trade easier to coordinate.
• Trade barriers between countries have fallen and are likely to continue to fall.
• A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.
• Factors that can affect the balance of trade include the currency exchange rate, cost of inputs, barriers to trade such as tariffs and regulations, and the prices of domestic goods.
• The twin deficits hypothesis contends that there is a strong positive relationship between a national economy’s current account balance and its government budget balance.
Key Terms
• comparative advantage: The ability of a party to produce a particular good or service at a lower margin and opportunity cost over another.
• production possibilities curve: The various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production
• net capital outflow: The net flow of funds being invested abroad by a country during a certain period of time.
• net exports: The difference between the monetary value of exports and imports.
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Tariffs
Tariffs are taxes levied on goods entering or exiting a country, and have consequences for both domestic consumers and producers.
learning objectives
• Discuss the consequences of a tariff for a domestic economy
One barrier to international trade is a tariff. A tariff is a tax that is imposed by a government on imported or exported goods. They are also known as customs duties.
Types of Tariffs
Tariffs can be classified based on what is being taxed:
• Import tariffs: Taxes on goods that are imported into a country. They are more common than export tariffs.
• Export tariffs: Taxes on goods that are leaving a country. This may be done to raise tariff revenue or to restrict world supply of a good.
Tariffs may also be classified by their purpose:
• Protective tariffs: Tariffs levied in order to reduce foreign imports of a product and to protect domestic industries.
• Revenue tariffs: Tariffs levied in order to raise revenue for the government.
Tariffs can also be classified on how the duty amount is valued:
• Specific tariffs: Tariffs that levy a flat rate on each item that is imported. For example, a specific tariff would be a fixed \$1,000 duty on every car that is imported into a country, regardless of how much the car costs.
• Ad valorem tariffs: Tariffs based on a percentage of the value of each item. For example, an ad valorem tariff would be a 20% tax on the value of every car imported into a country.
• Compound tariffs: Tariffs that are a combination of specific tariffs and ad valorem tariffs. For example, a compound tariff might consist of a fixed \$100 duty plus 10% of the value of every imported car.
Consequences of Levying a Tariff
To see the effects of levying an import tariff, consider the example shown in. Assume that there is an import tax levied on a good in a domestic country, Home. The domestic supply of the good is represented by the diagonal supply curve, and world supply is perfectly elastic and represented by the horizontal line at \(P_w\). Before a tariff is levied, the domestic price is at \(P_w\), and the quantity demanded is at \(D\) (with quantity \(S\) provided domestically, and quantity \(D−S\) imported).
Effects of a Tariff: When a tariff is levied on imported goods, the domestic price of the good rises. This benefits domestic producers by increasing producer surplus, but domestic consumers see a small consumer surplus.
When the tariff is imposed, the domestic price of the good rises to \(P_t\). Now, more of the good is provided domestically; instead of producing \(S\), it now produces \(S^*\). Imports of the good fall, from the quantity \(D−S\) to the new quantity \(D^*−S^*\). With the higher prices, domestic producers experience a gain in producer surplus (shown as area A). In contrast, because of the higher prices, domestic consumers experience a loss in consumer surplus; consumer surplus shrinks from the area above \(P_w\) to the area above \(P_t\) (it shrinks by the areas A, B, C, and D).
Because the tariff is a tax, the government gains some revenue. The government charges a tariff amount of \(P_t−P_w\) on every imported good. The amount of revenue is equal to the tariff amount times the number of imported goods, or \((P_t−P_w)(D^*−S^*)\). This results in a governmental gain of area C.
In this example, domestic producers and the government both gain from the import tariff, and domestic consumers lose. However, if the world price is higher than the domestic price, a tariff will not change the price or quantity consumed of a good.
Quotas
Quotas are limitations on imported goods, come in an absolute or tariff-rate varieties, and affect supply in the domestic economy.
learning objectives
• Discuss the economic consequences of different kinds of quotas
Barriers to trade exist in many forms. A tariff is a barrier to trade that taxes imports or exports, thus increasing the cost of a good. Another barrier to trade is an import quota, which places a limit on the amount of a good that may enter a country.
Types of Quotas
There are two main types of import quota: the absolute quota and the tariff-rate quota.
An absolute quota is a limit on the quantity of specific goods that may enter a country during a certain time period. Once the quota has been fulfilled, no other goods may be imported into the country. An absolute quota may be set globally, in which case goods may be imported from any country until the goal has been reached. An absolute quota may also be set selectively for certain countries. As an example, suppose an absolute, global quota for pens is set at 50 million. The government is setting a limit that, in total, only 50 million pens can be imported. If there were a selective, absolute quota, only 50 million pens would be able to be imported, but this total would be divided among exporting countries. Country A might only be able to export 10 million pens, Country B might be able to export 25 million pens, and Country C might be able to export 15 million pens. Collectively, the total imports equal 50 million pens, but the proportions of pens from each country are set.
A tariff-rate quota is a two-tier quota system that combines characteristics of tariffs and quotas. Under a tariff-rate quota system, an initial quota of a good is allowed to enter the country at a lower duty rate. Once the initial quota is surpassed, imports are not stopped; instead, more of the good may be imported, but at a higher tariff rate. For example, under a tariff-rate quota system, a country may allow 50 million pens to be imported at the low tariff rate of \$1 each. Any pen that is imported after this first-tier quota has been reached would be charged a higher tariff, say \$3 each.
Reasons to Implement Quotas
Quotas are often implemented for similar reasons as other trade barriers. Often, quotas are instituted to:
• Protect domestic industries and employment: By reducing the number of foreign imports, domestic suppliers must produce more to meet domestic demand. By producing more, the suppliers must hire more domestic workers, increasing employment. Additionally, setting quotas to reduce foreign competition allows domestic “infant industries,” or young, small industries, to grow and mature to a competitive level.
• Protect against unfair trade practices: Setting a quota helps protect a domestic economy from unfair trade practices such as dumping, the pricing of imports below production cost. By restricting imports, quotas minimize the impact of such activities.
• Protect national security: Import quotas discourage imports and encourage domestic production of goods that may be necessary to the security of the country. By protecting and encouraging the growth of these defense-related industries, a country will not have to be dependent on foreign imports in the event of a war.
Consequences of Quotas
Like other trade barriers, quotas restrict international trade, and thus, have consequences for the domestic market. In particular, quotas restrict competition for domestic commodities, which raises prices and reduces selection. This hurts the domestic consumer, who experiences a loss in consumer surplus. On the other hand, this very action benefits the domestic producer, who sees an increase in producer surplus. Often, the increase in producer surplus is not enough to offset the loss in consumer surplus, so the economy experiences a loss in total surplus.
Quotas may also foster negative economic activities. Import quotas may promote administrative corruption, especially in countries where import quotas are given to selected importers. There are incentives to give the quotas to importers who can provide the most favors or the largest bribes to officials. Quotas may also encourage smuggling. As quotas raise the price of domestic goods, it becomes profitable to try and circumvent the quota by bringing in goods illegally, or in excess of the quota.
Other Barriers
Barriers to trade include specific limitations to trade, customs procedures, governmental participation, and technical barriers to trade.
learning objectives
• Distinguish different barriers to trade
In addition to tariffs and quotas, other barriers to trade exist. They can be divided into four separate categories: specific limitations to trade, customs and administrative procedures, government participation, and technical barriers to trade.
Specific Limitations to Trade
This category of trade barriers stems from regulations on international trade. Some examples include:
• Local content requirements, or domestic content requirements, are rules that mandate how much of a product must be produced domestically in order to qualify for lowered tariffs or other preferential treatment.
• Embargoes are prohibitions on trade ban imports or exports, and may apply to certain categories of products, or strictly to goods supplied by certain countries.
Customs and Administrative Procedures
This category of trade barriers refers to trade impediments that stem from governmental procedures and controls. Some examples include:
• Bureaucratic delays: Delays at ports or other country entrances caused by administrative or bureaucratic red-tape increase uncertainty and the cost of maintaining inventory.
• Anti-dumping duties: In international trade, dumping refers to a form of predatory pricing in which exported products are priced below the cost of production or below the price charged in the home market. Anti-dumping duties are usually extra taxes levied on the product to neutralize the predatory pricing and bring the price closer to the “normal value. “
Government Participation
This category of trade barriers represents direct governmental involvement in international trade. Some examples include:
• Government procurement programs: Public authorities, such as government agencies, are much like private interests in that they must also buy goods and services. Unlike private interests, governments are more likely to buy domestically produced goods and services, rather than the lowest-cost commodities. Because government procurement often represent a significant portion of a country’s GDP, foreign suppliers are at a disadvantage to domestic ones when it comes to these programs.
• Export subsidies: Export subsidies are production subsidies granted to exported products, usually by a government. With export subsidies, domestic producers can sell their commodities in foreign markets below cost, which makes them more competitive.
• Countervailing duties: Countervailing duties, or anti-subsidy duties, are extra duties levied on imports in order to neutralize an export subsidy. If a country discovers that a foreign country subsidizes its exports, and domestic producers are injured as a result, a countervailing duty can be imposed in order to reduce the export subsidy advantage. In that respect, countervailing duties are similar to anti-dumping duties in that they both bring a imported product’s value closer to the “normal value. “
Technical Barriers to Trade
Technical barriers to trade are non-tariff barriers to trade that refer to standards implemented by countries. Because these standards must be met before goods are allowed to enter or leave a country, they represent international trade barriers. Some examples include:
• Sanitary and phytosanitary measures: These are health standards for plants, animals, and other products, and are designed to protect humans, animals, and plants from pests or diseases.
• Rules for product weights, sizes, or packaging.
• Standards for labeling and testing products.
• Ingredient or identity standards.
Key Points
• Tariffs can be levied on goods being imported in a country ( import tariff), or exported from a country ( export tariff). They may be levied in order to protect domestic producers (protective tariff), or to raise revenue for the government (revenue tariff).
• Specific tariffs levy a fixed duty on a good. Ad valorem tariffs are based on a percentage of the good’s value. Compound tariffs are a combination of specific and ad valorem tariffs.
• Tariffs often increase domestic producer surplus and the quantity of a good supplied domestically, but hurt domestic consumer surplus.
• There are two types of quotas: absolute and tariff -rate. Absolute quotas are quotas that limit the amount of a specific good that may enter a country. Tariff-rate quotas allow a quantity of a good to be imported under a lower duty rate; any amount above this is subject to a higher duty.
• Justifications for the use of quotas include protection for domestic employment and infant industries, protection against unfair foreign trade practices, and protection of national security.
• Quotas often hurt domestic consumers and benefit domestic producers. Quotas may also provide incentives for administrative corruption and smuggling.
• Specific limitations to trade barriers include local content requirements and embargoes. This category of barriers comes from trade regulations.
• Customs and administrative procedure barriers include bureaucratic red tape and anti- dumping practices. This category of barriers comes from government procedures.
• Governmental participation barriers include government procurement programs, export subsidies, and countervailing duties. This category of barriers involves the direct participation of government in trade.
• Technical barriers to trade include sanitary regulations, measurement and labeling standards, and ingredient standards. This category of barriers involves health, safety, and measurement standards.
Key Terms
• tariff: A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.
• absolute quota: A limitation of the quantity of certain goods that may enter commerce during a specific period.
• quota: A restriction on the import of something to a specific quantity.
• tariff-rate quota: Allows a specified quantity of imported goods to be entered at a reduced rate of duty during the quota period, with quantities entered in excess of the quota limit subject to a higher duty rate.
• Dumping: Selling goods at less than their normal price, especially in the export market.
• countervailing duty: A tax levied on an imported article to offset the unfair price advantage it holds due to a subsidy paid to producers or exporters by the government of the exporting country if such imports cause or threaten injury to a domestic industry.
• embargo: A ban on trade with another country.
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National Security Argument
National security protectionist arguments pertain to the risk of dependency upon other nations for economic sustainability.
learning objectives
• Evaluate the arguments in favor of the use of trade protectionism in the security industry
Economic interdependence and globalization has resulted in a system, where each country is largely dependent upon other countries for economic sustainability (though to varying degrees). This results in a substantial national security threat in the form of conflicting or offensive trade strategies between countries. Indeed, economics is often used directly as a weapon of war and conflict via trade sanctions. This highlights a critical protectionist argument pertaining to the very real risk of dependency upon other nations for economic sustainability.
Trade and Conflict
An interesting discussion in economics is the relationship between trade and conflict. It has been noted, somewhat intuitively and empirically, that conflict reduces trade. However, is it also the case that trade reduces conflict? This question is largely unanswered, although the stances are becoming more highly developed. It is hypothesized that trade does not necessarily reduce conflict, but instead changes the nature of the conflict. Economic levers are much more practical than military levers, and are often used for similar reasons. For this reason, it is difficult to separate trade and conflict completely because there is some critical overlap between the two. This is a fundamental foundation for the trade protectionism logic from a national security perspective.
Trade During Conflict
A more specific context for trade and conflict can be the way in which trade is complicated during wartime. Indeed, trade during wartime can be a substantial threat to a nation depending on the scale and scope of the conflict (most notably who is involved). For example, consider World War II. In this scenario Germany was largely isolated in the conflict, and therefore had extremely limited trade partners. Direct conflict will almost always result in a complete cease in trading not only between the country in which the war is occurring, but also any of that country’s allies (who may or may not be directly involved). However, some argue self-sufficiency (via protectionism) in war is not necessary, as friendly nations will still provide trade and economic support.
Sanctions also play a dramatic role as an offensive militaristic maneuver. Iran and North Korea are strong modern examples as well as the recent history of the U.S.-Iraq war. In all of these circumstances, either the U.S. alone or along with a number of allies (representing substantial consumption percentages) actively limited the ability for these countries to trade and generate economic value for their nations (and subsequently their people). While this looks purely economic, it has important social and humanitarian implications as well. The chart makes this case quite clearly, pointing out the death toll in wartime if economic levers are utilized.
Infant Mortality in Iraq During Sanctions: This graphic underlines the indirect consequences of employing economic levers (i.e. sanctions) in a militaristic fashion during a conflict. While the justification for these figures is complex, including other war-related factors, the correlation is quite clear. Diminishing a country’s economic prospects will in turn result in loss of life, particularly in developing nations.
Protectionism
Combining these ideas, it is clear that there is substantial national security value to trade protectionism. However, the opportunity cost of leveraging the ever-growing global markets make this an unattractive prospect if taken to any extreme, as the benefits of global trade rapidly offset the risk of economic dependency upon hostile nations.
Infant Industry Argument
Economic markets are inherently competitive and newer economies are vulnerable to their more developed counterparts in other countries.
learning objectives
• Discuss the use of trade protectionism to promote new industries
Trade protectionism is defined as national policy restricting international economic trade to alter the balance between imports and goods manufactured domestically, usually executed via policies and governmental regulations such as import quotas, tariffs, taxes, anti-dumping legislation, and other limitations.
Arguments for Protecting Infant Industry
The primary purpose for this system is as the name implies: protection. Economic markets are inherently competitive, and newer economies are highly vulnerable to their more developed counterparts in other countries for a variety of reasons. The infant industry argument is that new industries need protection until they have become efficient enough to compete in the world market.
Despite the standard argument from mainstream economists postulating that free trade and open markets is the ideal system to allow for capitalistic development, there are many economists who believe that some degree of protectionism is the only way to minimize income gaps and substantial inequity from economy to economy (see ). The primary advantage to countries with higher economic power and bigger corporations is simply economies of scale and economies of scope, in addition to being further along the experience curve.
Economies of Scale: The basic premise behind economies of scale is that higher production quantity reduces cost per unit, ultimately allowing for the derivation of economic advantage in the market. Infant industries generally do not have the capacity to do this.
GDP by Country: This map demonstrates the vast difference in overall economic power across the globe, underlining the inequities that need to be addressed in economic policy formulation.
History has proven the value of protection for the countries employing tariff-based international trade policies. Alexander Hamilton first pointed out the inequities of developing economies with young industry in 1790, which was later picked up and developed by Daniel Raymond and Friedrich List in the 19th century. Around this time frame, the United States was employing heavy tariffs to protect their fragile economic system as the economy began to achieve autonomy after British rule. Indeed, Britain employed similarly protectionist policies during this time frame, setting the tone for large economic expansion in the longer term.
Criticism
Of course, protective policy while industry develops domestically is not a cure all. In Brazil in the 1980’s there were heavy protective policies in place to defend Brazil’s nascent computer industry from highly evolved competitors internationally. While this seemed practical, what ended up happening was quite damaging for Brazil. Technology advanced rapidly, and without strategic alliances on a global scale, Brazil largely missed out on these advances. This protectionism seems to have damaged industry prospects on a global level for Brazil in this scenario.
From a broader and more far-reaching perspective, protectionism as a general principle has been heavily criticized (even in infant industry situations). The reason for this is quite simply the significant jump in prosperity as international trade expanded, and the huge capacity for specialization, economies of scale, technology sharing, and a host of other advantages that have been a direct result of free global markets. The problem still remains, however, that this prosperity is often unregulated and of the greatest benefit to the influential players in established economies, sometimes at the expense of exploitation of developing nations (cheaper labor, reduced governmental oversight, etc.). As a result of this, protecting infant industries can benefit the nation employing them, but generally with the opportunity cost of global value.
Unfair Competition Argument
One of the strongest arguments for trade protectionism is unfair competition emerging due to differences in policy and enforcement ability.
learning objectives
• Examine the use of protectionism as a way of addressing unfair competitive practices
Protectionist policies are a highly charged topic in economic debates, as economies work to attain the optimal balance of free trade and trade protectionism to capture the most value. In many ways, the global markets are torn between pursuing what is best on the global level and what is best at the domestic level, and there is sometimes dissonance between the two. One of the strongest arguments for some degree of trade protectionism is the tendency for unfair competition to emerge, particularly in developing markets without the infrastructure to monitor their businesses and enforce penalties. This is called the unfair competition argument.
Dumping
A popular recent topic is anti-dumping policies directed at international players looking to undercut domestic business through selling at dramatically reduced prices. This can be a substantial threat, particularly from economies where labor laws are lax and workers are exploited to create extremely low cost goods. This is also a risk when governments get too involved in business, a criticism often pointed out in China. Governments can provide subsidies to reduce costs for domestic companies. This can also be a threat in infant industries, where larger and more established players can push out smaller players via undercutting prices, absorbing losses until the competition goes bankrupt.
Offsetting this threat has been an ongoing struggle, with the emergence of international trade agreements and organizations like the World Trade Organization (WTO) playing an increasingly large role. One of the struggles with international trade is the difficulty of enforcement between nations, and the WTO plays a critical role in identifying malpractice and addressing it.
Intellectual Property
Another critical risk in the global market is intellectual property (IP) protection. Patents, in a domestic system, protect the innovator to allow them to generate returns on the substantial time investment required to invent or innovate new products or technologies. On a global scale, however, it is quite common for developing nations to copy new technologies via reverse engineering. This results in copycats violating the patents in an environment where the infrastructure domestically will probably not take legal action. This reduces the desire for innovation and places large economic risks on countries dependent upon this for growth.
This is addressed through international patent laws and trade agreements as well, alongside political pressures such as raising tariffs and placing import quotas on countries suspected to be in violation of patents. The downside to this is that utilizing these measures creates political unrest, global factions, and strained business relationships.
Mergers, Acquisitions, and Market Dominance
Another unfair competition threat is the emergence of global monopolies. Some of the larger ones attain enough global power and geographic diversification to be difficult to break up via domestic antitrust laws. demonstrates the substantial threat of deadweight losses being incurred in economies where consolidation results in a lack of competitive forces to drive down price.
Economic Losses in a Monopoly: This chart highlights the very real risk of lost economic value in a monopolistic situation (deadweight loss in yellow).
On the domestic level monopolies are widely seen as being addressed (though this is hotly debated by many economists in light of the ‘too big to fail’ and ‘too big to jail’ banks). On a global scale it is even more difficult to regulate, as the size and scale of these companies often extends beyond the power of the governments where these companies are located. This is addressed through international standards and trade agreements, standardizing governmental policy on a global level to reduce the risk of monopoly and unfair consolidation towards market dominance.
Jobs Argument
Many policy makers who are proponents of trade protectionism argue that limiting imports will create or save more jobs at home.
learning objectives
• Analyze the use of trade restrictions for strategic purposes
Many policy makers who are proponents of trade protectionism make the argument that limiting imports will create more jobs at home. This argument is predicated on the idea that buying more domestically will drive up national production, and that this increased production will in turn result in a healthier domestic job market. Domestic industries will not have to compete with foreign producers, and are therefore protected from losing marketshare to cheaper imports.
Trade Balance
It is useful to consider the concept of a trade balance, or net exports, in the context of the jobs argument. It is interesting to look at to assess the extremity to which some nations are ‘consumer nations’ and others are ‘producer nations’. The U.S. and China are a great example of opposite sides of the spectrum, where the trade balance is heavy on one side of the spectrum.
Trade Balances on a Global Scale: It is interesting to look at this graph and assess the extremity to which some nations are ‘consumer nations’ and others are ‘producer nations. ‘ The U.S. and China are a great example of opposite sides of the spectrum, where the trade balance is heavily on one side of the spectrum.
In the U.S. this has created a dramatic push for trade protectionism policies; something the United States has not actively pursued in quite some time. The disastrous 2008 economic collapse via the clear-cut abuses by the banks, and the resulting drop in employment rates, has created an incredibly tangible social and political agenda to bring production back to domestic jobs from overseas. This sentiment towards protectionism is a direct result of the jobs argument in view of an imbalanced trade ratio, where more exports (production and jobs at home) are required to sustain the ongoing consumption of imports.
Outsourcing
Along similar lines, it is common practice for companies to identify strategic alliances abroad and send much of the production work to these locations. This is often a result of cheaper labor and easier systems of governance in those regions. The obvious perspective, from a policy making context, is that these are jobs lost to overseas competitors. While this perspective is often criticized for being short-sighted and against the modern economic view of free markets, it has resulted in policy makers providing incentives to ‘bring jobs back home. ‘
This idea of limiting outsourcing in light of the protectionist jobs argument has resulted in governmental subsidies that work to offset the costs of manufacturing domestically (in the U.S. particularly). These subsidies are essentially grants or tax breaks for companies operating domestically and creating jobs, driving up employment rates via protectionist strategies.
Trade Restriction Strategies
Offsetting the threats of outsourcing and trade imbalances and driving domestic purchasing, and thus domestic production, is done through a variety of political vehicles. Most notable among them are:
• Import Quotas: This is the act of limiting the number of a certain good that can be purchasing from a given country, ensuring that domestic producers maintain a portion of the market share.
• Tariffs: Tariffs are fairly straight-forward, essentially taxes to bring goods into a given country. High tariffs will raise the cost for foreign producers to sell their goods in a domestic system, providing strategic advantages for local producers. One of the pitfalls of tariffs is the likelihood of retaliation, where the foreign government returns with similar tariffs. This will in turn damage global prospects for domestic suppliers.
• Anti-dumping:Anti-dumping legislation actively offsets the ability of low cost or highly subsidized producers in foreign countries to undercut prices in a domestic system. Dumping is the process of selling goods far below market value to drive out competition, often in pursuit of creating a monopoly.
• Subsidies: On the other end of the spectrum, and as noted above, governments can provide subsidies to domestic producers to lower their costs and drive up competitive ability. This can in turn create jobs.
A Summary of International Trade Agreements
International trade agreements are agreements across national borders that reduce or eliminate trade barriers to promote economic exchange.
learning objectives
• Identify at least three main international trade agreements
International trade agreements are trade agreements across national borders intended to reduce or eliminate trade barriers to promote economic exchange. International trade encounters a variety of obstacles, some of which pertain to the protectionism identified in other atoms, which reduce trade incentives. This is usually through tariffs, quotas, taxes, and other trade restrictions. It is also useful to create standards and norms across different countries, particularly for things like intellectual property law recognition, which enables businesses to operate across borders.
There are quite a few international trade agreements, some of which are more formal than others. The trade agreements below provide a fairly comprehensive overview of the current international trade environment:
World Trade Organization (WTO)
The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995, designed to enable international trade while reducing unfair practices. In many ways, the WTO is more complex than other international trade agreements because it incorporates a variety of smaller agreements into a larger framework. The WTO includes upwards of 60 different agreements alongside 159 official members and 25 observers. underlines how effective and universal international trade agreements are becoming. The WTO performs several objective functions as well if trade disputes arise, acting as a framework for assessing appropriate international trade practices.
WTO Members: The World Trade Organization (WTO) is an organization designed to oversee and enable international trade. This map shows how successful this has been on a global scale.
The core of the WTO is the most-favored nation (MFN) rule, which states that each WTO member must be charged the lowest tariffs that an importer places on any country. For example, if the US charges Brazil a 5% tariff on imported clothes, and this is the lowest tariff it has placed on any country in the WTO, all other WTO members must also be charged a 5% tariff. Every WTO member gets charged the lowest tariff that an importer charges any other member.
North American Free Trade Agreement (NAFTA)
Unlike the WTO, which is an entirely global approach, most international agreements stem from geographic proximity. NAFTA is a trilateral agreement between the United States, Canada and Mexico designed to minimize any trade or investment barriers between any of these countries (primarily in the form of tariffs). Generally speaking, the United States demonstrates a trade deficit with these countries relative to goods and a surplus relative to services. The United States also demonstrates high and fast-growing foreign direct investment (FDI) in both regions.
NAFTA Participants: This map outlines each of the countries involved in the North American Free Trade Agreement, an international trade agreement focused on a geographic proximity.
There has been a great deal of controversy surrounding this trade agreement. Agriculture is not included in this agreement, and is often a tough point of discussion for the WTO as well. Mexico is also a point tension due to the fact that it is developing economically (compared to the U.S. and Canada who are considered already developed). Finally, Canadians have often objected to the NAFTA agreements due to the way in which the United States FDI employs hostile takeovers. These agreements demonstrate some of the validity behind trade protectionism and isolationism (as discussed in other atoms in this chapter).
Asia-Pacific Economic Cooperation (APEC)
The APEC forum is particularly interesting in the context of the above agreements, as it is slightly less formal than the above two (it is referred to as a ‘forum’). The APEC forum is a cooperative discussion between 21 countries in the Pacific Rim region promoting free trade, with a focus on newly industrialized economies (NIE). Developing nations gaining access to capital investment and export agreements is the central outcome of APEC, driving economic growth through controlled global expansion. This region represents over half of the world’s GDP and 40% of the overall world population, making this a critical region of the world economy.
APEC Participants: The Asia-Pacific Economic Cooperation (APEC) is a forum of 21 countries in the Pacific Rim region, focusing on free trade and economic cooperation.
Key Points
• Economic interdependence and globalization has resulted in a unique capitalistic system, where each country is largely dependent upon other countries for economic sustainability.
• It has been noted, somewhat intuitively and empirically, that conflict reduces trade. This highlights the risk of conflict harming an economy.
• A more specific context for trade and conflict can be the way in which trade is complicated during wartime. Indeed, trade during wartime can be a substantial threat to a nation, as economic levers such as sanctions can be utilized.
• Iran and North Korea are strong modern examples as well as the recent history of the U.S.-Iraq war. All of these economies struggle(d) against harsh economic sanctions.
• Combining these ideas, it is clear that there is substantial national security value to trade protectionism.
• Trade protectionism is national policies restricting international economic trade to alter the balance between imports and goods manufactured domestically through import quotas, tariffs, taxes, anti-dumping legislation, and other limitations.
• The primary advantage to countries with higher economic power and bigger corporations is simply economies of scale, which infant industries in developing countries often protect against.
• The United States was employing heavy tariffs to protect their fragile economic system as the economy began to achieve autonomy after British rule, which proved effective.
• From a broader and more far-reaching perspective, protectionism as a general principle has been heavily criticized (even in infant industry situations). The argument is that free markets add value on a global level, while protectionism confines economic value to the nation employing it.
• Protectionist policies are a highly charged topic in economic debates, as economies work to attain the optimal balance of free trade and trade protectionism to capture the most value.
• A recent topic is anti- dumping policies directed at international players looking to undercut domestic business through selling at dramatically reduced prices.
• Another critical risk in the global market is intellectual property (IP) protection as patents are often ignored globally, particularly by countries which lack the infrastructure to enforce IP laws.
• Another unfair competition threat is the emergence of global monopolies. Some of the larger ones attain enough global power and geographic diversification to be difficult to break up via domestic anti-trust laws.
• This argument is predicated on the simply fact that buying more domestically will drive up national production, and that this increased production will in turn result in a healthier domestic job market.
• Local governments leverage subsidies, tariffs, import quotas, and anti- dumping policies to maximize strategic capacity domestically, thus creating jobs.
• A sentiment towards protectionism has developed in the U.S. due to the jobs argument in view of an imbalanced trade ratio, where more exports (production and jobs at home) is required to sustain the ongoing consumption of imports.
• Along similar lines, it is common practice for companies to identify strategic alliances abroad and send much of the production work to these locations (outsourcing), motivating governments to bring these jobs back home.
• Local governments leverage subsidies, tariffs, import quotas, and anti-dumping policies to maximize strategic capacity domestically, thus creating jobs.
• International trade encounters a variety of obstacles which reduce trade incentives. This is usually through tariffs, quotas, taxes, and other trade restrictions.
• The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995, designed to enable international trade while reducing unfair practices.
• NAFTA is a trilateral agreement between the United States, Canada and Mexico designed to minimize any trade or investment barriers between any of these countries (primarily in the form of tariffs).
• The APEC forum is a cooperative discussion between 21 countries in the Pacific Rim region promoting free trade, with a focus on newly industrialized economies (NIE).
Key Terms
• sanction: A penalty, or some coercive measure, intended to ensure compliance; especially one adopted by several nations, or by an international body.
• Self-sufficiency: Able to provide for oneself independently of others.
• Nascent: Emerging; just coming into existence.
• Dumping: Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.
• Subsidies: Financial support or assistance, such as a grant.
• Reverse engineering: The process of analyzing the construction and operation of a product in order to manufacture a similar one.
• Import Quota: A restriction on the import of something to a specific quantity.
• Trade Balance: The difference between the monetary value of exports and imports in an economy over a certain period of time.
• Foreign direct investment: Investment into production or business in a country by an individual or company of another country.
• tariff: A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.
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The Balance of Payments
The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world.
learning objectives
• Explain the components and importance of the balance of payments
The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world. This includes payments for the country’s exports and imports, the sale and purchase of assets, and financial transfers. The BOP is given for a specific period of time (usually a year) and in terms of the domestic currency.
Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Sources of funds include exports, the receipt of loans or investment, and income from foreign assets. Whenever a country has an outflow of funds, such as when the country imports goods and services or when it invests in foreign assets, it is recorded as a debit on the balance of payments.
When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves, or by receiving loans from other countries.
U.S. Current Account: The chart shows the current account deficit of the U.S., both in dollars and as a percent of GDP. Deficits in the current account must be offset by surpluses in the financial and capital accounts.
Components of the Balance of Payments
The BOP can be expressed as:
\[BOP=Current \; Account+Financial \; Account+Capital \; Account+Balancing \; Item\]
The current account records the flow of income from one country to another. It includes the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers.
The financial account records the flow of assets from one country to another. It is composed of foreign direct investment, portfolio investment, other investment, and reserve account flows.
The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not affect national income. Debt forgiveness would affect the capital account, as would the purchase of non-financial and non-produced assets such as the rights to natural resources or patents.
The balancing item is simply an amount that accounts for any statistical errors and ensures that the total balance of payments is zero.
The Current Account
The current account represents the sum of net exports, factor income, and cash transfers.
learning objectives
• Calculate the current account
The current account represents the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers. It is called the current account as it covers transactions in the “here and now” – those that don’t give rise to future claims.
The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade deficit if its imports exceed its exports. Because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. This, however, is not always the case. Secluded economies like Australia are more likely to feature income deficits larger than their trade surplus.
The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money received from investments made abroad (note: the investments themselves are recorded in the capital account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad, known as remittances, to their families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc.
Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return. Typically, such transfers are done in the form of donations, aids, or official assistance.
Calculating the Current Account
Normally, the current account is calculated by adding up the 4 components of current account: goods, services, income and cash transfers.
Goods are traded by countries all over the world. When ownership of a good is transferred from a local country to a foreign country, this is called an export. When a good’s ownership is transferred from a foreign country to a local country, this is called an import. In calculating the current account, exports are marked as a credit (inflow of money) and imports are marked as a debit (outflow of money).
Services can also be traded by countries. This happens frequently in the case of tourism. When a tourist from a local country visits a foreign country, the local country is consuming the foreign services and this is counted as an import. Likewise, when a foreign tourist comes and enjoys the services of a local country, this is counted as an export. Other services can also be transferred between countries, such as when a financial adviser in one country assists clients in another.
A credit of income happens when a domestic individual or company receives money from a foreign individual or company. This would typically take place when a domestic investor receives dividends from an investment made in a foreign country, or when a worker abroad sends remittances back to the local country. Likewise, a debit in the income account takes place when a foreign entity receives money from an investment in the local economy.
Finally, a credit in the cash transfers column would be a gift of aid from a foreign country to the domestic country. Similarly, a debit in the cash transfers column might be the provision of official assistance by the local economy to a foreign economy.
Thus, a country’s current account can by calculated by the following formula:
\(CA=(X−M)+NY+NCT\)
Where \(CA\) is the current account, \(X\) and \(M\) and the export and import of goods and services respectively, \(NY\) is net income from abroad, and \(NCT\) is the net current transfers. When the sum of these four components is positive, the current account has a surplus.
Global Current Accounts: The map shows the per capita current accounts surpluses and deficits of countries around the world from 1980 to 2008. Deeper red implies a higher per capita deficit, while deeper green implies a higher per capita surplus.
The Financial Account
The financial account measures the net change in ownership of national assets.
learning objectives
• Calculate the financial account
The financial account (also known as the capital account under some balance of payments systems) measures the net change in ownership of national assets. When financial account has a positive balance, we say that there is a financial account surplus. A financial account surplus means that the net ownership of a country’s assets is flowing out of a country – that is, foreign buyers are purchasing more domestic assets than domestic buyers are purchasing of assets from the rest of the world. Likewise, we say that there is a financial account deficit when the financial account has a negative balance. This occurs when domestic buyers are purchasing more foreign assets than foreign buyers are purchasing of domestic assets. For example, a financial accounts deficit would exist when Country A’s citizens buy \$200 million worth of real estate overseas, while overseas investors purchase only \$100 million worth of real estate within Country A.
Calculating the Financial Account
The financial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account flows.
Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants. If foreigners are investing in a country, that is an inbound flow and counts as a surplus item on the financial account. If a nation’s citizens are investing in foreign countries, there is an outbound flow that will count as a deficit. After the initial investment, any yearly profits not re-invested will flow in the opposite direction, but will be recorded in the current account rather than the financial account.
FDI in Austria: Austria has experienced a surplus of foreign direct investment: more foreign investors invest in Austria than Austrian investors do in the rest of the world. This contributes to a financial account surplus.
Portfolio investment refers to the purchase of shares and bonds. It is sometimes grouped together with “other” as short term investment. As with FDI, the income derived from these assets is recorded in the current account; the financial account entry will just be for any buying or selling of the portfolio assets in the international financial markets.
Other investment includes capital flows into bank accounts or provided as loans. Large short term flows between accounts in different nations are commonly seen when the market is able to take advantage of fluctuations in interest rates and/or the exchange rate between currencies. Sometimes this category can include the reserve account.
The reserve account is operated by a nation’s central bank to buy and sell foreign currencies; it can be a source of large capital flows to counteract those originating from the market. Inbound capital flows (from sales of the account’s foreign currency), especially when combined with a current account surplus, can cause a rise in value (appreciation) of a nation’s currency, while outbound flows can cause a fall in value (depreciation). If a government (or, if authorized to operate independently in this area, the central bank itself) does not consider the market-driven change to its currency value to be in the nation’s best interests, it can intervene. Such intervention affects the financial account. Purchases of foreign currencies, for example, will increase the deficit and vis versa.
To calculate the total surplus or deficit in the financial account, sum the net change in FDI, portfolio investment, other investment, and the reserve account.
Interest Rates and the Financial Account
The outflow or inflow of assets in the financial account depends in large part on the domestic interest rate and how it compares to interest rates in other countries. A higher central bank interest rate will tend to increase the interest rate on all domestic financial assets, such as bonds, loans, and government securities. In general, if interest rates are higher in one country than another, an investor would prefer to purchase financial assets in the country with the higher interest rate.
An increase in the domestic interest rate will therefore cause foreign investors to purchase more domestic assets, creating a financial account surplus. Likewise, a fall in the domestic interest rate will cause domestic investors to purchase foreign assets in place of domestic assets, and will cause a financial account deficit.
The Capital Account
The capital account acts as a sort of miscellaneous account, measuring non-produced and non-financial assets, as well as capital transfers.
learning objectives
• Calculate the Capital Account
There are two common definitions of the capital account in economics. The first is a broad interpretation that reflects the net change in ownership of national assets. Under the International Monetary Fund (IMF) definition, however, most of these asset flows are captured in the financial account. Instead, the capital account acts as a sort of miscellaneous account, measuring non-produced and non-financial assets, as well as capital transfers. The capital account is normally much smaller than the financial and current accounts.
Like the financial account, a deficit in the capital account means that money is flowing out of a country and the country is accumulating foreign assets. Likewise, a surplus in the capital account means that a money is flowing into a country and the country is selling (or otherwise disposing of) non-produced, non-financial assets.
Calculating the Capital Account
The capital account can be split into two categories: non-produced and non-financial assets, and capital transfers. Non-produced and non-financial assets include things like drilling rights, patents, and trademarks. For example, if a domestic company acquires the rights to mineral resources in a foreign country, there is an outflow of money and the domestic country acquires an asset, creating a capital account deficit.
Natural Gas Rights: If a U.S. company sold its rights to drill for natural gas off the southern coast of the U.S., it would be recorded as a credit in the capital account.
Capital transfers include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and uninsured damage to fixed asset. For example, if the domestic country forgives a loan made to a foreign country, this transfer creates a deficit in the capital account.
Thus, the balance of the capital account is calculated as the sum of the surpluses or deficits of net non-produced, non-financial assets, and net capital transfers.
Reason for a Zero Balance
Equilibrium in the market for a country’s currency implies that the balance of payments is equal to zero.
learning objectives
• Discuss the long term equilibrium of a country’s balance of payments
Capital Flows
Trade within a country differs in one important way from trade between countries: unless the two nations share a common currency, any trade requires that countries go through the foreign exchange market to trade currency, in addition to trading goods and services. For example, imagine that buyers in France purchase oranges produced in Chile. The French buyers use the euro in order to make the purchase but the Chilean orange producers must be paid with the Chilean peso. This exchange between France and Chile requires that the firms exchange euros for pesos.
In general, there are two reasons for demanding a country’s currency: to purchase assets within the country and to purchase a country’s exports – that is, the goods and services produced within that country. The country’s currency is supplied when it is used to purchase foreign currencies. This also happens for two reasons: to purchase assets in other countries and to import goods or services from other countries.
Imaging that we are analyzing Italy’s economy and its currency transactions with the rest of the world. If an American buyer wishes to purchase bonds issued by an Italian corporation, she becomes part of the world demand for euros to buy Italian assets. Adding the demand for exports to the demand for assets outside of a country, we get the total demand for a country’s currency.
Likewise, a country’s currency is supplied when it is used to purchase currencies in the rest of the world. Italian euros, for eample, are supplied when Italian consumers or firms import goods and services from the rest of the world. Italian euros are also supplied when Italian purchasers acquire assets from other countries.
Equilibrium and Zero Balance
When a country’s balance of payments is equal to zero, there is equilibrium in the market for that country’s currency. Equilibrium occurs when:
Quantity of currency demanded = quantity of currency supplied
We have already seen that the quantity of currency demanded is equal to the demand for exports and demand for domestic assets. The quantity of currency supplied is equal to the demand for imports and the domestic demand for foreign assets. Thus, we can rewrite the relationship:
Exports + (foreign purchases of domestic assets) = imports + (domestic purchases of foreign assets)
Finally, we can rearrange the above formula as:
Exports – imports = (domestic purchases of foreign assets) – (foreign purchases of domestic assets)
The left-hand term is net exports – the difference between the amount of goods and services a country exports and the amount that it imports. We refer to this difference as the current account. When a country exports more goods than it imports, this number is positive and we say that the country has a current accounts surplus. When a country imports more than it exports this number is negative and we say that the country has a current accounts deficit.
The right-hand term is the difference between the foreign assets that people within the country purchase and the domestic assets that are purchased by foreigners. This is called the financial account. These assets include the reserve account (the foreign exchange market operations of a nation’s central bank ), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The financial account is also sometimes used in a narrower sense that excludes the foreign exchange operation of the central bank. When a country buys more foreign assets that other countries buy of its assets, this balance is positive and there is a financial account surplus.
If the above equation holds true, then any current account surplus must be matched by a financial account deficit, and vice versa. This holds true when a country’s currency market is in equilibrium and there are no external currency controls.
Exchange Rates: Exchange rates are constantly fluctuating to ensure that the quantity of currency supplied equals the quantity demanded. Because of this, the inflows and outflows of money are equal, creating a balance of payments equal to zero.
Key Points
• Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Whenever a country has an outflow of funds, it is recorded as a debit on the balance of payments.
• When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit.
• BOP=Current Account+Financial Account+ Capital Account+Balancing Item.
• The current account records the flow of income from one country to another.
• The financial account records the flow of assets from one country to another.
• The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not affect national income.
• The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade deficit if its imports exceeds its exports.
• The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money received from investments made abroad but also to remittances.
• Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return.
• A country’s current account can by calculated by the following formula: \(CA=(X−M)+NY+NCT\).
• A financial account surplus means that buyers in the rest of the world are purchasing more of a country’s assets than buyers in the domestic economy are spending on rest-of-world assets.
• The financial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account flows.
• Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants.
• Portfolio investment refers to the purchase of shares and bonds.
• Other investment includes capital flows into bank accounts or provided as loans.
• The reserve account is operated by a nation’s central bank to buy and sell foreign currencies.
• A deficit in the capital account means that money is flowing out of a country and the country is accumulating foreign assets.
• The capital account can be split into two categories: non-produced and non-financial assets, and capital transfers.
• Non-produced and non-financial assets include things like drilling rights, patents, and trademarks.
• Capital transfers include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, and the transfer of ownership on fixed assets.
• Equilibrium in the foreign exchange market implies that the quantity of currency demanded = quantity of currency supplied.
• The quantity of a currency demanded is from two sources: exports and rest-of-world purchases of domestic assets. The quantity supplied of a currency is also from two sources: imports and domestic purchases of rest-of-world assets.
• Therefore, exports + (rest-of-world purchases of domestic assets) = imports + (domestic purchases or rest-of-world assets).
• Finally, this means that exports – imports = (domestic purchases of rest-of-world assets) – (rest-of-world purchases of domestic assets).
• In other words, the current account balances out the financial account and the balance of payments is zero.
Key Terms
• balance of payments: A record of all monetary transactions between a country and the rest of the world
• credit: An addition to certain accounts.
• balance of trade: The difference between the monetary value of exports and imports in an economy over a certain period of time.
• debit: A sum of money taken out of an account.
• central bank: The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.
• interest rate: The percentage of an amount of money charged for its use per some period of time (often a year).
• debt forgiveness: The partial or total writing down of debt owed by individuals, corporations, or nations.
• net exports: The difference between the monetary value of exports and imports.
• foreign exchange: The changing of currency from one country for currency from another country.
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Introducing Exchange Rates
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another.
learning objectives
• Explain the concept of a foreign exchange market and an exchange rate
In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. For example, an inter-bank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, US\$) means that ¥91 will be exchanged for each US\$1 or that US\$1 will be exchanged for each ¥91.
Exchange Rates: In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.
Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today, but for delivery and payment on a specific future date.
How the Foreign Exchange Market Works
In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.
Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveler’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveler’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.
Finding an Equilibrium Exchange Rate
There are two methods to find the equilibrium exchange rate between currencies; the balance of payment method and the asset market model.
learning objectives
• Differentiate between the Balance of Payment and Asset Market Models
Countries have a vested interest in the exchange rate of their currency to their trading partner’s currency because it affects trade flows. When the domestic currency has a high value, its exports are expensive. This leads to a trade deficit, decreased production, and unemployment. If the currency’s value is low, imports can be too expensive though exports are expected to rise.
Purchasing Power Parity
Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs \$20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/\$, the book in England is selling for \$30, so the book is actually more expensive in England
If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.
The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.
Balance of Payments Model
The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.
Asset Market Model
Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.
Share of Stock: The key difference between the balance of payments and asset market models is that the former includes financial assets, such as stock, in its calculation.
The asset market model views currencies as an important element in finding the equilibrium exchange rate. Asset prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of the assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. These assets are not limited to consumables, such as groceries or cars. They include investments, such as shares of stock that is denominated in the currency, and debt denominated in the currency.
Real Versus Nominal Rates
Real exchange rates are nominal rates adjusted for differences in price levels.
learning objectives
• Calculate the nominal and real exchange rates for a set of currencies
Currency is complicated and its value can be measured in several different ways. For example, a currency can be measured in terms of other currencies, or it can be measured in terms of the goods and services it can buy. An exchange rate between two currencies is defined as the rate at which one currency will be exchanged for another. However, that rate can be interpreted through different perspectives. Below are descriptions of the two most common means of describing exchange rates.
Nominal Exchange Rate
A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms. The nominal rate is set on the open market and is based on how much of one currency another currency can buy.
Real Exchange Rate
The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.
A measure of the differences in price levels is Purchasing Power Parity (PPP). The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency.
Groceries: Purchasing Power Parity evaluates and compares the prices of goods in different countries, such as groceries. PPP is then used to help determine real exchange rates.
If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1. However, since these assumptions are almost never met in the real world, the real exchange rate will never equal 1.
Calculating Exchange Rates
Imagine there are two currencies, A and B. On the open market, 2 A’s can buy one B. The nominal exchange rate would be A/B 2, which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.
The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So, in this example, say it take 10 A’s to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket of goods expressed in A (10). In this case, the real A/B exchange rate is 3.
Exchange Rate Policy Choices
A government should consider its economic standing, trade balance, and how it wants to use its policy tools when choosing an exchange rate regime.
learning objectives
• Explain the factors countries consider when choosing an exchange rate policy
When a country decides on an exchange rate regime, it needs to take several important things in account. Unfortunately, there is no system that can achieve every possible beneficial outcome; there is a trade-off no matter what regime a nation picks. Below are a few considerations a country needs to make when choosing a regime.
Stage of Economic Development
A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies. Developing economies often have the majority of their liabilities denominated in other currencies instead of the local currency. Businesses and banks in these types of economies earn their revenue in the local currency but have to convert it to another currency to pay their debts. If there is an unexpected depreciation in the local currency’s value, businesses and banks will find it much more difficult to settle their debts. This puts the entire economy’s financial sector stability in danger.
Developing Countries: The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate. This is because sudden depreciation in their currency value poses a significant threat to the stability of their economies.
Balance of Payments
Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs in an economy with a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will increase the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and decreases the trade deficit. Under fixed exchange rates, this automatic re-balancing does not occur.
Monetary and Fiscal Policy
A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. In general, fixed-rates are not established by law, but are instead maintained through government intervention in the market. The government does this through the buying and selling of its reserves, adjusting its interest rates, and altering its fiscal policies. Because the government must commit its monetary and fiscal tools to maintaining the fixed rate of exchange, it cannot use these tools to address other macroeconomics conditions such as price level, employment, and recessions resulting from the business cycle.
Exchange Rate Systems
The three major types of exchange rate systems are the float, the fixed rate, and the pegged float.
learning objectives
• Differentiate common exchange rate systems
One of the key economic decisions a nation must make is how it will value its currency in comparison to other currencies. An exchange rate regime is how a nation manages its currency in the foreign exchange market. An exchange rate regime is closely related to that country’s monetary policy. There are three basic types of exchange regimes: floating exchange, fixed exchange, and pegged float exchange.
Foreign Exchange Regimes: The above map shows which countries have adopted which exchange rate regime. Dark green is for free float, neon green is for managed float, blue is for currency peg, and red is for countries that use another country’s currency.
The Floating Exchange Rate
A floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime wherein a currency’s value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating currency.
Many economists believe floating exchange rates are the best possible exchange rate regime because these regimes automatically adjust to economic circumstances. These regimes enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism.
The Fixed Exchange Rate
A fixed exchange rate system, or pegged exchange rate system, is a currency system in which governments try to maintain a currency value that is constant against a specific currency or good. In a fixed exchange-rate system, a country’s government decides the worth of its currency in terms of either a fixed weight of an asset, another currency, or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price.
To ensure that a currency will maintain its “pegged” value, the country’s central bank maintain reserves of foreign currencies and gold. They can sell these reserves in order to intervene in the foreign exchange market to make up excess demand or take up excess supply of the country’s currency.
The most famous fixed rate system is the gold standard, where a unit of currency is pegged to a specific measure of gold. Regimes also peg to other currencies. These countries can either choose a single currency to peg to, or a “basket” consisting of the currencies of the country’s major trading partners.
The Pegged Float Exchange Rate
Pegged floating currencies are pegged to some band or value, which is either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes. There are three types of pegged float regimes:
• Crawling bands: The market value of a national currency is permitted to fluctuate within a range specified by a band of fluctuation. This band is determined by international agreements or by unilateral decision by a central bank. The bands are adjusted periodically by the country’s central bank. Generally the bands are adjusted in response to economic circumstances and indicators.
• Crawling pegs:A crawling peg is an exchange rate regime, usually seen as a part of fixed exchange rate regimes, that allows gradual depreciation or appreciation in an exchange rate. The system is a method to fully utilize the peg under the fixed exchange regimes, as well as the flexibility under the floating exchange rate regime. The system is designed to peg at a certain value but, at the same time, to “glide” in response to external market uncertainties. In dealing with external pressure to appreciate or depreciate the exchange rate (such as interest rate differentials or changes in foreign exchange reserves), the system can meet frequent but moderate exchange rate changes to ensure that the economic dislocation is minimized.
• Pegged with horizontal bands:This system is similar to crawling bands, but the currency is allowed to fluctuate within a larger band of greater than one percent of the currency’s value.
Fixed Exchange Rates
A fixed exchange rate is a type of exchange rate regime where a currency’s value is fixed to a measure of value, such as gold or another currency.
learning objectives
• Explain the mechanisms by which a country maintains a fixed exchange rate
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.
Reasons for Fixed Exchange Rate Regimes
A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP.
This belief that fixed rates lead to stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation’s government can use to regulate flows from capital markets into and out of the country’s capital account. A fixed exchange rate regime should be viewed as a tool in capital control.
How a Fixed Exchange Regime Works
Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.
Another, method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency. Some countries, such as China in the 1990s, are highly successful at using this method due to government monopolies over all money conversion. China used this method against the U.S. dollar.
PRC Flag: China is well-known for its fixed exchange rate. It was one of the few countries that could impose a fixed rate by making it illegal to trade its currency at any other rate.
Managed Float
Managed float regimes are where exchange rates fluctuate, but central banks attempt to influence the exchange rates by buying and selling currencies.
learning objectives
• Describe a managed float exchange rate and explain why countries choose managed floats
Managed float regimes, otherwise known as dirty floats, are where exchange rates fluctuate from day to day and central banks attempt to influence their countries’ exchange rates by buying and selling currencies. Almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. So when a country claims to have a floating currency, it most likely exists as a managed float.
How a Managed Float Exchange Rate Works
Generally, the central bank will set a range which its currency’s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range.
India: India has a managed float exchange regime. The rupee is allowed to fluctuate with the market within a set range before the central bank will intervene.
Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in reserve. By putting more of its currency in circulation, the central bank will decrease the currency’s value.
Why Do Countries Choose a Managed Float
Some economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates. Floating exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign business cycles. This ultimately preempts the possibility of having a balance of payments crisis. A floating exchange rate also allows the country’s monetary policy to be freed up to pursue other goals, such as stabilizing the country’s employment or prices.
However, pure floating exchange rates pose some threats. A floating exchange rate is not as stable as a fixed exchange rate. If a currency floats, there could be rapid appreciation or depreciation of value. This could harm the country’s imports and exports. If the currency’s value increases too drastically, the country’s exports could become too costly which would harm the country’s employment rates. If the currency’s value decreases too drastically, the country may not be able to afford crucial imports.
This is why a managed float is so appealing. A country can obtain the benefits of a free floating system but still has the option to intervene and minimize the risks associated with a free floating currency. If a currency’s value increases or decreases too rapidly, the central bank can intervene and minimize any harmful effects that might result from the radical fluctuation.
Key Points
• Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous.
• In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.
• The foreign exchange rate is also regarded as the value of one country’s currency in terms of another currency.
• The balance of payment model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance.
• The balance of payments model focuses largely on tradeable goods and services, ignoring the increasing role of global capital flows.
• The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. This includes financial assets.
• The measure of the differences in price levels is Purchasing Power Parity. The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies.
• If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1.
• When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms.
• Changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
• To calculate the nominal exchange rate, simply measure how much of one currency is necessary to acquire one unit of another. The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries.
• A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies since most of their liabilities are denominated in other currencies.
• Floating exchange rates automatically adjust to trade imbalances while fixed rates do not.
• A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. Because these tools are reserved for preserving the fixed rate, countries can’t use its monetary or fiscal policies to address other economic issues.
• A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency ‘s value is allowed to freely fluctuate according to the foreign exchange market.
• A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to maintain their currency value constant against a specific currency or good.
• Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes.
• A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to.
• A fixed exchange rate regime should be viewed as a tool in capital control. As a result, a fixed exchange rate can be viewed as a means to regulate flows from capital markets into and out of the country’s capital account.
• Typically, a government maintains a fixed exchange rate by either buying or selling its own currency on the open market.
• Another method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate.
• Generally the central bank will set a range which its currency ‘s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range.
• Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance.
• A managed float regime is a hybrid of fixed and floating regimes. A managed float captures the benefits of floating regimes while allowing central banks to intervene and minimize the risk of harmful effects due to radical currency fluctuations that are a characteristic of floating regimes.
Key Terms
• exchange rate: The amount of one currency that a person or institution defines as equivalent to another when either buying or selling it at any particular moment.
• depreciate: To reduce in value over time.
• purchasing power parity: A theory of long-term equilibrium exchange rates based on relative price levels of two countries.
• real exchange rate: The purchasing power of a currency relative to another at current exchange rates and prices.
• nominal exchange rate: The amount of currency you can receive in exchange for another currency.
• fixed exchange rate: A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.
• floating exchange rate: A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.
• exchange rate regime: The way in which an authority manages its currency in relation to other currencies and the foreign exchange market.
• pegged float exchange rate: A currency system that fixes an exchange rate around a certain value, but still allows fluctuations, usually within certain values, to occur.
• Managed Float Regime: A system where exchange rates are allowed fluctuate from day to day within a range before the central bank will intervene to adjust it.
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Open Economy Equilibrium
In an open economy, equilibrium is achieved when no external influences are present; the state of equilibrium between the variables will not change.
learning objectives
• Summarize the factors that determine the macroeconomic equilibrium state
Open Economy
In an open economy there there is a flow of funds across borders due to the exchange of goods and services. An open economy can import and export without any barriers to trade, such as quotas and tariffs. Citizens in a country with an open economy typically have access to a larger variety of goods and services. They also have the ability to invest savings outside of the country.
An open economy allows a country to spend more or less than what it earns through the output of goods and services every year. When a country spends more than it make, it borrows money from abroad. If a country saves more money than it makes, it can lend the difference to foreigners.
The equation used to determine the economic output of a country is $Y=C_d+I_d+G_d+NX$
The economy’s output ($Y$) equals the sum of the consumption of domestic goods ($C_d$), the investment in domestic goods and services ($I_d$), the government purchase of domestic goods and services ($G_d$), and the net exports of domestic goods and services ($NX$). The sum of $C,I$, and $G$ provides the domestic spending of a country, while $X$ provides the foreign sources of spending.
The amount that a country saves is total of investment and net exports:
$S=I+NX$
$NX$ can also be considered the trade balance of a country. Therefore
$\text{Trade Balance} =NX=S−I$
Consider, for example, what happens if domestic interest rates rise relative to foreign interest rates. Savings will increase and investment will drop as investors borrow and invest abroad instead. The balance of trade will increase, affecting the health of the economy. In an open economy, market actors can choose to save, spend, and invest either domestically or internationally, so relative changes affect not only the flow of capital, but also the health of the economy as a whole.
Economic Equilibrium
In an open economy, equilibrium is achieved when supply and demand are balanced. When no external influences are present, the state of equilibrium between the variables will not change. In the case of market equilibrium in an open economy, equilibrium occurs when a market price is established through competition. For example, when the amount of goods and services sought by buyers is equal to the amount of goods and services produced by sellers. When equilibrium is reached and the market price is established in an open economy, the price of the goods or service will remain the same unless the supply or demand changes.
Equilibrium: The graph shows that the point of equilibrium is where the supply and demand are equal. In an open economy, equilibrium is achieved when the amount demanded by consumers is equal to the amount of a goods or service provided by producers.
There are three properties of equilibrium:
1. The behavior of agents is consistent,
2. No agent has an incentive to change its behavior, and
3. Equilibrium is the outcome of some dynamic process (stability).
In an open economy, equilibrium is reached through the price mechanism. For example, if there is excess supply (market surplus), this would lead to prices cuts which would decrease the quantity supplied (reduces the incentive to produce and sell the product) and increase the quantity demanded (by offering bargains), which would eliminate the original excess of supply. The interest rates also adjust to reach equilibrium. Although consumption does not always equal production, the net capital outflow does equal the balance of trade. The capital flows, which depend on interest rates and savings rates, also adjust to reach equilibrium.
Impacts of Policies and Events on Equilibrium
Government policies and outside events may affect the macroeconomic equilibrium by shifting aggregate supply or aggregate demand.
learning objectives
• Analyze the effects that events and policies can have on economic equilibrium
The macroeconomic equilibrium is determined by aggregate supply and aggregate demand. Much of economics focuses on the determinants of aggregate supply and demand that are endogenous – that is, internal to the economic system. These include factors such as consumer preferences, the price of inputs, and the level of technology. However, there are many factors that affect the macroeconomic equilibrium that are exogenous to the economic system – that is, external to the economic model.
Supply Shock
One type of event that can shift the equilibrium is a supply shock. This is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good, which in turn affects the equilibrium price. A negative supply shock (sudden supply decrease) will raise prices and shift the aggregate supply curve to the left. A negative supply shock can cause stagflation due to a combination of raising prices and falling output. A positive supply shock (an increase in supply) will lower the price of said good by shifting the aggregate supply curve to the right. A positive supply shock could be an advance in technology (a technology shock) which makes production more efficient, thus increasing output.
Supply Shock and Equilibrium: A supply shock shifts the aggregate supply curve. In this case, a negative supply shock raises prices and lowers output in equilibrium.
One extreme case of a supply shock is the 1973 Oil Crisis. When the U.S. chose to support Israel during the Yom Kippur War, the Organization of Arab Petroleum Exporting Countries (OAPEC) responded with an oil embargo, which increased the market price of a barrel of oil by 400%. This supply shock in turn contributed to stagflation and persistent economic disarray.
Inflation
Inflation can result from increased aggregate demand, but can also be caused by expansionary monetary policy or supply shocks that cause large price changes. Changes in prices can shift aggregate demand, and therefore the macroeconomic equilibrium, as a result of three different effects:
• The wealth effect refers to the change in demand that results from changes in consumers’ perceived wealth. When individuals feel (or are) wealthier, they spend more and aggregate demand increases. Since inflation causes real wealth to shrink and deflation causes real wealth to increase, the wealth effect of inflation will cause lower demand and the wealth effect of deflation will cause higher demand.
• The interest rate effect refers to the way in which a change in the interest rate affects consumer spending. When prices rise, a nominal amount of money becomes a smaller real amount of money, which means that the real value of money in the economy falls and the interest rate (i.e. the price of money) rises. A higher interest rate means that fewer people borrow and consumer spending (aggregate demand) falls.
• Finally, the exchange rate effectrelates changes in the exchange rate to changes in aggregate demand. As above, inflation typically causes the interest rate to rise. When the domestic interest rate is high compared to that in other countries, capital flows into the country, the international supply of the domestic currency falls, and the price (i.e. exchange rate) of the domestic currency rises. An increase in the exchange rate has the effect of increasing imports and decreasing exports, since domestic goods are relatively more expensive. A decrease in net exports leads to a decrease in aggregate demand, since net exports is one of the components of aggregate demand.
Trade Policies
Trade policies can shift aggregate demand. Protectionism, for example, is a policy that interferes with the free workings of the international marketplace. By implementing protectionism policies such as tariffs and quotas, a government can make foreign goods relatively more expensive and domestic goods relatively cheaper, increasing net exports and therefore aggregate demand. Since the world demands more goods produced in the home country, the demand for the domestic currency increases and the exchange rate rises.
Capital Flight
Capital flight occurs when assets or money rapidly flow out of a country due to an event of economic consequence. Such events could be an increase in taxes on capital or capital holders, or the government of the country defaulting on its debt that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic strength.
This leads to an increase in the supply of the local currency and is usually accompanied by a sharp drop in the exchange rate of the affected country. This leads to dramatic decreases in the purchasing power of the country’s assets and makes it increasingly expensive to import goods. Net exports rise as a component of aggregate demand.
Effect of a Government Budget Deficit on Investment and Equilibrium
A budget deficit will typically increase the equilibrium output and prices, but this may be offset by crowding out.
learning objectives
• Evaluate the consequences of imbalances in the government budget
A government’s budget balance is determined by the difference in revenues (primarily taxes) and spending. A positive balance is a surplus, and a negative balance is a deficit. The consequences of a budget deficit depend on the type of deficit.
U.S. Budget Deficits: The graph shows the budget deficits and surpluses incurred by the U.S. government between 1901 and 2006. Although deficits may have an expansionary effect, this is not the primary purpose of running a deficit.
Cyclical Deficits
A cyclical deficit is a deficit incurred due to the ups and downs of a business cycle. At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditures (e.g., on social security and unemployment benefits) are high, naturally leading to a budget deficit. Conversely, at the peak of the cycle, unemployment is low, increasing tax revenue and decreasing spending, which leads to a budget surplus. The additional borrowing required at the low point of the cycle is the cyclical deficit. By definition, the cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle.
This type of budget deficit serves as a stabilizer, insulating individuals from the effects of the business cycle without any specific legislation or other intervention. This is because budget deficits can have stimulative effects on the economy, increasing demand, spending, and investment. Higher spending on transfer payments puts more money into the economy, supporting demand and investment. Furthermore, lower revenues mean that more money is left in the hands of individuals and businesses, encouraging spending. As the economy grows more quickly, the budget deficit falls and the fiscal stimulus is slowly removed.
Structural Deficits
The structural deficit is the deficit that remains across the business cycle because the general level of government spending exceeds prevailing tax levels. Structural deficits are permanent, and occur when there is an underlying imbalance between revenues and expenses.
This is the budget gap still exists when the economy is at full employment and producing at full potential output levels. It can only be closed by increasing revenues or cutting spending. Unlike the cyclical budget deficit, a structural deficit is the result of discretionary, not automatic, fiscal policy. While automatic stabilizers don’t actually shift the aggregate demand curve (because transfer payments and taxes are already built into aggregate demand), discretionary fiscal policy can shift the aggregate demand curve. For example, if the government decides to implement a new program to build military aircraft without adjusting any sources of revenue, aggregate demand will shift to the right, raising prices and output.
Although both types of government budget deficits are typically expansionary during a recession, a structural deficit may not always be expansionary when the economy is at full employment. This is due to a phenomenon called crowding out. When an increase in government expenditure or a decrease in government revenue increases the budget deficit, the Treasury must issue more bonds. This reduces the price of bonds, raising the interest rate. The increase in the interest rate reduces the quantity of private investment demanded (crowding out private investment). The higher interest rate increases the demand for and reduces the supply of dollars in the foreign exchange market, raising the exchange rate. A higher exchange rate reduces net exports. All of these effects work to offset the increase in aggregate demand that would normally accompany an increase in the budget deficit.
Key Points
• In the case of market equilibrium in an open economy, equilibrium occurs when a market price is established through competition.
• The trade balance is a function of savings and investment. Since actors can save or invest domestically or internationally relative changes can have large effects on the trade balance and the health of the economy as a whole.
• There are three properties of equilibrium: the behavior of agents is consistent, no agent has an incentive to change its behavior, and equilibrium is the outcome of some dynamic process (stability).
• One type of event that can shift the equilibrium is a supply shock – an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good.
• An increase in the price level can lower aggregate demand as a result of the wealth effect, the interest rate effect, and the exchange rate effect.
• By implementing protectionism policies such as tariffs and quotas, a government can make foreign goods relatively more expensive and domestic goods relatively cheaper, increasing net exports and therefore aggregate demand.
• Capital flight occurs when assets or money rapidly flow out of a country. This leads to an increase in the supply of the local currency and a drop in the exchange rate. Net exports rise as a component of aggregate demand.
• A government’s budget balance is the difference in government revenues (primarily from taxes ) and spending. If spending is greater than revenue, there is a deficit. If revenue is greater than spending, there is a surplus.
• A government deficit can be thought of as consisting of two elements, structural and cyclical. At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditures are high, leading naturally to a budget deficit.
• The additional borrowing required at the low point of the cycle is the cyclical deficit. The cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle. This type of deficit serves as an automatic stabilizer.
• The structural deficit is the deficit that remains across the business cycle because the general level of government spending exceeds prevailing tax levels. Structural deficits are the result of discretionary fiscal policy and can shift the aggregate demand curve to the right.
• Crowding out is a negative consequence of budget deficits in which higher interest rates lead to less private investment, higher exchange rates, and fewer exports.
• Crowding out is a negative consequence of budget deficits in which higher interest rates lead to less private investment, higher exchange rates, and fewer exports.
Key Terms
• output: Production; quantity produced, created, or completed.
• equilibrium: The condition of a system in which competing influences are balanced, resulting in no net change.
• trade: Buying and selling of goods and services on a market.
• protectionism: A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.
• stagflation: Inflation accompanied by stagnant growth, unemployment, or recession.
• nominal: Without adjustment to remove the effects of inflation (in contrast to real).
• aggregate demand: The the total demand for final goods and services in the economy at a given time and price level.
• business cycle: A fluctuation in economic activity between growth and recession.
• structural deficit: The portion of the public sector deficit which exists even when the economy is at potential; government spending beyond government revenues at times of normal, predictable economic activity.
• cyclical deficit: The deficit experienced at the low point of the business cycle when there are lower levels of business activity and higher levels of unemployment.
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Causes of Banking Crises
Banking crises can be caused by inadequate governmental oversight, bank runs, positive feedback loops in the market and contagion.
learning objectives
• Describe some common causes of a banking crisis, Explain a bank run
In light of recent market and banking failures, the economic analysis of banking crises both historically and presently is a constant source of interest and speculation. Banking crises are when there are widespread bank runs: an abnormal number depositors try to withdraw their deposits because they don’t trust that the bank will have the deposits for withdrawal in the future.
Banking crises are not a new economic phenomenon, and similarly are not the only source of financial crises. Over the course of the past two centuries there have been a surprisingly large number of financial crises, as demonstrated in the attached figure. In understanding banking crises over time, it is useful to identify the causes in context with historic examples of banking collapses.
Financial Crises Globally since 1800: This chart is an interesting take on the relatively consistent frequency in which financial crises occur across the globe. It is interesting to note both the efficacy of Bretton Woods alongside the increasing risk of financial collapse in modern times.
Causes of Banking Crises
Banks can fail for several different reasons:
• Bank Run: A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand. This can quickly induce panic in the public, driving up withdrawals as everyone tries to get their money back from a system that they are increasingly skeptical of. This leads to a bank panic which can result in a systemic banking crisis, which simply means that all of the free capital in the banking system is withdrawn.
• Stock Market Positive Feedback Loops: One particularly interesting cause of banking disasters is a similar positive feedback loop effect in the stock markets, which was a much more dynamic factor in more recent banking crises (i.e. 2007-2009 sub-prime mortgage disaster). John Maynard Keynes once compared financial markets to a beauty contest, where investors are merely trying to pick what is attractive to other investors. There is a profound truth to this, creating an interdependent and potentially self-fulfilling investment thought process. This can create dramatic rises and falls (bubbles and crashes), which in turn can throw banks with poorly designed leverage into huge losses.
• Regulatory Failure: One of the simplest ways in which bank crises can occur is a lack of governmental oversight. As noted above, banks often leverage themselves to capture gains despite extremely high risks (such as over-dependence on derivatives).
• Contagion: Due to globalization and international interdependence, the failure of one economy can create something of a domino effect. In 2008, when the U.S. economy collapses, the reduced buying power and economic output from that economy dramatically damaged all economies dependent upon it (which includes most of the world). This is called contagion.
The Great Depression
The Great Depression highlights how bank runs caused a banking crisis, which ultimately became a global economic crisis.The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock market crash (Black Tuesday) and subsequent bank runs. As fear began to grip consumers across the United States, people became protective of their assets (including their cash). This caused a large number of people to the banks to withdraw, which in turn motivated others to go to the banks and get their capital out also. Since banks lend out some of their deposits, they did not have enough cash on hand to meet the immediate withdrawal requests (they became illiquid) and therefore went bankrupt. Within a few weeks this resulted in a systemic banking crisis.
1929 Stock Market Crash: As the market falls, investors create a positive feedback loop and self-fulfilling prophecy due to a lack of confidence that drives it down even further.
Consequences of Banking Crises
Banking crises have a range of short-term and long-term repercussions, domestically and globally, that reduce economic output and growth.
learning objectives
• Explain consequences of banking crises on the broader economy
Banking crises have a dramatic negative effect on the overall economy, often resulting in an eventual financial and economic crisis in a given economic system. Banking crises have a range of short-term and long-term repercussions, domestically and globally, that underline the severe repercussions of irresponsible banking practices, poor governmental regulation, and bank runs. The most useful way to frame the consequences of bank crises is by observing the critical role banks play in economic growth, primarily through investment and lending.
Domestic Consequences
Within a given system, banking failures create a range of negative repercussions from an economic perspective. Banks coordinate and economy’s savings and investment: the act of pooling money to capture higher returns for everyone while simultaneously funding business dependent upon leveraging debt and equity. With this in mind, a banking crises can have a variety of averse individual and economic consequences within the system.
First and foremost, investment suffers. When banks lack liquidity to invest, businesses that depend upon loans struggle to raise the capital required to execute upon their operations. When these businesses cannot produce the capital required to operate optimally, sales decline and prices rise. The overall economic performance of any debt-dependent industries becomes less dependable, driving down consumer and investor confidence while reduce overall economic output. Banks also perform more poorly, due to the fact that they have less capital to invest and returns to acquire.
This drives down the overall economic system, both in the short term and the long term, as companies struggle to succeed. The fall in liquidity and investment drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence (damaging equity markets, which in turn limits businesses access to capital). There is a distinctive cyclical nature to these adverse effects, as each are interconnected in a way that creates a domino effect across the domestic economic system.
Global Consequences
While these domestic consequences are expected and, in many ways, intuitive, the global dependency upon foreign trade in modern markets has exacerbated these effects. Imports and exports play an increasingly large role in the health of most developed economies, and as a result the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.
A good example of this is to look at the way in which the U.S. (and to some extent, European) banking disasters in 2008 and 2009 led to a complete global financial meltdown, destroying economies not involved in the irresponsible investing practices executed by banks in these specific regions. identifies the critical importance of economic well-being in trading partners, as the U.S. banking and financial crises spread rapidly (within the course of just one year) across a substantial portion of the globe (though there are certainly other factors that contributed to the financial crisis and its consequences). The domestic reduction of capital for businesses, income for consumers and tax revenue for governments ultimately results in a reduction of trade and economic activity for other economies.
2009 GDP Growth Rates: This figure shows the growth in GDP for world economies in 2009. The slow and negative growth demonstrates all of the economic losses that resulted in part from the U.S. financial crisis, highlighting the dependency of global economies.
Key Points
• A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand.
• Due to the mass interdependence of economies across the globe, a banking crisis in one nation is likely to dramatically affect other international economies.
• The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock market crash (Black Tuesday) and subsequent bank runs.
• Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.
• Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.
• Banks play a critical role in economic growth, primarily through investment and lending.
• After a banking crisis, investment suffers. When banks lack liquidity to invest, growing business depending upon loans struggle to raise the capital required to execute upon their operations.
• The fall in liquidity and investment, in turn, drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence.
• Imports and exports play an increasingly large role in the health of most developed economies, and as a result, the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.
Key Terms
• Bank Run: A large number of customers withdraw their deposits from a financial institution at the same time due to a loss of confidence in the banks.
• leverage: The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return, but usually at high risk.
• Economic crisis: A period of economic slowdown characterised by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.
• liquidity: The degree to which an asset can be easily converted into cash.
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Causes and Immediate Impacts of the Crisis
Banks, consumers, and the government all contributed to improper borrowing and lending, which in turn created a downward spiraling economy.
learning objectives
• Summarize the causes that led to the 2007 banking crisis
The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, was borne of the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to homeowners into a falsely ‘safe’ investment. To simplify this, banks pushed mortgages on prospective homeowners who could not afford to repay them. Then they combined and packaged varying mortgage-backed securities based off of these loans and sold them as highly dependable and safe investments, either through a lack of due diligence (negligence) or lack of ethical consideration. This created an economic meltdown, starting with the United States, that spread across the global markets.
The inherent complexity of the causes and dramatic repercussions (most of which are still ongoing) require a great deal of context. It is a fiercely debated and widely discussed issue in the field of economics (and in mainstream media), providing a real-life case study for many of the critical concepts of economic theory.
How Did This Happen?
The inputs to the 2007-2008 economic collapse, briefly touched upon above, are complex and still evolving. That being said, there are a few key talking points from an economic perspective that should be discussed. A useful perspective to take is the various stakeholders and their contributions:
Inputs to the Mortgage Crisis: This graph outlines two of the three parties in the collapse (excludes government), as the banks and the buyers both took on ridiculous amounts of risk.
• Banks: Simply put, the banks made two critical errors. First, they lent money to people who could not pay it back (to buy homes). They pursued what is referred to as ‘predatory lending,’ or lending to individuals they knew could never pay it back. Secondly, banks knowingly grouped these loans into bundles called collateralized debt obligations (CDOs) and sold them as extremely safe derivative investments. They were not safe.
• Consumers: Consumers played their role as well, acting as easy prey for the banks predatory practices. Individuals bought homes they could not afford utilizing loans they could not pay back. This drove them into debt, to the extent at which they had to default. This meant that the capital banks expected to get back did not arrive, it simply was not there.
• Government: The government did not regulate the housing market, as a result of the elimination of two critical legal clauses that required the verification of income and a 20% down payment. In short, the U.S. government used to ensure that prospective home buyers could put down 20% of the their borrowing in addition to verify that their income could cover their mortgage payments. Without such verification, it became easier for people to get mortgages they could not afford.
Combining these factors, the problem largely revolved around irresponsible lending and borrowing which was then turned into derivatives that were labeled safe despite their massive risks. This resulted in an economic realization of loans that could not be repaid, which spread through the banking system and turned into large scale obligations that could not be met.
Economic Impact
What happened next is well captured in the diagram below. In short, the banks eventually failed due to their investments. In order to prevent the entire financial system from collapsing, some of the banks (and other financial institutions) were bailed out.
2008 Crisis Flow Chart: This chart embodies critical checkpoints in the economic decline reactions to poor mortgage management by the banks. Understanding the implications of each point on this diagram will greatly enhance the larger understanding of the short term effects of this economic collapse.
Of course the negative effects did not stop there. The U.S. stock market lost confidence in financial institutions and some of the companies connected to them and subsequently crashed. The NYSE fell by half, drastically reducing the value of the U.S. economy. This was then telegraphed into a loss of consumer confidence and business access to investment. Within a few months, there were job cuts, bankruptcies, and reduced spending, as the crisis spread throughout the economy (both domestically and globally).
Recovery
The objective of economic recovery when in crisis is to stabilize the economy and recapture the value lost using economic stimulus strategies.
learning objectives
• Discuss the characteristics of the recovery from the 2007 crisis
The 2007-2009 economic crisis has had far-reaching and profound effects on both the domestic and global markets, primarily as a result of the sub-prime mortgage disaster originating in the United States. Addressing these economic ramifications to induce recovery has been the focal point of global governments and global agencies such as the International Monetary Fund (IMF). The objective of economic recovery when in crisis is to stabilize the economy, and from there recapture the value lost through economic stimulus strategies while addressing the factors which contributed to the collapse in the first place.
Stimulus Package
One of the key components to the crisis recover in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA), put into place by the Obama administration just as the first days of his term were beginning. This act has seen substantial debate, both positively and negatively, as to the efficacy and overall implementation of the program. Understanding the inputs, and expected outcomes, is critical to understanding the economics behind reacting to economic crises (particularly from a Keynesian perspective).
The stimulus package can be broken down via the attached figure in regards to monetary investment in specific places, totaling \$831 billion (USD) between 2009 and 2019. The goal of investing or providing tax relief and subsidies for individuals and companies is to drive up purchasing behavior and offset the positive feedback loop attributed to economic crises. This is largely based on the Keynesian concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further. President Obama’s administration was criticized by classical economists for employing this as well as Keynesian economists (such as Paul Krugman) for not employing it enough. That being said, the efficacy in the attached figure demonstrates that it was likely a strategic reaction to the economic crisis.
ARRA Efficacy Projections: This graph points out the economic opportunity cost of not utilizing the ARRA, which would likely have left the U.S. (and subsequently, the global) economy in significantly worse shape than it is now.
Stimulus Investments (U.S.) of ARRA: This graphic demonstrates the different silos receiving government aid within the domestic economy, as a direct result of the American Recover and Reinvestment Act (ARRA).
Troubled Asset Relief Program (TARP)
Perhaps more debatable still, is the reaction to the inevitable and deserved bankruptcy of the banks and insurers involved in the toxic mortgage-backed securities (i.e. CDO’s) that drove the economy into disaster were bailed out by the government. These companies, such as AIG, Bank of America, Citigroup, and other distributors of toxic investments were handed the required capital by the government to offset their massive losses due to undue risk and poor leveraging. This was in the form of the government utilizing tax money to purchase these securities, removing the toxic assets from the books of the companies involved (who were deemed ‘too big to fail’). This move saved the economic decline and restored consumer confidence through direct government intervention.
TARP was also largely criticized, with a high number of seemingly reasonable objections. The first, and most intuitive, is that these businesses deserved to go under. Bad business practice, poor investment, and grossly unethical behavior deserves bankruptcy. Instead, the government demonstrated that, as long as certain fiscal influence is achieved, these competitive rules are negligible. Secondly, and slightly more complex, is the implementation of the TARP act (which necessitated SIG-TARP, an oversight group ensuring that TARP money went out to those who it was intended for). It was noted on many occasions that TARP money was ill-used.
Outcomes
While the long-term outcomes of these practices cannot yet be predicted, the progress made so far is worth analyzing economically. First and foremost, job numbers have improved, although not as much as had been hoped or expected (see ). While this is positive, it does not capture the large number of people who are underemployed or the individuals who have abandoned the search for employment. GDP growth has inched along to positive numbers, as has the profitability of many businesses and industries. Interestingly enough, as of the end of 2013, the stock market has not only recovered but expanded beyond 2007 levels.
U.S. Job Gains and Losses: This graph demonstrates the negative affect that the collapse had on jobs as well as the pacing of economic recovery in the short-term.
Global Impacts
The 2007-2009 economic collapse was damaging not only to the U.S. but also global markets, driving the global economy into recession.
learning objectives
• Analyze the extent to which the 2007 crisis was global
Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being will have a dramatic impact on national economic well-being and vice versa. As a result, the 2007-2009 economic collapse had large effects not only at the origin (in the United States), but also on a global scale. The speed in which the market decline spread across the globe underlines just how far globalization and international interdependence has come, with GDP growth numbers in 2009 already demonstrating substantial losses across the map (see ).
2009 Global GDP Growth and Decline): As this map illustrates, many international markets fell rapidly into decline as a direct result of the U.S. sub-prime mortgage disaster.
Recession: Domestic to Global
In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth (over two consecutive quarters). This recessionary period spread rapidly around the map, creating a global recession in Q3 and Q4 in 2008 and Q1 of 2009 (defined as a contraction in global GDP growth during that time) as is represented in this figure. To provide additional context to the global adverse effects of the sub-prime mortgage crisis, of 65 countries that record and report GDP only 11 escaped a recessionary period between 2006 and today.
World GDP Growth: It is quite clear in this graphic, the global GDP growth dropped dramatically following the U.S. crisis, pitching the entire global economy into a recession.
Even countries where double-digit economic growth had been a consistent trend going into 2008, such as China, began to experience growth reductions due to reduced consumer purchasing power on a global scale. China has seen reductions towards the 7%-8% economic GDP growth (year on year), from clear double-digits in previous years.
Political Instability
Another indirect global impact that occurred as a result of the economic collapse is political instability, primarily due to the inability of developed nations to pursue social welfare investments and global poverty reduction processes during recessionary times. Indeed, these instabilities are not only isolated to developing nations. Countries in the EU, such as Greece, Spain and Italy, have seen dramatic GDP decreases and unemployment numbers reaching or exceeding 20% in some cases. This instability has placed a great deal of pressure on government officials to solve these huge economic problems in the short-term. The United States has also seen an incredible reduction in governmental efficacy with the least effective house of representatives for nearly a century alongside dramatic polarization of public opinion towards left-wing and right-wing ideas.
Global Responses
Positively, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence in the future. Reducing interest rates to drive up borrowing and investment, providing tax benefits to the unemployed and underemployed, and subsidizing new business have created positive steps towards meaningful recovery globally.
There have also been a series of banking and financial regulatory changes across the world.These global safety nets and prevention policies are setting the tone for future strategies to avoid economic crises and minimize the prospective damage that occurs as a result of these unethical practices.
Key Points
• The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, began with the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to home-owners into a falsely ‘safe’ investment.
• Banks offered loans to debtors that couldn’t afford them, and then bundles these debt instruments and sold them.
• The banking crisis spread into a broader financial crisis as companies were negatively affected by the crisis in financial institutions to which they were connected.
• The government did not regulate the housing market at all, as a result of the elimination of two critical clauses: verification of income and a 20% down payment.
• The U.S. stock market, realizing the scale of errors of the banks, lost all investment confidence. This cut the NYSE in half, drastically reducing the value of the U.S. economy.
• One of the key components to the crisis recovery in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA). It invests money in the economy to drive spending and recovery.
• ARRA is largely based on the Keynesian macro-environmental concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further.
• The Troubled Asset Relief Program (TARP) was another recovery strategy, buying toxic assets off the banks to prevent them from failing.
• TARP was criticized for protecting banks who behaved unethically and with a lack of strategic intelligence as businesses, essentially implying that they should have failed.
• While the stock market has recovered and the banks are in better shape now than before the collapse, the average American is still less likely to have a job or to be underemployed.
• Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being will have a dramatic impact on national economic well-being and vice versa.
• In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth, which This spread rapidly around the map to create a global recession in Q3 and Q4 in 2008 and Q1 of 2009.
• Another indirect global impact that occurred as a result of the economic collapse was political instability, primarily due to the inability of developed nations to pursue altruistic investments and global poverty reduction processes during recessionary times.
• On the upside, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence in the future.
Key Terms
• CDO: A type of asset-backed security and structured credit product constructed from a portfolio of fixed-income assets.
• Sub-prime: Designating a loan (typically at a greater than usual rate of interest) offered to a borrower who is not qualified for other loans (e.g. because of poor credit history).
• stimulus: Anything that may have an impact or influence on a system. In 2009, it is the monetary investments in the economy to recover from the collapse.
• Economic crises: A period of economic slowdown characterized by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.
• recession: A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, and industrial production.
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Defining Capital
In economics, capital references non-financial assets used in the production of goods and services.
learning objectives
• Define and explain capital.
Capital
In economics, capital (also referred to as capital goods, real capital, or capital assets ) references non-financial assets used in the production of goods and services. Capital is important because it is a significant factor in the creation of wealth.
Capital goods are used in the production process and may depreciated through accounting practice to incorporate utilization, though they are not consumed. It is possible for capital goods to be maintained or regenerated depending on the type of capital.
Classifications of Capital
In a broad sense, capital can be divided into two categories:
• Physical Capital: capital that must be produced by human labor before it can become a factor of production (also referred to as manufactured capital). Examples include machinery and buildings.
• Natural Capital: a factor of production that occurs naturally in the environment; for example, land or minerals.
Fundamentally, capital is any product that is produced and has the ability to enhance a person’s power to perform work that is economically useful. For example, roads are capital for individuals who live in a city.
Capital is directly impacted by both interest and profit. Interest is a fee that is paid by a borrower of assets. It is a form of compensation for the use of the assets. Commonly, it is the price that is paid for the use of borrowed money. Profit is the accumulation of capital, which is the driving force behind economic activity. Interest allows capital to be obtained, while profit is the accumulation of the capital.
Features of Capital
There are certain features that determine whether a good is considered capital. These features include:
1. the good can be used in the production of other goods (this makes it a factor of production),
2. the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and
3. the good was produced.
Modern Types of Capital
There are detailed classifications of capital which include the following types:
• Financial Capital is capital that is liquidated as money for trade, and owned by legal entities. It is a form of capital assets that is traded in financial markets. The value of financial capital is based on the market perception of expected revenues and risk.
• Natural Capital is capital that occurs naturally in the environment and is protected because it supports human life. Examples of natural capital include land and water.
• Social Capital is capital that is captured as goodwill or brand value. It is the general concept of inter-relationships between humans have money-like value that motivates actions.
• Instructional Capital is capital that is defines as the aspect of teaching knowledge and transferring knowledge that is not inherent in individual or social relationships.
• Human Capital is capital that includes social, instructional, and individual human talent combined together. As a term, it is used to define balanced growth where the goal is to improve human capital and economic capital equally.
Interest Rates and Economic Rationale
Economic rationale, the reasons or thought processes that impact economic decisions, is influenced substantially by the interest rate.
learning objectives
• Define and explain the relationship between interest rates and economic rationale.
Economic Rationale
Rationale is defined as an explanation of the basis or fundamental reasons for something. In economics, rationale are the reasons or thought processes that impact economic decisions. The interest rate is one of the primary influences on economic rationale.
Interest Rate
The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor). It is the percent of principal paid a certain amount of times per period.
Impact of the Interest Rate
The interest rate guides economic rationale because it is a vital tool of monetary policy. The interest rate is taken into account when dealing with economic variables such as investment, inflation, and unemployment. Central banks usually reduce the interest rate to increase investment and consumption in the country’s economy. The interest rate directly impacts economic choices such as spending, investment, and consumption.
Interest Rates: This graph shows the fluctuation in interest rates in Germany from 1967 to 2003. The interest rates reached 14% in 1969 and lowered to 2% by 2003. The interest rate in an economy directly impacts economic choices including spending, investment, and consumption.
Interest rates also influence inflationary expectations. People form an expectation of what will happen to inflation in the future. The current and projected interest rates are influential in these economic expectations. Investments are made based on the nominal interest rate and the degree of risk involved. Low interest rates are enticing, but can be problematic if an economic bubble forms. For example, low interest rates can lead to large amounts of investments poured into the real-estate market and stock market. When these bubbles pop, the investments fail, resulting in large unpaid debts and financial bankruptcy for individuals and banking institutions.
When interest rates increase, investments decrease, which causes the national income to fall. High interest rates do encourage more savings, which over time leads to more investment and higher levels of employment to meet production needs. Higher rates discourage economically unproductive lending such as consumer credit and mortgage lending.
The interest rate also directly impacts money and inflation because the government can affect the markets and alter the total of loans, bonds, and shares that are issued. When the interest rate is lower, it usually increases the broad supply of money. An increase in the money supply leads to inflation.
Key Points
• Fundamentally, capital is any product that is produced and has the ability to enhance the power of an individual to perform economically useful work.
• Capital is directly impacted by both interest and profit. Interest allows capital to be obtained, while profit is the accumulation of the capital.
• Features that determine whether a good is capital include: 1) the good can be used in the production of other goods (this makes it a factor of production ), 2) the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and 3) the good was produced.
• Types of capital include: physical, financial, natural, social, instructional, and human.
• The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor).
• The interest rate guides economic rationale because it is a vital tool of monetary policy.
• The interest rate directly impacts economic choices such as spending, investment, and consumption.
• When interest rates decrease, investment and spending increase. When interest rates increase, investments decrease which causes the national income to fall.
Key Terms
• capital: Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).
• depreciate: To reduce in value over time.
• interest rate: The percentage of an amount of money charged for its use per some period of time (often a year).
• monetary policy: The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
• inflation: An increase in the general level of prices or in the cost of living.
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Defining Health, Health Care, and Medical Care
Health care economics is a segment of economic study pertaining to the value, effectiveness, and efficiency in health care services.
learning objectives
• List the parties involved in the healthcare system in the United States
Health care economics is a segment of economic study pertaining to the value, effectiveness, and efficiency in medical care and health care services and issues. The study of health care, from an economic perspective, requires taking a broad lens on a complex system with a wide variety of stakeholders. In 1963, Kenneth Arrow differentiated health care economics from other economics due to the wide range of unique considerations involved. Health care, due to the severity of the need/demand, wide variety of externalities, government intervention, and role of doctors as third-parties (making critical purchasing decisions for other people), cannot be considered from the same perspective as other industries.
Defining Health Care
Health care is a significant concern for patients, insurance companies, governments, businesses, health care providers, researchers, and non-profits. It is a vast economic system with many internal players and externalities. Understanding the basic factors involved, both logistically and economically, will provide useful context in defining health care and the medical care services.
The chart below outlines who is involved, and in what fashion.
Health Care System Flow Chart: This flow chart does an excellent job of outlining the various stakeholders and influences in the broader health care system context.
• Health (Box B): Health metrics for health attributes from a value of life and overall utility-based perspective.
• Demand for Health Care (Box C): The overall health care demand, which is a complex array of inputs that can be summarized as health care seeking behaviors, and what factors influence them (i.e. externalities, price, time, perspectives, etc.).
• Supply of Health Care Costs (Box D):The supply of health care in most systems is quite complex, inclusive of direct inputs such as drugs, medical suppliers, and diagnostics to insurance companies (third parties) to health care professionals (doctors, nurses, etc.) to research.
• Evaluation of the Whole System (Box F): This is where the government factors in, particularly in countries with a more socialized system for health care, alongside the comparisons both internally and externally.
This process flow is what defines health care and the medical industry from an economic standpoint, and the relative influence of each of these components, and the interdependence between them, is worth studying to determine where higher degrees of efficiency and efficacy can be found.
Health Care System in the U.S.
With this in mind, it is useful to also outline the inputs and outputs of the U.S. health care system, particularly during this transitional time. At the time of this writing (2013), the Affordable Care Act (often referred to as ‘Obamacare’) will be coming into play shortly. While the details and implications of this are beyond the scope of this discussion, it is useful to understand what the basic construct that exists in the United States currently.
At the moment, health care is largely privatized with the exception of medicaid and medicare, the former being for low income groups and the latter for retirees. For most of us, health care insurance is generally purchased on a capital market by a policy-holder (who may be a company the beneficiary works for or the beneficiary themselves, depending upon the profession and contractual obligations of an employer). This health insurance plan offers a construct for what will be covered under an umbrella of monthly health care payments, and what is considered outside of the plan. There are many large health care insurance providers out there, offering this service to prospective beneficiaries.
Now, either the insurance company, the government (medicaid and medicare), or the individual (if they are not covered or if their particular procedure is not covered) is the direct client of the hospitals, pharmacies, and doctor’s offices. These institutions are also quite complicated, and require their own insurances against liability due to the high consequences in the field. Doctors and nurses provide a service, either actively performing a recommended approach (e.g. surgery) or recommending a treatment (e.g drugs). These medical professionals are largely overseen by the government from a quality control perspective (various standardized test and degree requirements), adding an additional line of complexity to the operation.
Overall, this system of healthcare in the U.S. is quite convoluted. There are many players involved and the stakes are extremely high. Picture a demand curve for a treatment for a deadly disease, what would the price point be? Considering the consequences, healthcare services often fall outside of standard macroeconomic concepts, defying supply and demand frameworks due to the nature of the business (i.e. life and death, the well-being of people). This underlines a social issue: how can we improve healthcare economics to maximize value and minimize costs?
Where a Dollar Spent on Health Care Goes: Introducing the Inputs to Health Care
Health care has many inputs and a variety of incumbents, namely insurance providers, administrators, governments, and pharmaceuticals.
learning objectives
• Discuss the factors that affect the cost of and access to healthcare
Healthcare has many inputs and a wide variety of interested parties profiteering. Understanding what drives the need for health care (and what prevents it), what is included in the cost, and the overall accessibility of this essential service is critical to understanding economics issues in healthcare. A dollar spent on health care can find it’s way to insurance providers, medical service providers, pharmaceutical companies, governments, administrative bodies (managing these businesses), and laboratories. Understanding what individuals pay for and why, alongside what is available, is important data for navigating this market.
Where the Money Goes
While a percentage breakdown of who procures the largest capital gains from health care is difficult to ascertain across such a complex system, it is safe to say that quite a few players contribute to the constantly rising price of even simple procedures and doctor’s visits. A breakdown of the critical players illuminates this further:
• Health Care Providers: On the surface, this is who a beneficiary feels like they are paying. This is their doctors, nurses, psychologists, dietitians, technologists, chiropractors, surgeons, and a wide range of other hands on and customer facing roles. These individuals are further differentiated by the fact that they often act as references as opposed to direct suppliers, making them both a direct to consumer provider and a third party provider.
• Pharmaceutical Companies: Drugs are playing an increasingly large role in health care, and likely will continue to do so in the future. The constant development of new drugs, alongside the distribution of established medications, is an enormous part of the market.
• Insurance Providers: There is a divider between most medical service consumers and their providers, and this is the insurance company. For those who are covered by their full-time jobs (or dependents of these individuals), this is largely a matter of who their business purchases from. For others not covered, insurance issues are a complex and highly expensive issue, and getting coverage is quite difficult (this is being addressed in the U.S. by new legislation, and is not an issue in most other developed nations). The insurance companies command a huge profit and represent a substantial part of the medical price tag.
• Government: The role of government in health care is fiercely debated in the United States, but in most of the developed world the government is essentially the provider of health care plans (using social services models to consolidate tax revenues to be allocated for this service). In the U.S., this is only done for medicaid and medicare. The government also takes tax revenues from involved parties in this industry, driving prices up further.
• Administration: This is the hospital itself, or the doctors office, where the management team attempts to run a largely profitable business in the medical industry. Administration pays the health care providers and the government, taking income from direct consumers, the government, and the insurance companies to cover the cost of business (and often turn substantial profits).
With these group of incumbents in mind, it becomes quite clear why the costs are rising exponentially and are so unsustainable. The constant struggle between these large and powerful players coupled with an essentially infinite demand has left the consumer as an extremely weak player in the market. Indeed, with this in mind, the graph displays the trajectory of health care spending due to excess costs in the long term.
Health Care Costs: This graph illustrates the danger of continuing down path of using the excessively high cost-structure U.S. health care incumbents have dictated in the context of spending as a % of GDP.
Accessibility
One of the most discussed topics in health care is accessibility. Due to the fact that health care represents the ability for an individual to maintain a healthy and happy life, it seems intuitive that accessibility must as unlimited as possible. Of course, in a capitalistic system, this will not be the case. Economics dictates that price points will be determined based on supply and demand, and the demand in this industry is often essentially infinite. As a result, accessibility and profitability do not always align from an economic perspective. The U.S. employs medicaid and medicare to provide for low-income and elderly citizens that would otherwise be excluded from the market, while other countries have healthcare systems with more government intervention to address market failure.
One of the larger issues in accessibility is nations without the infrastructure required to support health care industries. Developing nations often do not have access to the skills or suppliers required to run modern hospitals and doctors offices, nor the ability to act preventatively (i.e. eating healthy, getting exercise, check ups, etc.). This creates enormous inefficiency in the system and reduces the economic viability of operating in these countries for insurance providers. Addressing this concern is one of the central issues for the United Nations (UN) and other nongovernmental organizations.
Different Health Care Systems Around the World
Health care systems differ from nation to nation depending upon the level of economic development and the political system in place.
learning objectives
• Identify different types of healthcare systems
Health care differs from nation to nation, sometimes substantially depending upon the level of economic development and the political system in place. Health care systems, on the global scale, is best defined via the World Health Organization’s definition: “A health system consists of all organizations, people and actions whose primary intent is to promote, restore or maintain health. This includes efforts to influence determinants of health as well as more direct health-improving activities. A health system is therefore more than the pyramid of publicly owned facilities that deliver personal health services. ” This definition is important when observing international health care systems, as it captures both developed and developing nations within this context.
Comparisons: Developed Nations
The World Health Organization has been actively measuring a variety of performance indicators to determine an overall ranking system for health care on a global scale. While this has seen some objections, primarily due to the selection of attributes which weigh into this ranking, it is designed to measure critical success factors which are easily comparably across borders (apples to apples). These measured attributes include health of the population, fair financial contributions, responsiveness of the system, preventable deaths, affordability and a range of other considerations.
The countries which perform the highest on these metrics are primarily located in Europe (generally northern Europe, see ), where social systems are well designed at a governmental level to ensure prices remain accessible and care remain available. Interestingly, the U.S. has consistently ranked poorly and continues to perform substantially below European counterparts deemed developed at similar economic levels. Two good examples are provided in the media relative to the overall capital costs and the subsequent returns on these costs, on being costs to hospital beds per capita and the other costs to physicians per capita. By these measures, European nations capture more value and efficiency within their systems. The most notable difference between these systems is that the US is that, of these countries, the US is the only country without universal healthcare.
Capital Costs and Physicians: Similar to the graph representing costs vs. beds, this chart illustrates the number of physicians available (relative to the population) in the context of capital expenditures. Once again the United States is a clear outlier, where the number of physicians is low and the cost quite high.
Capital Costs and Hospital Beds: This graph demonstrates the apparent correlation between beds (per 1000 people) and the costs involved in healthcare overall. This demonstrates that, on a per capita basis, the U.S. is spending a great deal without capturing much in return relative to available space for patients.
Economic Efficiency of Global Health Care Systems: Healthcare spending per capita is on the left y-axis and life expectancy is on the right. Country differences are apparent, especially when comparing the US to others.
Let us explore further through an example of health care in German (though not all European countries are the same). Germany has consistently demonstrated reductions in cost of health care per capita relative to GDP growth. German health care is regulated by the Federal Joint Commission, a public health organization which leverages governmental health reform bills to generate new regulations. This system also includes a total of 85% of the population on the government offered standardized health care plan, which covers a variety of health care needs across the board. The remaining 15% of the population has opted for private health insurance options, which provide unique niche benefits for specific groups. This system has been highly effective and affordable in providing health care to German citizens.
Developing Nations
With fewer resources, developing nations struggle to compete provide the same access to health care as do developed nations.
China is an interesting case study. China has a great deal of variance in quality and accessibility, with hospital wait times for the poor (depending on severity) taking many hours (sometimes days) compared to the rich, who are admitted immediately. Transitioning towards a system that provides care to the rich and the poor alike is the primary challenge in these developing regions.
Externalities in the Health Care Market
Health care can impact people beyond the person receiving and the person providing the care, causing positive and negative externalities.
learning objectives
• Describe externalities in the healthcare market
Defining Externalities
An externality is any impact, be it positive or negative, on individuals or groups not involved in a given economic transaction. That is to say, an externality is something that affects other people outside of the particular parties involved in an exchange.
Externalities: The basic premise of an externality is captured in this diagram, where external factors affect the internal economic system for a product or service.
A classic example of externalities is the automobile. Cars consistently produce air pollution whenever they are driven, slowly eroding the health of our ecosystem. This cost is shouldered not only by the driver of the vehicle, but also by every living thing on the planet. This is an example of parties not involved in the transaction (selling or buying the vehicle) being impacted, in this case negatively.
Health Care Externalities
In health care, the critical externality in most systems is the care provided to others. You benefit from others being healthy because it reduces the likelihood of you catching their illness (assuming it’s contagious). You benefit from a positive externality of others receiving health care.
Your health care costs are also affected by others choosing to purchase health care. The healthy pay more to the insurance company than they receive in treatment, while the opposite is true for the sick. Insurance fundamentally operates by taking the money from healthy people to pay for the procedures required by sick people.
Taxpayers should also be concerned with the state of the healthcare system not only because they pay for Medicare and Medicaid, but also because healthcare is a huge part of the US economy. In 2011, the US spent 17.2% of GDP on healthcare, more than any other country. Reducing the cost of health care can clearly increase the amount that the US can consume or invest.
Other negative externalities include:
• Infectious Disease: One of the largest reasons why health care is so critical is the fact that disease are infectious. Untreated disease will result higher population vulnerability to that disease due to increased exposure.
• Environmental Degradation: Health care produces a great deal of chemical waste, requires a great deal of emissions (ambulances, etc.) and alters the natural ecological environment of bacteria.
• Antibiotic Resistance: An interesting byproduct of the newer solutions to medical dilemmas is the slowly growing resistance of antibiotics in bacteria. Due to the way in which the health care industry has been operating, bacteria are dramatically altering to resist our solutions.
Positive externalities include:
• Health Affects Wealth: Healthy workers are absent from work less and are more productive workers. A health care market that effectively helps workers can lead to positive economic gains.
• Technology and Information: The study of health care, and the research involved in generating new solutions, has dramatically increased the knowledge and technological capacity of society in general. This has affected other industries, as research and development in health care affects the technological efficacy in other markets.
• Vaccinations: An interesting new development in health care is the advent of vaccines. Vaccination results in herd immunity, or essentially the fact that many individuals will become immune and thus reduce the likelihood that everyone in the population will contract certain diseases.
Current Issues in Health Care
Current issues in the U.S. health care system largely revolve around the significant policy changes resulting from the Affordable Care Act.
learning objectives
• Explain the main parts of the Affordable Care Act and the current American healthcare system
Current issues in the U.S. health care system largely revolve around the significant policy changes imposed by the Affordable Care Act (ACA, or Obamacare), which attempts to provide health insurance coverage for all citizens. This legislation was designed to respond to many flaws in the current U.S. system of healthcare. It is also important to understand the criticisms of this change, as many voters in the U.S. disagree with proposed changes to the system.
U.S. House Votes for the Affordable Health Care Act: This map outlines the voting distribution in 2009 when the Affordable Health Care Act was brought to the floor.
U.S. Health Care Currently
The U.S., despite having some of the greatest technological advances and medical professionals, has consistently struggled to provide affordable, effective health care to everyone. The costs alone, on a per capita basis, underline the way in which the U.S. system has struggled to meet international standards in providing affordable care. illustrates the costs incurred by each individual in the system based on a country to country comparison. As it illustrates, consumers in the U.S. are faced with much higher (and growing) costs than international counterparts.
Health Costs Per Capita: This chart illustrates the costs incurred by each individual in the system based on a country to country comparison. As is demonstrated, consumers in the U.S. are faced with much higher costs (and consistently growing higher) than international counterparts.
Most Americans with private health insurance have it provided by their employers. There are also social welfare programs such as Medicaid and Medicare. The insurers negotiate rates with hospitals for different procedures. Patients then go into the hospital and get procedures recommended by doctors. The doctors are then paid by hospitals. This is a classic case of moral hazard: the two parties deciding for the transaction to occur- patients and doctors- are not the same two exchanging money.
Healthcare has a demand curve that fluctuates wildly based upon the extent of the issue – consumers who are facing serious health problems will likely demand healthcare at almost any price, allowing medical providers to take advantage of the inelastic demand. Further issues include the fact that doctors represent a third party (recommending drugs and procedures) and that insurance companies have the power to deny coverage to individuals who need it most.
The Affordable Health Care Act
In December of 2009, the Senate passing a bill called Patient Protection and Affordable Care Act. The Affordable Care Act is a complex piece of legislation, but a number of bullets from the bill are highly useful to understand:
• Pre-existing Conditions: Individuals with pre-existing conditions are much more likely to be expensive clients, and thus are not profitable to insure. This results in insurers refusing to insure these patients. The Affordable Care Act addresses this through legislation, saying providers cannot refuse coverage.
• Changing Insurance Rates: As a complement to the analysis above, insurance agencies also cannot alter rates based on pre-existing conditions or gender. This levels the playing field for the consumer, who historically had limited buyer power.
• Antitrust: Previously, insurance companies were immune to antitrust laws. This means they could generate monopolies geographically and exploit consumers. This immunity has been repealed.
• Standards: Obamacare also closes loopholes regarding to quality standards, ensuring that insurance providers do not reduce what is provided to clients in an effort to cut costs.
• Healthcare.gov: This is a way to enable consumers in finding health care insurers in a way that promotes capitalistic competition between providers. Previously, discussing pricing and plans with insurers was highly complex for many individuals (designed for businesses, not individual consumers).
• Medicaid and Medicare: Overall, medicare has been reduced while medicaid has been expanded. Medicare spending has been increasing dramatically. This has been cut by \$400 billion, which is a source of discontent for many individuals. Medicaid has been expanded to 133% of the poverty level, covering more people.
Criticisms
The ACA will only work if both healthy and sick people alike buy insurance: if the healthy choose to pay the fine for not having insurance and only the sick buy insurance, then costs will increase. There is also a political critique of the ACA. Some feel that the government should not mandate that private citizens purchase insurance in the first place. They feel that the government is overstepping its bounds.
Many individuals also believe that this new legislation will increase costs for small businesses that are now required to buy insurance for their employees, and will motivate ‘freeloaders’, or individuals who take government handouts. Overall, while the goal is to enable more people to health care more affordably, many people believe this new approach will do not accomplish that.
Key Points
• Kenneth Arrow, in 1963, differentiated health care economics from other economics due to the wide range of unique considerations involved (i.e. infinite demand, wide range of stakeholders, etc. ).
• Health care is a significant concern for patients, insurance companies, governments, businesses, health care providers, researchers, and non-profits. These parties determine the supply, demand, oversight, and externalities of the system.
• Currently, U.S. health care is largely privatized with the exception of medicaid and medicare, the former being for low income groups and the latter for retirees. This is unlike many developed nations, who have socialized support in place.
• The insurance company, the government (medicaid and medicare), or the individual (if they are not covered or if their particular procedure is not covered) is the direct client of the hospitals, pharmacies, and doctor’s offices.
• Overall, this system of health care in the U.S. is quite convoluted. There are many players involved and the stakes are extremely high.
• While a percentage breakdown of who procures the largest capital gains from health care is difficult to ascertain across such a complex system, it is safe to say that quite a few players contribute to the constantly rising price.
• In short, the dollar value of health care is largely provided by beneficiaries to insurance companies (or governments), and paid out to administrative systems who employ and pay health care providers.
• One of the most discussed topics in health care is accessibility. Governments and insurers provide economics means for this in developed nations.
• One of the larger issues in accessibility is nations without the infrastructure required to support health care industries. Developing nations often do not have access to the skills or suppliers required.
• A health system consists of all organizations, people and actions whose primary intent is to promote, restore or maintain health. This includes efforts to influence determinants of health as well as more direct health-improving activities.
• The World Health Organization has been actively measuring a variety of performance indicators to determine an overall ranking system for health care on a global scale.
• The countries which perform the highest on these metrics are primarily located in Europe, where social systems are well designed at a governmental level to ensure prices remain accessible and care remain available.
• The U.S. has consistently ranked poorly and continues to perform substantially below European counterparts deemed developed at similar economic levels.
• Developing nations struggle to compete and compare apples to apples to developed nations, primarily due to the required infrastructure and capital requirements.
• An externality is any impact, be it positive or negative, on individuals or groups not involved in a given economic transaction.
• Negative externalities include tax costs, infectious disease, anti-biotic resistance and environmental degradation. The negative components impact others despite their participation in the system.
• Positive externalities include increases in wealth due to increased health, vaccinations to limit disease exposures and increases in technology and knowledge.
• Positive externalities include increases in wealth due to increased health, vaccinations to limit disease exposures and increases in technology and knowledge.
• U.S. citizens pay substantially more per capita for health care than do residents of other countries, and many people lack access to affordable health care.
• Patients have procedures performed by doctors, by the actual exchange of money occurs between the patient’s insurance provider and the doctor’s employer.
• The Affordable Care Act addresses issues like pre-existing conditions, anti-trust, unfair rates based on gender, universal standards and a range of other considerations.
• Many individuals believe that this new legislation will increase costs for small businesses, and will motivate ‘freeloaders’, or individuals who take government handouts.
Key Items
• Health care: The prevention, treatment, and management of illness or the preservation of mental and physical well-being through the services offered by the medical, nursing, and allied health professions.
• Medicare: The system of government subsidies for health care for the elderly and disabled.
• Medicaid: U.S. government system for providing medical assistance to persons unable to afford medical treatments.
• Beneficiary: One who benefits or receives an advantage.
• World Health Organization: The World Health Organization (WHO) is a specialized agency of the United Nations (UN) that is concerned with international public health.
• Universal healthcare: A system where every citizen is guaranteed access to a certain basic level of health services.
• Determinants: A determining factor; an element that determines the nature of something
• externality: An impact, positive or negative, on any party not involved in a given economic transaction or act.
• Vaccinations: Inoculation with a vaccine in order to protect a particular disease or strain of disease
• Affordable Care Act: The ACA was enacted with the goals of increasing the quality and affordability of health insurance.
• Pre-existing Conditions: A pre-existing condition is a risk with extant causes that is not readily compensated by standard, affordable insurance premiums.
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Types of Natural Resources
Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources.
learning objectives
• Analyze natural resource economics and explain the types of natural resources that exist.
Natural Resource Economics
Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources. It’s goal is to gain a better understanding of the role of natural resources in the economy. Learning about the role of natural resources allows for the development of more sustainable methods to manage resources and make sure that they are maintained for future generations.The goal of natural resource economics is to develop an efficient economy that is sustainable in the long-run.
Importance of the Environment: This diagram illustrates how society and the economy are subsets of the environment. It is not possible for societal and economic systems to exist independently from the environment. For this reason, natural resource economics focuses on understanding the role of natural resources in the economy in order to develop a sufficient and sustainable economy that protects natural resources.
Types of Natural Resources
Natural resources are derived from the environment. Some of the resources are essential to survival, while others merely satisfy societal wants. Every man-made product in an economy is composed of natural resources to some degree.
There are numerous ways to classify the types of natural resources, they include the source of origin, the state of development, and the renewability of the resources.
In terms of the source of origin, natural resources can be divided into the following types:
• Biotic: these resources come from living and organic material, such as forests and animals, and include the materials that can be obtained them. Biotic natural resources also include fossil fuels such as coal and petroleum which are formed from organic matter that has decayed.
• Abiotic: these resources come from non-living and non-organic material. Examples of these resources include land, fresh water, air, and heavy metals (gold, iron, copper, silver, etc.).
Natural resources can also be categorized based on their stage of development including:
• Potential resources: these are resources that exist in a region and may be used in the future. For example, if a country has petroleum in sedimentary rocks, it is a potential resource until it is actually drilled out of the rock and put to use.
• Actual resources: these are resources that have been surveyed, their quantity and quality has been determined, and they are currently being used. The development of actual resources is dependent on technology.
• Reserve resources: this is the part of an actual resource that can be developed profitably in the future.
• Stock resources: these are resources that have been surveyed, but cannot be used due a lack of technology. An example of a stock resource is hydrogen.
Natural resources are also classified based on their renewability:
• Renewable natural resources: these are resources that can be replenished. Examples of renewable resources include sunlight, air, and wind. They are available continuously and their quantity is not noticeably affected by human consumption. However, renewable resources do not have a rapid recovery rate and are susceptible to depletion if they are overused.
• Non-renewable natural resources: these resources form extremely slow and do not naturally form in the environment. A resource is considered to be non-renewable when their rate of consumption exceeds the rate of recovery. Examples of non-renewable natural resources are minerals and fossil fuels.
There is constant worldwide debate regarding the allocation of natural resources. The discussions are centered around the issues of increased scarcity (resource depletion) and the exportation of natural resources as a basis for many economies (especially developed nations). The vast majority of natural resources are exhaustible which means they are available in a limited quantity and can be used up if they are not managed correctly. Natural resource economics aims to study resources in order to prevent depletion.
Natural resource utilization is regulated through the use of taxes and permits. The government and individual states determine how resources must be used and they monitor the availability and status of the resources. An example of natural resource protection is the Clean Air Act. The act was designed in 1963 to control air pollution on a national level. Regulations were established to protect the public from airborne contaminants that are hazardous to human health. The act has been revised over the years to continue to protect the quality of the air and health of the public in the United States.
Wind: Wind is an example of a renewable natural resource. It occurs naturally in the environment and has the ability to replenish itself. It has also been used as a form of energy development through wind turbines.
Basic Economics of Natural Resources
Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources to create a more efficient economy.
learning objectives
• Explain basic natural resource economics
Natural Resource Economics
Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources. The main objective of natural resource economics is to gain a better understanding of the role of natural resources in the economy. By studying natural resources, economists learn how to develop more sustainable methods of managing resources to ensure that they are maintained for future generations. Economists study how economic and natural systems interact in order to develop an efficient economy.
As a field of academic research, natural resource economics addresses the connections and interdependence between human economies and natural ecosystems. The focus is how to operate an economy within the ecological constraints of the earth’s natural resources.
Natural Resource Economics: This diagram illustrates that society and the economy are subsets of the environment. It is not possible for social and economic systems to exist independently from the environment. Natural resource economics focuses on the demand, supply, and allocation of natural resources to increase sustainability.
Areas of Study
Economists study the commercial and recreational use and exploitation of resources. Traditionally, natural resource economics focused on fishery, forestry, and mineral models. However, in recent years many more topics have become increasingly important, including air, water, and the global climate. Natural resource economics is studied on an academic level, and the findings are used to shape and direct policy-making for environmental issues.
Examples of areas of study in natural resource economics include:
• welfare theory
• pollution control
• resource exhaustibility
• environmental management
• resource extraction
• non-market valuation
• environmental policy
Additionally, research topics of natural resource economists can include topics such as the environmental impacts of agriculture, transportation and urbanization, land use in poor and industrialized countries, international trade and the environment, and climate change.
Impact of Natural Resource Economics
The findings of natural resource economists are used by governments and organizations to better understand how to efficiently use and sustain natural resources. The findings are used to gain insight into the following environmental areas:
• Extraction: the process of withdrawing resources from nature. Extractive industries are a basis for the primary sector of the economy. The extraction of natural resources substantially increases a country’s wealth. Economists study extraction rates to make sure that resources are not depleted. Also, if resources are extracted too quickly, the sudden inflow of money can cause inflation. Economists seek to maintain a sense of balance within extraction industries.
• Depletion: the using up of natural resources, which is considered to be a global sustainable development issue. Many governments and organizations have become increasingly involved in preserving natural resources. Economists provide data to determine how to balance the needs of societies now and preserve resources for the future.
• Protection: the preservation of natural resources for the future. The findings of economists help governments and organization develop measures of protection to sustain natural resources. Protection policies state the necessary actions internationally, nationally, and individually that must take place to control natural resource depletion that is a result of human activity.
• Management: the use of natural resources taking into account economic, environmental, and social concerns. This process deals with managing natural resources such as land, water, soil, plants, and animals. Particular focus is placed on how the preservation of natural resources impacts the quality of life now and for future generations.
Externalities and Impacts on Resource Allocation
Production and use of resources can have a positive or negative effect on the allocation of the natural resources.
learning objectives
• Examine externalities and how they the impact resource allocation of natural resources.
Resource Allocation
Resource allocation is division of goods for the use of production within the economy. The needs and wants of society as well as industries impact what is produced. Suppliers focus on producing the varieties of goods and services that will yield the greatest satisfaction to consumers. In the long run, externalities directly impact resource allocation. It must be determined whether the production, as well as the process of production, creates more benefits that costs for the producers, consumers, and society as a whole.
Externalities
An externality is a cost or benefit that affects a party who did not choose to incur the cost or benefit. In regards to natural resources, production and use of resources can have a positive or negative effect on the allocation of the resources.
External Costs
A negative externality, also called the external cost, imposes a negative effect on a third party to an economic transaction. Many negative externalities impact natural resources negatively because of the environmental consequences of production and use. For example, air pollution from factories and vehicles can cause damage to crops. Likewise, water pollution has a negative impact of plants and animals.
Negative externality: Air pollution from vehicles is an example of a negative externality. It affects other than those who drive the vehicle and those who sell the gas.
In the case of negative externalities, the marginal private cost of consuming a good is less than the marginal social or public cost. The marginal social benefit should equal the marginal social cost (i.e. production should only be increased when the marginal social benefit exceeds the marginal social cost). When external costs are present, the use of natural resources is inefficient because the social benefit is less than the social cost. In other words, society and the natural resources involved would have been better off if the natural resources had not been used at all.
Developed countries use more natural resources and must enact sustainable development plan for the use of resources. Human needs must be met, but the environment and natural resources must be preserved. Examples of resource depletion include mining, petroleum extraction, fishing, forestry, and agriculture.
External Benefits
Positive externalities, also referred to as external benefits, impose a positive effect on a third party. An example of a positive externality is when crops are pollinated by bees from a neighboring bee farm. In order to achieve the socially optimal equilibrium, the marginal social benefit should equal the marginal social cost (i.e. production should be increased as long as the marginal social benefit exceeds the marginal social cost). Assuming that natural resources are used and also sustained, the external benefits of goods produced by natural resources impacts the majority of the public in a positive way.
Key Points
• Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources.
• Every man-made product in an economy is composed of natural resources to some degree.
• Natural resources can be classified as potential, actual, reserve, or stock resources based on their stage of development.
• Natural resources are either renewable or non-renewable depending on whether or not they replenish naturally.
• Natural resource utilization is regulated through the use of taxes and permits. The government and individual states determine how resources must be used and they monitor the availability and status of the resources.
• As a field of academic research, natural resource economics addresses the connections and interdependence between human economies and natural ecosystems.
• By studying natural resources, economists learn how to develop more sustainable methods of managing resources to ensure that they are maintained for future generations.
• Natural resource economics is studied on an academic level, and the findings are used to shape and direct policy-making for environmental issues. These issues include resource extraction, depletion, protection, and management.
• Natural resource economics findings impact policies for environmental work including issues such as extraction, depletion, protection, and management.
• An externality is a cost or benefit that affects a party who did not choose to incur the cost or benefit.
• A negative externality, also called the external cost, imposes a negative effect on a third party.
• When external costs are present, the market equilibrium use of natural resources is inefficient because the social benefit is less than the social cost. In other words, society would have been better off if fewer natural resources had been used.
• Positive externalities, also referred to as external benefits, imposes a positive effect on a third party.
• Assuming that natural resources are used and also sustained, the external benefits of goods produced by natural resources impacts the majority of the public in a positive way.
Key Terms
• natural resource: Any source of wealth that occurs naturally, especially minerals, fossil fuels, timber, etc.
• Renewable: Sustainable; able to be regrown or renewed; having an ongoing or continuous source of supply; not finite.
• depletion: The consumption of a resource faster than it can be replenished.
• sustainable: Able to be sustained for an indefinite period without damaging the environment, or without depleting a resource.
• externality: An impact, positive or negative, on any party not involved in a given economic transaction or act.
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The Agricultural Market Landscape
The agricultural market landscape is the economic system that produces, distributes, and consumes agricultural products and services.
learning objectives
• Outline the evolution of the agriculture market over time
Agriculture, in many ways, has been the fundamental economic industry throughout history. The production and exchange of food laid the groundwork for all bartering, making it likely to be the oldest market in history. The production of food in modern times in developed nations is oddly taken for granted, as surpluses tend to define the market in pursuit of providing options.
Developing nations view agriculture quite differently, where famines and low yield years can dramatically affect the overall food supply in a given region. Due to the critical importance of food production, the agricultural market landscape is one of the most studied and evolved economic segments.
The History of Agriculture
The history of agriculture is complex, spanning back thousands of years across a wide variety of different geographic regions, climates, cultures, and technological approaches. Over 10,000 years ago, tribes began executing forest gardening. This evolved in the Fertile Crescent region into the domestication of animals (i.e. cattle, sheep, goats, pigs), growing of wheat and barley in Jordan Valley and the growth of cereal in Syria (all still about 10,000 years ago).
As population expanded dramatically over time (see ), so did the efficiency of agriculture economics. This began with agricultural improvements such as the hoe and the plow (2500 B.C.), irrigation via canals, and biological pest control as early as the bronze and iron ages. This evolved further in the middle ages with the advent of fertilizers, three field techniques, draft horses, and improved international exchange. Indeed, until the Industrial Revolution (18th and 19th centuries) the vast majority of the human population labored long hard days to generate enough food to feed the masses.
Human Population Growth: This chart illustrates the way in which human population growth evolved over time, underlining the difficulty in maintaining supplies to fill the needs of such a large population.
The modern era of farming is increasingly defined by selective breeding, crop rotation, economies of scale, electronic machinery, genetic modification, pesticides, and a host of other solutions that have rapidly expanded the overall potential capacity in farming.
Agricultural Economics
This rapid expansion coupled with the essential role of food in our society has generated a field of economics solely dedicated to observing and predicting trends within the agriculture market landscape. Basic macro and micro-economic principles apply to farming, as do the existence of externalities such as climate change and nutritional health. Agricultural economics is defined as the economic system that produces, distributes, and consumes agricultural products and services. This represents a large interconnected supply chain on a global scale.
Interesting trends in the agricultural market pertain to the decrease in cost for the actual farming aspects and an increase in costs for the distribution and sales system (particularly in the U.S.). This is largely a result of technological progress greatly reducing the need for human labor in the production of agricultural goods, weighting the costs more heavily on the human resources side of the equation.
The politics and economics of agriculture are also relevant issues on the global scale. US agricultural subsidies have had a large impact on international trade flows. The subsidies make US agricultural products artificially cheap, too cheap for developing nations to compete with. Developing nations, which may rely more heavily on agriculture in their economy than developed nations, argue that the US should reduce its agriculture subsidies. This tension is perhaps the biggest cause of the failure of the Doha Round, a World Trade Organization push for more open global trade, to make any progress since its initiation in 2001.
Subsidies and Income Supports
An agricultural subsidy is a government grant paid to incumbents in the industry to reduce costs and influence the supply of commodities.
learning objectives
• Analyze the positive and negative affects of subsidies on agricultural economics.
When governments want to ensure their citizens have access to healthy foods at reasonable prices, a variety of governmental supports are provided to the industry to ensure it maintains low costs of production and high output. This is generally in the form of subsidy and income supports, which alleviate some competitive dynamics and operating expenses to maintain reasonable price points in the market economically.
Subsidies
An agricultural subsidy is defined as a government grant paid to farmers to supplement income and influence the overall cost and supply of certain commodities. In this industry, subsidized goods generally include wheat, corn, barley, oats, sorghum, milk, rice, peanuts, tobacco, soybean, cotton, lamb, beef, chicken and pork. illustrates the governmental priorities, based upon subsidies provided, for specific agricultural goods in the United States. These subsidies play a large role in enabling higher supply at lower price points, supporting the domestic agricultural industry.
Agriculture Subsidies in the U.S. (2005): This chart illustrates the governmental priorities, based upon subsidies provided, for specific agriculture goods in the United States.
Another, less direct, form of subsidy is in the taxing system for consumers. Consumers are not charged tax on food goods and clothes, which are considered necessities and thus should be provided at the lowest costs possible. These consumer-based subsidies are another governmental attempt to enable citizens in the country to purchase basic food stuffs required to survive. Food stamps are a similar concept, used to empower low income individuals and ensure they have access to these basic foods as well (food stamps are often limited to milk, eggs, bread and other core foods).
Impacts of Subsidies
While these subsidies above are designed to have a positive effect on consumers looking to purchase foods, there are externalities to this process that can have a damaging affect on other groups:
• Global Effects: While domestic subsidies are good for driving up production domestically, it suppresses competition in the context of international trade. Government assistance in an industry is argued to provide an unfair competitive advantage for those companies, artificially lowering their costs of production, sometimes below the feasible level for countries (especially developing nations) not receiving these supports.
• Developing Nations: A complement to the above discussion is the effect on poverty and developing nations without the infrastructure to provide subsidies for their own farmers. The International Food Policy Research Institute has estimated a total loss of economic growth in developing nations at \$24 billion in 2003, all of which translate to lost income for individuals who desperately need it.
• Nutrition: Another interesting side effect of subsidies and the artificially reduced price of food is obesity and overeating. Some argue that these low prices provide the incentive to buy more food than is necessary, and this over consumption has resulted in a highly unhealthy culture (particularly in the U.S.).
• Environmental Implications: As food prices reduce distribution increases, thus driving an environmental externality which already existed even further. The cost, environmentally, of transporting a high quantity of agricultural goods across the globe has resulted in high degrees of pollution and waste.
Overall, while subsidies are largely a good thing and enable individuals to buy the necessities, there are clear cut downsides to subsidies as well. Politics must find a way to mitigate the negative consequences while increasing the positive effects, allowing for balanced and healthy consumption across all demographics.
Price Supports
Price supports are subsidies or price controls used by the government to artificially increase or decrease prices in the agriculture market.
learning objectives
• Assess the way in which price controls affect supply, demand, and equilibrium pricing in agricultural economics.
The agriculture industry is a critical component of any national economy because it represents both a substantial portion of gross domestic product and it is a core necessity for citizens within the system. Due to the fact that these goods are necessities, it is also important to keep in mind the way in which supply and demand would operate if there was a limited supply (required for survival, and thus potential demand upsides could be boundless). Due to these factors, governments enact a variety of price controls on the agriculture business, both in the U.S. and abroad.
Defining Price Supports
Price supports are defined as subsidies or price controls that are leveraged by the government to artificially increase or decrease prices, and thus alter the supply consumed/quantity demanded by individuals within the system. Understanding the effects of subsidies and price controls is critical in industries with a high degree of government involvement, and agriculture is one of the most affected industries.
is simply a supply and demand curve that demonstrates the consumer surplus and producer surplus opportunities in basic supply and demand chart. In this scenario, without external governmental intervention, the price equilibrium will remain in the center of the graph. However, the government may implement price supports that artificially consume some of the consumer surplus (in, this is 200 units). This drives the price upwards to \$6 per unit despite the fact that the consumer is not gaining additional quantity (it is artificial quantity, as purchased by the government).
Consumer Surplus with Price Support: This graph is a complement to the first graph. It demonstrates the effect of implementing a price support on a basic supply and demand chart. The overall consumption will decrease as the government buys up consumer surplus. This demonstrates a price control on behalf of the government.
Consumer Surplus: This chart, in conjunction with the one below, illustrates the way in which price supports can alter supply and overall consumption. It demonstrates the consumer surplus and producer surplus opportunities on a basic supply and demand chart.
This can happen in reverse as well in the form of subsidies. Subsidies are the reduction of costs for producers, generally in the form of governmental grants provided to suppliers. In this scenario, prices are artificially reduced, allowing for an outward shift of the supply curve along the demand line, which creates a higher amount of consumption by consumers as a result of the reduced price. This is illustrated in, where the governmental subsidy allows for increased consumption power on behalf of the consumers in that market.
Subsidies and Supply: This chart shows how subsidies and price controls affect supply and demand. A subsidy, as illustrated here, will reduce the price and extend the overall supply demanded and consumed by individuals within the system. This is the most relevant chart to agricultural economics specifically.
Applying Price Supports to Agricultural Economics
The United States currently pays out around \$20 billion annually to farmers and producers in agriculture in the form of subsidies via farm bills in order to artificially reduce prices and shift the supply curve outward to ensure the overall supply in the market is high enough to satisfy all prospective consumers. It is important to note how dramatically the recipients of farming subsidies have changed over time in the United States. In 1925, there were around 6,000,000 small farms of which 25% of the nation resided. By 1997, 72% of farm sales come from 157,000 large farms and only 2% of the U.S. population resides there. This is an interesting economic factor in farm subsidies, as these subsidies are largely going to corporations of substantial size, as opposed to small farmers.
The subsidies provide a price floor (or a minimum price in which farmers can be reimbursed for certain products). This is a significant economic policy of price control to ensure farmers have proper incentive and revenues to continue to produce at the level of goods desired by the U.S. government. Agricultural economics is a highly complicated market as a result of these price supports and controls, particularly from the perspective of subsidization and price control.
Supply Reduction
Agricultural aggregate supply can be reduced through external capacity potential or governmental interventions.
learning objectives
• Identify factors resulting in global reductions in agricultural supply levels.
Agricultural economics is largely bound by concepts of climate and overall world food producing capacity (i.e. farmlands and infrastructure), while simultaneously being enabled by government policy, technological advances, and the continued growth of developing nations. Understanding the reductions in aggregate supply in this industry, as a result of governmental policy or economic limits, is a critical component in understanding agricultural economics. We will look at both the governmental components and the climatic/aggregate demand components contributing to overall supply in this industry.
Governmental Policy
Government policy has a large impact on the agriculture market. Both subsidies and price ceilings are common and affect the overall supply and demand equilibrium points in the market. Governmental policy to reduce supply also exists and is executed often from a global trade perspective. One of the largest risks in this industry, due to the high degree of subsidization, is ‘ dumping. ‘ Dumping is the process of selling undervalued goods in another market, upsetting price points and equilibrium. In this scenario, government policies may set quotas, or import limits, to reduce supply.
A second reduction in supply that is quite common in developed nations is utilizing surplus for foreign aid. Many developing nations lack the requisites to generate the appropriate supply of agriculture to feed the population. In this scenario, the leveraging of the surplus in one country can benefit the other country via aid, and in turn correct the supply/demand equilibrium in the donating country to the desired level.
Climate Change
Environmental concerns have also been widely cited as a reductive influence on the agriculture market. Global warming has been slowly increasing temperatures as the ozone layer erodes due to a variety of pollutants, altering the ecosystem averages outside of the evolutionary environment in which many agricultural products historically grew. Climate changes means a different growing environment for plants, which are not used to it. illustrates the reduction in yield as a result of altering climatic environments. Shifts in climate drastically reduce aggregate supply.
Climate Change Affecting Agriculture: This chart illustrates the reduction in yield as a result of altering climatic environments. Essentially, deviations outside of the normal temperature ranges drastically reduce aggregate supply.
Other concerns revolve around dramatic soil damage due to short-term yield increasing strategies, growing immunity to pesticides, loss of rural space for farming (due to urbanization), and availability of clean water for irrigation. All of these factors may reduce the aggregate supply and thus drive up prices. demonstrates rising food prices, perhaps from a number of the supply reduction factors discussed in this atom (or potentially unidentified factors). Controlling supply is a critical component of ensuring everyone has access to affordable food, and maintaining our ecosystem will clearly play a critical role in the years ahead.
Food Price Increases Over Time: Food prices over time, particularly in recent years, are demonstrating a trend upwards that may reflect a reduction in overall efficiency of agricultural production or reductions in supply.
Evaluating Policies
Agriculture requires a vast support system and a great deal of oversight, addressing industry threats and utilizing policy-based tools.
learning objectives
• Evaluate the economics of agriculture policies.
The political frame of the agriculture market is hugely complex, with a wide range of critical concerns that need to be addressed both domestically and internationally. Agricultural policy differs from nation to nation, but has a number of key questions and considerations that occur across the board. The purpose of this atom is to outline the various trends in agricultural economic policy, and how these governmental policies can be evaluated for efficacy in their respective markets.
Policy Concerns
Agriculture requires a vast support system and a great deal of oversight, as the consumption of grown foods poses a huge safety threat alongside a critical need for the health and survival of a civilization. Below is a list of core questions to keep in mind when evaluating agricultural policy:
• Biosecurity: The ability of a country to consistently provide enough food for its citizens is a major concern. Pests and diseases are a significant threat to yield rates and must be closely observed and regulated.
• International Trading Environment: Global agricultural trade is a complex issue, with quality control, pricing (dumping), and import/export tariffs. The dangers of biosecurity, or lack thereof, in particular are quite stringent.
• Infrastructure: Transporting goods, irrigation facilities, land utilization, and a variety of other logistics concerns are required by the government to enable effective economic trade (domestically and internationally).
• Technology: This is a critical driving force in increasing yield and lowering costs in the agriculture business. Enabling technological progress is a critical investment and something governments must provide incentives for.
• Water: Access to clean, potable water is a basic necessity to which not everyone has access.Effective sewage systems for irrigation and effective water treatment for sanitation are a required input, and must be provided via governmental centralized infrastructure.
• Resource Access: Ensuring access to land and biodiversity is another important component to a successful agricultural industry. Protection of environmental land and the overall ecosystem is an important policy consideration.
Policy Tools
With the above concerns in mind, it is also useful to understand some of the tools leveraged by governments to enable this industry:
• Subsidies: The government can utilize subsidies to reduce price points and increase the overall supply within a system. The use of subsidies in developed nations has been a major point of international contention, since they may force developing nations out of the global agriculture market.
• Price Floors/Ceilings: Price floors provide a minimum price point for a given product while price ceilings create a maximum price point. These are used to ensure appropriate pricing in a given industry (see ), and are often used in agriculture to control price points.
• Import Quotas: Policy makers often implement quotas in agriculture to retain more control over prices and protect domestic incumbents. Quotas, like other forms of trade protection, benefit the local industry.
• Aid: When aggregate supply is too high in a home country or there is a crisis in another, governments can provide their surplus to nations in need of food. This is both a way to provide utilitarian value while reducing aggregate supply.
Combining the issues above with tools provided, the agricultural business can change dramatically as a result of the concerns and activities of the respective government in a given economy. This is useful in controlling food prices, reducing waste, enabling efficiency and avoiding biosecurity issues.
Key Points
• The history of agriculture is complex, spanning back thousands of years across a wide variety of different geographic regions, climates, cultures, and technological approaches.
• The roots of agriculture are derived over 10,000 years ago, with tribes executing forest gardening alongside the domestication of animals in the Fertile Crescent region.
• As population expanded dramatically over time (see, so did the efficiency of agriculture economics. This began with agricultural improvements such as the hoe and is represented today with genetic engineering, robotics, irrigatiion, etc.
• This rapid expansion coupled with the essential role of food in our society has generated a field of economics solely dedicated to observing and predicting trends within the agriculture market landscape.
• Interesting trends in the agricultural market pertain to the decrease in cost for the actual farming aspects and an increase in costs for the distribution and sales system (particularly in the U.S.). This is largely a result of technological progress.
• Subsidized goods generally include wheat, corn, barley, oats, sorghum, milk, rice, peanuts, tobacco, soybean, cotton, lamb, beef, chicken and pork.
• Another, less direct, form of subsidy is in the taxing system for consumers. Consumers are not charged tax on food goods and clothes, which are considered necessities and thus should be provided at the lowest costs possible.
• In the context of international trade, government assistance in industry provides an unfair competitive advantage for those companies receiving the support.
• Overall, while subsidies are largely a good thing and enable individuals to buy the necessities, there are clear cut downsides to subsidies as well.
• Overall, while subsidies are largely a good thing and enable individuals to buy the necessities, there are clear cut downsides to subsidies as well. Politics must find a way to mitigate the negative externalities.
• Governments enact a variety of price controls on the agriculture business, both in the U.S. and abroad, to ensure desired supply and prices for specific necessities.
• Price supports are defined as subsidies or price controls that are leveraged by the government to artificially increase or decrease prices, and alter the supply consumed/quantity demanded by individuals within the system.
• The government may artificially increase prices through purchasing a portion of the consumer surplus or artificially increase quantity through offering subsidies to producers. This allows the government control over the established equilibrium in agriculture.
• The United States currently pays out around \$20 billion annually to farmers and producers in agriculture in the form of subsidies via farm bills in order to artificially reduce prices and shift the supply curve.
• The subsidies provide a price floor (or a minimum price in which farmers can be reimbursed for certain products). This is a significant economic policy of price control to ensure farmers have proper incentive and revenues to continue to produce.
• Government policy has a large impact on the agriculture market, usually in the form of subsidies and price ceilings, by controlling the overall supply and demand equilibrium points in the market.
• Governments may reduce supply through utilizing quotas (limiting imports ) or providing foreign aid (actively reducing domestic demand).
• Environmental concerns have also been widely cited as a reductive influence on the agriculture market. Global warming (increased average temperatures) has demonstrated a negative effect on overall plant yield for certain products.
• Other concerns reducing supply revolve around dramatic soil damage due to short-term yield increasing strategies, growing immunity to pesticides, loss of rural space for farming (due to urbanization), and availability of clean water for irrigation.
• The political frame of the agriculture market is complex, with a wide range of critical concerns that need to be addressed both domestically and internationally.
• Concerns to keep in mind revolve around the international markets, bio-security, infrastructure, technology, water, and resource allocation to enable effective agricultural markets.
• Governments can use import quotas, subsidies, price floors, price ceilings, and aid to control their domestic market supply, demand, and equilibrium price point.
• Combining the issues above with tools provided, the agricultural business can change dramatically as a result of the concerns and activities of the respective government in a given economy.
Key Terms
• Agricultural Economics: The study of the production, distribution, and consumption of goods and services related to food.
• subsidy: Government assistance to a business or economic sector.
• externalities: Impacts, positive or negative, on any party not involved in a given economic transaction or act.
• Price support: A subsidy or a price control with the intended effect of keeping the market price of a good higher or the quantity consumer higher within a market.
• Subsidies: Financial support or assistance, such as a grant.
• Dumping: Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.
• Quotas: A restriction on the import of a good to a specific quantity.
• infrastructure: The basic facilities, services, and installations needed for the functioning of a community or society.
• Biosecurity: The protection of plants and animals against harm from disease or from human exploitation.
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Dimensionalizing Immigration: Numbers of Immigrants around the World
Annually, millions of people around the world decide to emigrate to another country, and this rate is expected to increase over time.
learning objectives
• Describe trends of global immigration
Immigration
Immigration is defined as the movement of people from their home country or region to another country, of which they are not native, to live. There are specific economic factors that contribute to immigration, including the desire to obtain higher wage rates, improve the standard of living, have better job opportunities, and gain an education. Non-economic factors are also significant and include leaving a home country due to persecution, ethnic cleansing, genocide, war, natural disasters, and political control (for example, dictatorship). Throughout history, with improved transportation and technology, immigration has become increasingly common worldwide. Immigration numbers impact both the home country and the host country.
Immigration Statistics
In 2005, the United Nations reported that there were nearly 191 million international immigrants worldwide, which accounted for about 3% of the world population. This represented an increase in the number of immigrants by about 26 million since 1990. It is estimated that 60% of the immigrants moved to developed countries.
Country Immigrant Populations in 2005: The darker the color, the higher the percent immigrants in the population. The darkest blue indicates more than 50% of the population are immigrants. There is no data for countries in grey.
In 2006, the International Organization for Migration estimated the number of immigrants to be more than 200 million globally. Europe, the United States, and Asia were found to host the largest number of immigrants at 70 million, 45 million, and 25 million.
Moreover, it is predicted that immigration rates will continue to increase over time. A 2012 survey that was conducted by Gallup determined that nearly 640 million adults would want to immigrate if they had the chance. About one quarter of those surveyed (23%, or 150 million adults) stated that they would choose to immigrate to the United States. Seven percent (45 million adults) stated that they would choose to immigrate to the United Kingdom. Other top countries listed in the survey included Canada, France, Saudi Arabia, Australia, Germany, and Spain.
Net Immigration Rate: This graph shows the worldwide net immigration rate in 2011. The blue shows positive rates, the orange is negative, green is stable, and gray represents no data available. It is predicted that global immigration rates will continue to increase in the future.
Regional Factors for Immigration
Regional factors contribute to immigrants’ selection of a specific host country. The prospects for employment, wage rate, standard of living, and immigration laws all contribute to relocation decisions. Examples of immigration patterns in certain countries help to illustrate how specific factors influence immigration numbers worldwide.
• Europe: Immigrants helped to rebuild and repopulate Europe after World War II. In 2005 Europe experienced an overall net gain of 1.8 million people from immigration. This accounted for almost 85% of Europe’s total population growth that year. In 2010, according to Eurostat, there were 47.3 million immigrants living throughout Europe, which accounted for 9.4% of the total population; Germany, France, the United Kingdom, Spain, Italy, and the Netherlands experienced the highest immigration rates.
• Japan: Japan had strict immigration policies, but in the early 1990’s, issues such as low birth rates and an aging work force caused the country to reevaluate its laws. It is estimated that the number of foreign residents living in Japan in 2008 was more than 2.2 million. The largest groups of immigrants were from Korea, China, and Brazil.
• Mexico: Mexico does experience large numbers of immigrants crossing over the Guatemalan border, but many of these individuals enter illegally and get deported. There were an estimated 200,000 undocumented immigrants in Mexico in 2005 alone. Mexico is also the leading country for migrants moving to the United States. The tighter immigration laws have made immigrating to the U.S. from Mexico very challenging. Many Mexican immigrants enter and live in the U.S. illegally.
• United States: Factors that influence immigration to the U.S. include family reunification, employment opportunities, and humanitarian needs. When President Bill Clinton was in office, the U.S. Commission on Immigration Reform sought to limit legal immigration to about 550,000 people a year. Immigration has remained a heavily debated issue since then. U.S. borders have tightened in recent years to help control illegal immigration. It was documented in 2010 that 1 million immigrants obtained legal permanent resident status for that year.
Impact of Immigration on the Immigrant
Immigrants move to another country with the intent to improve their life; however, immigration presents both benefits and challenges for immigrants.
learning objectives
• Assess the impact that immigration has on immigrants
Immigration
Immigration involves the movement of people from their home country to a host country or region, to which they are not native, to live. There are many reasons why immigrants choose to leave their home countries, including economic issues, political issues, family reunification, and natural disasters. In general, no matter what the reasoning is, immigrants move to another country to improve their life. Immigration presents both benefits and challenges for immigrants.
Benefits of Immigration
There are many benefits associated with immigration. Primarily, immigrants choose to leave their home country in order to improve their quality of life. Economic reasons for immigrating include seeking higher wage rates, better employment opportunities, a higher standard of living, and educational opportunities. It is also common for immigrants to leave their home country to escape from poverty, religious persecution, oppression, ethnic cleansing, genocide, wars, or a political structure (e.g. repressive dictatorship). No matter what the reasoning is behind immigration, it provides the immigrant with a new start on life and more growth opportunities than were previously available. Success in a new country is not guaranteed and often requires hard work and sacrifices, but many immigrants are willing to take risks for the possibility of a better future for themselves.
Immigration: This picture shows a group of North African immigrants on a boat near the island of Sicily. When most immigrants choose to leave their home country, the intent is to move in order to obtain a higher quality of life in the host country.
Challenges of Immigration
One of the initial challenges faced by immigrants is the cost of immigrating. Many immigrants are seeking better economic conditions in a new country, so the cost of moving can be substantial for them. It is not uncommon for immigrants to liquidate their assets, potentially at a substantial loss, to be able to afford to move. Also, during immigration many individuals are without work and must find work once they get settled.
The majority of challenges associated with immigration deal with assimilating into life in the host country. Many immigrants take low wage jobs until they can adjust to society, gain housing, and obtain an education. Immigrants must learn a new way of life and become familiar with the language and laws of the host country. While many immigrants leave their home country to escape persecution, it is possible that they could face discrimination or even racism in the host country. The process of immigrating is not easy, but for many individuals staying in their home country does not provide them with a promising future. Most immigrants are willing to take risks and work hard to build a solid future even though the process can be challenging.
Impact of Immigration on the Host and Home Country Economies
Immigration has both positive and negative effects on the host and home countries including population totals, employment, and production.
learning objectives
• Explain how immigration impacts the host country and the home country of immigrants
Immigration
Immigration involves the movement of people from their home country to a host country, of which they are not native, to settle and live. People immigrate for many reasons; some of which include economic or political reasons, family reunification, natural disasters, or the desire to change one’s surroundings.
In 2006, the International Organization for Migration estimated the number of foreign migrants worldwide to be more than 200 million. Europe, North America, and Asia host the largest number of immigrants totaling 70 million, 45 million, and 25 million in 2005, respectively.
Immigration Rates: This map shows the migration rates worldwide in 2011. The blue countries experienced positive rates, orange indicates negative rates, green shows stable rates, and the gray shows where no data was available. Immigration involves individuals moving from their home country to live in a non-native country. In 2005, Europe, the United States, and Asia had the highest levels of immigration worldwide.
Impacts on the Host Country
A host country experiences both advantages and challenges as a result of immigration. At certain times throughout history, larger migrations have taken place which created huge population surges. The higher population numbers placed strain on the infrastructure and services within the host country. When immigrants move to a new country, they are faced with many unknowns, including finding employment and housing, as well as adjusting to new laws, cultural norms, and possibly a new language. It can be a challenge for a host country to assimilate immigrants into society and provide the necessary support.
Immigration does cause an increase in the labor force. This can impact great quantities of them if the immigrants are generally the same type of worker (e.g. low-skilled) and immigrate in large enough numbers so as to significantly expand the supply of labor.
Immigration is still a heavily debated topic in many host countries. Some believe that immigration brings many advantages to a country both for the economy and society as a whole. Others believe that high immigration numbers threaten national identity, increase dependence on welfare, and threaten national security (through illegal immigration or terrorism). Another argument is that high immigration rates cheapens labor. Empirically, research has shown this may be partially true. The Brookings Institute found that from 1980 to 2007, immigration only caused a 2.3% depression in the wages of the host country. The Center for Immigration Studies found a 3.7% depression in wages during 1980 to 2000.
Impacts on the Home Country
The home country also faces specific challenges in regards to immigration. In many cases, immigrants move to another country to provide positive changes for their future. Reasons to immigrate can include the standard of living not being high enough, the value of wages being too low, a slow job market, or a lack of educational opportunities. A home country must analyze immigration statistics to determine and address why citizens are moving to other countries. In the long-run, large amounts of immigration will weaken the home country by decreasing the population, the level of production, and economic spending. If a country is losing citizens due to economic reasons, the situation will not improve until economic changes are made.
At times, citizens of a country may leave because of non-economic reasons such as religious persecution, ethnic cleansing, genocide, war, or to escape the government (for example, a dictatorship). In these cases, it is not uncommon for the citizens to return to the home country at some point once the threat is no longer present. While a citizen is living in another country, if they receive an education and create a solid life, their individual success can also be beneficial to the home country, if they use their acquired skills to make a difference. Many individuals do not forget their home country and continue to support family members financially through the income from the country they migrate to.
Key Points
• It is predicted that immigration rates will continue to increase over time. A 2012 Gallup survey determined that nearly 640 million adults would want to immigrate if they had the chance to.
• In 2005, the United Nations reported that there were nearly 191 million international immigrants worldwide; about 3% of the world population. In 2006, Europe, the United States, and Asia were found to host the largest number of immigrants at 70 million, 45 million, and 25 million, respectively.
• Regional factors contribute to immigrants selecting a specific host country. The prospects for employment, wage rate, standard of living, and immigration laws all contribute the immigrants’ decision of where to relocate.
• Some reasons immigrants choose to leave their home countries include economic issues, political issues, family reunification, or natural disasters. Economic reasons include seeking higher wages, better employment opportunities, a higher standard of living, and educational opportunities.
• No matter the reasons behind an immigration decision, immigration provides the immigrant with a new start on life and more growth opportunities than were previously available.
• One of the initial challenges faced by immigrants is the cost of immigrating. However, the majority of challenges associated with immigration deal with assimilating into life in the host country.
• One of the initial challenges faced by immigrants is the cost of immigrating. It is not uncommon for immigrants to liquidate their assets, potentially at a substantial loss, to be able to afford to move.
• The majority of challenges associated with immigration deal with assimilating into life in the host country.
• People immigrate for many reasons, some of which include economic or political reasons, family reunification, natural disasters, or the desire to change one’s surroundings.
• Immigration can represent an expansion of the supply of labor in the host country.
• Host countries are faced with a variety of challenges due to immigration including population surges, support services, employment, and national security.
• Reasons to immigrate can include the standard of living not being high enough, the value of wages being low, a slow job market, or a lack of educational opportunities.
• In the long run, large amounts of immigration will weaken the home country by decreasing the population, the level of production, and economic spending.
Key Terms
• immigration: The act of coming into a country for the purpose of permanent residence.
• immigrant: A person who comes to a country from another country in order to permanently settle in the new country.
• assimilate: To absorb a group of people into a community.
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Learning objectives
Explain the relationship between price and quantity demanded
Willingness to Pay and the Demand Curve
In general as the price of a good increases, the quantity demanded of that good decreases.
A demand curve is the graphical depiction of the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that price. Demand curves are used to estimate behaviors in competitive markets and are often used with supply curves to estimate the market equilibrium price, or the price at which sellers are willing to sell the same amount of a product as the market’s buyers are willing purchase. A demand graph can reflect the preferences of a single consumer, a group of consumers or an entire market. For demand graphs that reflect a group, the individual demands at each price are added together.
Demand is the willingness and ability of a consumer to purchase a good under the prevailing circumstances. It is defined by three elements:
• Individual Utility: An item’s utility is based on its ability to satisfy an individual’s needs or wants. Some utility is universal; every human needs water to survive so it has high utility for everyone. Some utility is based on personal preference; some people prefer Coke over Pepsi so for them Coke has the higher utility. The more people that find utility in the good the greater the market demand; the greater the individual utility in the product the greater the individual demand.
• Purchasing Power: Demand is measured based on a person’s willingness to buy under the prevailing circumstances. If an individual lacks the money to purchase the product, she can’t demand it because she cannot afford it.
• Ability to Decide: The individual must be able to choose to make a purchase. Sometimes circumstances may prevent a person from purchasing something they might desire, even if they have the necessary money. For example, an underaged person may not be permitted by law to purchase cigarettes. That person might want the cigarettes and can afford to purchase them, but since it is against the law for him to purchase it, there is no demand.
For the vast majority of goods and services, an increase in price will lead to a decrease in the quantity demanded. There are two exceptions to this general rule.
Supply and demand graph: The downward sloping demand curve reflects the fact that as price increases, consumers willing to purchase less of the good or service.
Veblen Goods
Veblen goods are expensive luxury products, such as designer handbags and high-end cars. In these rare circumstances, decreasing the price actually decreases the demand for the good. The reason for this is because part of the value of the good is exclusivity. These items are status symbols and lowering the price diminishes the status.
Giffen Goods
Giffen goods are another example where rising prices can lead to increased demand for a product. Giffen goods are very rare and are defined by three characteristics:
• It is an inferior good, or a good for which demand decreases as consumer income rises,
• There must be a lack of substitute product,
• The good must constitute a substantial percentage of the buyer’s income, but not such a substantial percentage of the buyer’s income that none of the associated normal goods are consumed.
For example, imagine a significant portion of a family’s grocery bill is bread. Bread is a staple and it is the cheapest option out of the food available. If bread prices rise, the family will need to cut back on other groceries to make up the difference. However, since the family still need to eat a certain amount of calories each day and bread is still the cheapest option, they will purchase more bread to make up for the food they aren’t purchasing and consuming. In this instance, bread is a giffen good.
The Demand Curve and Consumer Surplus
Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay.
Learning objectives
Illustrate consumer surplus with the demand schedule and demand curve
Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay. If a consumer would be willing to pay more than the current asking price, then they are getting more benefit from the purchased product than they spent to buy it. Consumer surplus plus producer surplus equals the total economic surplus in the market.
This chart graphically illustrates consumer surplus in a market without any monopolies, binding price controls, or any other inefficiencies. The price in this chart is set at the pareto optimal. This means that the price could not be increased or decreased without one of the parties being made worse off. The consumer surplus, as marked in red, is bound by the y-axis on the left, the demand curve on the right, and a horizontal line where y equals the equilibrium price. This area represent the amount of goods consumers would have been willing to purchase at a price higher than the pareto optimal price. Generally, the lower the price, the greater the consumer surplus.
Consumer Surplus: Consumer surplus, as shown highlighted in red, represents the benefit consumers get for purchasing goods at a price lower than the maximum they are willing to pay.
Another way to define consumer surplus in less quantitative terms is as a measure of a consumer’s well-being. Some goods, like water, are valuable to everyone because it is a necessity for survival. But the utility, or “usefulness,” of most goods vary depending on a person’s individual preferences. Since the utility a person gets from a good defines her demand for it, utility also defines the consumer surplus an individual might get from purchasing that item. If a person has no use for a good, there is no consumer’s surplus for that person in purchasing the good no matter the price. However, if a person finds a good incredibly useful, consumer surplus will be significant even if the price is high. An individual’s customer surplus for a product is based on the individual’s utility of that product.
Impacts of Price Changes on Consumer Surplus
Consumer surplus decreases when price is set above the equilibrium price, but increases to a certain point when price is below the equilibrium price.
Learning objectives
Explain how shifting a price away from pareto optimal will impact consumer surplus
Consumer surplus is defined, in part, by the price of the product. Recall that the consumer surplus is calculating the area between the demand curve and the price line for the quantity of goods sold. Assuming that there is no shift in demand, an increase in price will therefore lead to a reduction in consumer surplus, while a decrease in price will lead to an increase in consumer surplus.
Consumer Surplus: An increase in the price will reduce consumer surplus, while a decrease in the price will increase consumer surplus.
Below are two scenarios that illustrate how changes in price can affect consumers’ surplus. It is important to note that any shift from the good’s pareto optimal price will result in a decrease in the total economic surplus. The total economic surplus equals the sum of the consumer and producer surpluses.
Price Ceiling
A binding price ceiling is one that is lower than the pareto efficient market price. This means that consumers will be able to purchase the product at a lower price than what would normally be available to them. It might appear that this would increase consumer surplus, but that is not necessarily the case.
For consumers to achieve a surplus they have to be able to purchase the product, which means that producers have to make enough to be purchased at a price. If a good’s price drops below the market equilibrium for whatever reason, manufacturing the product will be less profitable for the producers. So while more consumers will want to purchase the product because of its low price, they will not be able to. This means the market will have a shortage for that good. This shortage will create a deadweight loss, or a market wide loss of efficiency and value that neither producer nor consumers obtain.
So any increase in consumer surplus due to the decrease in price may be offset by the fact that consumers that want the good cannot purchase it. At some point the benefit from the drop in price will be outweighed by the decrease in the good’s availability.
Price Floor
When a price floor is set above the equilibrium price, consumers will have to purchase the product at a higher price. Therefore, fewer consumers will purchase the product because some will decide that the utility they get from the good is not worth the price. Necessarily, this reflects a drop in consumer surplus.
Key Points
• Demand is the willingness and ability of a consumer to purchase a good under certain circumstances.
• Demand curves are used to estimate behaviors in competitive markets and are often used with supply curves to estimate the market equilibrium price, or the price at which sellers are willing to sell the same amount of a product as the market’s buyers are willing purchase.
• An individual’s demand is defined by her utility, purchasing power, and ability to make a purchasing decision.
• On a supply and demand chart, consumer surplus is bound by the y-axis on the left, the demand curve on the right, and a horizontal line where y equals the current market price.
• Another way to define consumer surplus in less quantitative terms is as a measure of a consumer’s well-being.
• An individual’s customer surplus for a product is based on the individual’s utility of that product.
• Consumer surplus will only increase as long as the benefit from the lower price exceeds the costs from the resulting shortage.
• Consumer surplus always decreases when a binding price floor is instituted in a market above the equilibrium price.
• The total economic surplus equals the sum of the consumer and producer surpluses.
• Price helps define consumer surplus, but overall surplus is maximized when the price is pareto optimal, or at equilibrium.
Key Terms
• demand curve: The graph depicting the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that given price.
• utility: The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
• consumer surplus: The difference between the maximum price a consumer is willing to pay and the actual price they do pay.
• price floor: A mandated minimum price for a product in a market.
• Price ceiling: A government-imposed price control or limit on how high a price is charged for a product.
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Market Power
Market power is a measure of a firm’s economic strength that affects its pricing and supply decisions.
Learning objectives
Summarize the relationship between market power and a firm’s supply decision
Market power is a measure of the economic strength of a firm. It is the ability of a firm to influence the quantity or price of goods and services in a market. A firm is said to have significant market power when price exceeds marginal cost and long run average cost, so the firm makes economic profits. Such firms are often referred to as “price makers.” In contrast, firms with limited to no market power are referred to as “price takers.”
Determinants of Market Power
A firm usually has market power by virtue of controlling a large portion of the market. However, market size alone is not the only indicator of market power. Other factors that affect a firm’s market power include:
• Number of producers
• Size of firms in the market
The numbers and size of firms determine the extent that firms can withstand pressures and threats to change prices or product flows. However, being a large firm does not necessarily equal market power. For example, while conglomerates may be very large, they may play only small roles in many different markets and have no ability to influence prices in any of them.
• Barriers to entry
Barriers to entry determine how contestable the market is. Even highly concentrated markets may be contestable markets if there are no barriers to entry or exit, which limits a firm’s ability to raise its price above competitive levels.
Common barriers to entry include control of a scarce resource, increasing returns to scale, technological superiority, and government-imposed barriers.
• Availability of substitute goods
Greater availability of substitute goods will weaken a firm’s market power.
Relationship between Market Power and Firm Behavior
A firm’s market power influences its behavior. For example, market power gives firms the ability to engage in unilateral anti-competitive behavior. Some of the behaviors that firms with market power are accused of engaging in include predatory pricing, product tying, and creation of overcapacity or other barriers to entry. If no individual participant in the market has significant market power, then anti-competitive behavior can take place only through collusion, or the exercise of a group of participants’ collective market power.
Google Logo: In 2012, the U.S. Federal Trade Commission opened an antitrust probe against Google’s search practices. Google allegedly used its market dominance to promote its own products over competitors’ products in web searches.
A monopoly, a price maker with market power, can raise prices and retain customers because the monopoly has no competitors. If a customer has no other place to go to obtain the goods or services, they either pay the increased price or do without.
An oligopoly may also be a price maker with market power, as firms may be able to collude and control the market price or quantity demanded.
A perfectly competitive firm, a price taker with no market power, cannot raise its price without losing its customers.
Measurement of Market Power
Measurement of market power is often accomplished with concentration ratios or the Herfindahl-Hirschman Index (HHI).
Concentration Ratios
The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest). This measure of market power relates the size of firms to the size of the market. For monopolies, the four firm concentration ratio is 100 percent, while the ratio is zero for perfect competition.
Herfindahl-Hirschman Index (HHI)
The Herfindahl-Hirschman Index (HHI) is a measure of the size of firms in relation to the industry, and an indicator of the amount of competition among them. The HHI is calculated by summing the squares of the percentage market shares of all participants in the market. The HHI for perfect competition is zero; for a monopoly, it is 10,000.
For example, if a market consists of five firms with market shares of 40, 20, 20, 15, and 5 percent each, the HHI is 2650. \( (40^2+20^2+20^2+15^2+5^2=2650)\).
Measurement Problems
The use of the concentration ratio or the HHI to measure market power is not perfect. A high concentration ratio or large firm size is not the only way to achieve market power. Many smaller firms acting in unison can achieve the same result. Additionally, the measurements do not convey the extent to which market power may be concentrated in a local market.
Defining Producer Surplus
Producer surplus is the difference between the amount producers get for selling a good and the amount they want to accept for that good.
Learning objectives
Define producer surplus
Producer surplus is the difference between what price producers are willing and able to supply a good for and what price they actually receive from consumers. It is the extra money, benefit, and/or utility producers get from selling a product at a price that is higher than their minimum accepted price, as shown by the supply curve.
Economic Surplus: Producer surplus is the shaded area directly above the supply curve, up to the equilibrium point. Consumer surplus is the shaded area directly under the demand curve, up to the equilibrium point.
For example, above, the equilibrium price is \(P′\). However, at \(P_1\), the producers are willing to sell one unit of a commodity for a price that is lower than \(P′\). The resulting rectangle from \(P_1\) on the \(y\)-axis, to its intersection with the supply curve, up to the level of \(P′\) is the producer surplus at price level \(P_1\).
Similarly, at \(P_2\), the producers are willing to sell two units of a commodity at a price that is still lower than \(P′\). The rectangle from \(P_2\) on the \(y\)-axis, to its intersection with the supply curve, up to the level of \(P′\) is the new producer surplus at price \(P_2\). The total producer surplus at \(P_2\) is the first rectangle at the \(P_1\) price, plus the new rectangle from the \(P_2\) price.
This process is repeated for every price level up to the equilibrium price. To find the resulting total producer surplus, all of the rectangles for the individual price levels are added together, and the total area is the total producer surplus. Below, the total producer surplus is made of all three pink rectangles – the surpluses at price levels of \(P_1\), \(P_2\), and \(P_3\) – added together.
Producer surplus: In the figure, producer surplus at different prices is represented by the pink rectangles.
Impact of Changing Price on Producer Surplus
Producer surplus is affected by changes in price, the demand and supply curve, and the price elasticity of supply.
Learning objectives
Examine producer surplus in terms of changes in demand, supply, price, and price elasticity
Producer surplus is affected by many different factors. Changes in the price level, the demand and supply curves, and price elasticity all influence the total amount of producer surplus, other things held constant.
Changes in Price
Changes in price are directly associated with the amount of surplus a producer will receive. Graphically, the producer surplus is directly above the supply curve, but below the price. Other things equal, as equilibrium price increases, the amount of potential producer surplus and the number of goods supplied increases. Lower prices result in lower potential producer surplus and goods supplied: with a lower equilibrium price, the producer surplus triangle will be smaller.
Economic Surplus: The producer surplus is directly above the supply curve and is shaded in blue.
Demand Curve
Shifts in the demand curve are directly related to the amount of producer surplus. If demand decreases, and the demand curve shifts to the left, producer surplus decreases. Conversely, if demand increases, and the demand curve shifts to the right, producer surplus increases.
At an initial demand represented by the “Demand (1)” curve, producer surplus is the blue triangle made of \(P_1, A\), and \(B\). When demand increases, represented by the “Demand (2)” curve, producer surplus is the larger gray triangle made of \(P_2, A\), and \(C\).
Producer Surplus and the Demand Curve: If the demand curve shifts out, producer surplus increases, as seen by size of the gray triangle.
Supply Curve
Similarly, shifts in the supply curve are also directly related to the amount of potential surplus. Decreases in the supply curve will cause decreases in producer surplus. Increases in the supply curve will cause increases in producer surplus.
At an initial supply represented by the “Supply (1)” curve, producer surplus is the blue triangle made of \(P_1, A\), and \(C\). If supply increases, represented by the “Supply (2)” curve, producer surplus is the larger gray triangle made of \(P_2, B\), and \(D\).
Price Elasticity of Supply
Price elasticity of supply is the relationship between price and quantity changes. It measures how quantity supplied is affected by changes in price. When supply is elastic, producers can increase production without much price or cost change. When supply is inelastic, producers cannot change production easily.
When supply is perfectly elastic, it is depicted as a horizontal line. Producer surplus is zero because the price is not flexible. Producers cannot provide a higher price than market price.
When supply is perfectly inelastic, it is depicted as a vertical line. Producer surplus is infinite because the price is completely flexible.
Key Points
• Firms with market power are said to be “price makers.” They can raise prices and change the quantity supplied of goods and services without hurting profits. Market power often exists when there is a monopoly or oligopoly.
• Firms with limited to no market power are said to be “price takers.” They cannot raise their prices or change the quantity supplied of goods and services without hurting profits. Perfectly competitive firms are examples of price takers with no market power.
• Market power is determined by the number of producers in the market, the size of each firm, barriers to entry in the market, and availability of substitute goods. Firm size and market size alone do not dictate market power.
• Market power is often measured with concentration ratios or the Herfindahl-Hirschman Index, but these are not perfect measures.
• Producer surplus can be thought of as the extra money, utility, or benefits the producer receives by selling a product at a price that is higher than its minimum acceptable price.
• The minimum acceptable price for producers is represented by the supply curve.
• Graphically, producer surplus is the shaded region just above the supply curve, but below the equilibrium price level.
• Changes in the equilibrium price are directly related to producer surplus, other things equal. As the equilibrium price increases, the potential producer surplus increases. As the equilibrium price decreases, producer surplus decreases.
• Shifts in the demand curve are directly related to producer surplus. If demand increases, producer surplus increases. If demand decreases, producer surplus decreases.
• Shifts in the supply curve are directly related to producer surplus. If supply increases, producer surplus increases. If supply decreases, producer surplus decreases.
• Price elasticity of supply is inversely related to producer surplus. If supply is completely elastic, it is drawn as a horizontal line, and producer surplus is zero. If supply is completely inelastic, it is shown as a vertical line, and producer surplus is infinite.
Key Terms
• Herfindahl-Hirschman Index: A measure of the size of firms in relation to the industry and an indicator of the amount of competition among them.
• concentration ratio: The proportion of total industry output produced by the largest firms (usually the four largest).
• contestable market: An imperfectly competitive industry subject to potential entry if prices or profits increase.
• market power: The ability of a firm to profitably raise the market price of a good or service over marginal cost. A firm with total market power can raise prices without losing any customers to competitors.
• producer surplus: The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.
• price elasticity of supply: A numerical measure of the responsiveness of the quantity supplied of a product to a change in the price of the product alone.
• producer surplus: The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.
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Defining Utility
Utility is an economic measure of how valuable, or useful, a good or service is to a consumer.
Learning objectives
Define Utility
Utility is a term used by economists to describe the measurement of “useful-ness” that a consumer obtains from any good or service. Utility may measure how much one enjoys a movie or the sense of security one gets from buying a deadbolt. The utility of any object or circumstance can be considered. Some examples include the utility from eating an apple, from living in a certain house, from voting for a specific candidate, or from having a given wireless phone plan. In fact, every decision that an individual makes in their daily life can be viewed as a comparison between the utility gained from pursuing one option or another.
Apples and Oranges: Utility allows you to compare apples and oranges based on which you prefer.
Utility may be positive or negative with no effect on its interpretation. If one option gives −15−15utility and another gives −12−12, selecting the second is not, as it might seem, the “lesser of two evils,” but can only be interpreted as the better option.
Utility can be measured in one of two ways:
• Ordinal utility ranks a series of options in order of preference. This ranking does not show how much more valuable one option is than another, only that one option is preferable over another. An example of a statement reflecting ordinal utility is that “I would rather read than watch television.” Generally, ordinal utility is the preferred method for gauging utility.
• Cardinal utility also ranks a series of options in order of preference, but it also measures the magnitude of the utility differences. An example of a statement reflecting cardinal utility is “I would enjoy reading three times more than watching television.” Given how difficult it is to precisely measure preference, cardinal utility is rarely used.
Theory of Utility
The theory of utility states that, all else equal, a rational person will always choose the option that has the highest utility.
Learning objectives
Explain the Theory of Utility
The theory of utility is based on the assumption of that individuals are rational. Rationality has a different meaning in economics than it does in common parlance. In economics, an individual is “rational” if that individual maximizes utility in their decisions. Whenever an individual is to choose between a group of options, they are rational if they choose the option that, all else equal, gives the greatest utility. Recalling that utility includes every element of a decision, this assumption is not particularly difficult to accept. If, when everything is taken into account, one decision provides the greatest utility, which is equivalent to meaning that it is the most preferred, then we would expect the individual to take that most preferred option. This should not necessarily be taken to mean that individuals who fail to quantify and measure every decision they make are behaving irrationally. Rather, this means that a rational individual is one who always selects that option that they prefer the most.
Consumer making a decision: When making an economically rational purchasing decision, a consumer must consider all of their personal preferences.
It is important to emphasize how rationality relates to a person’s individual preferences. People prioritize different things. For example one person may prioritize flavor while another person may value making healthy choices more. As a result the first person may choose a sugary cereal while the second may choose granola. Based on their preferences, both made the economically rational choice.
The rationality assumption gives a basis for modeling human behavior and decision making. If we could not assume rationality, it would be impossible to say what, when presented with a set of choices, an individual would select. The notion of rationality is therefore central to any understanding of microeconomics.
Marginal Utility
Marginal utility of a good or service is the gain from an increase or loss from a decrease in the consumption of that good or service.
Learning objectives
Define Marginal Utility
In economic terms, marginal utility of a good or service is the gain from an increase or loss from a decrease in the consumption of that good or service. The idea of marginal value is an important consideration when making production or purchasing decisions. A person should produce or purchase an additional item when the marginal utility exceeds the marginal cost.
Marginal Utility of Housing: The marginal utility of owning a second house is likely less than the marginal utility of owning the first house.
Marginal utility is measured on a per unit basis. When evaluating the marginal utility of any item, it is important to know in what unit utility is measured. The unit is based on the type of activity that you are trying to measure. If you are a consumer of potato chips, you might measure utility based on whether to buy another bag or have another hand full with your lunch. If you are a producer of potato chips, your marginal value might be defined by a pallet of potato chips. In general, marginal value should be measured based on the smallest unit of consumption or production related to the product in question.
It is also important to remember that utility is difficult to quantify since preferences vary based on the individual. Utility is rarely measured in terms of magnitude; utility is normally just about determining which option is the best choice. Since utility is rarely measured using cardinal means, it may seem difficult to determine a product’s marginal value. Economists get around this by substituting dollar values. While this may fail to capture a specific individual’s preferences and utility, it offers a good approximation based on everyone’s collective preferences as defined by the market.
Principle of Diminishing Marginal Utility
The principle of diminishing marginal utility states that as more of a good or service is consumed, the marginal benefit of the next unit decreases.
Learning objectives
Explain diminishing marginal utility
The principle of diminishing marginal utility states that as an individual consumes more of a good, the marginal benefit of each additional unit of that good decreases.
The concept of diminishing marginal utility is easy to understand since there are numerous examples of it in everyday life. Imagine it is a hot summer day and you are hungry, so you get some ice cream. The first bite is great and so is the second. But with each spoonful, your hunger decreases and you become cooler. So while the last bite might still be good, it is probably not as satisfying as the first. This is a simple illustration of diminishing marginal utility.
Total and marginal utility: As you can see in the chart, the more of a good you consume, the further its marginal utility decreases.
Negative Marginal Utility
While there are some circumstances where there will always be some marginal utility to producing or consuming more of a good, there are also circumstances where marginal utility can become negative. For example, while some antibiotics may be useful in curing diseases. However, if you take too much you can become sick or resistant to the drugs which could lead to future illnesses being incurable. So it is important to remember that “diminishing” does not necessarily mean to zero; you can have too much of a good thing.
Exceptions to the General Rule
This concept suggests a uniform steady decline of marginal utility, but that may not always be the case. There can be situations in which one might gain more utility from consuming a later unit of a good than from earlier consumption. If you are going on a date, for example, getting one ticket to a concert will have some utility but the second arguably has more because it enhances the value of the first.
Generally these exceptions occur when what is being consumed is a component of a larger whole. While utility may increase for a period, there is usually a “tipping point” where afterwards marginal utility decreases. Getting a third ticket for your date will have low marginal utility than the second.
Key Points
• Utility is measured by comparing multiple options.
• Utility can be positive and negative.
• Ordinal utility ranks a series of preferences without measuring how much more valuable one option is than another. Cardinal utility measures how much more preferable one option is in comparison to another.
• Ordinal utility is generally the preferred method of measuring utility.
• The rationality assumption gives a basis for modeling human behavior and decision making.
• Utility includes every element of a decision.
• Rationality is dependent on a person’s individual preferences. Therefore, what might be a rational decision for one person may not be a rational decision for another.
• Marginal utility is measured on a per unit basis.
• Since an individual’s utility is rarely measured using cardinal means, calculating a product’s marginal value for an individual may be difficult.
• Instead of trying to calculate a product’s marginal value for an individual, economists assign dollar values to products based on their market price. This allows economists to estimate a product’s marginal value based on all the consumer’s preferences.
• The idea of marginal value is an important consideration when making production or purchasing decisions. A person should produce or purchase an additional item when the marginal utility exceeds the marginal cost.
• If you consume too much, the marginal utility of a good or service can become negative.
• In some circumstances, the marginal utility of producing or consuming an additional unit will increase for a short period of time. Generally there will be a “tipping point” at which marginal utility will then decrease.
• Generally these exceptions occur when what is being consumed is a component of a larger whole.
Key Terms
• utility: The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
• ordinal: Of a number, indicating position in a sequence.
• cardinal: Describing a “natural” number used to indicate quantity (e.g., one, two, three), as opposed to an ordinal number indicating relative position.
• Rational individual: A person who chooses the option that, all else equal, gives the greatest utility.
• marginal: Of, relating to, or located at or near a margin or edge; also figurative usages of location and margin (edge).
• cardinal: Describing a “natural” number used to indicate quantity (e.g., one, two, three), as opposed to an ordinal number indicating relative position.
• utility: The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
• marginal benefit: The extra benefit received from a small increase in the consumption of a good or service. It is calculated as the increase in total benefit divided by the increase in consumption.
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Introducing the Budget Constraint
Budget constraints represent the plausible combinations of products and services a buyer can purchase with the available capital on hand.
Learning objectives
Discuss the role of the budget set and indifference curve in determining the choice that gives a consumer maximum satisfaction
The concept of budget constraints in the field of economics revolves around the idea that a given consumer is limited in consumption relative to the amount of capital they possess. As a result, consumers analyze the optimal way in which to leverage their purchasing power to maximize their utility and minimize opportunity costs. This is achieved through using budget constraints, which represent the plausible combinations of products and/or services a buyer is capable of purchasing with their capital on hand.
Trade-offs
To expand upon this definition further, the business concept of opportunity cost via trade-offs is a central building block in understanding budget constraints. An opportunity cost is defined as the foregone value of the next best alternative in a given action. To apply this to a real-life situation, pretend you have \$100 to spend on food for the month. You have a wide variety of options, but some will provide you with higher opportunity costs than others. You could purchase enough bread, rice, milk and eggs to feed yourself for the full month or you could buy premium cut steak and store-prepared dinners by the pound (which would last about one week). The opportunity cost of the former is the high quality foods which have the convenience factor of already being prepared for you while the opportunity cost of the latter is having enough food to feed yourself for the entire month. In this circumstance the decision is easy, and the trade off will be sacrificing convenience and high quality food for the ability to have enough food on the table over the course of the whole month.
Budget Curves and Indifference Curves
Understanding these trade-offs underlines the true function of budget constraints in economics, which is identifying which consumer behaviors will maximize utility. Consumers are inherently equipped with an infinite demand and a finite pool of resources, and therefore must make budgetary decisions based on their preferences. The way economists demonstrate this arithmetically and visually is through generating budget curves and indifference curves.
Budget curves: This indicates the relationship between two goods relative to opportunity costs, which defines the value of each good relative to one another. For example, on the figure provided a quantity of 5 for ‘good yy‘ is identical in price (economic value) as a quantity of 7 for ‘good xx‘. This demonstrates the trade-off ratio between the two available products or services. It is important to keep in mind that prices and valuations of goods are constantly changing, and that the ratio between any two goods is not fixed over the long-term for most products/services.
Budget Curve: A budget curve demonstrates the relationship between two goods relative to opportunity costs, essentially deriving the relative value of each good based on quantity and utility. Keep in mind that moving from one point on the in to another is trading off ‘xx‘ amount of one good for ‘yy‘ amount of another.
Indifference curves: Indifference curves underline the way in which a given consumer interprets the value of each good relative to one another, demonstrating how much of ‘good xx‘ is equivalent in utility to a certain quantity of ‘good yy‘ (and vice versa). Any point along the indifference curve will represent indifference to the consumer, or simply put equivalent preference for one combination of goods or the other. In the figure it is clear that the budget curve has been included in conjunction with the indifference curves, which allows insight as to the ideal actual quantity of each good is optimal for this specific consumer.
Indifference Curves: Indifference curves are designed to represent an equal perception of overall value in a given basket of goods relative to a specific consumer. That is to say that each point along the curve is considered by the consumer of equivalent value despite alterations in the quantity of each good, as these trade-offs are consider of equal value and thus indifferent.
Through utilizing these economic tools, economists can predict consumer behavior and consumers can maximize their overall utility based upon their budget constraints.
Mapping Preferences with Indifference Curves
Economists mapping consumer preferences use indifference curves to illustrate a series of goods that represent equivalent utility.
Learning objectives
Describe the indifference curves for goods that are perfect substitutes and complements
A critical input to understanding consumer purchasing behaviors and the general demand present in a given market or economy for specific goods and services is the identification of consumer preferences. Consumer preference varies substantially from individual to individual and market to market, requiring comprehensive economic observation of consumer choices and behaviors. One of the primary tools leveraged by economists mapping consumer preferences is the indifference curve, which illustrates a series of bundled goods in which a consumer is indifferent. A consumer would be just as happy with any combination of Good X and Good Y on the curve. This could synonymous to saying baskets of goods that provide the same utility.
Indifference Curve: A consumer will be just as happy with any combination of Good X and Y on indifference curve I1, though s/he will prefer any bundle on indifference curve I2 or I3.
These indifference curves, when mapped graphically alongside other curves, is called an indifference map. A key consideration in creating any indifference map is what relative preferences should be isolated. While it is possible to create a complex array of preference maps to compare more than two products/services, each specific standard indifference map will be about creating a benchmark between two. For example one could compare relatively similar goods/services (i.e. apples vs. oranges) or dramatically different goods/services (i.e. university training vs. automobile purchasing). These two items being compared represent the x and y axis of a indifference map. A consumer will always prefer to be on the indifference curve farthest from the origin.
Implications of Indifference Maps
After constructing the required inputs to generate a comprehensive indifference map, an economist can derive conclusions based upon the properties of the illustration. In framing these implications it is useful to identify the two potential extremes that can be outlined via with indifference curves:
• Perfect Substitutes: To understand what a indifference curves will look like when products are perfect substitutes, please see the graph below. These lines are essentially perfectly straight, and that demonstrates that the relative utility of ‘Good X’ compared to that of ‘Good Y’ is equivalent regardless of the amount in question. It is reasonable to assume in this scenario that purchasing all of one or all of the other will not decrease the overall satisfaction of the consumer. Perfect substitutes are often homogeneous goods. A consumer with no preference between Burger King and McDonald’s, for example, might consider them perfect substitutes and be indifferent to spending all of their fast food money on one or the other.
• Perfect Complements: The opposite of a perfect substitute is a perfect complement, which is illustrated graphically through curves with perfect right angles at the center. These right angles, and the subsequent straight horizontal and vertical lines, demonstrate that ‘Good X’ and ‘Good Y’ are inherently tied to one another and that the consumption of one is dependent upon the consumption of the other. An example of complementary goods might be university tuition and academic textbook purchases, an automobile and automobile insurance, or a cable and a television.
Combining an understanding of these inputs with the extremes demonstrated an indifference map, economists are able to draw meaningful conclusions regarding consumer choices and purchasing behaviors in the context of two goods. The comparison between the goods demonstrates the relative utility one has compared to another, and the way in which consumers will act when posed with a decision between various products and services.
Perfect Substitute Indifference Curve: In this particular series of indifference curves it is clear that ‘Good X’ and ‘Good Y’ are perfect substitutes for one another. That is to say that the utility of one is identical to the utility of the other across all quantities represented on the map.
Perfect Complement Indifference Curve: The perfect right angle in this series of indifference curves implies that the utility of ‘Good X’ and ‘Good Y’ are entirely interdependent. This is to say that in order to enjoy one good it is necessary to also have the other.
Properties of Indifference Curves
Almost all indifference curves will be negatively sloped, convex, and will not intersect.
Learning objectives
Analyze the properties that are common to many indifference curves
Indifference curves trace the combination of goods that would give a consumer a certain level of utility. The indifference curve itself represents a series of combinations of quantities of goods (generally two) that a consumer would be indifferent between, or would value each of them equally in regards to overall utility. Indifference curves allow economists to predict consumer purchasing behaviors based upon utility maximization for a bundle of goods within the context of a given consumer’s budget constraints and preferences.
Properties of Indifference Curves
The concept of an indifference curve is predicated on the idea that a given consumer has rational preferences in regard to the purchase of groupings of goods, with a series of key properties that define the process of mapping these curves:
• Indifference curves only reside in the non-negative quadrant of a two-dimensional graphical illustration (or the upper right). This assumes that negative quantities are meaningless – one can’t consume a negative amount of a good.
• Indifference curves are always negatively sloped. This is based on the assumption that a consumer is always better off consuming more of a good, so as quantity consumed of one good increases, total satisfaction would increase if not offset by a decrease in the quantity consumed of another good. This also assumes that the marginal rate of substitution is always positive.
• All curves projected on the indifference map must also be transitive to ensure that if AA is preferred to BBand BB is preferred to CC, CC is not also preferred to AA. This is manifested in indifference curves that never intersect.
• Nearly all indifference lines will be convex, or curving inwards at the center (towards the bottom left). This demonstrates that increasingly high quantities of one good over another have a cost in respect to their overall utility per unit (diminishing returns). It is technically possible for indifference curves to be perfectly straight as well, which would imply that the two goods are identical (perfect substitutes).
Combining these various properties, one can highlight a number of critical implications of consumer purchasing behavior and the concept of utility. Consumers naturally desire a bundle of goods that is varied (hence the convex curves for most comparisons) in order to maximize their utility. Similarly, all indifference curves will naturally identify diminishing rates of substitution as the quantity increases for a certain good compared to another, and can create demand projections of prospective supply.
Impact of Income on Consumer Choices
One of the central considerations for a consumer’s consumption choice is income or wage levels, and thus their budgetary constraints.
Learning objectives
Break down changes in consumption into the income effect and the wealth effect
Consumer choices are predicated on various economic circumstances, and recognizing the relationship between these circumstances and an individual’s purchasing behavior allows economists to recognize and predict consumer choice trends. One of the central considerations for a consumer in deciding upon their purchasing behaviors is their overall income or wage levels, and thus their budgetary constraints. These budgetary constraints, when applied to a series of products and services, can be optimized to capture the most utility for the consumer based on their purchasing power.
Income from a Consumer Theory Perspective
The simplest way to demonstrate the effects of income on overall consumer choice, from the viewpoint of Consumer Theory, is via an income-consumption curve for a normal good. The basic premise behind this curve is that the varying income levels (as illustrated by the green income line curving upwards) will determine different quantities and balanced baskets along the provided indifference curves for the two goods being compared in this graph. These differences in quantity reflect the increase or decrease an a given individual’s purchasing power, thus the income effect could be summarized as the increase in relative utility captured by a consumer with more monetary power.
Income-Consumption Curve: Simply put, increases or decreases in income will alter the optimal quantity (and thus relative utility) of a given basket of goods for a specific consumer.
The wealth effect differs slightly from the income effect. The wealth effect reflects changes in consumer choice based on perceived wealth, not actual income. For example, if a person owns a stock that appreciates in price, they perceive that they are wealthier and may spend more, even though they have not realized those gains so their income has not increased.
Effects of Income on Different Goods
Income effects on consumer choice grow more complex as the type of good changes, as different product and services demonstrate different properties relative to both other products/services and a consumers preferences and utility. As a result, it is useful to outline the differences in income effects on normal, inferior, complementary and substitute goods:
• Normal: A normal good is a good with incremental increases or decreases in utility as quantity changes, demonstrating a predictable and simple linear relationship as income increases or decreases. demonstrates a graphical representation of the effects of income changes upon preference map.
• Inferior: Inferior goods, or goods that are less preferable, will demonstrate inverse relationships with income compared to normal goods. That is to say that an increase in income will not necessarily result in an increase in quantity for the inferior good, as the consumer derives minimal utility in purchasing the inferior good compared to other goods. Inferior goods are often sacrificed as income rises and consumers gain more choice/options. This can be represented in.
• Complementary: Complementary goods are goods that are interdependent in consumption, or essentially goods that require simultaneous consumption by the consumer. An example of this would be like purchasing an automobile and car insurance, the consumption of one requires the consumption of the other. As income increases, these will increase relative to one another (as a ratio). demonstrates this concept in graphical form.
• Substitutes: Perfect substitutes are essentially interchangeable goods, where the consumption of one compared to another has no meaningful impact on the consumer’s utility derived. Substitutes are goods that a consumer cannot differentiate between in terms of the need being filled and the satisfaction obtained. Income increases will thus affect the consumption of these goods interchangeably, resulting in increase in the quantity of either or both.
In merging Consumer Theory and consumer choices with income level, the primary takeaway is that an increase in income will increase the prospective utility that consumer can acquire in the market. Understanding how this applies in a general fashion, alongside the specific circumstances dictating specific types of goods, it becomes fairly straight-forward to predict consumer purchasing behaviors at differing income levels.
Income Levels and Inferior Goods: This graph demonstrates the inverse relationship between income and the consumption of inferior goods. As income rises, the quantity consumed of ‘X1’ decreases. This illustrates increased variance in consumer choice as income rises.
Income Effect on Complementary Goods: In this graphical depiction of income increases, the consumption of these two goods are complementary and thus interdependent.
Impact of Price on Consumer Choices
The demand curve shows how consumer choices respond to changes in price.
Learning objectives
Construct the demand curve using changes in consumption due to price changes
In almost all cases, consumer choices are driven by prices. As price goes up, the quantity that consumers demand goes down. This correlation between the price of goods and the willingness to make purchases is represented clearly by the generation of a demand curve (with price as the y-axis and quantity as the x-axis). The construction of demand, which shows exactly how much of a good consumers will purchase at a given price, is defining of consumer choice theory.
Deriving Overall Demand
The generation of a demand curve is done by calculating what price consumers are willing to pay for a given quantity of a good or service. For normal goods or services, demand is illustrated with a downward sloping curve, where the quantity on the x-axis will generally increase as the price on the y-axis decreases (and vice versa). The quantity demanded may change in response to both to shifts in demand (and the creation of a new demand curve, as demonstrated in ) and movements along the established demand curve. A demand shift usually takes place when an external factor increases or decreases demand across the board, while a movement upwards or downwards on the curve is indicative of a change in the good’s price.
Demand Shifts: This graph demonstrates a shift in overall demand in the market, where the generation of a new parallel demand curve is required to accurately represent consumer choices.
As the demand curve implies, price is often the central driving force behind a decision to purchase a given product or service. Consumers must weigh the overall utility they can capture by making a purchase and benchmark that against their overall monetary resources to optimize their purchasing decisions. This practice regulates the price companies can set for their products and services, as the income effects and the prospective substitutions (substitution effect) will drive consumer purchase towards purchases that create the most value for themselves.
Price Elasticity
A critical consideration of product/service pricing is the price elasticity of a given good, which indicates how responsive demand is to a change in price. Price elasticity is essentially a measurement of how much any deviations in price will drive the overall quantity purchased up or down, underlining to what extent consumer purchasing decisions will be dictated by pricing. The figure pertaining to price elasticity shows how the slope of the demand curve will change depending on the degree of price sensitivity in the marketplace for a good. A highly elastic good will see consumers much less likely to purchase when prices are high and much more likely to purchase when prices are low, while a good with low elasticity will see consumers purchasing the same quantity regardless of small price changes.
Price Elasticity: As this graph demonstrates, the slope of the demand curve will vary as a direct result of how elastic consumer purchasing behaviors will be compared to price changes.
Using demand curves, economists can project the impact of a price change on the consumer choices in a given market.
Deriving the Demand Curve
The law of demand pursues the derivation of a demand curve for a given product that benchmarks the relative prices and quantities desired.
Learning objectives
Explain how Giffen goods violate the law of demand
The law of demand in economics pertains to the derivation and recognition of a consumer’s relative desire for a product or service coupled with a willingness and ability to pay for or purchase that good. Consumer purchasing behavior is a complicated process weighing varying products/services against a constantly evolving economic backdrop. The derivation of demand is a useful tool in this pursuit, often combined with a supply curve in order to determine equilibrium prices and understand the relationship between consumer needs and what is readily available in the market.
Deriving Demand Curves
Despite a wide array of prospective goods and services in a constantly altering economic environment, the law of demand pursues the derivation of a demand curve for a given product that benchmarks the relative prices and quantities desired by consumers in a given marketplace. The inherent relationship between the price of a good and the relative amount of that good consumers will demand is the fulcrum of recognizing demand curves in the broader context of consumer choice and purchasing behavior.
Generally speaking, normal goods will demonstrate a higher demand as a result of lower prices and vice versa. The derivation of demand curves for normal goods is therefore relatively predictable in respect to the direction of the slope on a graph. The downward slope represented in this figure underline the critical principle that a given price point will reflect a given quantity demanded by a given marketplace, allowing suppliers and economists to measure the value of a product/service based on a price/quantity analysis of consumer purchasing behaviors.
Deriving the Demand Curve (Normal Goods): This illustration demonstrates the way in which economists can identify a series of prices and quantities for goods demanded, which ultimately represents the overall demand curve for a given product/service.
One important consideration in demand curve derivation is the differentiation between demand curve shifts and movement along the curve itself. Movement along the curve itself is the identification of what quantity will be purchased at different price points. This means that the factors that underlie consumer desire for the product remains constant and consistent, but the quantity or price alters to a new point along the established curve. Alternatively, sometimes external factors can shift the actual demand for a given good, pushing the demand curve outwards to the right and up or inwards down and left. This represents a substantial change in the actual demand for that product, as opposed to a quantity or price shift at a fixed demand level.
Exceptions: Giffen Goods and Neutral Goods
With the concept of general demand curves in mind, it is important to recognize that some goods do not conform to the traditional assumption that higher prices will always demonstrate lower demand. Giffen goods and neutral goods break this rule, with the former demonstrating an increase in demand as a result of a price rise and the latter demonstrating indifference to price in regards to the quantity demanded (illustrated as a completely vertical demand curve):
Demand Curve for Giffen Goods: Giffen goods are essentially goods that demonstrate an increase in demand as a result of an increase in price, generally considered counter-intuitive in traditional economic models. This graph illustrates the derivation of a demand curve for these goods.
• Giffen Goods – Giffen goods are a situation where the income effect supersedes the substitution effect, creating an increase in demand despite a rise in price. Goods such as high-end luxury items like expensive fashion often demonstrate this type of counter-intuitive trend, where the high price of an item is attractive to the consumer for the sake of displaying wealth.
• Neutral Goods – Neutral goods, unlike Giffen goods, demonstrate complete ambivalence to price. That is to say that consumers will pay any price to get a fixed quantity. These goods are often necessities, defying the standard law of demand due to the fact that they must be purchased regardless of price/situation. A good example of this is water or healthcare, where not getting what is required will have dramatic consequences.
Applications of Principles on Consumer Choices
The income effect and substitution effect combine to create a labor supply curve to represent the consumer trade-off of leisure and work.
Learning objectives
Explain the labor-leisure tradeoff in terms of income and substitution effects
Economics assumes a population of rational consumers, subjected to the complexities of modern economics while they attempt to maximize the utility obtainable within their income range. Central principles to analyzing consumer actions and choices are income effect and the substitution effect, which ultimately generate a labor supply to illustrate the labor-leisure trade-off for consumers.
Income Effect
The income effect needs two simple inputs: the average price of goods and the consumer’s income level. This creates a relative buying power, which will play a substantial role in the quantity of goods purchased. Predicting consumer choice requires inputs on consumer purchasing power and the goods in which they are deciding between. In we are comparing ‘Good X’ and ‘Good Y’ to identify how a change in income will alter the overall amount of each good would likely be purchased along a series of indifference curves. This graphical representation of a consumer’s income (I) and budget constraints (BC) underlines the variance in quantity of ‘Good X’ and ‘Good Y’ that will be demanded dependent upon income circumstance. Naturally, a higher income will result in a shift towards increase in quantity for many consumable goods/services.
Income Effects on Consumption and Budget Constraints: This graphical representation of a consumers income(I) and budget constraints (BC) underlines the variance in quantity of ‘Good X’ and ‘Good Y’ that will be demanded dependent upon income circumstance. Naturally, a higher income will result in a shift towards increase in quantity for many consumable goods/services.
Substitution Effect
The substitution effect is closely related to that of the income effect, where the price of goods and a consumers income will play a role in the decision-making process. In the substitution effect, a lower purchasing power will generally result in a shift towards more affordable goods (substituting cheaper in place of more expensive goods) while a higher purchasing power often results in substituting more expensive goods for cheaper ones. This shows the relationship between two graphs, pointing out how the substitution effect identifies the relationship between the price of a given good and the quantity purchased by a given consumer. As the bottom half of the figure implies, a higher price will dictate a lower quantity consumer for ‘Good Y’, while a lower price will create a higher quantity. This translates to the graph above as the consumer makes choices to maximize utility when comparing the price of different goods to a given income level, substituting cheaper goods and more expensive goods dependent upon purchasing power.
Substitution Effect: This two-part graphical representation of the substitution effect identifies the relationship between the price of a given good and the quantity purchased by a given consumer. As the bottom half effectively highlights, a higher price will dictate a lower quantity consumer for ‘Good Y’, while a lower price will create a higher quantity. This translates to the graph above as the consumer makes choices to maximize utility when comparing the price of different goods to a given income level.
Types of Goods
One additional important component of consumer choice is the way in which different goods demonstrate different reactions to income alterations and price changes:
• Income Changes: When income changes rises or falls, consumption of certain types of goods will have a positive or negative correlation with these changes. With normal goods, an increase of income will correlate with a higher quantity of consumption while a decrease in income will see a decrease in consumption. Inferior goods, on the other hand, will demonstrate an inverse relationship. A rise in income will cause a decrease in their consumption and vice versa.
• Price Changes: When price rises or falls, consumption of certain types of good will either demonstrate positive or negative correlations to these shifts in regard to quantity consumed. Ordinary goods will demonstrate the intuitive situation, where a rise in price will result in a decrease in quantity consumer. Inversely, Giffen goods demonstrate a positive relationship, where the price rises will result in higher demand for the good and high consumption.
Labor Supply Curve
These concepts of income versus required monetary inputs (prices) for goods/services generates a relationship between how much an individual will choose to work and how much an individual can take in terms of leisure time. Simply put, desired labor and leisure time are dependent upon income and prices for goods. The relationship between the number of hours worked and the overall wage levels results in something of a boomerang effect, with hours worked as the x-axis and wages as the y-axis.
Graphically represented, the labor supply curve looks like a backwards-bending curve, where an increase in wages from W1 to W2 will result in more hours being worked and an increase from W2 to W3 will result in less. This is primarily due to the fact that there is a certain amount of capital attained by consumers where they will be satisfied with their monetary utility, at which point working more has diminishing returns on their satisfaction. A rational consumer will begin to work less hours after meeting their consumption requirements in order to capture the value of leisure (and enjoy their income in a meaningful way).
Labor Supply Curve: The concept of labor supply economics is most efficiently communicated via the following graphical representation. This graph demonstrates the relationship between hours work and overall wage rates, demonstrating the shift in utility as wages increase.
To apply this to the concept of different types of goods above, one can view wage rates and leisure time as consumer goods. Depending on which point on the backwards-bending curve we are on, the trade-offs and thus the consumer decision will change. If a worker choose to work more when the wage rate rises, leisure is an ordinary good.
Key Points
• Consumers analyze the optimal way in which to leverage their purchasing power to maximize their utility and minimize opportunity costs through employing trade -offs.
• The way economists demonstrate this arithmetically and visually is through generating budget curves and indifference curves.
• Budget curves indicate the relationship between two goods relative to opportunity costs, which defines the value of each good relative to one another.
• Indifference curves underline the way in which a given consumer interprets the value of each good relative to one another, demonstrating how much of ‘good xx‘ is equivalent in utility to a certain quantity of ‘good yy‘ (and vice versa).
• Through utilizing these economic tools, economists can predict consumer behavior and consumers can maximize their overall utility based upon their budget constraints.
• Indifference curves illustrate bundles of goods that provide the same utility.
• An economist can derive conclusions based upon the properties of the illustration. In framing these implications it is useful to identify the two potential extremes of substitute goods and complementary goods.
• The comparison between the goods demonstrates the relative utility one has compared to another, and the way in which consumers will act when posed with a decision between various products and services.
• The comparison between the goods demonstrates the relative utility one has compared to another, and the way in which consumers will act when posed with a decision between various products and services.
• The concept of an indifference curve is predicated on the idea that a given consumer has rational preferences in regard to the purchase of groupings of goods, with a series of key properties that define the process of mapping these curves.
• Indifference curves only reside in the non-negative quadrant of a two-dimensional graphical illustration (or the upper right).
• Indifference curves are always negatively sloped. Essentially this assumes that the marginal rate of substitution is always positive.
• All curves projected on the indifference map must not intersect in order to ensure transitivity.
• Nearly all indifference lines will be convex, or curving inwards at the center (towards the bottom left).
• The basic premise behind the income effect is that varying income levels will determine different quantities and balanced baskets along the provided indifference curves for any two goods being compared.
• These differences in quantity reflect the increase or decrease an a given individual’s purchasing power, thus the income effect could be summarized as the increase in relative utility captured by a consumer with more monetary power.
• Income effects on consumer choice grow more complex as the type of good changes, as different product and services demonstrate different properties relative to both other products/services and a consumers preferences and utility.
• The four key types of goods to consider are normal goods, inferior goods, complements and substitutes.
• For normal goods or services, demand is illustrated with a downward sloping curve, where the quantity on the x-axis will generally increase as the price on the y-axis decreases (and vice versa).
• As the demand curve implies, price is the central driving force behind a decision to purchase a given product or service.
• A critical consideration of product/service pricing is the price elasticity of a given good, which indicates how responsive demand is to a change in price.
• Using demand curves, economists can project the impact of a price change on the consumer choices in a given market.
• The quantity demanded may change in response to both to shifts in demand (and the creation of a new demand curve, as demonstrated in and movements along the established demand curve.
• The derivation of demand is a useful tool in this pursuit, often combined with a supply curve in order to determine equilibrium prices and understand the relationship between consumer needs and what is readily available in the market.
• The inherent relationship between the price of a good and the relative amount of that good consumers will demand is the fulcrum of recognizing demand curves in the broader context of consumer choice and purchasing behavior.
• Generally speaking, normal goods will demonstrate a higher demand as a result of lower prices and vice versa.
• Giffen goods are a situation where the income effect supersedes the substitution effect, creating an increase in demand despite a rise in price.
• Neutral goods, unlike Giffen goods, demonstrate complete ambivalence to price. That is to say that consumer swill pay any price to get a fixed quantity.
• Economics assumes a population of rational consumers, subjected to the complexities of modern economics while they attempt to maximize the utility obtainable within their income range.
• The income effect says that a consumers overall income level will have an effect on the quantities of goods that consumer will purchase.
• The substitution effect, similar to the income effect, identifies ways in which consumer purchasing power will alter the relative quantities of goods/services purchased by consumers at varying income levels and budgetary constraints.
• Combining the substitution effect and the income effect, one can derive an overall labor -leisure trade-off based on a given consumers purchasing power (income) relative to the price of necessary bundles of goods (substitution effect).
• A rational consumer will begin to work less hours after meeting their consumption requirements in order to capture the value of leisure (and enjoy their income in a meaningful way).
Key Terms
• Trade-offs: Any situation in which the quality or quantity of one thing must be decreased for another to be increased.
• utility: The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
• substitute: A good with a positive cross elasticity of demand, meaning the good’s demand is increased when the price of another is increased.
• Complement: A good with a negative cross elasticity of demand, meaning the good’s demand is increased when the price of another good is decreased.
• utility: The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.
• Transitive: Having the property that if an element x is related to y and y is related to z, then x is necessarily related to z.
• Inferior goods: A good that decreases in demand when consumer income rises; having a negative income elasticity of demand.
• Income Effect: The change in consumption choices due to changes in the amount of money available for an individual to spend.
• Wealth Effect: The change in an individual’s consumption choices due to changes in perception of how rich s/he is.
• elasticity: The sensitivity of changes in a quantity with respect to changes in another quantity.
• Giffen good: A good which people consume more of as only the price rises; Having a positive price elasticity of demand.
• Derivation: The operation of deducing one function from another according to some fixed law, called the law of derivation, as the of differentiation or of integration.
• substitution effect: The change in demand for one good that is due to the relative prices and availability of substitute goods.
• purchasing power: The amount of goods and services that can be bought with a unit of currency or by consumers.
• Income Effect: The change in consumption resulting from a change in real income.
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Learning objectives
• Define the price elasticity of demand.
The price elasticity of demand (PED) is a measure that captures the responsiveness of a good’s quantity demanded to a change in its price. More specifically, it is the percentage change in quantity demanded in response to a one percent change in price when all other determinants of demand are held constant.
The formula for the coefficient of PED is:
$PED=\dfrac{\% \; \text{change in quantity demanded}}{\% \; \text{change in price }}$
The law of demand states that there is an inverse relationship between price and demand for a good. As a result, the PED coefficient is almost always negative. However, economists tend to ignore the sign in everyday use. Only goods that do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED.
The numerical values for the PED coefficient could range from zero to infinity. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a less than proportional effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one. In this case, changes in price have a more than proportional effect on the quantity of a good demanded.
A PED coefficient equal to one indicates demand that is unit elastic; any change in price leads to an exactly proportional change in demand (i.e. a 1% reduction in demand would lead to a 1% reduction in price). A PED coefficient equal to zero indicates perfectly inelastic demand. This means that demand for a good does not change in response to price.
Perfectly Inelastic Demand: When demand is perfectly inelastic, quantity demanded for a good does not change in response to a change in price.
Finally, demand is said to be perfectly elastic when the PED coefficient is equal to infinity. When demand is perfectly elastic, buyers will only buy at one price and no other.
Perfectly Elastic Demand: When the demand for a good is perfectly elastic, any increase in the price will cause the demand to drop to zero.
Measuring the Price Elasticity of Demand
The price elasticity of demand (PED) is calculated by dividing the percentage change in quantity demanded by the percentage change in price.
Learning Objectives
• Calculate the own-price elasticity of demand
he price elasticity of demand (PED) captures how price-sensitive consumers are for a given product or service by measuring the responsiveness of quantity demanded to changes in the good’s own price. This is in contrast to measuring the responsiveness of the good’s demand to a change in price for some other good (a complement or substitute), which is called the cross-price elasticity of demand. The own-price elasticity of demand is often simply called the price elasticity.
The following formula is used to calculate the own-price elasticity of demand:
$\text{Elasticity}= \dfrac{ \% \text{Change in Quantity Demanded}}{\% \text{Change in Price}}$
The formula above usually yields a negative value because of the inverse relationship between price and quantity demanded. However, economists often disregard the negative sign and report the elasticity as an absolute value. For example, if the price of a good increases by 5 percent and the quantity demanded decreases by 5 percent, then the elasticity at the initial price and quantity is -5%/5% = -1. This number is likely to be reported simply as 1.
Sale: There is an inverse relationship between price and quantity demanded, so the elasticity coefficient is almost always negative.
There are a few other important points to note about the coefficient value provided by this formula. First, the elasticity coefficient is a pure number, meaning that it does not have units of measurement associated with it. Second, the coefficient value can range from zero to negative infinity. Finally, the result provided by the formula will be accurate only when the changes in price and quantity are small. The result will be less accurate when the changes are large.
Since PED is based off of percent changes, the starting nominal quantity and price matter. At low prices and high quantities, the PED is therefore more inelastic. For example, a drop in the price of $1 from a starting price of$100 is a 1% drop, but if the starting price is \$10, it is a 10% drop. Similarly, at high prices and low quantities, PED is more elastic.
Price Elasticity of Demand and Revenue: PED is based off of percent changes, so the starting nominal values of price and quantity are significant.
Interpretations of Price Elasticity of Demand
The price elasticity of demand (PED) explains how much changes in price affect changes in quantity demanded.
Learning Objectives
• Describe the relationship between price elasticity and the shape of the demand curve.
The price elasticity of demand (PED) is a measure of the responsiveness of the quantity demanded of a good to a change in its price. It can be calculated from the following formula:
$\dfrac{\% \; \text{change in quantity demanded}}{\% \; \text{change in price }}$
When PED is greater than one, demand is elastic. This can be interpreted as consumers being very sensitive to changes in price: a 1% increase in price will lead to a drop in quantity demanded of more than 1%.
When PED is less than one, demand is inelastic. This can be interpreted as consumers being insensitive to changes in price: a 1% increase in price will lead to a drop in quantity demanded of less than 1%.
The effect of price changes on total revenue PED may be important for businesses attempting to distinguish how to maximize revenue For example, if a business finds out its PED is very inelastic, it may want to raise its prices because it knows that it can sell its products for a higher price without losing many sales. Conversely, if a business finds that its PED is very elastic, it may wish to lower its prices. This would allow the business to dramatically increase the number of units sold without losing much revenue per unit.
There are two notable cases of PED. The first is when demand is perfectly elastic. Perfectly elastic demand is represented graphically as a horizontal line. In this case, any increase in price will lead to zero units demanded.
Perfectly Elastic Demand: Perfectly elastic demand is represented graphically by a horizontal line. In this case the PED value is the same at every point of the demand curve.
The second is perfectly inelastic demand. Perfectly inelastic demand is graphed as a vertical line and indicates a price elasticity of zero at every point of the curve. This means that the same quantity will be demanded regardless of the price.
Perfectly Inelastic Demand: Perfectly inelastic demand is graphed as a vertical line. The PED value is the same at every point of the demand curve.
Since PED is measured based on percent changes in price, the nominal price and quantity mean that demand curves have different elasticities at different points along the curve. Elasticity along a straight line demand curve varies from zero at the quantity axis to infinity at the price axis. Below the midpoint of a straight line demand curve, elasticity is less than one and the firm wants to raise price to increase total revenue. Above the midpoint, elasticity is greater than one and the firm wants to lower price to increase total revenue. At the midpoint, E1, elasticity is equal to one, or unit elastic.
Elasticity and the Demand Curve: The price elasticity of demand for a good has different values at different points on the demand curve.
Determinants of Price Elasticity of Demand
A good’s price elasticity of demand is largely determined by the availability of substitute goods.
Learning Objectives
• Explain how a good’s price elasticity of demand may be different in the short term than in the long term
The price elasticity of demand (PED) is a measure of how much the quantity demanded changes with a change in price. The PED for a given good is determined by one or a combination of the following factors:
• Availability of substitute goods: The more possible substitutes there are for a given good or service, the greater the elasticity. When several close substitutes are available, consumers can easily switch from one good to another even if there is only a small change in price. Conversely, if no substitutes are available, demand for a good is more likely to be inelastic.
• Proportion of the purchaser’s budget consumed by the item: Products that consume a large portion of the purchaser’s budget tend to have greater elasticity. The relative high cost of such goods will cause consumers to pay attention to the purchase and seek substitutes. In contrast, demand will tend to be inelastic when a good represents only a negligible portion of the budget.
• Degree of necessity: The greater the necessity for a good, the lower the elasticity. Consumers will attempt to buy necessary products (e.g. critical medications like insulin) regardless of the price. Luxury products, on the other hand, tend to have greater elasticity. However, some goods that initially have a low degree of necessity are habit-forming and can become “necessities” to consumers (e.g. coffee or cigarettes).
• Duration of price change: For non-durable goods, elasticity tends to be greater over the long-run than the short-run. In the short-term it may be difficult for consumers to find substitutes in response to a price change, but, over a longer time period, consumers can adjust their behavior. For example, if there is a sudden increase in gasoline prices, consumers may continue to fuel their cars with gas in the short-run, but may lower their demand for gas by switching to public transportation, carpooling, or buying more fuel-efficient vehicles over a longer period of time. However, this tendency does not hold for consumer durables. The demand for durables (cars, for example) tends to be less elastic, as it becomes necessary for consumers to replace them with time.
• Breadth of definition of a good: The broader the definition of a good, the lower the elasticity. For example, potato chips have a relatively high elasticity of demand because many substitutes are available. Food in general would have an extremely low PED because no substitutes exist.
• Brand loyalty: An attachment to a certain brand (either out of tradition or because of proprietary barriers) can override sensitivity to price changes, resulting in more inelastic demand.
Key Points
• The PED is the percentage change in quantity demanded in response to a one percent change in price.
• The PED coefficient is usually negative, although economists often ignore the sign.
• Demand for a good is relatively inelastic if the PED coefficient is less than one (in absolute value).
• Demand for a good is relatively elastic if the PED coefficient is greater than one (in absolute value).
• Demand for a good is unit elastic when the PED coefficient is equal to one.
• PED captures the change in quantity demanded in response to a change in the good’s own price (as opposed to the price of some other good).
• The formula for price elasticity yields a value that is negative, pure, and ranges from zero to negative infinity.
• The result provided by the formula will be accurate only if the changes in price and quantity demanded are small.
• Elastic PED can be interpreted as consumers being very sensitive to changes in price.
• Inelastic PED can be interpreted as consumes being insensitive to changes in price.
• Firms use PED to figure out how to change their prices in order to increase revenue.
• PED varies along a straight demand curve.
• A good with more close substitutes will likely have a higher elasticity.
• The higher the percentage of a consumer’s income used to pay for the product, the higher the elasticity tends to be.
• For non-durable goods, the longer a price change holds, the higher the elasticity is likely to be.
• The more necessary a good is, the lower the price elasticity of demand.
Key Terms
• elastic: Demand for a good is elastic when a change in price has a relatively large effect on the quantity of the good demanded.
• Unit Elastic: Demand for a good is unit elastic when the percentage change in quantity demanded is equal to the percentage change in price.
• inelastic: Demand for a good is inelastic when a change in price has a relatively small effect on the quantity of the good demanded.
• Own-price elasticity of demand: Responsiveness of quantity demanded to a change in the good’s own price
• Cross-price elasticity of demand: Measures the responsiveness of the demand for a good to a change in the price of another good.
• Price elasticity of demand: The percent change in quantity demanded due to a 1% change in price.
• Substitute Good: A good that fulfills a consumer need in a way that is similar to another good.
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Cross-Price Elasticity of Demand
The cross-price elasticity of demand measures the change in demand for one good in response to a change in price of another good.
Learning objectives
• Use the cross elasticity of demand to describe a good
The cross-price elasticity of demand shows the relationship between two goods or services. More specifically, it captures the responsiveness of the quantity demanded of one good to a change in price of another good. Cross-Price Elasticity of Demand (EA,B) is calculated with the following formula:
$E_{A,B}= \dfrac{\% \text{Change in Quantity Demanded for Good A}}{\% \text{Change in Price of Good B}}$
The cross-price elasticity may be a positive or negative value, depending on whether the goods are complements or substitutes. If two products are complements, an increase in demand for one is accompanied by an increase in the quantity demanded of the other. For example, an increase in demand for cars will lead to an increase in demand for fuel. If the price of the complement falls, the quantity demanded of the other good will increase. The value of the cross-price elasticity for complementary goods will thus be negative.
Complements: Two goods that complement each other have a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls.
A positive cross-price elasticity value indicates that the two goods are substitutes. For substitute goods, as the price of one good rises, the demand for the substitute good increases. For example, if the price of coffee increases, consumers may purchase less coffee and more tea. Conversely, the demand for a substitute good falls when the price of another good is decreased. In the case of perfect substitutes, the cross elasticity of demand will be equal to positive infinity.
Substitutes: Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for good X rises.
Two goods may also be independent of each other. In this instance, if the price of one good changes, demand for the other good will stay constant. For independent goods, the cross-price elasticity of demand is zero: the change in the price of one good with not be reflected in the quantity demanded of the other.
Independent: Two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for good X stays constant.
Income Elasticity of Demand
The income elasticity of demand measures the responsiveness of the demand for a good or service to a change in income.
learning objectives
• Analyze the characteristics of the income elasticity of demand.
The income elasticity of demand (YED) measures the responsiveness of demand for a good to a change in the income of the people demanding that good, ceteris paribus. It is calculated as the ratio of the percentage change in demand to the percentage change in income:
$YED= \dfrac{ \% \text{change in quantity demanded}}{\% \text{change in real income}}$
If an increase in income leads to an increase in demand, the income elasticity of that good or service is positive. A positive income elasticity is associated with normal goods. In contrast, if a rise in income leads to a decrease in demand, the good or service has a negative income elasticity of demand. A negative income elasticity is associated with inferior goods.
In all, there are five types of income elasticity of demand:
Income Elasticity of Demand: Income elasticity of demand measures the percentage change in quantity demanded as income changes.
• High income elasticity of demand (YED>1): An increase in income is accompanied by a proportionally larger increase in quantity demanded. This is typical of a luxury or superior good.
• Unitary income elasticity of demand (YED=1): An increase in income is accompanied by a proportional increase in quantity demanded.
• Low income elasticity of demand (YED<1): An increase in income is accompanied by less than a proportional increase in quantity demanded. This is characteristic of a necessary good.
• Zero income elasticity of demand (YED=0): A change in income has no effect on the quantity bought. These are called sticky goods.
• Negative income elasticity of demand (YED<0): An increase in income is accompanied by a decrease in the quantity demanded. This is an inferior good (all other goods are normal goods). The consumer may be selecting more luxurious substitutes as a result of the increase in income.
Calculating Elasticities
The basic elasticity formula has shortcomings which can be minimized by using the midpoint method or calculating the point elasticity.
learning objectives
• Calculate price elasticity of demand with the midpoint method
The basic formula for the price elasticity of demand (percentage change in quantity demanded divided by the percentage change in price) yields an accurate result when the changes in quantity and price are small. As the difference between the two prices or quantities increases, however, the accuracy of the formula decreases. This happens because the price elasticity of demand often varies at different points along the demand curve and because the percentage change is not symmetric. Instead, the percentage change between any two values depends on which is chosen as the starting value. For example, when the quantity demanded increases from 10 units to 15 units, the percentage change is 50%. If the quantity demanded decreases from 15 units to 10 units, the percentage change is -33.3%. Two alternative elasticity measures can be used to avoid or minimize the shortcomings of the basic elasticity formula.
The midpoint method calculates the arc elasticity, which is the elasticity of one variable with respect to another between two given points on the demand curve. This measure requires just two points for quantity demanded and price to be known; it does not require a function for the relationship. The midpoint method uses the midpoint rather than the initial point for calculating percentage change, so it is symmetric with respect to the two prices and quantities demanded. The arc elasticity is obtained using this formula:
Arc Elasticity: To calculate the arc elasticity, you need to know two points on the demand curve. The calculation does not require a function for the relationship between price and quantity demanded.
$\text{Price Elasticity of Demand} =\dfrac{(Q2−Q1)/[(Q2+Q1)/2]}{(P2−P1)/[(P2+P1)/2]}$
Suppose that the price of hot dogs changes from $3 to$1, leading to a change in quantity demanded from 80 to 120. The formula provided above would yield an elasticity of 0.4/(-1) = -0.4. As elasticity is often expressed without the negative sign, it can be said that the demand for hot dogs has an elasticity of 0.4.
The point elasticity is the measure of the change in quantity demanded to a tiny change in price. It is the limit of the arc elasticity as the distance between the two points approaches zero, and hence is defined as a single point. In contrast to the midpoint method, calculating the point elasticity requires a defined function for the relationship between price and quantity demanded. The point elasticity can be calculated with the following formula:
$\text{Point}−\text{Price Elasticity}=\dfrac{P}{Q_d} \times \dfrac{ΔQ_d}{ΔP}$
In the formula above, dQ/dP is the partial derivative of quantity with respect to price, and P and Q are price and quantity, respectively, at a given point on the demand curve.
Key Points
• Complementary goods have a negative cross- price elasticity: as the price of one good increases, the demand for the second good decreases.
• Substitute goods have a positive cross-price elasticity: as the price of one good increases, the demand for the other good increases.
• Independent goods have a cross-price elasticity of zero: as the price of one good increases, the demand for the second good is unchanged.
• The income elasticity of demand is the ratio of the percentage change in demand to the percentage change in income.
• Normal goods have a positive income elasticity of demand (as income increases, the quantity demanded increases).
• Inferior goods have a negative income elasticity of demand (as income increases, the quantity demanded decreases).
• When changes in price and quantity are big, the arc elasticity or point elasticity formulas provide a more accurate elasticity coefficient than the basic elasticity formula.
• The arc elasticity captures the responsiveness of one variable to another between two given points.
• The midpoint method can be used if just two points on the demand curve are known. You do not need to know the function relating price and quantity demanded to use this method.
• The point elasticity captures the change in quantity demanded to a tiny change in price. To calculate the point elasticity, you must have a function for the relationship between price and quantity.
Key Terms
• Complement: A good with a negative cross elasticity of demand, meaning the good’s demand is increased when the price of another good is decreased.
• substitute: A good with a positive cross elasticity of demand, meaning the good’s demand is increased when the price of another is increased.
• Necessary Good: A type of normal good. An increase in income leads to a smaller than proportional increase in the quantity demanded.
• Superior Good: A type of normal good. Demand increases more than proportionally as income rises.
• Point elasticity: The measure of the change in quantity demanded to a very small change in price.
• Arc elasticity: The elasticity of one variable with respect to another between two given points.
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Definition of Price Elasticity of Supply
The price elasticity of supply is the measure of the responsiveness in quantity supplied to a change in price for a specific good.
learning objectives
• Differentiate between the price elasticity of demand for elastic and inelastic goods
In economics, elasticity is a summary measure of how the supply or demand of a particular good is influenced by changes in price. Elasticity is defined as a proportionate change in one variable over the proportionate change in another variable:
$\text{Elasticity}=\dfrac{\% \text{Change in quantity}}{\% \text{Change in price}}$
The price elasticity of supply (PES) is the measure of the responsiveness in quantity supplied (QS) to a change in price for a specific good (% Change QS / % Change in Price). There are numerous factors that directly impact the elasticity of supply for a good including stock, time period, availability of substitutes, and spare capacity. The state of these factors for a particular good will determine if the price elasticity of supply is elastic or inelastic in regards to a change in price.
The price elasticity of supply has a range of values:
• PES > 1: Supply is elastic.
• PES < 1: Supply is inelastic.
• PES = 0: The supply curve is vertical; there is no response of demand to prices. Supply is “perfectly inelastic.”
• PES = ∞∞ (i.e., infinity): The supply curve is horizontal; there is extreme change in demand in response to very small change in prices. Supply is “perfectly elastic.”
Inelastic goods are often described as necessities. A shift in price does not drastically impact consumer demand or the overall supply of the good because it is not something people are able or willing to go without. Examples of inelastic goods would be water, gasoline, housing, and food.
Elastic goods are usually viewed as luxury items. An increase in price for an elastic good has a noticeable impact on consumption. The good is viewed as something that individuals are willing to sacrifice in order to save money. An example of an elastic good is movie tickets, which are viewed as entertainment and not a necessity.
The price elasticity of supply is determined by:
• Number of producers: ease of entry into the market.
• Spare capacity: it is easy to increase production if there is a shift in demand.
• Ease of switching: if production of goods can be varied, supply is more elastic.
• Ease of storage: when goods can be stored easily, the elastic response increases demand.
• Length of production period: quick production responds to a price increase easier.
• Time period of training: when a firm invests in capital the supply is more elastic in its response to price increases.
• Factor mobility: when moving resources into the industry is easier, the supply curve in more elastic.
• Reaction of costs: if costs rise slowly it will stimulate an increase in quantity supplied. If cost rise rapidly the stimulus to production will be choked off quickly.
The result of calculating the elasticity of the supply and demand of a product according to price changes illustrates consumer preferences and needs. The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or perfectly inelastic.
Price elasticity over time: This graph illustrates how the supply and demand of a product are measured over time to show the price elasticity.
Perfectly Inelastic Supply: A graphical representation of perfectly inelastic supply.
Measuring the Price Elasticity of Supply
The price elasticity of supply is the measure of the responsiveness of the quantity supplied of a particular good to a change in price.
learning objectives
• Calculate elasticities and describe their meaning
The price elasticity of supply (PES) is the measure of the responsiveness of the quantity supplied of a particular good to a change in price (PES = % Change in QS / % Change in Price). The intent of determining the price elasticity of supply is to show how a change in price impacts the amount of a good that is supplied to consumers. The price elasticity of supply is directly related to consumer demand.
Elasticity
The elasticity of a good provides a measure of how sensitive one variable is to changes in another variable. In this case, the price elasticity of supply determines how sensitive the quantity supplied is to the price of the good.
Calculating the PES
When calculating the price elasticity of supply, economists determine whether the quantity supplied of a good is elastic or inelastic. The percentage of change in supply is divided by the percentage of change in price. The results are analyzed using the following range of values:
• PES > 1: Supply is elastic.
• PES < 1: Supply is inelastic.
• PES = 0: Supply is perfectly inelastic. There is no change in quantity if prices change.
• PES = infinity: Supply is perfectly elastic. An decrease in prices will lead to zero units produced.
Factors that Influence the PES
There are numerous factors that impact the price elasticity of supply including the number of producers, spare capacity, ease of switching, ease of storage, length of production period, time period of training, factor mobility, and how costs react.
The price elasticity of supply is calculated and can be graphed on a demand curve to illustrate the relationship between the supply and price of the good.
Applications of Elasticities
In economics, elasticity refers to how the supply and demand of a product changes in relation to a change in the price.
learning objectives
• Give examples of inelastic and elastic supply in the real world
In economics, elasticity refers to the responsiveness of the demand or supply of a product when the price changes.
The technical definition of elasticity is the proportionate change in one variable over the proportionate change in another variable. For example, to determine how a change in the supply or demand of a product is impacted by a change in the price, the following equation is used: Elasticity = % change in supply or demand / % change in price.
The price is a variable that can directly impact the supply and demand of a product. If a change in the price of a product significantly influences the supply and demand, it is considered “elastic.” Likewise, if a change in product price does not significantly change the supply and demand, it is considered “inelastic.”
For elastic demand, when the price of a product increases the demand goes down. When the price decreases the demand goes up. Elastic products are usually luxury items that individuals feel they can do without. An example would be forms of entertainment such as going to the movies or attending a sports event. A change in prices can have a significant impact on consumer trends as well as economic profits. For companies and businesses, an increase in demand will increase profit and revenue, while a decrease in demand will result in lower profit and revenue.
For inelastic demand, the overall supply and demand of a product is not substantially impacted by an increase in price. Products that are usually inelastic consist of necessities like food, water, housing, and gasoline. Whether or not a product is elastic or inelastic is directly related to consumer needs and preferences. If demand is perfectly inelastic, then the same amount of the product will be purchased regardless of the price.
Economists study elasticity and use demand curves in order to diagram and study consumer trends and preferences. An elastic demand curve shows that an increase in the supply or demand of a product is significantly impacted by a change in the price. An inelastic demand curve shows that an increase in the price of a product does not substantially change the supply or demand of the product.
Inelastic Demand: For inelastic demand, when there is an outward shift in supply and prices fall, there is no substantial change in the quantity demanded.
Elastic Demand: For elastic demand, when there is an outward shift in supply, prices fall which causes a large increase in quantity demanded.
Key Points
• Elasticity is defined as a proportionate change in one variable over the proportionate change in another variable: $\text{Elasticity}=\dfrac{\% \text{Change in quantity}}{\% \text{Change in price}}$
• The impact that a price change has on the elasticity of supply also directly impacts the elasticity of demand.
• Inelastic goods are often described as necessities, while elastic goods are considered luxury items.
• The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or perfectly inelastic.
• The price elasticity of supply = % change in quantity supplied / % change in price.
• When calculating the price elasticity of supply, economists determine whether the quantity supplied of a good is elastic or inelastic.
• PES > 1: Supply is elastic. PES < 1: Supply is inelastic. PES = 0: if the supply curve is vertical, and there is no response to prices. PES = infinity: if the supply curve is horizontal.
• To determine the elasticity of a product, the proportionate change of one variable is placed over the proportionate change of another variable (Elasticity = % change of supply or demand / % change in price ).
• For elastic demand, a change in price significantly impacts the supply and demand of the product.
• For inelastic demand, a change in the price does not substantially impact the supply and demand of the product.
• Economists use demand curves in order to document and study elasticity.
Key Terms
• luxury: Something very pleasant but not really needed in life.
• supply: The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.
• demand: The desire to purchase goods and services.
• mobility: The ability for economic factors to move between actors or conditions.
• capacity: The maximum that can be produced on a machine or in a facility or group.
• elastic: Sensitive to changes in price.
• demand: The desire to purchase goods and services.
• inelastic: Not sensitive to changes in price.
• supply: The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.
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Market Failure
learning objectives
• Identify common market failures and governmental responses
Market failure occurs when the price mechanism fails to account for all of the costs and benefits necessary to provide and consume a good. The market will fail by not supplying the socially optimal amount of the good.
Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the marginal benefit of consumption. The imbalance causes allocative inefficiency, which is the over- or under-consumption of the good.
The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to inefficient producers, externalities, environmental concerns, and lack of public goods. An externality is an effect on a third party which is caused by the production or consumption of a good or service.
Air pollution: Air pollution is an example of a negative externality. Governments may enact tradable permits to try and reduce industrial pollution.
During market failures the government usually responds to varying degrees. Possible government responses include:
• legislation – enacting specific laws. For example, banning smoking in restaurants, or making high school attendance mandatory.
• direct provision of merit and public goods – governments control the supply of goods that have positive externalities. For example, by supplying high amounts of education, parks, or libraries.
• taxation – placing taxes on certain goods to discourage use and internalize external costs. For example, placing a ‘sin-tax’ on tobacco products, and subsequently increasing the cost of tobacco consumption.
• subsidies – reducing the price of a good based on the public benefit that is gained. For example, lowering college tuition because society benefits from more educated workers. Subsidies are most appropriate to encourage behavior that has positive externalities.
• tradable permits – permits that allow firms to produce a certain amount of something, commonly pollution. Firms can trade permits with other firms to increase or decrease what they can produce. This is the basis behind cap-and-trade, an attempt to reduce of pollution.
• extension of property rights – creates privatization for certain non-private goods like lakes, rivers, and beaches to create a market for pollution. Then, individuals get fined for polluting certain areas.
• advertising – encourages or discourages consumption.
• international cooperation among governments – governments work together on issues that affect the future of the environment.
Causes of Market Failure
Market failure occurs due to inefficiency in the allocation of goods and services.
learning objectives
• Explain some common causes of market failure
Market failure occurs due to inefficiency in the allocation of goods and services. A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced. To fully understand market failure, it is important to recognize the reasons why a market can fail. Due to the structure of markets, it is impossible for them to be perfect. As a result, most markets are not successful and require forms of intervention.
Reasons for market failure include:
• Positive and negative externalities: an externality is an effect on a third party that is caused by the consumption or production of a good or service. A positive externality is a positive spillover that results from the consumption or production of a good or service. For example, although public education may only directly affect students and schools, an educated population may provide positive effects on society as a whole. A negative externality is a negative spillover effect on third parties. For example, secondhand smoke may negatively impact the health of people, even if they do not directly engage in smoking.
• Environmental concerns: effects on the environment as important considerations as well as sustainable development.
• Lack of public goods: public goods are goods where the total cost of production does not increase with the number of consumers. As an example of a public good, a lighthouse has a fixed cost of production that is the same, whether one ship or one hundred ships use its light. Public goods can be underproduced; there is little incentive, from a private standpoint, to provide a lighthouse because one can wait for someone else to provide it, and then use its light without incurring a cost. This problem – someone benefiting from resources or goods and services without paying for the cost of the benefit – is known as the free rider problem.
• Underproduction of merit goods: a merit good is a private good that society believes is under consumed, often with positive externalities. For example, education, healthcare, and sports centers are considered merit goods.
• Overprovision of demerit goods: a demerit good is a private good that society believes is over consumed, often with negative externalities. For example, cigarettes, alcohol, and prostitution are considered demerit goods.
• Abuse of monopoly power: imperfect markets restrict output in an attempt to maximize profit.
When a market fails, the government usually intervenes depending on the reason for the failure.
Introducing Externalities
An externality is a cost or benefit that affects an otherwise uninvolved party who did not choose to be subject to the cost or benefit.
learning objectives
• Give examples of externalities that exist in different parts of society
In economics, an externality is a cost or benefit resulting from an activity or transaction, that affects an otherwise uninvolved party who did not choose to be subject to the cost or benefit. An example of an externality is pollution. Health and clean-up costs from pollution impact all of society, not just individuals within the manufacturing industries. In regards to externalities, the cost and benefit to society is the sum of the value of the benefits and costs for all parties involved.
Externality: An externality is a cost or benefit that results from an activity or transaction and that affects an otherwise uninvolved party who did not choose to incur that cost or benefit.
Negative vs. Positive
A negative externality is an result of a product that inflicts a negative effect on a third party. In contrast, positive externality is an action of a product that provides a positive effect on a third party.
Negative Externality: Air pollution caused by motor vehicles is an example of a negative externality.
Externalities originate within voluntary exchanges. Although the parties directly involved benefit from the exchange, third parties can experience additional effects. For those involuntarily impacted, the effects can be negative (pollution from a factory) or positive (domestic bees kept for honey production, pollinate the neighboring crops).
Economic Strain
Neoclassical welfare economics explains that under plausible conditions, externalities cause economic results that are not ideal for society. The third parties who experience external costs from a negative externality do so without consent, while the individuals who receive external benefits do not pay a cost. The existence of externalities can cause ethical and political problems within society.
In regards to externalities, one way to correct the issue is to internalize the third party costs and benefits. However, in many cases, internalizing the costs is not financially possible. Governments may step in to correct such market failures.
Externality Impacts on Efficiency
Economic efficiency is the use resources to maximize the production of goods; externalities are imperfections that limit efficiency.
learning objectives
• Analyze the effects of externalities on efficiency
Economic Efficiency
In economics, the term “economic efficiency” is defined as the use of resources in order to maximize the production of goods and services. An economically efficient society can produce more goods or services than another society without using more resources.
A market is said to be economically efficient if:
• No one can be made better off without making someone else worse off.
• No additional output can be obtained without increasing the amounts of inputs.
• Production proceeds at the lowest possible cost per unit.
Externalities
An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur the cost or benefit. Externalities are either positive or negative depending on the nature of the impact on the third party. An example of a negative externality is pollution. Manufacturing plants emit pollution which impacts individuals living in the surrounding areas. Third parties who are not involved in any aspect of the manufacturing plant are impacted negatively by the pollution. An example of a positive externality would be an individual who lives by a bee farm. The third parties’ flowers are pollinated by the neighbor’s bees. They have no cost or investment in the business, but they benefit from the bees.
Externality: This diagram shows the voluntary exchange that takes place within a market system. It also shows the economic costs that are associated with externalities.
Externalities and Efficiency
Positive and negative externalities both impact economic efficiency. Neoclassical welfare economics states that the existence of externalities results in outcomes that are not ideal for society as a whole. In the case of negative externalities, third parties experience negative effects from an activity or transaction in which they did not choose to be involved. In order to compensate for negative externalities, the market as a whole is reducing its profits in order to repair the damage that was caused which decreases efficiency. Positive externalities are beneficial to the third party at no cost to them. The collective social welfare is improved, but the providers of the benefit do not make any money from the shared benefit. As a result, less of the good is produced or profited from which is less optimal society and decreases economic efficiency.
In order to deal with externalities, markets usually internalize the costs or benefits. For costs, the market has to spend additional funds in order to make up for damages incurred. Benefits are also internalized because they are viewed as goods produced and used by third parties with no monetary gain for the market. Internalizing costs and benefits is not always feasible, especially when the monetary value or a good or service cannot be determined.
Externalities directly impact efficiency because the production of goods is not efficient when costs are incurred due to damages. Efficiency also decreases when potential money earned is lost on non-paying third parties.
In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the market declines.
Key Points
• Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the marginal benefit of consumption.
• The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to inefficient producers, externalities, environmental concerns, and lack of public goods.
• Government responses to market failure include legislation, direct provision of merit goods and public goods, taxation, subsidies, tradable permits, extension of property rights, advertising, and international cooperation among governments.
• A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced.
• Due to the structure of markets, it may be impossible for them to be perfect.
• Reasons for market failure include: positive and negative externalities, environmental concerns, lack of public goods, underprovision of merit goods, overprovision of demerit goods, and abuse of monopoly power.
• In regards to externalities, the cost and benefit to society is the sum of the benefits and costs for all parties involved.
• Market failure occurs when the price mechanism fails to consider all of the costs and benefits necessary for providing and consuming a good.
• In regards to externalities, one way to correct the issue is to internalize the third party costs and benefits. However, in many cases, internalizing the costs is not feasible. When externalities exist, it is possible that the particular industry will experience market failure.
• In many cases, the government intervenes when there is market failure.
• An economically efficient society can produce more goods or services than another society without using more resources.
• An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur the cost or benefit. Externalities are either positive or negative depending on the nature of the impact on the third party.
• Neoclassical welfare economics states that the existence of externalities results in outcomes that are not ideal for society as a whole.
• In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the market declines.
• In order for economic efficiency to be achieved, one defining rule is that no one can be made better off without making someone else worse off. When externalities are present, not everyone benefits from the production of the good or service.
Key Terms
• public good: A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.
• merit good: A commodity which is judged that an individual or society should have on the basis of some concept of need, rather than ability and willingness to pay.
• externality: An impact, positive or negative, on any party not involved in a given economic transaction or act.
• public good: A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.
• free rider: One who obtains benefit from a public good without paying for it directly.
• monopoly: A market where one company is the sole supplier.
• intervene: To interpose; as, to intervene to settle a quarrel; get involved, so as to alter or hinder an action.
• externality: An impact, positive or negative, on any party not involved in a given economic transaction or act.
• efficient: Making good, thorough, or careful use of resources; not consuming extra. Especially, making good use of time or energy.
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Negative Externalities
Negative externalities are costs caused by an activity that affect an otherwise uninvolved party who did not choose to incur that cost.
Learning Objectives
• Describe the impact of a negative externality on society
A negative externality is a cost that results from an activity or transaction and that affects an otherwise uninvolved party who did not choose to incur that cost.
Reasons for Negative Externalities
The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in calculating the costs of production. Production decisions are generally based on financial data and most social costs are not measured that way. For example, when a firm decides to open up a new factory, it will not account for the cost that residents accrue by drinking water from a river the factory polluted. As a result, a product that shouldn’t be produced, because the total expenses exceed the return, are made because social costs were not considered.
In other words, the costs of production represent individual, or private, marginal costs. The private marginal costs are lower than societal marginal costs, which also capture the true costs of the negative externalities. As a result, producers will overestimate the ideal quantity of the good to produce.
Negative Externality: Graphically, negative externalities occur when social costs are lower than private costs, and firms produce more units than is socially optimal. The ideal equilibrium quantity that reflects negative externalities is Qs, but firms may produce at Qp.
Government Solutions for Negative Externalities
In these cases, government intervention is necessary to help “price” negative externalities. Governments can either use regulation (e.g. outlaw an action) or use market solutions. By instituting policies such as pollution penalties, permitting civil lawsuits by private parties to recover damages for negligent actions, and levying environmental taxes, governments can achieve two things. First, these regulations recover funds to help fix the damage caused by negative externalities. Second, these acts help put a financial price on social costs. With that information, businesses can arrive at a more accurate figure for the costs of production. Businesses can then avoid producing products whose financial and social costs exceed the financial return.
Cigarette smoke: Secondhand smoke is an example of a negative externality; a person chooses to smoke, but others who do not choose to smoke are harmed.
Positive Externalities
Positive externalities are benefits caused by activities that affect an otherwise uninvolved party who did not choose to incur that benefit.
Learning Objectives
• Use an example to discuss the concept of a positive externality
Positive externalities are benefits caused by transactions that affect an otherwise uninvolved party who did not choose to incur that benefit. Externalities occur all the time because economic events do not occur within a vacuum. Transactions often require the use of common resources that are shared with parties are not involved with the exchange. The use of these resources, in turn, impacts the uninvolved parties.
In the case of positive externalities, a transaction has positive side effects for non-related parties. Let’s take a look at some example:
• A homeowner keeps his house maintained, the neighborhood benefits through higher home values. The homeowner’s neighbors benefit from a positive externality.
• A person may keep bees for her own enjoyment, but gardeners in the area benefit because their flowers are pollinated. The beekeeper’s transaction of purchasing bees ends up positively affecting parties who are not involved in the transaction.
• A person becomes inoculated against a disease, those around him benefit because they cannot catch the disease from him. There was an exchange between the doctor and the patient, but others also benefit.
In each of these cases, the people taking action are presumably not doing it for the sake of the community, but for their own purposes. The people taking the action may also enjoy the additional benefits described above, but initiators of actions are not considered beneficiaries of externalities.
The problem with positive externalities is that the people who create these advantages cannot charge the beneficiaries; the beneficiaries can “free ride,” or benefit without paying. For example, assume everyone in a community, except one person, got a flu shot. That one person could choose to abstain from receiving the shot; since everyone else got inoculated, he can’t get the disease from the others because they can’t catch the flu. That person would be a free rider since he would benefit from inoculations without incurring any cost.
Since parties that create the externality aren’t compensated, they do not have any incentive to create more. This results in a suboptimal result, because the producers of the externality will generally create less of the benefit than the larger community needs.
Key Points
• The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in calculating the costs of production.
• Government intervention is necessary to help ” price ” negative externalities. They do this through regulations or by instituting market-based policies such as taxes, subsidies, or permit systems.
• Graphically, social costs will be lower than private costs because they do not take into account the additional costs of negative externalities. As a result, firms may produce more units than is optimal from a societal standpoint.
• Graphically, social costs will be lower than private costs because they do not take into account the additional costs of negative externalities. As a result, firms may produce more units than is optimal from a societal standpoint.
• Externalities occur all the time because economic events do not occur within a vacuum. Transactions often require the use of common resources that are shared with parties are not involved with the exchange. The use of these resources in turn impacts the uninvolved parties.
• The problem with positive externalities is that the people who create the externality cannot charge the beneficiaries; the beneficiaries can “free ride,” or benefit without paying.
• Free riding results in a suboptimal result, because the producers of the externality will generally create less of the benefit than the larger community needs.
Key Terms
• externality: An impact, positive or negative, on any party not involved in a given economic transaction or act.
• free rider: One who obtains benefit from a public good without paying for it directly.
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Regulation
The government can respond to externalities through command-and-control policies or market-based policies.
Learning Objectives
• Describe the role of government regulation in addressing externalities
The government can respond to externalities in two ways. The government can use command-and-control policies to regulate behavior directly. Alternatively, it can implement market-based policies such as taxes and subsidies to incentivize private decision makers to change their own behavior.
Command-and-control regulation can come in the form of government-imposed standards, targets, process requirements, or outright bans. Such measures make certain behaviors either required or forbidden with the goal of addressing the externality. For example, the government may make it illegal for a company to dump certain chemicals in a river. By doing so, the government hopes to protect the environment or other companies or individuals that use the river that would otherwise suffer a negative impact.
No Smoking: The prohibition of smoking in certain areas is a regulation designed to reduce the negative externalities suffered by non-smokers when they are around smokers.
In practice, implementing regulation effectively is difficult. It requires the regulator to have in-depth knowledge of a certain industry or sphere of economic activity. If done incorrectly, regulation can introduce inefficiency. For example, if the government makes it illegal to dump in the river, the companies and their customers may suffer because the products must be produced using less efficient methods. On the other hand, if the government allows too much to be dumped in the river, they have failed to mitigate the negative externality.
If the government is unsure of how to effectively regulate the market, it should seek other methods of mitigating the externality. Advocates of market-based policies for reducing negative externalities point to the difficulty of creating and enforcing effective regulation for reasons why the government should create systems of incentives and disincentives instead of using the force of regulation.
Tax
Corrective taxes incentivize economic actors to reduce the production of goods or services generating negative externalities.
Learning Objectives
• Describe the role of taxes in addressing externalities
Taxes are a market-based policy option available to the government to address externalities. A corrective tax (also called a Pigovian tax) is applied to a market activity that is generating negative externalities (costs for a third party). The tax is set equal to the value of the negative externality and provides incentives for allocation of resources closer to the social optimum.
In the case of negative externalities, the social cost of an activity is greater than the private cost of the activity. In such a case, the market outcome is not efficient and may lead to overproduction of the good. Taxes make it more expensive for firms to produce the good or service generating the externality, thus providing an incentive to produce less of it. As the figure demonstrates, a tax shifts the marginal private cost curve up. In response, producers change the output to the socially-optimum level.
Corrective Tax: A tax shifts the marginal private cost curve up by the amount of the tax. This gives producers an incentive to reduce output to the socially optimum level.
Take environmental pollution as an example. The private cost of pollution to a polluter is less than its social cost. If the government levies a tax on pollution, it increases the polluter’s private cost. The polluter now has an incentive to generate less pollution.
The level of the corrective tax is intended to counterbalance the externality. In practice, however, it is extremely difficult for the government to determine the appropriate level for the tax. Moreover, in determining the tax level, the government might come under pressure from various interest groups that would benefit from a higher or lower taxation level. Nevertheless, by introducing corrective taxes in response to negative externalities the government can not only increase efficiency, but raise revenues as well.
Quotas
Tradable permits are a market-based approach allowing the government to limit negative externalities produced by a group of firms.
Learning Objectives
• Evaluate a permit system as a method to address externalities
To address the problem of negative externalities, governments may use a quota system to try and limit them. In a quota system, the negative externality is capped at a certain amount. In the example of pollution, the government may put a quota on the amount of pollution a factory can produce by issuing tradable permits.
Tradable permits are one of the market-based approaches the government can use to address externalities. In the past tradable permits have been primarily used to control pollution.
Emissions Trading: Emissions trading or “cap and trade” is a market-based approach used to control pollution by providing economic incentives for reducing the emissions of pollutants.
When pursuing this approach the government sets a limit or cap on the amount of a pollutant that may be emitted. It then allocates emissions permits up to the specified limit among firms. The permits represent the right to emit or discharge a specific volume of a specified pollutant. Firms are required to hold a number of permits equivalent to their emissions. Firms that need to increase their volume of emissions must buy permits from firms that require fewer of them. This transfer is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions. The outcome achieved by the market for permits is more efficient, regardless of the initial allocation of permits.
The market for tradable permits creates incentives for firms to produce less pollution. Firms that have a high cost of reducing emissions are willing to pay for the permits, while those that can reduce emissions in the most cost-efficient manner will do so and sell their permits. Tradable permits thus achieve a desired level of the externality by allowing the market to determine which market actors can create the externality.
There are several active trading programs for air pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme. In the United States there is a national market for sulfur dioxide emissions to reduce acid rain. Markets for other pollutants tend to be smaller and more localized.
Key Points
• Command-and-control regulation requires or forbids certain behaviors with the goal of addressing an externality.
• Regulation is difficult to implement and enforce correctly.
• Command-and-control regulation can come in the form of government-imposed standards, targets, process requirements, or outright bans.
• The allocation of tradable permits is a market-based policy that has been primarily used to combat pollution.
• A corrective tax is a market-based policy option used by the government to address negative externalities.
• Taxes increase the cost of producing goods or services generating the externality, thus encouraging firms to produce less output.
• The tax should be set equal to the value of the negative externality, which is very difficult to do in practice.
• Corrective taxes increase efficiency and provide the government with revenues as well.
• A permit is a right to produce a certain amount of a negative externality, such as pollution.
• Permits are traded among firms. Firms that are able to cheaply reduce production of the externality can sell permits to firms that are unable to make such reductions and are willing to pay for the permits.
• Regardless of the initial allocation of permits, the market for permits achieves an outcome that is more efficient for society.
Key Terms
• Negative Externality: A detremental effect suffered by a party due to a transaction it was not a part of.
• Pigovian tax: A tax applied to a market activity that is generating negative externalities (costs for somebody else).
• Permit: The right to produce a given amount of a negative externality (for example, the right to emit a specific volume of a pollutant).
• quota: A restriction on the import of something to a specific quantity.
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Types of Private Solutions
Private actors will sometimes effectively address externalities and reach efficient outcomes without government intervention.
Learning Objectives
• Evaluate how effective private solutions may be in solving market failures produced by externalities
Government intervention is not always necessary to address externalities. Private actors will sometimes arrive at their own solutions.
There are several types of private solutions to market failures:
• Moral codes: Moral codes guide individuals’ behavior. Individuals know that certain actions are simply not “the right thing to do” or would elicit disapproving reactions from others. This is illustrated in the case of littering. The likelihood of being fined may be small, but moral codes provide an incentive to refrain from littering.
• Charities: Charities channel donations from private individuals towards fighting to limit behaviors that result in negative externalities or promoting behaviors that generate positive externalities. The former can be seen in the case of organizations that protect the environment, while the latter is exemplified through organizations that raise money for education.
• Business mergers or contracts in the self interest of relevant parties: Two businesses that offer positive externalities to each other can merge or enter into a contract that makes both parties better off.
The Coase theorem, which was developed by Ronald Coase, posits that two parties will be able to bargain with each other to reach an agreement that efficiently addresses externalities. However, the theorem notes several conditions in order for such a solution to occur, including low transaction costs (the costs the parties incur by negotiating and coming to agreement) and well-defined property rights. If the conditions are met, the bargaining parties are expected to reach an agreement where everyone is better off. In practice, however, transaction costs do exist, and the bargaining process does not always run smoothly. As a result, private individuals often fail to resolve problems.
The Coase Theorem
The Coase theorem states that private parties can find efficient solutions to externalities without government intervention.
Learning Objectives
• Explain the usefulness and shortcomings of the Coase Theorem.
The Coase Theorem, named after Nobel laureate Ronald Coase, states that in the presence of an externality, private parties will arrive at an efficient outcome without government intervention. According to the theorem, if trade in an externality is possible and there are no transaction costs, bargaining among private parties will lead to an efficient outcome regardless of the initial allocation of property rights.
Efficient Solution: According to the Coase theorem, two private parties will be able to bargain with each other and find an efficient solution to an externality problem.
Imagine a farm and a ranch next to each other. The rancher’s cows occasionally wander over to the farm and damage the farmer’s crops. The farmer has an incentive to bargain with the rancher to find a more efficient solution. If it is more efficient to prevent cattle trampling a farmer’s field by fencing in the farm, rather than fencing in the cattle, the outcome of the bargaining will be the fence around the farm.
Take another example. The Jones family plants pear trees on their property which is adjacent to the Smith family. The Smith family gets an external benefit from the Jones family’s pear trees because they pick up the pears that fall on the ground on their side of the property line (see ). This is an externality because the Smith family does not pay the Jones family for the utility received from gathering fallen pears. As a result, the Jones family plants too few pear trees. In response, the Jones family can put up a net that will prevent pears from falling on the Smith’s side of the property line, eliminating the externality. Alternatively, the Jones could impose a cost on the Smith family if they want to continue to enjoy the pears from the pear trees. Both parties will be better off if they can agree to the second scenario, as the Smith family will continue to enjoy pears and the Jones family can increase the production of pears.
Effects of Externalities: This graph exemplifies how Coase’s Theorem functions in a practical manner, underlining the effects of an externality in an economic model.
In practice, transaction costs are rarely low enough to allow for efficient bargaining and hence the theorem is almost always inapplicable to economic reality.
Key Points
• Private solutions to externalities include moral codes, charities, and business mergers or contracts in the self interest of relevant parties.
• The Coase theorem states that when transaction cost are low, two parties will be able to bargain and reach an efficient outcome in the presence of an externality.
• In practice, private parties often fail to resolve the problem of externalities on their own.
• According to the theorem, the parties affected by an externality will bargain to reach an outcome that will be more efficient.
• Transaction costs must be low in order for parties to arrive at a more efficient outcome.
• In the real world, transaction costs are rarely low, so the Coase theorem is often inapplicable.
Key Terms
• Transaction cost: The cost incurred in making an economic exchange, such as the costs required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate contract and so on.
• Coase Theorem: The theorem states that private economic actors can solve the problem of externalities among themselves.
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Defining a Good
There are four types of goods in economics, which are defined based on excludability and rivalrousness in consumption.
Learning Objectives
• Define a good
There are four categories of goods in economics, which are defined based on two attributes. The first attribute is excludability, or whether people can be prevented from using the good. The second is whether a good is rival in consumption: whether one person’s use of the good reduces another person’s ability to use it.
National defense provides an example of a good that is non-excludable. America’s national defense establishment offers protection to everyone in the country. Items on sale in a store, on the other hand, are excludable. The store owner can prevent a customer from obtaining a good unless the customer pays for it. National defense also provides an example of a good that is non- rivalrous. One person’s protection does not prevent another person from receiving protection. In contrast, shoes are rivalrous. Only one person can wear a pair of shoes at a time.
Combinations of these two attributes create four categories of goods:
Four Types of Goods: There are four categories of goods in economics, based on whether the goods are excludable and/or rivalrous in consumption.
• Private goods: Private goods are excludable and rival. Examples of private goods include food, clothes, and flowers. There are usually limited quantities of these goods, and owners or sellers can prevent other individuals from enjoying their benefits. Because of their relative scarcity, many private goods are exchanged for payment.
• Common goods: Common goods are non-excludable and rival. Because of these traits, common goods are easily over-consumed, leading to a phenomenon called “tragedy of the commons. ” In this situation, people withdraw resources to secure short-term gains without regard for the long-term consequences. A classic example of a common good are fish stocks in international waters. No one is excluded from fishing, but as people withdraw fish without limits being imposed, the stocks for later fishermen are depleted.
• Club goods: Club goods are excludable but non-rival. This type of good often requires a “membership” payment in order to enjoy the benefits of the goods. Non-payers can be prevented from access to the goods. Cable television is a classic example. It requires a monthly fee, but is non-rival after the payment.
• Public goods: Public goods are non-excludable and non-rival. Individuals cannot be effectively excluded from using them, and use by one individual does not reduce the good’s availability to others. Examples of public goods include the air we breathe, public parks, and street lights. Public goods may give rise to the “free rider problem. ” A free-rider is a person who receives the benefit of a good without paying for it. This may lead to the under-provision of certain goods or services.
Private Goods
A private good is both excludable and rivalrous.
Learning Objectives
• Define a private good
In economics, a private good is defined as an asset that is both excludable and rivalrous. It is excludable in that it is possible to exercise private property rights over it, preventing those who have not paid from using the good or consuming its benefits. For example, person A may have the means and will to pay \$20 for a t-shirt. Person B may not wish to pay \$20 or may not be able to do so. Person B would not be able to purchase the t-shirt. Additionally, the private good is rivalrous in that its consumption by one person necessarily prevents consumption by another. When person A purchases and drinks a bottle of water, the same bottle of water is not available for person B to purchase and consume.
A private good is a scare economic resource, which causes competition for it. Generally, people have to pay to enjoy the benefits of a private good. Because people have to pay to obtain it, private goods are much less likely to encounter a free-rider problem than public goods. Thus, generally, the market will efficiently allocate resources to produce private goods.
In daily life, examples of private goods abound, including food, clothing, and most other goods that can be purchased in a store. Take an example of an ice cream cone. It is both excludable and rivalrous. It is possible to prevent someone from consuming the ice cream by simply refusing to sell it to them. Additionally, it can be consumed only once, so its consumption by one individual would definitely reduce others’ ability to consume it.
Ice Cream Cone: An ice cream cone is an example of a private good. It is excludable and rival.
Public Goods
Individuals cannot be excluded from using a public good, and one individual’s use of it does not limit its availability to others.
Learning Objectives
• Define a public good
A public good is a good that is both non-excludable and non-rivalrous. This means that individuals cannot be effectively excluded from its use, and use by one individual does not reduce its availability to others. Examples of public goods include fresh air, knowledge, lighthouses, national defense, flood control systems, and street lighting.
Streetlight: A streetlight is an example of a public good. It is non-excludable and non-rival in consumption
Public goods can be pure or impure. Pure public goods are those that are perfectly non-rivalrous in consumption and non-excludable. Impure public goods are those that satisfy the two conditions to some extent, but not fully.
The production of public goods results in positive externalities for which producers don’t receive full payment. Consumers can take advantage of public goods without paying for them. This is called the “free-rider problem. ” If too many consumers decide to “free-ride,” private costs to producers will exceed private benefits, and the incentive to provide the good or service through the market will disappear. The market will thus fail to provide enough of the good or service for which there is a need.
For example, a local public radio station relies on support from listeners to operate. The station holds pledge drives several times a year, asking listeners to make contributions or face possible reduction in programming. Yet only a small percentage of the audience makes contributions. Some audience members may even listen to the station for years without ever making a payment. Those listeners who do not make a contribution are “free-riders. ” If the station relies solely on funds contributed by listeners, it would under-produce programming. It must obtain additional funding from other sources (such as the government) in order to continue to operate.
Optimal Quantity of a Public Good
The government is providing an efficient quantity of a public good when its marginal benefit equals its marginal cost.
Learning Objectives
• Explain the optimal quantity of a public good
To determine the optimal quantity of a public good, it is necessary to first determine the demand for it. Demand for public goods is represented through price-quantity schedules, which show the price someone is willing to pay for the extra unit of each possible quantity. Unlike the market demand curve for private goods, where individual demand curves are summed horizontally, individual demand curves for public goods are summed vertically to get the market demand curve. As a result, the market demand curve for public goods gives the price society is willing to pay for a given quantity. It is equal to the marginal benefit curve. Due to the law of diminishing marginal utility, the demand curve is downward sloping.
Often, the government supplies the public good. The supply curve for a public good is equal to its marginal cost curve. Because of the law of diminishing returns, the marginal cost increases as the quantity of the good produced increases. The supply curve therefore has an upward slope.
As already noted, the demand curve is equal to the marginal benefit curve, while the supply curve is equal to the marginal cost curve. The optimal quantity of the public good occurs where MB (society’s marginal benefit) equals MC (provider’s marginal cost), or where the two curves intersect. When MB = MC, resources have been allocated efficiently.
Optimal Quantity of a Public Good: The optimal quantity of public good occurs where MB = MC.
The public good provider uses cost-benefit analysis to decide whether to provide a particular good by comparing marginal costs and marginal benefits. Cost-benefit analysis can also help the provider decide the extent to which a project should be pursued. Output activity should be increased as long as the marginal benefit exceeds the marginal cost. An activity should not be pursued when the marginal benefit is less than the marginal cost. An activity should be stopped at the point where MB equals MC. This is the MC=MB rule, by which the provider of the public good can determine which plan, will give society maximum net benefit.
Demand for Public Goods
The aggregate demand curve for a public good is the vertical summation of individual demand curves.
Learning Objectives
• Analyze the demand for a public good.
The aggregate demand for a public good is derived differently from the aggregate demand for private goods.
To an individual consumer, the total benefit of a public good is the dollar value that he or she places on a given level of provision of the good. The marginal benefit for an individual is the increase in the total benefit that results from a one-unit increase in the quantity provided. The marginal benefit of a public good diminishes as the level of the good provided increases.
Public goods are non-rivalrous, so everyone can consume each unit of a public good. They also have a fixed market quantity: everyone in society must agree on consuming the same amount of the good. However, each individual’s willingness to pay for the quantity provided may be different. The individual demand curves show the price someone is willing to pay for an extra unit of each possible quantity of the public good.
The aggregate demand for a public good is the sum of marginal benefits to each person at each quantity of the good provided. The economy’s marginal benefit curve (demand curve) for a public good is thus the vertical sum all individual’s marginal benefit curves. The vertical summation of individual demand curves for public goods also gives the aggregate willingness to pay for a given quantity of the good.
Demand for a Public Good: The sum of the individual marginal benefit curves (MB) represent the aggregate willingness to pay or aggregate demand (∑MB). The intersection of the aggregate demand and the marginal cost curve (MC) determines the amount of the good provided.
This is in contrast to the aggregate demand curve for a private good, which is the horizontal sum of the individual demand curves at each price. Unlike public goods, society does not have to agree on a given quantity of a private good, and any one person can consume more of the private good than another at a given price.
The efficient quantity of a public good is the quantity that maximizes net benefit (total benefit minus total cost), which is the same as the quantity at which marginal benefit equals marginal cost.
Cost-Benefit Analysis
The government uses cost-benefit analysis to decide whether to provide a public good.
Learning Objectives
• Explain how to determine the net cost/benefit of providing a public good
The government uses cost-benefit analysis to decide whether to provide a particular public good and how much of it to provide. Cost-benefit analysis, which is also sometimes called benefit-cost analysis, is a systematic process for calculating the benefits and costs of a project to society as a whole.
The positive and negative effects captured by cost-benefit analysis may include effects on consumers, effects on non-consumers, externality effects, or other social benefits or costs. The guiding principle is to list all parties affected by a project and add a negative or positive value that they ascribe to the project’s effect on their welfare. Benefits and costs are expressed in monetary terms, and are adjusted for the time value of money, so that all flows of benefits and costs over time are expressed on a common basis in terms of their net present value. Financial costs tend to be most thoroughly represented in cost-benefit analyses due to relatively abundant market data. It is much more difficult to capture non-financial welfare impacts. For example, it is very difficult to place a dollar value on human life, consumers’ time, or environmental impact.
Imagine that the government is considering a project to widen a highway. The benefits side of the analysis might include time savings for passengers who can now avoid traffic, an increase in the number of passenger trips (as more people could now use the road), and lives saved by dint of fewer car accidents. The cost side of the analysis would include the cost of land that must be acquired prior to construction, construction, and maintenance. These costs and benefits will need to be translated into monetary terms for the sake of analysis.
The Highway as a Public Good: The benefits of a highway expansion project might include time savings for passengers, additional passenger trips, and saved lives. Costs might include construction and maintenance.
The procedure for conducting cost-benefit analysis is as follows:
1. Identify project(s) to be analyzed.
2. Estimate all costs and benefits to society associated with the project(s) over a relevant time horizon.
3. Assign a monetary value to all costs and benefits.
4. Calculate the net benefit of the project (total benefit minus total cost).
5. Adjust for inflation and apply the discount rate to calculate present value of the project.
6. Calculate the net present value for the project(s).
7. Make recommendation about project(s). If the benefit outweighs the cost, then the government should proceed with the project.
Key Points
• Private goods are excludable and rival. Examples of private goods include food and clothes.
• Common goods are non-excludable and rival. A classic example is fish stocks in international waters.
• Club goods are excludable but non-rival. Cable television is an example.
• Public goods are non-excludable and non-rival. They include public parks and the air we breathe.
• The owners or sellers of private goods exercise private property rights over them.
• A consumer generally has to pay for a private good.
• Generally, the market will efficiently allocate resources for the production of private goods.
• A public good is both non-excludable and non-rivalrous.
• Pure public goods are perfectly non-rival in consumption and non-excludable. Impure public goods satisfy those conditions to some extent, but not perfectly.
• Public goods provide an example of market failure. Because of the free-rider problem, they may be underpoduced.
• Collective demand for a public good is the vertical summation of individual demand curves. It shows the price society is willing to pay for a given quantity of a public good.
• The demand curve for a public good is downward sloping, due to the law of diminishing marginal utility. The supply curve is upward sloping, due to the law of diminishing returns.
• The optimal quantity of a public good occurs where the demand ( marginal benefit ) curve intersects the supply ( marginal cost ) curve.
• The government uses cost-benefit analysis to decide whether to provide a particular good. If MB is greater than MC there is an underallocation of a public good. If MC is greater than MB there is an overallocation of a public good. When MC = MB then there is an optimal allocation of public goods.
• For public goods, aggregate demand is the sum of marginal benefits to each person at each quantity of the good provided.
• As for private goods, the individual demand curves show the price someone is willing to pay for an extra unit of each possible quantity of a good.
• The efficient quantity of a public good is the quantity at which marginal benefit equals marginal cost.
• Cost -benefit analysis is a systematic way of calculating the costs and benefits of a project to society as a whole.
• Benefits and costs are expressed in monetary terms and are adjusted for the time-value of money.
• Financial costs are much easier to capture in the analysis than non-financial welfare impacts, such as impacts on human life or the environment.
• The government should provide a public good if the benefits to society outweigh the costs.
Key Terms
• Rival: A good whose consumption by one consumer prevents simultaneous consumption by other consumers
• Excludable: A good for which it is possible to prevent consumers who have not paid for it from having access to it.
• Rivalrous: A good whose consumption by one consumer prevents simultaneous consumption by other consumers.
• free rider: Someone who enjoys the benefits of a good without paying for it
• Non-excludable: Non-paying consumers cannot be prevented from accessing a good
• Non-rivalrous: A good whose consumption by one consumer does not prevent simultaneous consumption by other consumers
• Cost-benefit analysis: A systematic process for calculating and comparing the marginal benefits and marginal costs of a project or activity.
• public good: A good that is non-rivalrous and non-excludable.
• net present value: The present value of a project determined by summing the discounted incoming and outgoing future cash flows resulting from the decision.
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The Tragedy of the Commons
The tragedy of the commons is the overexploitation of a common good by individual, rational actors.
learning Objectives
• Describe the tragedy of the commons
Common Goods
Common goods are goods that are rivalrous and non-excludable. This means that anyone has access to the good, but that the use of the good by one person reduces the ability of someone else to use it. A classic example of a common good are fish stocks in international waters; no one is excluded from fishing, but as people withdraw fish without limits being imposed, the stocks for later fishermen are potentially depleted.
Tragedy of Commons
The tragedy of the commons is the depletion of a common good by individuals who are acting independently and rationally according to each one’s self-interest. Consider, the example of fish in international waters. Each individual fisherman, acting independently, will rationally choose to catch some of the fish to sell. This makes sense: there is a resource that the fisherman is able to use to generate a profit. However, when a lot of fishermen, all thinking this way, catch the fish, the total stock of fish may be depleted. When the stock of fish is depleted, none of the fishermen are able to continue fishing, even though, in the long run, each fisherman would have preferred that the fish not be depleted. The tragedy of the commons describes such situations in which people withdraw resources to secure short-term gains without regard for the long-term consequences.
Not all common goods, however, suffer from the tragedy of the commons. If individuals have enlightened self-interest, they will realize the negative long-term effects of their short-term decisions. This would be the same as the fishermen realizing that they should limit their fishing to preserve the stock of fish in the long-term.
In the absence of enlightened self-interest, the government may step in and impose regulations or taxes to discourage the behavior that leads to the tragedy of the commons. This would be like the government imposing limits on the amount of fish that can be caught.
Bluefin Tuna Caught in Net: Fish populations are at risk of becoming fully extinct due to overfishing. The Food and Agriculture Association estimated 70% of the world’s fish species are either fully exploited or depleted.
The Free-Rider Problem
The free-rider problem is when individuals benefit from a public good without paying their share of the cost.
learning objectives
• Describe the Free-Rider Problem
It is easy to think about public goods as free. In your everyday life, you benefit from public goods such as roads and bridges even though no transaction occurs when you use them. However, even public goods need to be paid for. In the case of roads and bridges, everyone pays taxes to the government, who then uses the taxes to pay for public goods.
Roads: Free riders are able to use roads without paying their taxes because roads are a non-excludable public good.
Public goods, as you may recall, are both non-rivalrous and non-excludable. It is the second trait- the non-excludability- that leads to what is called the free-rider problem. The free-rider problem is that some people may benefit from a public good without paying their share of the cost.
Since public goods are non-excludable, free-riders not only can’t be prevented from using the good, but actually have an incentive to continue to free-ride. If they will be able to use the public good whether they pay their share of the costs, they might as well not pay.
Take the military, for example. National security is a public good: it is both non-rivalrous and non-excludable. In order to have such a public good, everyone pays taxes which are then used by the government to finance the military. However, there are undoubtedly people who have not paid their taxes. These people, without having paid their share of the cost of having a military, still benefit from the protection the military provides. They are free-riders.
Of course, there are commonly regulations that attempt to discourage free-riding. For government-provided public goods, the government makes sure that everyone pays their share of the costs by enforcing tax laws. The threat of fines or jail time are enough of a threat that most people find it more appealing (in the US, at least) to pay their share of public goods via taxes than to free-ride.
Key Points
• Common goods are non-excludable and rivalrous.
• When individuals act independently and rationally, they may collectively trade long-term benefit for short-term gain.
• Enlightened self-interest and government intervention are two ways that the tragedy of the commons may be avoided.
• Public goods are non-excludable, but have a cost, so those who don’t pay their share of the cost can still easily benefit from the good.
• Free-riders have an incentive to free ride because they can benefit from a good at a reduced personal cost.
• The providers of public goods often create enforcement mechanisms to mitigate the free-rider problem.
Key Terms
• Common good: Goods which are rivalrous and non-excludable.
• Enlightened Self-Interest: The ability for individuals to realize when their actions, collectively, will trade long-term benefit for short-term gain.
• public good: A good that is non-rivalrous and non-excludable.
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Defining the Production Function
The production function relates the maximum amount of output that can be obtained from a given number of inputs.
learning objectives
• Define the production function
In economics, a production function relates physical output of a production process to physical inputs or factors of production. It is a mathematical function that relates the maximum amount of output that can be obtained from a given number of inputs – generally capital and labor. The production function, therefore, describes a boundary or frontier representing the limit of output obtainable from each feasible combination of inputs.
Firms use the production function to determine how much output they should produce given the price of a good, and what combination of inputs they should use to produce given the price of capital and labor. When firms are deciding how much to produce they typically find that at high levels of production, their marginal costs begin increasing. This is also known as diminishing returns to scale – increasing the quantity of inputs creates a less-than-proportional increase in the quantity of output. If it weren’t for diminishing returns to scale, supply could expand without limits without increasing the price of a good.
Factory Production: Manufacturing companies use their production function to determine the optimal combination of labor and capital to produce a certain amount of output.
Increasing marginal costs can be identified using the production function. If a firm has a production function \(Q=F(K,L)\) (that is, the quantity of output (Q) is some function of capital (K) and labor (L)), then if \(2Q<F(2K,2L)\), the production function has increasing marginal costs and diminishing returns to scale. Similarly, if \(2Q>F(2K,2L)\), there are increasing returns to scale, and if \(2Q=F(2K,2L)\), there are constant returns to scale.
Examples of Common Production Functions
One very simple example of a production function might be \(Q=K+L\), where Q is the quantity of output, K is the amount of capital, and L is the amount of labor used in production. This production function says that a firm can produce one unit of output for every unit of capital or labor it employs. From this production function we can see that this industry has constant returns to scale – that is, the amount of output will increase proportionally to any increase in the amount of inputs.
Another common production function is the Cobb-Douglas production function. One example of this type of function is \(Q=K^{0.5}L^{0.5}\). This describes a firm that requires the least total number of inputs when the combination of inputs is relatively equal. For example, the firm could produce 25 units of output by using 25 units of capital and 25 of labor, or it could produce the same 25 units of output with 125 units of labor and only one unit of capital.
Finally, the Leontief production function applies to situations in which inputs must be used in fixed proportions; starting from those proportions, if usage of one input is increased without another being increased, output will not change. This production function is given by \(Q=Min(K,L)\). For example, a firm with five employees will produce five units of output as long as it has at least five units of capital.
The Law of Diminishing Returns
The law of diminishing returns states that adding more of one factor of production will at some point yield lower per-unit returns.
Learning Objectives
• Explain the Law of Diminishing Returns
In economics, diminishing returns (also called diminishing marginal returns) is the decrease in the marginal output of a production process as the amount of a single factor of production is increased, while the amounts of all other factors of production stay constant. The law of diminishing returns states that in all productive processes, adding more of one factor of production, while holding all others constant (“ceteris paribus”), will at some point yield lower per-unit returns. The law of diminishing returns does not imply that adding more of a factor will decrease the total production, a condition known as negative returns, though in fact this is common.
Diminishing Returns: As a factor of production (F) increases, the resulting gain in the volume of output (V) gets smaller and smaller.
For example, the use of fertilizer improves crop production on farms and in gardens; but at some point, adding more and more fertilizer improves the yield less per unit of fertilizer, and excessive quantities can even reduce the yield. A common sort of example is adding more workers to a job, such as assembling a car on a factory floor. At some point, adding more workers causes problems such as workers getting in each other’s way or frequently finding themselves waiting for access to a part. In all of these processes, producing one more unit of output will eventually cost increasingly more, due to inputs being used less and less effectively.
This increase in the marginal cost of output as production increases can be graphed as the marginal cost curve, with quantity of output on the x axis and marginal cost on the y axis. For many firms, the marginal cost curve will initially be downward sloping, representing added efficiency as production increases. If the law of diminishing returns holds, however, the marginal cost curve will eventually slope upward and continue to rise, representing the higher and higher marginal costs associated with additional output.
The Law of Diminishing Returns and Average Cost
The average total cost of production is the total cost of producing all output divided by the number of units produced. For example, if the car factory can produce 20 cars at a total cost of \$200,000, the average cost of production is \$10,000. Average total cost is interpreted as the the cost of a typical unit of production. So in our example each of the 20 cars produced had a typical cost per unit of \$10,000. Average total cost can also be graphed with quantity of output on the x axis and average cost on the y-axis.
What will this average total cost curve look like? In the short run, a firm has a set amount of capital and can only increase or decrease production by hiring more or less labor. The fixed costs of capital are high, but the variable costs of labor are low, so costs increase more slowly than output as production increases. As long as the marginal cost of production is lower than the average total cost of production, the average cost is decreasing. However, as marginal costs increase due to the law of diminishing returns, the marginal cost of production will eventually be higher than the average total cost and the average cost will begin to increase. The short run average total cost curve (SRAC) will therefore be U-shaped for most firms.
Cost Curves in the Short Run: Both marginal cost and average cost are U-shaped due to first increasing, and then diminishing, returns. Average cost begins to increase where it intersects the marginal cost curve.
The long-run average cost curve (LRAC) depicts the cost per unit of output in the long run—that is, when all productive inputs’ usage levels can be varied. The typical LRAC curve is also U-shaped but for different reasons: it reflects increasing returns to scale where negatively-sloped, constant returns to scale where horizontal, and decreasing returns (due to increases in factor prices) where positively sloped.
Inputs and Outputs of the Function
In the basic production function, inputs are typically capital and labor and output is whatever good the firm produces.
Learning Objectives
• Describe the inputs and outputs in a generalized production function
A production function relates the input of factors of production to the output of goods. In the basic production function inputs are typically capital and labor, though more expansive and complex production functions may include other variables such as land or natural resources. Output may be any consumer good produced by a firm. Cars, clothing, sandwiches, and toys are all examples of output.
Capital refers to the material objects necessary for production. Machinery, factory space, and tools are all types of capital. In the short run, economists assume that the level of capital is fixed – firms can’t sell machinery the moment it’s no longer needed, nor can they build a new factory and start producing goods there immediately. When looking at the production function in the short run, therefore, capital will be a constant rather than a variable. Although in reality a firm may own the capital that it uses, economists typically refer to the ongoing cost of employing capital as the rental rate because the opportunity cost of employing capital is the income that a firm could receive by renting it out. Thus, the price of capital is the rental rate.
Capital Goods: Capital equipment, like these motor graders, can vary in the long run but are fixed in the short run.
Labor refers to the human work that goes into production. Typically economists assume that labor is a variable factor of production; it can be increased or decreased in the short run in order to produce more or less output. The price of labor is the prevailing wage rate, since wages are the cost of hiring an additional unit of capital.
The marginal product of an input is the amount of output that is gained by using one additional unit of that input. It can be found by taking the derivative of the production function in terms of the relevant input. For example, if the production function is Q=3K+2L (where K represents units of capital and L represents units of labor), then the marginal product of capital is simply three; every additional unit of capital will produce an additional three units of output. Inputs are typically subject to the law of diminishing returns: as the amount of one factor of production increases, after a certain point the marginal product of that factor declines.
Key Points
• The production function describes a boundary or frontier representing the limit of output obtainable from each feasible combination of inputs.
• Firms use the production function to determine how much output they should produce given the price of a good, and what combination of inputs they should use to produce given the price of capital and labor.
• The production function also gives information about increasing or decreasing returns to scale and the marginal products of labor and capital.
• One consequence of the law of diminishing returns is that producing one more unit of output will eventually cost increasingly more, due to inputs being used less and less effectively.
• The marginal cost curve will initially be downward sloping, representing added efficiency as production increases. If the law of diminishing returns holds, however, the marginal cost curve will eventually slope upward and continue to rise.
• The SRAC is typically U-shaped with its minimum at the point where it intersect the marginal cost curve. This is caused by the first increasing, and then decreasing, marginal returns to labor.
• The typical LRAC curve is also U-shaped, reflecting increasing returns of scale where negatively-sloped, constant returns to scale where horizontal and decreasing returns where positively sloped.
• Capital refers to the material objects necessary for production. In the short run, economists assume that the level of capital is fixed.
• Labor refers to the human work that goes into production. Typically economists assume that labor is a variable factor of production.
• The marginal product of an input is the amount of output that is gained by using one additional unit of that input. It can be found by taking the derivative of the production function in terms of the relevant input.
Key Terms
• Production function: Relates physical output of a production process to physical inputs or factors of production.
• marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.
• output: Production; quantity produced, created, or completed.
• returns to scale: A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).
• rental rate: The price of capital.
• marginal product: The extra output that can be produced by using one more unit of the input.
• capital: Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).
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Types of Costs
Variable costs change according to the quantity of goods produced; fixed costs are independent of the quantity of goods being produced.
Learning Objectives
• Differentiate fixed costs and variable costs
Total Cost
In economics, the total cost (TC) is the total economic cost of production. It consists of variable costs and fixed costs. Total cost is the total opportunity cost of each factor of production as part of its fixed or variable costs.
Calculating total cost: This graphs shows the relationship between fixed cost and variable cost. The sum of the two equal the total cost.
Variable Costs
Variable cost (VC) changes according to the quantity of a good or service being produced. It includes inputs like labor and raw materials. Variable costs are also the sum of marginal costs over all of the units produced (referred to as normal costs). For example, in the case of a clothing manufacturer, the variable costs would be the cost of the direct material (cloth) and the direct labor. The amount of materials and labor that is needed for each shirt increases in direct proportion to the number of shirts produced. The cost “varies” according to production.
Fixed Costs
Fixed costs (FC) are incurred independent of the quality of goods or services produced. They include inputs (capital) that cannot be adjusted in the short term, such as buildings and machinery. Fixed costs (also referred to as overhead costs) tend to be time related costs, including salaries or monthly rental fees. An example of a fixed cost would be the cost of renting a warehouse for a specific lease period. However, fixed costs are not permanent. They are only fixed in relation to the quantity of production for a certain time period. In the long run, the cost of all inputs is variable.
Economic Cost
The economic cost of a decision that a firm makes depends on the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost is the sum of all the variable and fixed costs (also called accounting cost) plus opportunity costs.
Average and Marginal Cost
Marginal cost is the change in total cost when another unit is produced; average cost is the total cost divided by the number of goods produced.
Learning Objectives
• Distinguish between marginal and average costs
Marginal Cost
In economics, marginal cost is the change in the total cost when the quantity produced changes by one unit. It is the cost of producing one more unit of a good. Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced. Economic factors that impact the marginal cost include information asymmetries, positive and negative externalities, transaction costs, and price discrimination. Marginal cost is not related to fixed costs. An example of calculating marginal cost is: the production of one pair of shoes is \$30. The total cost for making two pairs of shoes is \$40. The marginal cost of producing the second pair of shoes is \$10.
Average Cost
The average cost is the total cost divided by the number of goods produced. It is also equal to the sum of average variable costs and average fixed costs. Average cost can be influenced by the time period for production (increasing production may be expensive or impossible in the short run). Average costs are the driving factor of supply and demand within a market. Economists analyze both short run and long run average cost. Short run average costs vary in relation to the quantity of goods being produced. Long run average cost includes the variation of quantities used for all inputs necessary for production.
Relationship Between Average and Marginal Cost
Average cost and marginal cost impact one another as production fluctuate:
Cost curve: This graph is a cost curve that shows the average total cost, marginal cost, and marginal revenue. The curves show how each cost changes with an increase in product price and quantity produced.
• When the average cost declines, the marginal cost is less than the average cost.
• When the average cost increases, the marginal cost is greater than the average cost.
• When the average cost stays the same (is at a minimum or maximum), the marginal cost equals the average cost.
Short Run and Long Run Costs
Long run costs have no fixed factors of production, while short run costs have fixed factors and variables that impact production.
learning objectives
• Explain the differences between short and long run costs
In economics, “short run” and “long run” are not broadly defined as a rest of time. Rather, they are unique to each firm.
Long Run Costs
Long run costs are accumulated when firms change production levels over time in response to expected economic profits or losses. In the long run there are no fixed factors of production. The land, labor, capital goods, and entrepreneurship all vary to reach the the long run cost of producing a good or service. The long run is a planning and implementation stage for producers. They analyze the current and projected state of the market in order to make production decisions. Efficient long run costs are sustained when the combination of outputs that a firm produces results in the desired quantity of the goods at the lowest possible cost. Examples of long run decisions that impact a firm’s costs include changing the quantity of production, decreasing or expanding a company, and entering or leaving a market.
Short Run Costs
Short run costs are accumulated in real time throughout the production process. Fixed costs have no impact of short run costs, only variable costs and revenues affect the short run production. Variable costs change with the output. Examples of variable costs include employee wages and costs of raw materials. The short run costs increase or decrease based on variable cost as well as the rate of production. If a firm manages its short run costs well over time, it will be more likely to succeed in reaching the desired long run costs and goals.
Differences
The main difference between long run and short run costs is that there are no fixed factors in the long run; there are both fixed and variable factors in the short run. In the long run the general price level, contractual wages, and expectations adjust fully to the state of the economy. In the short run these variables do not always adjust due to the condensed time period. In order to be successful a firm must set realistic long run cost expectations. How the short run costs are handled determines whether the firm will meet its future production and financial goals.
Cost curve: This graph shows the relationship between long run and short run costs.
Economies and Diseconomies of Scale
Increasing, constant, and diminishing returns to scale describe how quickly output rises as inputs increase.
learning objectives
• Identify the three types of returns to scale and describe how they occur
In economics, returns to scale describes what happens when the scale of production increases over the long run when all input levels are variable (chosen by the firm). Returns to scale explains how the rate of increase in production is related to the increase in inputs in the long run. There are three stages in the returns to scale: increasing returns to scale (IRS), constant returns to scale (CRS), and diminishing returns to scale (DRS). Returns to scale vary between industries, but typically a firm will have increasing returns to scale at low levels of production, decreasing returns to scale at high levels of production, and constant returns to scale at some point in the middle.
Long Run ATC Curves: This graph shows that as the output (production) increases, long run average total cost curve decreases in economies of scale, constant in constant returns to scale, and increases in diseconomies of scale.
Increasing Returns to Scale
The first stage, increasing returns to scale (IRS) refers to a production process where an increase in the number of units produced causes a decrease in the average cost of each unit. In other words, a firm is experiencing IRS when the cost of producing an additional unit of output decreases as the volume of its production increases. IRS may take place, for example, if the cost of production of a manufactured good would decrease with the increase in quantity produced due to the production materials being obtained at a cheaper price.
Constant Return to Scale
The second stage, constant returns to scale (CRS) refers to a production process where an increase in the number of units produced causes no change in the average cost of each unit. If output changes proportionally with all the inputs, then there are constant returns to scale.
Diminishing Return to Scale
The final stage, diminishing returns to scale (DRS) refers to production for which the average costs of output increase as the level of production increases. The DRS is the opposite of the IRS. DRS might occur if, for example, a furniture company was forced to import wood from further and further away as its operations increased.
Economic Costs
The economic cost is based on the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen.
learning objectives
• Break down the components of a firm’s economic costs
Economic Cost
Throughout the production of a good or service, a firm must make decisions based on economic cost. The economic cost of a decision is based on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost includes opportunity cost when analyzing economic decisions.
An example of economic cost would be the cost of attending college. The accounting cost includes all charges such as tuition, books, food, housing, and other expenditures. The opportunity cost includes the salary or wage the individual could be earning if he was employed during his college years instead of being in school. So, the economic cost of college is the accounting cost plus the opportunity cost.
Components of Economic Costs
Economic cost takes into account costs attributed to the alternative chosen and costs specific to the forgone opportunity. Before making economic decisions, there are a series of components of economic costs that a firm will take into consideration. These components include:
• Total cost (TC): total cost equals total fixed cost plus total variable costs (TC = TFC + TVC).
• Variable cost (VC): the cost paid to the variable input. Inputs include labor, capital, materials, power, land, and buildings. Variable input is traditionally assumed to be labor.
• Total variable cost (TVC): same as variable costs.
• Fixed cost (FC): the costs of the fixed assets (those that do not vary with production).
• Total fixed cost (TFC): same as fixed cost.
• Average cost (AC): total costs divided by output (AC = TFC/q + TVC/q).
• Average fixed cost (AFC): the fixed costs divided by output (AFC = TFC/q). The average fixed cost function continuously declines as production increases.
• Average variable cost (AVC): variable costs divided by output (AVC = TVC/q). The average variable cost curve is normally U-shaped. It lies below the average cost curve, starting to the right of the y axis.
• Marginal cost (MC): the change in the total cost when the quantity produced changes by one unit.
• Cost curves: a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use the curves to decide output quantities to achieve production goals.
Key Points
• Total cost is the sum of fixed and variable costs.
• Variable costs change according to the quantity of a good or service being produced. The amount of materials and labor that is needed for to make a good increases in direct proportion to the number of goods produced. The cost “varies” according to production.
• Fixed costs are independent of the quality of goods or services produced. Fixed costs (also referred to as overhead costs) tend to be time related costs including salaries or monthly rental fees.
• Fixed costs are only short term and do change over time. The long run is sufficient time of all short-run inputs that are fixed to become variable.
• The marginal cost is the cost of producing one more unit of a good.
• Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost.
• Economists analyze both short run and long run average cost. Short run average costs vary in relation to the quantity of goods being produced. Long run average cost includes the variation of quantities used for all inputs necessary for production.
• When the average cost declines, the marginal cost is less than the average cost. When the average cost increases, the marginal cost is greater than the average cost. When the average cost stays the same (is at a minimum or maximum), the marginal cost equals the average cost.
• In the short run, there are both fixed and variable costs.
• In the long run, there are no fixed costs.
• Efficient long run costs are sustained when the combination of outputs that a firm produces results in the desired quantity of the goods at the lowest possible cost.
• Variable costs change with the output. Examples of variable costs include employee wages and costs of raw materials.
• The short run costs increase or decrease based on variable cost as well as the rate of production. If a firm manages its short run costs well over time, it will be more likely to succeed in reaching the desired long run costs and goals.
• In economics, returns to scale describes what happens when the scale of production increases over the long run when all input levels are variable (chosen by the firm ).
• Increasing returns to scale (IRS) refers to a production process where an increase in the number of units produced causes a decrease in the average cost of each unit.
• Constant returns to scale (CRS) refers to a production process where an increase in the number of units produced causes no change in the average cost of each unit.
• Diminishing returns to scale (DRS) refers to production where the costs for production do not decrease as a result of increased production. The DRS is the opposite of the IRS.
• Economic cost takes into account costs attributed to the alternative chosen and costs specific to the forgone opportunity.
• Components of economic cost include total cost, variable cost, fixed cost, average cost, and marginal cost.
• Cost curves – a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use the curves to decide output quantities to achieve production goals.
• Average cost (AC) – total costs divided by output (AC = TFC/q + TVC/q).
• Marginal cost (MC) – the change in the total cost when the quantity produced changes by one unit.
• Cost curves – a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use the curves to decide output quantities to achieve production goals.
Key Terms
• fixed cost: Business expenses that are not dependent on the level of goods or services produced by the business.
• variable cost: A cost that changes with the change in volume of activity of an organization.
• marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.
• average cost: In economics, average cost or unit cost is equal to total cost divided by the number of goods produced.
• return to scale: A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).
• economic cost: The accounting cost plus opportunity cost.
• cost: A negative consequence or loss that occurs or is required to occur.
• Opportunity cost: The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).
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Difference Between Economic and Accounting Profit
Economic profit consists of revenue minus implicit (opportunity) and explicit (monetary) costs; accounting profit consists of revenue minus explicit costs.
LEARNING OBJECTIVES
• Distinguish between economic profit and accounting profit
The term “profit” may bring images of money to mind, but to economists, profit encompasses more than just cash. In general, profit is the difference between costs and revenue, but there is a difference between accounting profit and economic profit. The biggest difference between accounting and economic profit is that economic profit reflects explicit and implicit costs, while accounting profit considers only explicit costs.
Explicit and Implicit Costs
Explicit costs are costs that involve direct monetary payment. Wages paid to workers, rent paid to a landowner, and material costs paid to a supplier are all examples of explicit costs.
In contrast, implicit costs are the opportunity costs of factors of production that a producer already owns. The implicit cost is what the firm must give up in order to use its resources; in other words, an implicit cost is any cost that results from using an asset instead of renting, selling, or lending it. For example, a paper production firm may own a grove of trees. The implicit cost of that natural resource is the potential market price the firm could receive if it sold it as lumber instead of using it for paper production.
Accounting Profit
Accounting profit is the difference between total monetary revenue and total monetary costs, and is computed by using generally accepted accounting principles (GAAP). Put another way, accounting profit is the same as bookkeeping costs and consists of credits and debits on a firm’s balance sheet. These consist of the explicit costs a firm has to maintain production (for example, wages, rent, and material costs). The monetary revenue is what a firm receives after selling its product in the market.
Accounting profit is also limited in its time scope; generally, accounting profit only considers the costs and revenue of a single period of time, such as a fiscal quarter or year.
Economic Profit
Economic profit is the difference between total monetary revenue and total costs, but total costs include both explicit and implicit costs. Economic profit includes the opportunity costs associated with production and is therefore lower than accounting profit. Economic profit also accounts for a longer span of time than accounting profit. Economists often consider long-term economic profit to decide if a firm should enter or exit a market.
Economic vs. Accounting Profit: The biggest difference between economic and accounting profit is that economic profit takes implicit, or opportunity, costs into consideration.
Sources and Determinants of Profit
Whether economic profit exists or not depends how competitive the market is, and the time horizon that is being considered.
LEARNING OBJECTIVES
• Describe sources of economic profit
Economic profit is total revenue minus explicit and implicit (opportunity) costs. In contrast, accounting profit is the difference between total revenue and explicit costs- it does not take opportunity costs into consideration, and is generally higher than economic profit.
Economic profits may be positive, zero, or negative. If economic profit is positive, other firms have an incentive to enter the market. If profit is zero, other firms have no incentive to enter or exit. When economic profit is zero, a firm is earning the same as it would if its resources were employed in the next best alternative. If the economic profit is negative, firms have the incentive to leave the market because their resources would be more profitable elsewhere. The amount of economic profit a firm earns is largely dependent on the degree of market competition and the time span under consideration.
Competitive Markets
In competitive markets, where there are many firms and no single firm can affect the price of a good or service, economic profit can differ in the short-run and in the long-run.
In the short run, a firm can make an economic profit. However, if there is economic profit, other firms will want to enter the market. If the market has no barriers to entry, new firms will enter, increase the supply of the commodity, and decrease the price. This decrease in price leads to a decrease in the firm’s revenue, so in the long-run, economic profit is zero. An economic profit of zero is also known as a normal profit. Despite earning an economic profit of zero, the firm may still be earning a positive accounting profit.
Long-Run Profit for Perfect Competition: In the long run for a firm in a competitive market, there is zero economic profit. Graphically, this is seen at the intersection of the price level with the minimum point of the average total cost (ATC) curve. If the price level were set above ATC’s minimum point, there would be positive economic profit; if the price level were set below ATC’s minimum, there would be negative economic profit.
Uncompetitive Markets
Unlike competitive markets, uncompetitive markets – characterized by firms with market power or barriers to entry – can make positive economic profits. The reasons for the positive economic profit are barriers to entry, market power, and a lack of competition.
• Barriers to entry prevent new firms from easily entering the market, and sapping short-run economic profits.
• Market power, or the ability to affect market prices, allows firms to set a price that is higher than the equilibrium price of a competitive market. This allows them to make profits in the short run and in the long run. This situation can occur if the market is dominated by a monopoly (a single firm), oligopoly (a few firms with significant market control), or monopolistic competition (firms have market power due to having differentiated products).
• Lack of competition keeps prices higher than the competitive market equilibrium price. For example, firms can collude and work together to restrict supply to artificially keep prices high.
Long-Run Profit for Monopoly: In the long run, a monopoly, because of its market power, can set a price above the competitive equilibrium and earn economic profit. If price were set equal to the minimum point of the average total cost (ATC) curve, the monopoly would earn zero economic profit. If the price were set lower than the minimum of ATC, the firm would earn negative economic profit.
Key Points
• Explicit costs are monetary costs a firm has. Implicit costs are the opportunity costs of a firm’s resources.
• Accounting profit is the monetary costs a firm pays out and the revenue a firm receives. It is the bookkeeping profit, and it is higher than economic profit. Accounting profit = total monetary revenue- total costs.
• Economic profit is the monetary costs and opportunity costs a firm pays and the revenue a firm receives. Economic profit = total revenue – (explicit costs + implicit costs).
• Economic profit = total revenue – ( explicit costs + implicit costs). Accounting profit = total revenue – explicit costs.
• Economic profit can be positive, negative, or zero. If economic profit is positive, there is incentive for firms to enter the market. If profit is negative, there is incentive for firms to exit the market. If profit is zero, there is no incentive to enter or exit.
• For a competitive market, economic profit can be positive in the short run. In the long run, economic profit must be zero, which is also known as normal profit. Economic profit is zero in the long run because of the entry of new firms, which drives down the market price.
• For an uncompetitive market, economic profit can be positive. Uncompetitive markets can earn positive profits due to barriers to entry, market power of the firms, and a general lack of competition.
Key Terms
• explicit cost: A direct payment made to others in the course of running a business, such as wages, rent, and materials, as opposed to implicit costs, which are those where no actual payment is made.
• implicit cost: The opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor hires.
• economic profit: The difference between the total revenue received by the firm from its sales and the total opportunity costs of all the resources used by the firm.
• accounting profit: The total revenue minus costs, properly chargeable against goods sold.
• normal profit: The opportunity cost of an entrepreneur to operate a firm; the next best amount the entrepreneur could earn doing another job.
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learning objective
1. What kinds of problems do we study in microeconomics?
You watch another customer go to the counter and place an order. She purchases some fried chicken, an order of fries, and a Coca-Cola. The cost is €10. She hands over a bill and gets the food in exchange. It’s a simple transaction; you have witnessed exchanges like it thousands of times before. Now, though, you think about the fact that this exchange has made both the customer and the store better off than they were previously. The customer has voluntarily given up money to get food. Presumably, she would do this only if having the food makes her happier than having the €10. KFC, meanwhile, voluntarily gave up the food to get the €10. Presumably, the managers of the store would sell the food only if they benefit from the deal as well. They are willing to give up something of value (their food) in exchange for something else of value (the customer’s money).
Think for a moment about all the transactions that could have taken place but did not. For the same €10, the customer could have bought two orders of fried chicken. But she didn’t. So even though you have never met the person, you know something about her. You know that—at this moment at least—she prefers having a Coca-Cola, fries, and one order of fried chicken to having two orders of fried chicken. You also know that she prefers having that food to any number of other things she could have bought with those euros, such as a movie theater ticket, some chocolate bars, or a book.
From your study of economics, you know that her decision reflects two different factors. The first is her tastes. Each customer likes different items on the menu. Some love the spicy fried chicken; others dislike it. There is no accounting for differences in tastes. The second is what she can afford. She has a budget in mind that limits how much she is willing to spend on fast food on a given day. Her decision about what to buy comes from the interaction between her tastes and her budget. Economists have built a rich and complicated theory of decision making from this basic idea.
You look back at the counter and to the kitchen area behind it. The kitchen, you now know, is an example of a production process that takes inputs and produces output. Some of the inputs are perhaps obvious, such as basic ingredients like raw chicken and cooking oil. Before you took the economics course, you might have thought only about those ingredients. Now you know that there are many more inputs to the production process, including the following:
• The building housing the restaurant
• The tables and chairs inside the room
• The people working behind the cash register and in the kitchen
• The people working at KFC headquarters managing the outlets in Paris
• The stoves, ovens, and other equipment in the kitchen used to cook the food
• The energy used to run the stoves, the ovens, the lighting, and the heat
• The recipes used to convert the ingredients into a finished product
The outputs of KFC are all the items listed on the menu. And, you realize, the restaurant provides not only the food but also an additional service, which is a place where you can eat the food. Transforming these inputs (for example, tables, chickens, people, recipes) into outputs is not easy. Let us examine one output—for example, an order of fried chicken. The production process starts with the purchase of some uncooked chicken. A cook then adds some spices to the chicken and places it in a vat of very hot oil in the huge pots in the kitchen. Once the chicken is cooked, it is placed in a box for you and served to you at the counter. That production process uses, to a greater or lesser degree, almost all the inputs of KFC. The person responsible for overseeing this transformation is the manager. Of course, she doesn’t have to analyze how to do this herself; the head office provides a detailed organizational plan to help her.
KFC management decides not only what to produce and how to produce it but also how much to charge for each item. Before you took your economics course, you probably gave very little thought to where those prices on the menu came from. You look at the price again: €5 for an order of fried chicken. Just as you were able to learn some things about the customer from observing her decision, you realize that you can also learn something about KFC. You know that KFC wouldn’t sell an order of fried chicken at that price unless it was able to make a profit by doing so. For example, if a piece of raw chicken cost €6, then KFC would obviously make a loss. So the price charged must be greater than the cost of producing the fried chicken.
KFC can’t set the price too low, or it would lose money. It also can’t set the price too high. What would happen if KFC tried to charge, say, €100 for an order of chicken? Common sense tells you that no one would buy it at that price. Now you understand that the challenge of pricing is to find a balance: KFC needs to set the price high enough to earn a good profit on each order sold but not so high that it drives away too many customers. In general, there is a trade-off: as the price increases, each piece sold brings in more revenue, but fewer pieces are sold. Managers need to understand this trade-off between price and quantity, which economists call demand. It depends on many things, most of which are beyond the manager’s control. These include the income of potential customers, the prices charged in alternative restaurants nearby, the number of people who think that going to KFC is a cool thing to do, and so on.
The simple transaction between the customer and the restaurant was therefore the outcome of many economic choices. You can see other examples of economics as you look around you—for example, you might know that the workers earn relatively low wages; indeed, they may very well be earning minimum wage. Across the street, however, you see a very different kind of establishment: a fancy restaurant. The chef there is also preparing food for customers, but he undoubtedly earns a much higher wage than KFC cooks.
Before studying economics, you would have found it hard to explain why two cooks should earn such different amounts. Now you notice that most of the workers at KFC are young—possibly students trying to earn a few euros a month to help support them through college. They do not have years of experience, and they have not spent years studying the art of cooking. The chef across the street, however, has chosen to invest years of his life training and acquiring specialized skills and, as a result, earns a much higher wage.
The well-heeled customers leaving that restaurant are likewise much richer than those around you at KFC. You could probably eat for a week at KFC for the price of one meal at that restaurant. Again, you used to be puzzled about why there are such disparities of income and wealth in society—why some people can afford to pay €200 for one meal while others can barely afford the prices at KFC. Your study of economics has revealed that there are many causes: some people are rich because, like the skilled chef, they have abilities, education, and experience that allow them to command high wages. Others are rich because of luck, such as those born of wealthy parents.
Everything we have discussed in this section—the production process, pricing decisions, purchase decisions, and the employment and career choices of firms and workers—are examples of what we study in the part of economics called microeconomics. Microeconomics is about the behavior of individuals and firms. It is also about how these individuals and firms interact with each other through markets, as they do when KFC hires a worker or when a customer buys a piece of fried chicken. When you sit in a fast-food restaurant and look around you, you can see microeconomic decisions everywhere.
key takeaway
• In microeconomics, we study the decisions of individual entities, such as households and firms. We also study how households and firms interact with each other.
CHECKING YOUR UNDERSTANDING
1. List three microeconomic decisions you have made today. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/01%3A_What_Is_Economics/1.01%3A_Microeconomics_in_a_Fast-Food_Restaurant.txt |
learning objective
1. What kinds of problems do we study in macroeconomics?
The economic decisions you witness inside Kentucky Fried Chicken (KFC) are only a few examples of the vast number of economic transactions that take place daily across the globe. People buy and sell goods and services. Firms hire and lay off workers. Governments collect taxes and spend the revenues that they receive. Banks accept deposits and make loans. When we think about the overall impact of all these choices, we move into the realm of macroeconomics. Macroeconomics is the study of the economy as a whole.
While sitting in KFC, you can also see macroeconomic forces at work. Inside the restaurant, some young men are sitting around talking and looking at the newspaper. It is early afternoon on a weekday, yet these individuals are not working. Like many other workers in France and around the world, they recently lost their jobs. Across the street, there are other signs that the economy is not healthy: some storefronts are boarded up because many businesses have recently been forced to close down.
You know from your economics class that the unemployed workers and closed-down businesses are the visible signs of the global downturn, or recession, that began around the middle of 2008. In a recession, several things typically happen. One is that the total production of goods and services in a country decreases. In many countries, the total value of all the goods and services produced was lower in 2008 than it was in 2007. A second typical feature of a recession is that some people lose their jobs, and those who don’t have jobs find it more difficult to find new employment. And a third feature of most recessions is that those who do still have jobs are unlikely to see big increases in their wages or salaries. These recessionary features are interconnected. Because people have lower income and perhaps because they are nervous about the future, they tend to spend less. And because firms are finding it harder to sell their products, they are less likely to invest in building new factories. And when fewer factories are being built, there are fewer jobs available both for those who build factories and for those who work in them.
Down the street from KFC, a large construction project is visible. An old road and a nearby bridge are in the process of being replaced. The French government finances projects such as these as a way to provide more jobs and help the economy recover from the recession. The government has to finance this spending somehow. One way that governments obtain income is by taxing people. KFC customers who have jobs pay taxes on their income. KFC pays taxes on its profits. And customers pay taxes when they buy their food.
Unfortunately for the government, higher taxes mean that people and firms have less income to spend. But to help the economy out of a recession, the government would prefer people to spend more. Indeed, another response to a recession is to reduce taxes. In the face of the recession, the Obama administration in the United States passed a stimulus bill that both increased government spending and reduced taxes. Before you studied macroeconomics, this would have seemed quite mysterious. If the government is taking in less tax income, how is it able to increase spending at the same time? The answer, you now know, is that the government borrows the money. For example, to pay for the \$787 billion stimulus bill, the US government issued new debt. People and institutions (such as banks), both inside and outside the United States, buy this debt—that is, they lend to the government.
There is another institution—called the monetary authority—that purchases government debt. It has specific names in different countries: in the United States, it is called the Federal Reserve Bank; in Europe, it is called the European Central Bank; in Australia, it is called the Reserve Bank of Australia; and so on. When the US government issues more debt, the Federal Reserve Bank purchases some of it. The Federal Reserve Bank has the legal authority to create new money (in effect, to print new currency) and then to use that to buy government debt. When it does so, the currency starts circulating in the economy. Similarly, decisions by the European Central Bank lead to the circulation of the euro notes and coins you saw being used to purchase fried chicken.
The decisions of the monetary authority have a big impact on the economy as well. When the European Central Bank decides to put more euros into circulation, this has the effect of reducing interest rates, which means it becomes cheaper for individuals to get a student loan or a mortgage, and it is cheaper for firms to buy new machinery and build new factories. Typically, another consequence is that the euro will become less valuable relative to other currencies, such as the US dollar. If you are planning a trip to the United States now that your class is finished, you had better hope that the European Central Bank doesn’t increase the number of euros in circulation. If it does, it will be more expensive for you to buy US dollars.
Today, the world’s economies are highly interconnected. People travel from country to country. Goods are shipped around the world. If you were to look at the labels on the clothing worn by the customers in KFC, you would probably find that some of the clothes were manufactured in China, perhaps some in Malaysia, some in France, some in the United States, some in Guatemala, and so on. Information also moves around the world. The customer sitting in the corner using a laptop might be in the process of transferring money from a Canadian bank account to a Hong Kong account; the person at a neighboring table using a mobile phone might be downloading an app from a web server in Illinois. This globalization brings many benefits, but it means that recessions can be global as well.
Your study of economics has taught you one more thing: the idea that you can take a trip to the United States would have seemed remarkable half a century ago. Despite the recent recession, the world is a much richer place than it was 25, or 50, or 100 years ago. Almost everyone in KFC has a mobile phone, and some people are using laptops. Had you visited a similar fast-food restaurant 25 years ago, you would not have seen people carrying computers and phones. A century ago, there was, of course, no such thing as KFC; automobiles were still a novelty; and if you cut your finger on the sharp metal edge of a table, you ran a real risk of dying from blood poisoning. Understanding why world economies have grown so spectacularly—and why not all countries have shared equally in this growth—is one of the big challenges of macroeconomics.
key takeaway
• In macroeconomics, we study the economy as a whole to understand why economies grow and why they sometimes experience recessions. We also study the effects of different kinds of government policy on the overall economy.
CHECKING YOUR UNDERSTANDING
1. If the government and the monetary authority think that the economy is growing too fast, what could they do to slow down the economy? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/01%3A_What_Is_Economics/1.02%3A_Macroeconomics_in_a_Fast-Food_Restaurant.txt |
learning objective
1. What methods do economists use to study the world?
Economists take their inspiration from exactly the kinds of observations that we have discussed. Economists look at the world around them—from the transactions in fast-food restaurants to the policies of central banks—and try to understand how the economic world works. This means that economics is driven in large part by data. In microeconomics, we look at data on the choices made by firms and households. In macroeconomics, we have access to a lot of data gathered by governments and international agencies. Economists seek to describe and understand these data.
But economics is more than just description. Economists also build models to explain these data and make predictions about the future. The idea of a model is to capture the most important aspects of the behavior of firms (like KFC) and individuals (like you). Models are abstractions; they are not rich enough to capture all dimensions of what people do. Yet a good model, for all its simplicity, is still capable of explaining economic data.
And what do we do with this understanding? Much of economics is about policy evaluation. Suppose your national government has a proposal to undertake a certain policy—for example, to cut taxes, build a road, or increase the minimum wage. Economics gives us the tools to assess the likely effects of such actions and thus to help policymakers design good public policies.
This is not really what you thought economics was going to be about when you walked into your first class. Back then, you didn’t know much about what economics was. You had a vague thought that maybe your economics class would teach you how to make money. Now you know that this is not really the point of economics. You don’t have any more ideas about how to get rich than you did when you started the class. But your class has taught you something about how to make better decisions and has given you a better understanding of the world that you live in. You have started to think like an economist.
key takeaway
• Economists gather data about the world and then build models to explain those data and make predictions.
check your understanding
1. Suppose you were building a model of pricing at KFC. Which of the following factors would you want to make sure to include in your model? Which factors do you think would be irrelevant?
• the age of the manager making the pricing decisions
• the price of chicken
• the number of customers who come to the store on a typical day
• the price of apples
• the kinds of restaurants nearby
1.04: End-of-Chapter Material
In Conclusion
Economics is all around us. We all make dozens of economic decisions every day—some big, some small. Your decisions—and those of others—shape the world we live in. In this book, we will help you develop an understanding of economics by looking at examples of economics in the everyday world. Our belief is that the best way to study economics is to understand how economists think about such examples.
With this in mind, we have organized our book rather differently from most economics textbooks. It is built not around the theoretical concepts of economics but around different applications—economic illustrations as you encounter them in your own life or see them in the world around you. As you read this book, we will show you how economists analyze these illustrations, introducing you to the tools of economics as we proceed. After you have read the whole book, you will have been introduced to all the fundamental tools of economics, and you will also have seen them in action. Most of the tools are used in several different applications, thus allowing you to practice using them and gain a deeper understanding of how they work.
You can see this organization at work in our table of contents. In fact, there are two versions of the table of contents so that both students and instructors can easily see how the book is organized. The student table of contents focuses on the applications and the questions that we address in each chapter. The instructor table of contents lists the theoretical concepts introduced in each chapter so that instructors can easily see how economic theory is developed and used in the book.
We have also gathered all the tools of economics into a toolkit. You will see many links to this toolkit as you read the book. You can refer to the toolkit as needed when you want to be reminded of how a tool works, and you can also use it as a study aid when preparing for exams and quizzes.
exercises
1. A map is a model constructed by geographers and cartographers. Like an economic model, it is a simplified representation of reality. Suppose you have a map of your hometown in front of you. Think of one question about your town that you could answer using the map. Think of another question about your town for which the map would be useless.
2. Which of the following questions do you think would be studied by a macroeconomist and which by a microeconomist? (Note: we don’t expect you to be able to answer all these questions yet.)
• What should the European Central Bank do about increasing prices in Europe?
• What happens to the price of ice cream in the summer?
• Should you take out a student loan to pay for college?
• What happens when the US government cuts taxes and pays for these tax cuts by borrowing money?
• What would happen to the prices of computers if Apple and Microsoft merged into a single firm?
Economics Detective
1. Look at a newspaper on the Internet. Find a news story about macroeconomics. How do you know that it is about macroeconomics? Find a news story about microeconomics. How do you know that it is about microeconomics? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/01%3A_What_Is_Economics/1.03%3A_What_Is_Economics_Really.txt |
Thumbnail: https://www.pexels.com/photo/1-us-dollar-bill-3943748/
02: Microeconomics in Action
Learning Objectives
1. What are two ways that you make economic choices all the time?
2. How do economists think about the way people react to a change in a rule?
3. What is the role of markets in an economy?
Here are four short and diverse illustrations of microeconomics you might encounter: deciding what to do with your time and money, buying or selling on eBay, visiting a large city, and reading about a soccer game. After you have finished your study of microeconomics, you will see these concepts very differently from the way you see them now. You may not know it, but your everyday life is filled with microeconomics in action.
Your Time and Money
Wouldn’t you rather be doing something else with your time right now, instead of reading an economics textbook? You could be surfing on the Internet, reading blogs, or updating your Facebook profile. You could be reading a novel or watching television. You could be out with friends. But you aren’t. You have made a choice—a decision—to spend time reading this chapter.
Your choice is an economic one. Economics studies how we cope with competing demands for our time, money, and other resources. You have only 24 hours each day, so your time is limited. Each day you have to divide up this time among the things you like or need to do: sleeping, eating, working, studying, reading, playing video games, hanging out in your local coffee shop, and so on. Every time you decide to do one thing instead of another, you have made an economic decision. As you study economics, you will learn about how you and other people make such choices, and you will also learn how to do a better job when making these decisions.
Money is also a limited resource. You undoubtedly have many things you would like to buy if money were no object. Instead you must choose among all the different things you like because your money—or, more precisely, your income—is a limited resource. Every time you buy something, be it a T-shirt, a breakfast bagel, or a new computer, you are choosing to forgo something else you could have bought instead. Again, these are economic decisions. Economics is about how you make choices. Whenever there is a limited resource—be it your time, the amount of oil reserves in the world, or tickets to the Super Bowl—and decisions to be made about how to use that resource, then economics is there to help. Indeed, the fundamental definition of economics is that it is the study of how we, as individuals and as a society, allocate our limited resources among possible alternative uses.
eBay and craigslist
Suppose you want to buy an MP3 player. There are many ways you can do this. You can go to a local store. You can look for stores on the Internet. You can also visit sites such as eBay ( www.ebay.com) or craigslist ( http://www.craigslist.org). eBay is an online auction site, meaning that you can look for an MP3 player and then bid against other potential buyers. The site craigslist is like an online version of the classified advertisements in a newspaper, so you can look to see if someone in your town or city is selling the player you want to buy. You can also use these sites if you want to sell something. Maybe you have some old baseball cards you want to sell. Perhaps you have a particular skill (for example, web design), and you want to sell your services. Then you can use sites such as eBay or craigslist as a seller instead of as a buyer.
We have said that economics is about deciding how to use your limited resources. It is also about how we interact with one another, and, more precisely, how we trade with one another. Adam Smith, the founder of modern economics, observed that humans are the only animal that makes bargains: “Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog.”Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1994 [1776]), 14. Barter or trade—the exchange of goods and services and money—is central to the world we live in today.
Economists often talk about trade taking place in markets. Some exchanges do literally take place in markets—such as a farmers’ market where local growers bring produce to sell. Economists use the term more generally, though: a market is any institution that allows us to exchange one thing for another. Sites such as eBay and craigslist create markets in which we can transact. Normally, we exchange goods or services for money. Sometimes we exchange one good or service for another. Sometimes we exchange one type of money for another.
Most of the time, nobody forces you to buy anything, so when you give up some money in return for an MP3 player, you are presumably happier after the transaction than before. (There are some exceptions, of course. Can you think of any cases where you are forced to engage in an economic transaction?) Most of the time, nobody forces you to sell anything, so when you give up your time in return for some money, you are presumably happier after the transaction than before. Leaving aside the occasional mistake or the occasional regret, nearly every voluntary transaction makes both participants better off. Markets matter because they are a means for people to become happier.
Breathing the Air
Welcome to Mexico City! It is a wonderful place in many respects. But not in every way: from the picture you can see that Mexico City has some of the most polluted skies in the world.“Researchers to Scrutinize Megacity Pollution during Mexico City Field Campaign,” University Corporation for Atmospheric Research, last modified March 2, 2006, accessed January 22, 2011, www.ucar.edu/news/releases/2006/mirage.shtml.
Source: This photo comes from the Center on Atmospheric Research, http://www.ucar.edu.
Mexico City was not always so polluted. Sadly, economic growth and population growth, together with the peculiarities of geography and climate, have combined to make its air quality among the worst you will encounter anywhere. Other cities around the world, from Beijing to Los Angeles, also experience significant air pollution, reducing the quality of life and bringing with it health risks and other costs.
It is hard to understand economists talking about the beauty and power of markets when you cannot breathe the air. So what is going wrong in Mexico City? Is it not full of people carrying out trades that make them better off? The problem is that transactions sometimes affect other people besides the buyer and the seller. Mexico City is full of gas stations. The owners of the gas stations are happy to sell gasoline because every transaction makes them better off. The owners of cars are happy to buy gasoline because every transaction makes them better off. But a side effect of all these transactions is that the air becomes more and more polluted.
Economics studies these kinds of problems as well. Economists seek to understand where and when markets work and where and when they don’t work. In those situations where markets let us down, economists search for ways in which economic policies can help.
Changing the Rules
We have explained that microeconomics studies choices and the benefits and problems that arise from trade. Perhaps most fundamentally, microeconomics studies how people respond to incentives. To illustrate the importance of incentives, here is an example of what can happen when they go wrong.
In February 1994, an extraordinary scene took place during a soccer match in the Caribbean. Grenada was playing Barbados, and with five minutes remaining in the match, Barbados was leading by two goals to one. As the seconds ticked away, it seemed clear that Barbados was going to win the match. Then, three minutes from the end of the game, the Barbados team did a remarkable thing. It intentionally scored an own goal, tying the game at two goals apiece.
After Grenada kicked off again, pandemonium ensued. The Grenada team tried not only to score against Barbados but also to score an own goal. Barbados desperately defended both its own goal and its opponents’ goal. The spectacle on the field had very little to do with soccer as it is usually played.
To explain this remarkable sight, we must describe the tournament in which the two teams were playing. There were two groups of teams, with the winner of each group progressing to the final. The match between Barbados and Grenada was the last group game and would determine which two teams would be in the final. The results of the previous matches were such that Barbados needed to win by two goals to go to the final. If Barbados won by only one goal, then Grenada would qualify instead. But the tournament organizers had introduced an unusual rule. The organizers decided that if a game were tied, the game would go to “golden goal” overtime, meaning that the first team to score would win the game, and they had also decided that the winning team would then be awarded a two-goal victory.
As the game was drawing to a close, Barbados realized it was unlikely to get the two-goal win that it needed. The team reasoned that a tie was a better result than a one-goal victory because it gave them roughly a fifty-fifty chance of winning in extra time. So Barbados scored the deliberate own goal. Grenada, once it realized what had happened, would have been happy either winning or losing by one, so it tried to score in either goal. Barbados’ strategy paid off. The game finished in a tie; Barbados scored in overtime and went on win the final.
The organizers should have consulted an economist before instituting the rules of the tournament. Economics has many lessons to teach, and among the most important is this: people respond to incentives. The change in the rules changed the incentives that the two teams faced. Because the tournament organizers had not realized that their rules could lead to a situation in which a team preferred a tie to a win, they failed to foresee the bizarre scene on the field.“Football Follies,” Snopes.com, last modified July 6, 2008, accessed January 22, 2011, http://www.snopes.com/sports/soccer/barbados.asp.
Key Takeaways
• You make economic decisions on the allocation of time by deciding how to spend each minute of the day. You make economic decisions on the allocation of your income by deciding how much to buy of various goods and services and how much to save.
• Economists study how changes in rules lead individual and firms to change their behavior. This is part of the theme in economics that incentives matter.
• Markets are one of the central ways in which individuals interact with each other. Market interactions provide a basis for the trade that occurs in an economy.
Exercises
1. When you are choosing how much time to allocate to studying, what incentives affect your decision? Does the decision depend on how much money you have? Does the decision depend on whether you have a quiz or an exam coming up in the course? If your instructor changed the rules of the course—for example, by canceling the final exam—would your choice change?
2. Instead of writing about air pollution in Mexico City, we could have written about water pollution from the 2010 oil spill in the Gulf of Mexico. Would that also be a good example of markets failing? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/02%3A_Microeconomics_in_Action/2.01%3A_Four_Examples_of_Microeconomics.txt |
Learning Objectives
1. What is the approach of microeconomics?
2. What are the big questions of economics?
There are several distinguishing features of the microeconomic approach to the world. We discuss them briefly and then conclude with a look at the big questions of economics.
Individual Choice
One element of the microeconomic approach is individual choice. Throughout this book, we explore how individuals make decisions. Economists typically suppose that individuals make choices to pursue their (broadly defined) self-interest given the incentives that they face.
We look at individuals in their roles both as members of households and as members of firms. Individuals in households buy goods and services from other households and—for the most part—firms. They also sell their labor time, mostly to firms. Managers of firms, meanwhile, make decisions in the effort to make their firms profitable. By the end of the book, we will have several frameworks for understanding the behavior of both households and firms.
Individuals look at the prices of different goods and services in the economy when deciding what to buy. They act in their own self-interest when they purchase goods and services: it would be foolish for them to buy things that they don’t want. As prices change, individuals respond by changing their decisions about which products to buy. If your local sandwich store has a special on a breakfast bagel today, you are more likely to buy that sandwich. If you are contemplating buying an Android tablet computer but think it is about to be reduced in price, you will wait until the price comes down.
Just as consumers look at the prices they face, so do the managers of firms. Managers look at the wages they must pay, the costs of the raw materials they must purchase, and so on. They also look at the willingness of consumers to buy the products that they are selling. Based on all this information, they decide how much to produce and what to buy. Your breakfast bagel may be on special because the owner of your local sandwich shop got a good deal on bagels from the supplier. So the owner thinks that breakfast bagels can be particularly profitable, and to sell a lot of them, she sets a lower price than normal.
The buying and selling of a bagel may seem trivial, but similar factors apply to much bigger decisions. Potential students think about the costs and benefits of attending college relative to getting a full-time job. For some people, the best thing to do is to work full time. For others, it is better to go to school full time. Yet others choose to go to school part time and work part time as well. Presumably your own decision—whichever of these it may be—is one you made in your own best interests given your own specific situation.
From this discussion, you may think that economics is all about money, but economists recognize that much more than money matters. We care about how we spend our time. We care about the quality of the air we breathe. We care about our friends and family. We care about what others think of us. We care about our own self-image: what sort of a person am I? Such factors are harder to measure and quantify, but they all play a role in the decisions we make.
Markets
A second element of microeconomics has to do with how individual choices are interconnected. Economics is partly about how we make decisions as individuals and partly about how we interact with one another. Most importantly—but not exclusively—economics looks at how people interact by purchasing and selling goods and services.
In a typical transaction, one person (the buyer) hands over money to another (the seller). In return, the seller delivers something (a good or a service) to the buyer. For example, if you buy a chocolate bar for a dollar, then a dollar bill goes from your hands to those of the seller, and a chocolate bar goes from the seller to you. At the level of an individual transaction, this sounds simple enough. But the devil is in the details. In any given (potential) transaction, we can ask the following questions:
• How many? Will you buy 1, 2, or 10 chocolate bars? Or will you buy 0—that is, will the transaction take place at all?
• How much? How much money does the buyer give to the seller? In other words, what is the price?
You will see in different chapters of this book that the answers to these questions depend on exactly how buyers and sellers interact. We get a different answer depending on whether there are many sellers or only a few. We get a different answer if the good is sold at a retail store or at an auction. We get a different answer if buyers and sellers can or cannot negotiate. The exact way in which people exchange goods and services matters a great deal for the how many? and how much? questions and thus for the gains from trade in the economy.
The Role of Government
We have pointed out that individuals acting in their own self-interest benefit from voluntary trade. If you are not forced to buy or sell, then there is a presumption that every transaction makes the participants happier. What is more, markets are often a very effective institution for allowing people to meet and trade with one another. In fact, there is a remarkable result in economics that—under some circumstances—individuals acting in their own self-interest and trading in markets can manage to obtain all the possible benefits that can come from trading. Every transaction carried out is for the good, and every good transaction is carried out. From this comes a powerful recommendation: do whatever is possible to encourage trade. The phrase under some circumstances is not a minor footnote. In the real world, transactions often affect people other than the buyer and the seller, as we saw in our example of gas stations in Mexico City. In other cases, there can be problems with the way that markets operate. If there is only a small number of firms in a market, then managers may be able to set high prices, even if it means that people miss out on some of the benefits of trade. Later in this book, we study exactly how managers make these decisions. The microeconomic arguments for government intervention in the economy stem from these kinds of problems with markets. In many chapters, we discuss how governments intervene in an attempt to improve the outcome that markets give us. Yet it is often unclear whether and how governments should be involved. Pollution in Mexico City illustrates how complex these problems can be. First, who is responsible for the pollution? Some of it comes from people and firms outside the city and perhaps even outside the country. If pollution in Mexico City is in part caused by factories in Texas, who should deal with the problem: the Mexico City government, the Mexican government, the US government, or the Texas state legislature? Second, how much pollution should we tolerate? We could shut down all factories and ban all cars, but few people would think this is a sensible policy. Third, what measures can we use to combat air pollution? Should we simply place limits on production by firms and the amount of driving? Should we use some kind of tax? Is there a way in which we can take advantage of our belief that people, including the managers of firms, respond to incentives?
There are two traps that we must avoid. The first is to believe that markets are the solution to everything. There is no imaginable market in which the residents of Mexico City can trade with the buyers and sellers of gasoline to purchase the right amount of clean air. The second trap is to believe that the government can fix every market failure. Governments are collections of individuals who respond to their own incentives. They can sometimes make things better, but they can sometimes make things worse as well.
There is room for lots of disagreement in the middle. Some economists think that problems with markets are pervasive and that government can do a great deal to fix these problems. Others think that such problems are rare and that governmental intervention often does more harm than good. These disagreements result partly from different interpretations of the evidence and partly from differences in politics. Economists are as prone as everyone else to view the world through their own ideological lens. As we proceed, we do our best to present the arguments on controversial issues and help you understand why even economists sometimes come to differing conclusions about economic policy.
Incentives
Perhaps our story of the Barbados-Grenada soccer game did not seem related to economics. Economists believe, though, that the decisions we make reflect the incentives we face. Behavior that seems strange—such as deliberately scoring an own goal in a soccer game—can make perfect sense once you understand the underlying incentives. In the economic world, it is often governments that make the rules of the game; like the organizers of soccer tournaments, governments need to be careful about how the rules they set can change people’s behavior.
Here is an example. In some European countries, laws are in place that give a lot of protection to workers and keep them from being unfairly fired by their employers. The intentions of these laws are good; some of their consequences are not so beneficial. The laws also make firms more reluctant to hire workers because they are worried about being stuck with an unsuitable employee. Thus these laws probably contribute to higher unemployment.
Incentives affect all transactions. When you buy a breakfast bagel on sale, both you and the owner of the sandwich shop are responding to the incentives that you face. The owner responds to the lower price of bagels. You respond to the lower price of the sandwich. Economists think that we can understand a great deal about people’s behavior if we have a good understanding of the incentives that they face.
Notice that not everyone makes the same choices. There are two main reasons for this:
• People have different desires or tastes. Some people like bagels; others hate them. Some people like being students; others would prefer to work rather than study.
• People have different incentives. Some people face very different job prospects and thus make different decisions about schooling. If you have this great idea for a new web product (for example, the next Google or Facebook), then you might be wise to spend your time on this project instead of studying.
The Big Questions of Economics
To conclude our introduction to microeconomics, let us look at the big picture of what happens in an economy. An economy possesses some resources. These include the time and abilities of the people who live in the economy, as well as natural resources such as land, mineral deposits, and so on. An economy also possesses some technologies. A technology is a means of changing, or transforming, one set of things into other things. For example, we have a technology for making tea. This technology takes cold water, energy, and dried leaves and transforms them into a hot beverage. Finally, an economy, of course, contains its people, and these people like to consume things. Economics studies all aspects of this process. It considers the following:
• What goods and services are produced in an economy?
• How are these goods and services produced?
• Who gets to consume these goods and services?
These questions concern the allocation of resources.
The what in the first question reflects the choice among the multitude of goods and services an economy could produce. Think for a moment about the clothes you are wearing right now, the food you have eaten today, and the activities you undertake during a typical day. Someone made those clothes; someone prepared that food. Somehow, society must decide how much of each type of good and service to produce.
The how in the second question reflects competing ways to produce goods and services. Take a basic commodity such as rice. A large amount of rice is produced in the United States on large-scale, mechanized farms. A large amount of rice is also produced in Vietnam, but the production methods are very different. In Vietnam, people do much more work manually rather than by machine. A big part of the how question is deciding what mix of resources and what technologies should be used to produce goods and services. The answer in a rich country such as the United States is frequently different from the answer in a poor country such as Vietnam. Indeed, the answer may be different in different states in the United States or in the same place at different times.
The who in the third question concerns the distribution of goods and services in the economy. Suppose you were responsible for the distribution of all goods and services to your family. If there are 4 people in your family and each consumed 50 products in a typical day, you would have to make about 200 allocation decisions each day. It would be a very hard task. Yet somehow the economies of the world allocate billions of products to billions of people.
These three questions are answered in the world partly through individual decisions. The way in which you allocate your time each day is part of the allocation of resources in the economy. If each of us lived alone, engaging in subsistence farming and not interacting with others, then we would each determine our own allocation of resources. Because we interact with others, however, these questions are also answered in part by the way in which society is organized. Most of us produce only a few goods but consume many. We specialize in production and generalize in consumption. To do so, we must exchange what we produce with others. Most of these exchanges take place as a result of individual decisions in different kinds of markets. It is the operation of these countless markets that determines the allocation of goods and services in the economy. Remarkably, these markets somehow coordinate the decisions of the billions of people in the world economy.
Some of these exchanges are controlled by the government. In some economies, the government plays a very active role; in others, it intervenes less. When a government makes decisions about the allocation of resources, this is another mechanism in the production of goods and the distribution to individuals.
Key Takeaways
• The approach of microeconomics starts with the decisions of an individual about the allocation of time and income. The impact of incentives on individual choices is a key part of economics. The approach of microeconomics then looks at the interactions of individuals directly and in markets.
• Economics answers the questions of what goods and services are produced, how they are produced, and who consumes them.
check your understanding
1. We said that most people specialize in production and generalize in consumption. What goods or services (if any) do you produce? What are the most important goods and services that you consume?
2. Police protection is a service provided by most governments. What are the what, how, and who aspects of the provision of this service? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/02%3A_Microeconomics_in_Action/2.02%3A_The_Microeconomic_Approach.txt |
In Conclusion
Our book is built around economic topics. Examples of these topics include the decisions you make in your everyday life, auctions such as those you see on eBay, whether you can make money on Wall Street, where jobs come from, and health care. As we introduce and discuss these applications, we remain keenly aware of the key themes in microeconomics: individuals responding to incentives, markets as the basis for interactions among firms and households, and the role of government intervention.
Throughout this book, we emphasize the measurement and interpretation of economic data. Understanding how to read charts and tables of economic data is a critical skill for anyone who wants to be a sophisticated consumer of economic and political news.
Mastering microeconomics involves both understanding the tools that microeconomists use and knowing how and when those tools should be applied. In this book, you will learn about these tools by example; you will see them in use as we study different questions in economics. At the same time, you will learn about many topics that should interest you as engaged and aware citizens of the world. We hope that, after reading this book, you will both better understand what it is that economists do and be better informed about the world in which we all live.
There is a considerable amount of core material in microeconomics that we use repeatedly as we tackle different problems. We highlight these core elements in the chapters and also gather them together in the toolkit. You can read any and every chapter in the book without necessarily having to refer to the toolkit, but you may often find it to be a helpful reference.
exercises
1. Think about the last item of clothing you bought for yourself. How much did you spend on it? List three other things that you like and could have bought with (approximately) the same amount of money. Why did you decide to buy the clothing rather than one of the things you just listed?
2. How have you spent the previous 24 hours? How much time did you spend sleeping? How much time did you spend working? What else could you have done with your time? Why are you reading this chapter instead of doing something else with your time?
3. Think about a game or sport that you enjoy. What rule of that game could be changed? How would this change in the rules affect the way in which the players behave?
4. When we discussed individual choice, we talked mainly about the choices of an individual person. However, in economics we often talk about the choice of a household consisting of two or more people. In what ways are the choices of a household different from the choices of an individual? In what ways are they similar?
5. Can you think of examples of economic choices that are made by the government?
Economics Detective
1. We explained the social problem of air pollution in Mexico as a situation where markets have failed to bring about good outcomes. Instead of writing about pollution, we could have written about other social problems, such as crime, illiteracy, or obesity. Browse the Internet to find another example of a social problem—either from this list or something else that interests you. Write one paragraph that explains the problem and another that discusses if and how the government might solve the problem. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/02%3A_Microeconomics_in_Action/2.03%3A_End-of-Chapter_Material.txt |
Thumbnail: https://pixabay.com/illustrations/trend-curve-hand-presentation-euro-1445464/
03: Macroeconomics in Action
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How might you encounter macroeconomics?
2. What are the main indicators of the macroeconomy?
3. What are the primary macroeconomic policy tools of the government?
The four screens in Figure 3.1.1 are diverse illustrations of macroeconomics as you might encounter it:
• An evening news show presents a story about whether the economy is in a recession.
• You wonder why prices seem to be higher now than they were a few years ago.
• You sit down to fill out your tax return.
• You make payments on a car loan or a student loan.
By the time you have finished this book, you will see these examples very differently from the way you do right now. You may not know it, but your everyday life is filled with macroeconomics in action.
Economic Activity in the United States
The top left screen in Figure 3.1.1 is tuned to the Bureau of Economic Analysis (BEA; http://www.bea.gov), which is a part of the US government. A newspaper article or blog that reports such news from the BEA is telling us about the state of the macroeconomy. The report from the BEA tells you how the economy has been doing over the previous three months. More specifically, it describes what has happened to something called real gross domestic product (real GDP).
As you will soon learn, real GDP is a measure of the overall level of economic activity within an economy. We won’t worry for the moment about exactly what GDP means or how it is measured. Looking at the BEA announcement ( www.bea.gov/newsreleases/national/gdp/2011/gdp1q11_2nd.htm), you can see that in the first quarter of 2011, real GDP increased by 1.8 percent, whereas in the fourth quarter of 2010, it increased by 3.1 percent. Because real GDP increased in both quarters, we know that the economy is growing. However, it grew much more slowly in the first quarter of 2011 than in the final quarter of 2010.
You might wonder why you would bother to listen to this report. Perhaps it looks rather dry and boring. Yet the performance of the economy has a direct impact on how easy it is to find a job if you are looking for one, how likely you are to lose your job if you are already employed, how much you will earn, and what you can buy with the income you receive from working. Overall economic activity is directly linked to the well-being of everyone in the economy, including yourself. Should you be worried when you see that real GDP is growing much more slowly than before? After you have read this book, we hope you will know the answer.
Because real GDP is such a general measure of economic activity, it can also be used to compare how economies throughout the world are performing. If you have traveled to other countries, you may have observed big differences in people’s standards of living. If you go to Canada, France, or Japan, you will generally see relatively prosperous people who can afford decent food, clothing, and shelter. If you go to Laos, Guatemala, or Malawi, you will see people living in severe poverty. To understand these differences, we need to understand what determines real GDP in an economy.
Inflation in the United States
The top right screen in Figure 3.1.1 reports on another economic variable that comes up all the time in the news: the rate of inflation. You have probably never visited the Bureau of Labor Statistics (BLS; http://www.bls.gov) website from which we took this quotation. But you have certainly heard a news story, perhaps on television or your car radio, telling you about the inflation rate.
After the BLS releases a report such as this one ( http://www.bls.gov/news.release/cpi.nr0.htm), news programs will note that the inflation rate reported in March 2011 was 2.7 percent. This means that, on average, prices in the economy are 2.7 percent greater than they were a year ago. If you bought a jacket for \$100 last year, you should expect the same jacket to cost about \$102.70 right now. Not every single good and service increases by exactly this amount, of course. But, on average, prices are now 2.7 percent higher.
A news report like this tells us that the things we buy have become more expensive. This matters to all of us. If your income has not increased over the last year, this inflation report tells you that you are worse off now than you were last year because you can no longer buy as much with your income.
Most of the time, you will hear news reports about inflation only for the country in which you are living. Occasionally, you might also hear a news report about inflation somewhere else. In early 2008, you might well have heard a news report that the inflation rate in Zimbabwe was over 100,000 percent. You would probably find it difficult to imagine living in a country where prices increase so quickly, and you might reasonably wonder how two different countries in the world could have such different rates of inflation. When you have finished this book, you will know the answer to this question.
Fiscal Policy in Action
The bottom left screen in Figure 3.1.1 is something you may have seen before. It is a US tax form. Residents of the United States must file this form or one like it every year by April 15. If you live in another country, you almost certainly have to file a similar form. As individuals, we typically see this form as a personal inconvenience, and we don’t think much about what it means for the economy as a whole. But this is much more than a form. It is a manifestation of decisions made by the government about how much tax you and everyone else should pay.
Decisions about how much to tax and how much to spend are known as fiscal policy. The fiscal policy adopted by a government affects your life in more ways than you can easily imagine. It not only tells you how much gets taken out of your paycheck, but it also affects real GDP and much more. It affects how likely you are to be unemployed in the future and how much money you will receive from the government if you do lose your job. It affects the interest rate you must pay on your car loan or student loan. It affects the tax rates you will pay 20 years from now and your likelihood of receiving social security payments when you retire.
Monetary Policy in Action
The bottom right screen in Figure 3.1.1 draws the attention of individuals and businesses all around the world. Every six weeks a group called the Federal Open Market Committee (FOMC) meets in Washington, DC, to make decisions on the course of US monetary policy. Their decisions affect the interest rates we pay on loans, including car loans, student loans, and mortgages. Their decisions also influence the level of economic activity and the inflation rate. The FOMC could, if it chose, create very high inflation by allowing rapid growth in the amount of money in the economy. It could, if it chose, create high rates of unemployment. It is a powerful organization. There are other similar organizations elsewhere in the world: every country conducts monetary policy in some form, and most have some equivalent of the FOMC.
International Channels
Figure 3.1.1 shows the kind of economic news you might see in the United States. If you are living or traveling in a different country, you would see similar announcements about real GDP, inflation, and economic policy. Using the Internet, it is also easy to check news sources in other countries. If you start reading about economics on the Internet, you will come to appreciate the global nature of economics. You can read stories in the United States about monetary policy in China or fiscal policy in Portugal. And you can read news stories in other countries about economic policy in the United States. In the modern globalized world, economic connections across countries are impossible to ignore.
Figure 3.1.2 "Price of Euro in British Pounds, March 2008" presents two stories that show globalization at work. Both share a common theme: the effects of a March 20, 2008, decision by the FOMC to cut the target federal funds rate. The graph at the top of Figure 3.1.2 "Price of Euro in British Pounds, March 2008" shows the market price of the euro—the currency used in most of Europe—in terms of the British pound. When you travel, you typically exchange one currency for another. For example, an American tourist traveling to France would buy euros with dollars to have money to spend in France. If that same tourist then wanted to travel from France to London, she might take some of her euros and buy British pounds. The graph tells the price she would have paid in February and March of 2008.
You can see that, over a little more than a week, the euro became much more valuable relative to the pound. Most notably, there was a big increase in the price of the euro between March 9 and March 19, and then prices settled down a bit. This was a wild week for the international economy. In the United States, the Federal Reserve announced major financial support for Wall Street firms on March 16 and then reduced interest rates on March 19. Around the same time, the European Central Bank (ECB) and the Bank of England in London were also taking actions to try to calm the financial markets. At least for a period of time, they seemed to succeed in stopping the rapid rise of the euro against the British pound. It is striking that much of the financial action was taking place in the United States, yet the markets in which Europeans trade currencies were also affected.
The story at the bottom of Figure 3.1.2 "Price of Euro in British Pounds, March 2008" discusses the response of Asian stock markets to the action of the US Federal Reserve. Markets all over the world increased in value after the action of the FOMC. The actions of the Fed matter well beyond the borders of the United States. Bankers and businesspeople all over the globe are “Fed watchers.”
Figure \(2\): Price of Euro in British Pounds, March 2008
Source: http://www.oanda.com.
Asian Stocks Rise after Fed Cut
TOKYO (AP)—Asian stock markets rose Wednesday as investors welcomed a hefty U.S. interest rate cut…
Japan’s benchmark Nikkei 225 index climbed 2.5 percent to close at 12,260.44 after rising more than 3 percent earlier. Hong Kong’s Hang Seng index, which rose as much as 3 percent earlier, closed up 2.3 percent at 21,866.94.
Australia’s main index jumped 4 percent, and markets in South Korea, China and India also rose.“Asian Stocks Rise after Fed Cut,” MSNBC.com, March 19, 2008, accessed June 27, 2011, http://www.msnbc.msn.com/id/23703748/ns/business- eye_on_the_economy.
Key Takeaways
• You encounter macroeconomics everyday through the news about the state of the macroeconomy, the price you pay for goods and services, the tax you pay on income, and the effects of macroeconomic policy on interest rates. Macroeconomic events and policies in other countries affect you as well.
• Real GDP, the rate of inflation, and the rate of unemployment are three primary indicators of the state of the macroeconomy.
• The government influences the macroeconomy through its level of spending, taxes, and control of the money supply.
check your understanding
1. What do we mean by “real” when we talk about GDP?
2. How might the state of the macroeconomy in another country, such as China, or in a group of countries, such as the European Union, affect the macroeconomy of the United States? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/03%3A_Macroeconomics_in_Action/3.01%3A_Four_Examples_of_Macroeconomics.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. How has real GDP changed over the past 40 years?
2. What is inflation and how does it affect the macroeconomy?
3. How can we see fiscal and monetary policy in action?
Let’s look at Figure 3.1.1 again in a bit more detail.
The State of the Economy
The top two panels in Figure 3.1.1 provide information on some key indicators of the state of the economy. The announcement from the Bureau of Economic Analysis (BEA) concerns one of the most closely watched indicators of the macroeconomy: real gross domestic product (real GDP). This is a measure of the goods and services produced by an economy in a year. We discuss real GDP in every macroeconomic application in this book.
Source: Alan Heston, Robert Summers, and Bettina Aten, Penn World Table Version 7.0, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, May 2011.
Figure 3.2.1 "Real GDP per Person in the United States, 1960–2009" shows real GDP per person (often called real GDP per capita) from 1960 to 2009. Pictures like this one show up all the time in newspapers, in magazines, on television, or on the Internet. One of the things you will learn in your study of macroeconomics is how to interpret such economic data. We devote an entire chapter to understanding exactly how real GDP is measured. For now, we draw your attention to some details to help you appreciate what the graph means.
The horizontal axis indicates the year. Real GDP per person is shown on the vertical axis. To read this graph, you would look at a particular year on the horizontal axis, such as 2000, and then use the curve to see that the real GDP per person in 1965 was about \$39,000.
If you look at this picture, the single most notable thing is that real GDP per person has been increasing. It was about 2.6 times larger in 2009 than in 1960. This tells us that, on average, the typical individual in the United States was 2.6 times richer in 2000 compared to 1960. The increase in GDP is not caused by the fact that there are more people in the economy because the figure shows GDP per person. The increase in GDP is not because prices are going up: the word real in this discussion means that it has been corrected for inflation.In the bottom right of the picture, you can see the phrase Data in 1996 dollars. This means that the numbers in the table are based on how much a dollar would have bought in 1996. Do not worry if you do not understand exactly what this phrase means right now. Chapter 18 "The State of the Economy" will provide much more detail.
Another thing you can see from the picture is that the growth of the economy has not been smooth. Sometimes the economy grows fast; sometimes it grows more slowly. Sometimes there are even periods in which the economy shrinks rather than grows. From this figure, you can see that real GDP per person decreased in the mid-1970s, the mid-1980s, and most notably in 2008 and 2009. During these times, people were becoming poorer on average, not richer.
We keep using the phrase on average. This reminds us that, even though the economy as a whole has been getting richer, the picture doesn’t tell us anything about how those gains have been shared across the economy. In fact, some people became a lot richer over this period, while many others saw only small gains, and some became poorer.
We see this uneven distribution very clearly when the economy shrinks. When that happens, one of the things we also observe is that more people in the economy are unemployed—that is, they are looking for a job but unable to find one. The burden of an economic downturn is borne disproportionately by those who lose their jobs.
Although this figure displays the history of the US economy over these 50 years, similar figures can be constructed for other countries around the world. They do not all look identical, but the pattern of uneven growth that we observe for the United States is one that we also see for most other countries. However, it is not true everywhere. We will also see examples of countries that have become poorer rather than richer in recent decades.
Real GDP is the most frequently watched indicator of economic performance. A second key indicator is the one in the top right screen of Figure 3.1.1: the inflation rate. The Bureau of Labor Statistics (BLS) collects information on prices on an ongoing basis; each month it releases information on how fast prices are changing. The rate at which prices are changing is the inflation rate. Other countries similarly have government agencies entrusted with gathering information about the inflation rate and other economic indicators.
It may seem that the job of the BLS is pretty easy: get information on prices and report it. Their task is, in fact, rather complex. In part, it is difficult because there are so many goods and services in the economy. So when we say that prices are increasing, we must decide which goods and services we are talking about. In addition, new goods appear, and obsolete goods disappear; the BLS must take this into account. And the quality of goods changes as well. If the price of a computer increases, is this an example of inflation or does it reflect an increase in the quality of the computer?
What are the implications of an inflation announcement? All else being the same, higher prices mean that we are unable to afford goods and services we were able to buy when prices were lower. But “all else” is not the same. Generally when prices increase, wages also increase. This means that the overall effects of inflation on our ability to buy goods and services are not self-evident.
Another implication of inflation is the policy response it elicits. The monetary authorities in the United States and many other countries are focused on ensuring that inflation does not get out of control. A report of inflation might therefore lead to a response by a monetary authority. Inflation affects us directly through the prices we pay and the wages we receive and indirectly through the policy response it induces.
Though not included in our screens, another significant variable also indicates the state of the macroeconomy: the rate of unemployment. The BLS ( http://www.bls.gov/news.release/empsit.toc.htm) reports the unemployment rate on a monthly basis. It measures the fraction of people in the labor force who do not have a job. When real GDP is relatively high, then the unemployment rate tends to be lower than average, but when real GDP decreases, more people find themselves out of a job.
The Making of Fiscal and Monetary Policy
The top screens in Figure 3.1.1 provide information that flows to the policymakers in an economy. These policymakers carefully watch the state of the economy and then, if appropriate, take actions. The bottom screens in Figure 3.1.1 show policy in action.
Fiscal Policy
For individuals and firms paying taxes in the United States, April 15 is an important day because tax forms are due for the previous calendar year. Each year US citizens fill out their tax forms and either make tax payments or receive reimbursements from the government.
The tax day differs across countries, but the experience is much the same everywhere: individuals and firms must pay taxes to the government. This is one of the key ways in which citizens interact with their governments.
A more complete version of the 1040EZ form for 2010 is shown in Figure 3.2.2 "Form 1040EZ".
Figure \(2\): Form 1040EZ
From the perspective of an individual filling out this form, the task is to get the data correct and determine exactly what figures go where on the form. This is no small challenge. From the perspective of economists working for the government, the tax form is an instrument of fiscal policy. Embedded in the tax form are various tax rates that must be paid on the different types of income you earn.
Where do these tax revenues go? The government collects taxes to finance its purchases of goods and services in the economy—such as roads, schools, and national defense—and also to make transfers to households, such as unemployment insurance.
The tax forms we fill out change each year, sometimes quite significantly. The tax rates households and firms confront are changed by governmental decisions. The government alters tax rates to affect the level of economic activity in the economy. It uses these tools when, in its judgment, the level of economic activity (as measured by real GDP, the unemployment rate, and other variables we will learn about) is insufficient. This is a delicate assessment that requires an understanding of the meaning and measurement of satisfactory economic performance and a deep understanding of how the economy works.
For example, consider the winter of 2008. Policymakers working in the White House and on Capitol Hill kept careful track of the state of the economy, looking as we just did at announcements from the BEA and the BLS on output and inflation. Eventually, they concluded that economic activity was not at a high enough level. They took actions to increase output by reducing taxes through the American Recovery and Reinvestment Act of 2009 ( www.irs.gov/newsroom/article/0,,id=204335,00.html). The idea is as follows: when people pay less in taxes, they have more income available to spend, so they will purchase more goods and services. The link between the legislation and you as an individual is through tax forms like the one shown in Figure 3.2.2 "Form 1040EZ".
Monetary Policy
The bottom right screen in Figure 3.1.1 shows a decision of the Federal Open Market Committee (FOMC) to reduce a key interest rate by three-fourths of a percentage point to 2.25 percent. As we shall see in our study of monetary policy, a reduction in interest rates is a tool to increase economic activity. Lower interest rates make it cheaper for households and firms to borrow, so they spend more on goods and services. The FOMC action was taken on account of weak economic conditions in the United States, but its consequences were felt worldwide.
Other monetary authorities likewise look at the state of their economies and adjust their monetary policy. The following is part of a statement from the European Central Bank (ECB), the monetary policy authority for the European Union. It was part of a press conference held in April 2005 in which Jean-Claude Trichet, president of the ECB, and Lucas Papademos, vice president of the ECB, provided a statement about economic outlook for Europe and the stance of monetary policy.
All in all, we have not changed our assessment of risks to price stability over the medium term. So far, we have seen no significant evidence of underlying domestic inflationary pressures building up in the euro area. Accordingly, we have left the key ECB interest rates unchanged. Both nominal and real rates are at exceptionally low levels, lending ongoing support to economic activity. However, upside risks to price stability over the medium term remain and continued vigilance is therefore of the essence.
I shall now explain our assessment in more detail, turning first to the economic analysis. Recent data and survey indicators on economic activity have been mixed. In general they point to ongoing economic growth at a moderate pace over the short term, with no clear signs as yet of a strengthening in underlying dynamics.
Looking further ahead, the conditions remain in place for moderate economic growth to continue. Global growth remains solid, providing a favourable environment for euro area exports. On the domestic side, investment is expected to continue to be supported by very favourable financing conditions, improved profits and greater business efficiency. Consumption growth should develop in line with real disposable income growth. However, at the same time, persistently high oil prices in particular pose downside risks to growth.
[…]“Introductory Statement with Q&A,” European Central Bank, April 7, 2005, accessed June 27, 2011, http://www.ecb.int/press/pressconf/2005/html/is050407.en.html.
Statements such as this are reported in the business press and widely read. Businesspeople all over the world closely follow the actions of central banks. That is, the people interested in this statement by the ECB were not only European citizens but also individuals in the United States and other countries. Likewise, when the Fed takes action, the news shows up on televisions and computer screens across the world.
The ECB quotation mentions several key economic variables: inflation, real interest rates, nominal interest rates, economic activity, investment, exports, consumption growth, and real disposable income growth. These variables are also important indicators of the state of the economy, as we can tell from the fact that they play such a prominent role in the ECB assessment.
The economists at the ECB need to know the current state of the economy when deciding on what policies to pursue. But there are compelling reasons for others to care about these variables as well. Suppose, for example, that you are an investor contemplating an investment in Spain. Your interest is in making profit from producing a good in Spain and selling it in that country and others. The profitability of the investment in Spain depends on the overall state of the Spanish economy and its neighbors in the European Union who are the target group for your sales.
For you as an investor, the ECB statement contains vital information about the state of the European economy. It also contains information on the likely conduct of monetary and fiscal policy in Europe. These factors matter for you simply because they impact the profitability of your investment. Thus you want to understand the statements from the ECB, starting with the definitions of key macroeconomic variables.
By now, you may well have a number of questions. What exactly are these monetary authorities in Europe and the United States? Where do they come from and what are their powers? How exactly do their actions have so much influence on our lives? Answering these questions is one of our tasks in this book. We devote two full chapters to the determination and the influence of monetary policy in the economy.
Key Takeaways
• Real GDP has grown on average over the past 50 years, but the growth is not always constant: sometimes the economy grows quickly and sometimes real GDP grows slowly (or not at all).
• The inflation rate measures the percent change in prices. If prices are increasing, then a unit of currency, such as a dollar, buys fewer goods and services. During a period of inflation, the monetary authority may take action to reduce the inflation rate.
• Each year, the income taxes we pay to the government reflect its choice of fiscal policy. The policy meetings of the FOMC in the United States, the ECB of the European Monetary Union, and other central banks around the world are examples of monetary policy.
check your understanding
1. Which of the macroeconomic variables discussed would a fiscal authority pay attention to?
2. Do the ECB and the FOMC always make the same policy decision?
3. Is a change in the tax code an example of fiscal or monetary policy? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/03%3A_Macroeconomics_in_Action/3.02%3A_Behind_the_Screens.txt |
Learning Objectives
After you have read this section, you should be able to answer the following questions:
1. What is the methodology of macroeconomics?
2. What is the role of models in the making of macroeconomic policy?
We have seen the news and policy in action. But there is a vital piece missing: given the economic news, how do policymakers know what to do? The answer to this question is at the heart of this book. The basic methodology of macroeconomics is displayed in Figure 3.3.1 "Macroeconomics Methodology". Macroeconomics involves the interplay of theory, data, and policy. We have already seen two of these components in Figure 3.1.1. Two screens highlighted data we have on the macroeconomy, and two screens highlighted policy actions.
Figure \(1\): Macroeconomics Methodology
The answer to the question “how do policymakers know what to do?” is on the top left of Figure 3.3.1 "Macroeconomics Methodology": theory. Macroeconomists typically begin by observing the world and then try to develop a theoretical framework to explain what they have seen. (An old joke says that the definition of an economist is “someone who sees something happen in practice and wonders whether on earth it is possible in theory.”) Usually, a theory developed by economists has a mathematical foundation—expressed by either equations or diagrams. There is even a bit of art here: the theoretical framework must be simple enough to work with yet realistic enough to be useful.
We hinted at these theories in our earlier discussion when we explained that both monetary policy and fiscal policy affect the economy by changing the willingness of households and firms to purchase goods and services. In our applications chapters, we develop these ideas and explain the frameworks that policymakers use when deciding on their policies.
Our frameworks—or models, as they are often called—are tested by their ability to match existing data and provide accurate predictions about new data. Models are constantly refined so that they can do a better job of matching facts. After many rounds of interaction between theory and data, a useful framework emerges. This then becomes the basis for policymaking.
How do policymakers know about the theories devised by economists? Politicians are typically not expert economists. In most countries, a large number of trained economists are employed as advisors to the government. These individuals have studied economic theory and are also familiar with economic statistics, allowing them to provide the link between the economic frameworks and the actual implementation of policy.
The big challenge for economists is to understand the links from policy to the aggregate economy. When you first learned to drive, you were presumably introduced to all the instruments in the car: the steering wheel, the accelerator, the brake, the mirrors, and so forth. At the same time, you were learning the rules of the road. For many, the instruments of the car are easy enough to grasp, and the rules of the road are reasonably intuitive. The difficulty (and this is why driving schools make money) is in making the connection between the controls in the car and the outcome you wish to achieve while driving. The same is true of economic modeling: policy tools are not very difficult to understand, yet it can take decades of experience to truly understand how to use these tools effectively.
Economists and businesspeople hope, for example, that the current chairman of the Federal Reserve, Ben Bernanke, has this understanding, as discussed in the following news article excerpt.
Economic View: Bernanke’s Models, and Their Limits
In terms of intellect, Ben S. Bernanke may be to the Federal Reserve what John G. Roberts Jr. is to the Supreme Court. And like Chief Justice Roberts, Mr. Bernanke, the nominee to replace Alan Greenspan at the Fed, has left a paper trail worth studying. What can it tell us about the sort of Fed chairman he would be?
In general, Mr. Bernanke’s work has been solidly in the mainstream—a mainstream he has helped define since he began publishing papers in major economic journals since 1981. He has written repeatedly about ways of using mathematical models of a dauntingly complex economy to set monetary policy. When he has strayed from that subject, his conclusions have sometimes raised eyebrows.
[…]
These topics, however, are not at the core of what Mr. Bernanke would be concerned with at the Fed. There, his opinions about domestic monetary policy would be more important. One tenet of Mr. Bernanke’s philosophy could not be clearer: that the central bank should use a model, not just hunches, to decide about interest rates and the money supply.
This is how he put it in 1997 in a paper with Michael Woodford, now a professor of political economy at Columbia: “We conclude that, although private-sector forecasts may contain information useful to the central bank, ultimately the monetary authorities must rely on an explicit structural model of the economy to guide their policy decisions.”
[…]Daniel Altman, “Economic View: Bernanke’s Models, and Their Limits,” New York Times, October 30, 2005, accessed June 27, 2011, http://www.nytimes.com/2005/10/30/business/yourmoney/30econview.html.
Key Takeaways
• The methodology of macroeconomics involves the interplay between data and models.
• Abstract models provide policymakers with a framework to understand what is happening in the macroeconomy and also a way to predict the effects of policy actions.
check you understanding
1. Why are economic models always being refined?
2. If a theory is inconsistent with some but not all observations, could it still be useful for policymaking purposes? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/03%3A_Macroeconomics_in_Action/3.03%3A_Between_News_and_Policy-_The_Framework_of_Macroeconomics.txt |
In Conclusion
Our book is built around economic topics, such as the income tax code, the social security system, the determination of monetary policy in Europe, and the contrasting economic health of different countries.
Throughout this book, we will emphasize the measurement and interpretation of economic data. Understanding how to read charts and tables of economic data is a critical skill for anyone who wants to be a sophisticated consumer of economic and political news. We also explain both policy tools and their links to economic outcomes. Understanding these links requires a model of the economy. We introduce models as needed, in the context of their applications. Mastering macroeconomics involves both understanding the tools that macroeconomists use and knowing how and when those tools should be applied. In this book, you will learn about these tools by example: you will see them in use as we study different questions in economics. At the same time, you will learn about many topics that should interest you as engaged and aware citizens of the world. We hope that, after reading this book, you will both better understand what it is that economists do and be better informed about the world in which we all live.
As you proceed through the chapters, you will often see reference to our toolkit. This is a collection of some of the most important tools that we use over and over in different chapters. Each tool is fully introduced somewhere in the book, but you can also use the toolkit as a reference when working through different chapters. In addition, it can serve as a study aid when you are preparing for quizzes and examinations.
We try to avoid getting too hung up on the mathematical expression of our theories (although the math will usually be lurking in the background where you can’t quite see it). In particular, our applications chapters contain very little mathematics. This means that you can read and understand the applications without needing to work through a lot of mathematics. Compared to our applications chapters, our toolkit contains slightly more formal versions of the frameworks that we develop. You will refer to the tools over and over again as we progress through the book, for the same tool is often used to shed light on all sorts of different questions.
exercises
1. Provide updated information for at least one of the four screens in Figure 3.1.1.
2. Use the Internet to find an article (for example, magazine, newspaper, publication of an economics research group) that contains a graph of real GDP for a country other than the United States. What purpose does the picture serve in the article? Why do you think it was included?
3. Find a statement about monetary policy from the monetary authority in the United States, Canada, or Australia. What are some of the indicators of the state of the economy that are used in the policy statement?
4. The article on Bernanke’s model contained the following quote: “We conclude that, although private-sector forecasts may contain information useful to the central bank, ultimately the monetary authorities must rely on an explicit structural model of the economy to guide their policy decisions.” What do you think is meant by this statement? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/03%3A_Macroeconomics_in_Action/3.04%3A_End-of-Chapter_Material.txt |
Thumbnail: https://pixabay.com/photos/hands-money-palm-trifle-coins-4604066/
04: Everyday Decisions
Economics is about you. It is about how you make choices. It is about how you interact with other people. It is about the work you do and how you spend your leisure time. It is about the money you have in your pocket and how you choose to spend it. Because economics is about your choices plus everyone else’s, this is where we begin. As far as your own life is concerned, you are the most important economic decision maker of all. So we begin with questions you answer every day:
• What will I do with my money?
• What will I do with my time?
Economists don’t presume to tell you what you should do with your time and money. Rather, studying economics can help you better understand your own choices and make better decisions as a consequence. Economics provides guidelines about how to make smart choices. Our goal is that after you understand the material in this chapter, you will think differently about your everyday decisions.
Decisions about spending money and time have a key feature in common: scarcity. You have more or less unlimited desires for things you might buy and ways that you might spend your time. But the time and the money available to you are limited. You don’t have enough money to buy everything you would like to own, and you don’t have enough time to do everything you would like to do.
Because both time and money are scarce, whenever you want more of one thing, you must accept that you will have less of something else. If you buy another game for your Xbox, then you can’t spend that money on chocolate bars or movies. If you spend an hour playing that game, then that hour cannot be spent studying or sleeping. Scarcity tells us that everything has a cost. The study of decision making in this chapter is built around this tension. Resources such as time and money are limited even though desires are essentially limitless.
Road Map
We tackle the two questions of this chapter in turn, but you will see that there are close parallels between them. We begin by looking at spending decisions. Although we have said that money is scarce, a more precise statement is that you have limited income. (Economists usually use the term “money” more specifically to mean the assets, such as currency in your wallet or funds in your checking account, that you use to buy things.) Because your income is limited, your spending opportunities are also limited. We show how to use the prices of goods and services, together with your income, to analyze what spending decisions are possible for you. Then we think about what people’s wants and desires look like. Finally, we put these ideas together and uncover some principles about how to make choices that will best satisfy these desires.
Your decisions about what to buy therefore depend on how much income you have and the prices of goods and services. Economics summarizes these decisions in a simple way by using the concept of demand. We show how demand arises from the choices you make. Demand is one of the most useful ideas in economics and lies at the heart of almost everything we study in this book.
Finally, we turn to the decision about how to spend your time. Again, we begin with the idea that your resources are limited: there are only so many hours in a day. As with the spending decision, you have preferences about how to spend your time. We explain the principles of good decision making in this setting. Based on this analysis, we introduce another central economic idea—that of supply.
Economics is both prescriptive and descriptive. Economics is prescriptive because it tells you some rules for making good decisions. Economics is descriptive because it helps us explain the world in which we live. As well as uncovering some principles of good decision making, we discuss whether these are also useful descriptions of how people actually behave in the real world. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/04%3A_Everyday_Decisions/4.01%3A_You_and_Your_Choices.txt |
Learning Objectives
1. What are an individual’s budget set and budget line?
2. What is an opportunity cost?
3. How do people make choices about how much to consume?
4. What features do we expect most people’s preferences to have?
5. What does it mean to make rational choices?
We start with the decision about how to spend your income. We want to know what possibilities are available to you, given that your income is limited but your desires are not.
The Budget Set
We describe your personal decision making on a month-by-month basis (although we could equally well look at daily, weekly, or even annual decisions because the same basic ideas would apply). Suppose you receive a certain amount of income each month—perhaps from a job or a student grant. The government takes away some of this income in the form of taxes, and the remainder is available for you to spend. We call the income that remains after taxes your disposable income.
You may want to put aside some of this income for the future; this is your savings. The remainder is your consumption, which is your spending on all the goods and services you buy this month: rent, food, meals out, movies, cups of coffee, CDs, music downloads, DVD rentals, chocolate bars, books, bus rides, haircuts, and so on. Figure 4.2.1 "What You Do with Your Income" shows this process.
Here is a schematic view of what happens to your income.
This view of your paycheck involves several economic decisions. Some of these are decisions made by the government. Through its tax policies, the government decides how much of your income it takes from you and how much is left as disposable income. You make other decisions when you allocate your disposable income among goods and services today and in the future. You choose how to divide your disposable income between consumption this month and saving for the future. You also decide exactly how much of each good and service you purchase this month. We summarize your ability to purchase goods and services by your budget set.
Toolkit: Section 31.1 "Individual Demand"
The budget set is a list of all the possible combinations of goods and services that are affordable, given both income and the prices of all goods and services. It is defined by
$total\ spending\ ≤\ disposable\ income.$
Begin by supposing you neither save nor borrow. We can construct your budget set in three steps.
1. Look at spending on each good and service in turn. For example, your monthly spending on cups of coffee is as follows: $spending\ on\ coffee = number\ of\ cups\ purchased \times price\ per\ cup.$
A similar equation applies to every other good and service that you buy. Your spending on music downloads equals the number of downloads times the price per download, your spending on potato chips equals the number of bags you buy times the price per bag, and so on.
2. Now add together all your spending to obtain your total spending: $total\ spending = spending\ on\ coffee + spending\ on\ downloads + … ,$
where … means including the spending on every different good and service that you buy.
3. Observe that your total spending cannot exceed your income after taxes: $total\ spending \leq disposable\ income.$
You are consuming within your budget set when this condition is satisfied.
In principle, your list of expenditures includes every good and service you could ever imagine purchasing, even though there are many goods and services you never actually buy. After all, your spending on Ferraris every month equals the number of Ferraris that you purchase times the price per Ferrari. If you buy 0 Ferraris, then your spending on Ferraris is also $0, so your total spending does include all the money you spend on Ferraris. Imagine now that we take some bundle of products. Bundle here refers to any collection of goods and services—think of it as being like a grocery cart full of goods. The bundle might contain 20 cups of coffee, 5 music downloads, 3 bags of potato chips, 6 hours of parking, and so on. If you can afford to buy this bundle, given your income, then it is in the budget set. Otherwise, it is not. The budget set, in other words, is a list of all the possible collections of goods and services that you can afford, taking as given both your income and the prices of the goods and services you might want to purchase. It would be very tedious to write out the complete list of such bundles, but fortunately this is unnecessary. We merely need to check whether any given bundle is affordable or not. We are using affordable not in the casual everyday sense of “cheap” but in a precise sense: a bundle is affordable if you have enough income to buy it. It is easiest to understand the budget set by working though an example. To keep things really simple, suppose there are only two products: chocolate bars and music downloads. An example with two goods is easy to understand and draw, but everything we learn from this example can be extended to any number of goods and services. Suppose your disposable income is$100. Imagine that the price of a music download is $1, while the price of a chocolate bar is$5. Table 4.2.1 "Spending on Music Downloads and Chocolate Bars" shows some different bundles that you might purchase. Bundle number 1, in the first row, consists of one download and one chocolate bar. This costs you $6—certainly affordable with your$100 income. Bundle number 2 contains 30 downloads and 10 chocolate bars. For this bundle, your total spending on downloads is $30 (= 30 ×$1), and your total spending on chocolate bars is $50 (= 10 ×$5), so your overall spending is $80. Again, this bundle is affordable. You can imagine many other combinations that would cost less than$100 in total.
Bundle Number of Downloads Price per Download ($) Spending on Downloads ($) Number of Chocolate Bars Price per Chocolate Bar ($) Spending on Chocolate Bar ($) Total Spending ($) 1 1 1 1 1 5 5 6 2 30 1 30 10 5 50 80 3 50 1 50 10 5 50 100 4 20 1 20 16 5 80 100 5 65 1 65 7 5 35 100 6 100 1 100 0 5 0 100 7 0 1 0 20 5 100 100 8 50 1 50 11 5 55 105 9 70 1 70 16 5 80 150 10 5,000 1 5,000 2,000 5 10,000 15,000 Table $1$: Spending on Music Downloads and Chocolate Bars Bundles 3, 4, 5, 6, and 7 are special because they are affordable if you spend all your income. For example, you could buy 50 downloads and 10 chocolate bars (bundle 3). You would spend$50 on music downloads and $50 on chocolate bars, so your total spending would be exactly$100. Bundle 4 consists of 20 downloads and 16 chocolate bars; bundle 5 is 65 downloads and 7 chocolate bars. Again, each bundle costs exactly $100. Bundle 6 shows that, if you chose to buy nothing but downloads, you could purchase 100 of them without exceeding your income, while bundle 7 shows that you could buy 20 chocolate bars if you chose to purchase no downloads. We could find many other combinations that—like those in bundles 3–7—cost exactly$100.
Bundles 8, 9, and 10 are not in the budget set. Bundle 8 is like bundle 3, except with an additional chocolate bar. Because bundle 3 cost $100, bundle 8 costs$105, but it is not affordable with your $100 income. Bundle 9 costs$150. Bundle 10 shows that you cannot afford to buy 5,000 downloads and 2,000 chocolate bars because this would cost $15,000. There is quite literally an infinite number of bundles that you cannot afford to buy. This figure shows the combinations of chocolate bars and music downloads from Table 4.2.1 "Spending on Music Downloads and Chocolate Bars". Figure 4.2.2 "Various Bundles of Chocolate Bars and Downloads" illustrates the bundles from Table 4.2.1 "Spending on Music Downloads and Chocolate Bars". The vertical axis measures the number of music downloads, and the horizontal axis measures the number of chocolate bars. Any point on the graph therefore represents a consumption bundle—a combination of music downloads and chocolate bars. We show the first nine bundles from Table 4.2.1 "Spending on Music Downloads and Chocolate Bars" in this diagram. (Bundle 10 is several feet off the page.) If you inspect this figure carefully, you may be able to guess for yourself what the budget set looks like. Look in particular at bundles 3, 4, 5, 6, and 7. These are the bundles that are just affordable—that cost exactly$100. It appears as if these bundles all lie on a straight line, which is in fact the case. All the combinations of downloads and chocolate bars that are just affordable represent a straight line.
Meanwhile, the bundles that are affordable with income to spare—like bundles 1 and 2—are below the line, and the bundles you cannot afford—like bundles 8, 9, and 10—are above the line. Building on these discoveries, we find that the budget set is a triangle ( Figure 4.2.3 "The Budget Set").
Figure $3$: The Budget Set
The bundles that are affordable are in the budget set, shown here as a triangle.
Every point—that is, every combination of downloads and chocolate bars—that lies on or inside this triangle is affordable. Points outside the triangle are not affordable, so they are not in the budget set.
What Have We Assumed?
We now have a picture of the budget set. However, you might be curious about whether we have sneaked in any assumptions to do this. This is a Principles of Economics book, so we must start by focusing on the basics. We do our best throughout the book to be clear about the different assumptions we make, including their importance.
• We have assumed that there are only two products. Once we have more than two products, we cannot draw simple diagrams. Beyond this, though, there is nothing special about our downloads-and-chocolate-bar example. We are using an example with two products simply because it makes our key points more transparent. We can easily imagine a version of Table 4.2.1 "Spending on Music Downloads and Chocolate Bars" with many more goods and services, even if we cannot draw the corresponding diagram.
• We assume that you cannot consume negative quantities of downloads or chocolate bars. In our diagram, this means that the horizontal and vertical axes give us two sides of the triangle. This seems reasonable: it is not easy to imagine consuming a negative quantity of chocolate bars. (If you started out with some chocolate bars and then sold them, this is similar to negative consumption.)
• An easier way to look at this is to add any money you get from selling goods or services to your income. Then we can focus on buying decisions only.
• By shading in the entire triangle, we suppose that you can buy fractional quantities of these products. For example, the bundle consisting of 17.5 downloads and 12.7 chocolate bars is inside the triangle, even though iTunes, for example, would not allow you to purchase half a song, and you are unlikely to find a store that will sell you 0.7 chocolate bars. For the most part, this is a technical detail that makes very little difference, except that it makes our lives much easier.
• We have supposed that the price per unit of downloads and chocolate bars is the same no matter how few or how many you choose to buy. In the real world, you may sometimes be able to get quantity discounts. For example, a store might have a “buy two get one free” offer. In more advanced courses in microeconomics, you will learn that we can draw versions of Figure 4.2.3 "The Budget Set" that take into account such pricing schemes.
• We assume no saving or borrowing. It is easy to include saving or borrowing in this story, though. We think of borrowing as being an addition to your income, and we think of saving as one more kind of spending. Thus if you borrow, the budget set is described by $total\ spending\ ≤\ disposable\ income\ +\ borrowing.$
If you save, the budget set is described by
$total\ spending\ +\ spending\ ≤\ disposable\ income.$
The Budget Line
Continuing with our two-goods example, we know that
$spending\ on\ chocolate\ =\ number\ of\ chocolate\ bars\ ×\ price\ of\ a\ chocolate\ bar$
and
$spending\ on\ downloads\ =\ number\ of\ downloads\ ×\ price\ of\ download.$
When total spending is exactly equal to total disposable income, then
$(number\ of\ chocolate\ bars\ ×\ price\ of\ a\ chocolate\ bar)\ +\ (number\ of\ downloads\ ×\ price\ of\ download)\ =\ disposable\ income.$
Toolkit: Section 31.1 "Individual Demand"
The budget line lists all the goods and services that are affordable, given prices and income, assuming you spend all your income.
The difference between the definitions of the budget set and the budget line is that there is an inequality in the budget set and an equality in the budget line:
$total\ spending\ =\ disposable\ income.$
Figure $4$: The Budget Line
The bundles that are exactly affordable are on the budget line.
In the two-goods example, the budget line is the outside edge of the budget set triangle, as shown in Figure 4.2.4 "The Budget Line". What information do we need to draw the budget line? If we know both prices and the total amount of income, then this is certainly enough. In fact, we need only two pieces of information (not three) because basic mathematics tells us that it is enough to know two points on a line: once we have two points, we can draw a line. In practice, the easiest way to draw a budget line is to find the intercepts—the points on each axis. These correspond to how much you can obtain of each product if you consume 0 of the other. If you don’t buy any chocolate bars, you have enough income to buy 100 downloads. If the number of chocolate bars is 0, then the budget line becomes
$number\ of\ downloads\ ×\ price\ of\ download\ =\ disposable\ income,$
so
Similarly, if the number of downloads is 0,
So we have two points on the budget line: (1) 0 chocolate bars and 100 downloads and (2) 0 downloads and 20 chocolate bars.
Another way to describe the budget line is to write the equation of the line in terms of its intercept (on the vertical axis) and its slope:To derive this equation, go back to the budget line and divide both sides by the price of a download:Rearranging, we get the equation in the text.
The intercept is which answers the following question: “How many downloads can you obtain if you buy no chocolate?” As we have already seen, this is 100 in our example.
The slope is
which answers the following question: “What is the rate at which you can trade off downloads for chocolate bars?” In our example, this is −5. If you give up 1 chocolate bar, you will have an extra $5 (the price of a chocolate bar), which allows you to buy 5 more downloads. The negative slope of the budget line says that to get more downloads, you must give up some chocolate bars. The cost of getting more downloads is that you no longer have the opportunity to buy as many chocolate bars. More generally, economists say that the opportunity cost of an action is what you must give up to carry out that action. Likewise, to get more chocolate bars, you must give up some downloads. The opportunity cost of buying a chocolate bar is that you do not have that the money available to purchase downloads. The idea of opportunity cost pervades economics. You may well have heard the following quotation that originated in economics: “There is no such thing as a free lunch.” This statement captures the insight that everything has an opportunity cost, even if it is not always obvious who pays. Economists’ habit of pointing out this unpleasant truth is one reason that economics is labeled “the dismal science.”Although economists may dislike this characterization of their profession, they can take pride in its origin. The term was coined by Thomas Carlyle about 150 years ago, in the context of a debate about race and slavery. Carlyle criticized famous economists of the time, such as John Stuart Mill and Adam Smith, who argued that some nations were richer than others not because of innate differences across races but because of economic and historical factors. These economists argued for the equality of people and supported the freedom of slaves. We said that a goal of this chapter is to help you make good decisions. One ingredient of good decision making is to understand the trade-offs that you face. Are you thinking of buying a new$200 mobile phone? The cost of that phone is best thought of, not as a sum of money, but as the other goods or services that you could have bought with that $200. Would you rather have 200 new songs for your existing phone instead? Or would you prefer 20 trips to the movies, 40 ice cream cones, or$200 worth of gas for your car? Framing decisions in this way can help you make better choices.
Your Preferences
Your choices reflect two factors. One is what you can afford. The budget set and the budget line are a way of describing the combinations of goods and services you can afford. The second factor is what you like, or—to use the usual economic term—your preferences.
Economists don’t pretend to know what makes everyone happy. In our role as economists, we pass no judgment on individual tastes. Your music downloads might be Gustav Mahler, Arctic Monkeys, Eminem, or Barry Manilow. But we think it is reasonable to assume three things about the preferences that underlie your choices: (1) more is better, (2) you can choose, and (3) your choices are consistent.
More Is Better
Economists think that you are never satisfied. No matter how much you consume, you would always like to have more of something. Another way of saying this is that every good is indeed “good”; having more of something will never make you less happy. This assumption says nothing more than people don’t usually throw their income away. Even Bill Gates is not in the habit of burning money.
“More is better” permits us to focus on the budget line rather than the budget set. In Figure 4.2.3 "The Budget Set", you will not choose to consume at a point inside the triangle of the budget set. Instead, you want to be on the edge of the triangle—that is, on the budget line itself. Otherwise, you would be throwing money away. It also allows us to rank some of the different bundles in Table 4.2.1 "Spending on Music Downloads and Chocolate Bars". For example, we predict you would prefer to have bundle 3 rather than bundle 2 because it has the same number of chocolate bars and more downloads. Likewise, we predict you would prefer bundle 8 to bundle 3: bundle 8 has the same number of downloads as bundle 3 but more chocolate bars.
By the way, we are not insisting that you must eat all these chocolate bars. You are always allowed to give away or throw away anything you don’t want. Equally, the idea that more is better does not mean that you might not be sated with one particular good. It is possible that one more chocolate bar would make you no happier than before. Economists merely believe that there is always something that you would like to have more of.
“More is better” does not mean that you necessarily prefer a bundle that costs more. Look at bundles 7 and 9. Bundle 7 contains 0 downloads and 20 chocolate bars; it costs $100. Bundle 9, which contains 70 downloads and 16 chocolate bars, costs$150. Yet someone who loves chocolate bars and has no interest in music would prefer bundle 7, even though its market value is less.
You Can Choose
Economists suppose that you can always make the comparison between any two bundles of goods and services. If you are presented with two bundles—call them A and B—then the assumption that “you can choose” says that one of the following is true:
• You prefer A to B.
• You prefer B to A.
• You are equally happy with either A or B.
Look back at Table 4.2.1 "Spending on Music Downloads and Chocolate Bars". The assumption that “you can choose” says that if you were presented with any pair of bundles, you would be able to indicate which one you liked better (or that you liked them both equally much). This assumption says that you are never paralyzed by indecision.
“More is better” allows us to draw some conclusions about the choices you would make. If we gave you a choice between bundle 3 and bundle 8, for example, we know you will choose bundle 8. But what if, say, we presented you with bundle 4 and bundle 5? Bundle 5 has more downloads, but bundle 4 has more chocolate bars. “You can choose” says that, even though we may not know which bundle you would choose, you are capable of making up your mind.
Your Choices Are Consistent
Finally, economists suppose that your preferences lead you to behave consistently. Based on Table 4.2.1 "Spending on Music Downloads and Chocolate Bars", suppose you reported the following preferences across combinations of downloads and chocolate bars:
• You prefer bundle 3 to 4.
• You prefer bundle 4 to 5.
• You prefer bundle 5 to 3.
Each choice, taken individually, might make sense, but all three taken together are not consistent. They are contradictory. If you prefer bundle 3 to bundle 4 and you prefer bundle 4 to bundle 5, then a common-sense interpretation of the word “prefer” means that you should prefer bundle 3 to bundle 5.
Consistency means that your preferences must not be contradictory in this way. Put another way, if your preferences are consistent and yet you made these three choices, then at least one of these choices must have been a mistake—a bad decision. You would have been happier had you made a different choice.
Your Choice
We have now looked at your opportunities, as summarized by the budget set, and also your preferences. By combining opportunities and preferences, we obtain the economic approach to individual decision making. Economists make a straightforward assumption: they suppose you look at the bundles of goods and services you can afford and choose the one that makes you happiest. If the claims we made about your preferences are true, then you will be able to find a “best” bundle of goods and services, and this bundle will lie on the budget line. We know this because (1) you can compare any two points and (2) your preferences will not lead you to go around in circles.
An individual’s preferred point reflects opportunities, as given by the budget line, and preferences. The preferred point will lie on the budget line, not inside, because of the assumption that more is better.
In Figure 4.2.5 "Choosing a Preferred Point on the Budget Line", we indicate an example of an individual’s preferred point. The preferred point is on the budget line and—by definition—is the best combination for the individual that can be found in the budget set. At the preferred point, the individual cannot be better off by consuming any other affordable bundle of goods and services.
There is one technical detail that we should add. It is possible that an individual might have more than one preferred point. There could be two or more combinations on the budget line that make an individual equally happy. To keep life simple, economists usually suppose that there is only a single preferred point, but nothing important hinges on this.
Rationality
Economists typically assume rationality of decision makers, which means that people can do the following:
• evaluate the opportunities that they face
• choose among those opportunities in a way that serves their own best interests
Is this a good assumption? Are people really as rational as economists like to think they are? We would like to know if people’s preferences do satisfy the assumptions that we have made and if people behave in a consistent way. If we could hook someone up to a machine and measure his or her preferences, then we could evaluate our assumptions directly. Despite advances in neurobiology, our scientific understanding has not reached that point. We see what people do, not the preferences that lie behind these choices. Therefore, one way to evaluate the economic approach is to look at the choices people make and see if they are consistent with our assumptions.
Imagine you have an individual’s data on download and chocolate bar consumption over many months. Also, suppose you know the prices of downloads and chocolate bars each month and the individual’s monthly income. This would give you enough information to construct the individual’s budget sets each month and look for behavior that is inconsistent with our assumptions. Such inconsistency could take different forms.
• She might buy a bundle of goods inside the budget line and throw away the remaining income.
• In one month, she might have chosen a bundle of goods—call it bundle A—in preference to another affordable bundle—call it bundle B. Yet, in another month, that same individual might have chosen bundle B when she could also have afforded bundle A.
The first option is inconsistent with our idea that “more is better.” As for the second option, it is generally inconsistent to prefer bundle A over bundle B at one time yet prefer bundle B over bundle A at a different time. (It is not necessarily inconsistent, however. The individual might be indifferent between bundles A and B, so she doesn’t care which bundle she consumes. Or her preferences might change from one month to the next.)
Inconsistent Choices
Economists are not the only social scientists who study how we make choices. Psychologists also study decision making, although their focus is different because they pay more attention to the processes that lie behind our choices. The decision-making process that we have described, in which you evaluate each possible option available to you, can be cognitively taxing. Psychologists and economists have argued that we therefore often use simpler rules of thumb when we make decisions. These rules of thumb work well most of the time, but sometimes they lead to biases and inconsistent choices. This book is about economics, not psychology, so we will not discuss these ideas in too much detail. Nevertheless, it is worth knowing something about how our decision making might go awry.
On occasion, we make choices that are apparently inconsistent. Here are some examples.
The endowment effect. Imagine you win a prize in a contest and have two scenarios to consider:
1. The prize is a ticket to a major sporting event taking place in your town. After looking on eBay, you discover that equivalent tickets are being bought and sold for $500. 2. The prize is$500 cash.
Rational decision makers would treat these two situations as essentially identical: if you get the ticket, you can sell it on eBay for $500; if you get$500 cash, you can buy a ticket on eBay. Yet many people behave differently in the two situations. If they get the ticket, they do not sell it, but if they get the cash, they do not buy the ticket. Apparently, we often feel differently about goods that we actually have in our possession compared to goods that we could choose to purchase.
Mental states. We may be in a different mental state when we buy a good from when we consume it. If you are hungry when you go grocery shopping, then you may buy too much food. When we buy something, we have to predict how we will be feeling when we consume it, and we are not always very good at making these predictions. Thus our purchases may be different, depending on our state of mind, even if prices and incomes are the same.
Anchoring. Very often, when you go to a store, you will see that goods are advertised as “on sale” or “reduced from” some price. Our theory suggests that people simply look at current prices and their current income when deciding what to buy, in which case they shouldn‘t care if the good used to sell at a higher price. In reality, the “regular price” serves as an anchor for our judgments. A higher price tends to increase our assessment of how much the good is worth to us. Thus we may make inconsistent choices because we sometimes use different anchors.
How should we interpret the evidence that people are—sometimes at least—not quite as rational as economics usually supposes? Should we give up and go home? Not at all. Such findings deepen our understanding of economic behavior, but there are many reasons why it is vital to understand the behavior of rational individuals.
1. Economics helps us make better decisions. The movie Heist has dialogue that sums up this idea:
D. A. Freccia: You’re a pretty smart fella.
Joe Moore: Ah, not that smart.
D. A. Freccia: [If] you’re not that smart, how’d you figure it out?
Joe Moore: I tried to imagine a fella smarter than myself. Then I tried to think, “what would he do?”
Most of us are “not that smart”; that is, we are not smart enough to determine what the rational thing to do is in all circumstances. Knowing what someone smarter would do can be very useful indeed.The quote comes from the Internet Movie Database ( http://www.imdb.com). We first learned of the scene from B. Nalebuff and I. Ayres, Why Not? (Boston: Harvard Business School Press, 2003), 46. Further, if we understand the biases and mistakes to which we are all prone, then we can do a better job of recognizing them in ourselves and adjusting our behavior accordingly.
2. Rationality imposes a great deal of discipline on our thinking as economists. If we suppose that people are irrational, then anything is possible. A better approach is to start with rational behavior and then see if the biases that psychologists and economists have identified are likely to alter our conclusions in a major way.
3. Economics has a good track record of prediction in many settings. A lot of the time, even if not all the time, the idea that people behave rationally seems more right than wrong.
More Complicated Preferences
People may be rational yet have more complicated preferences than we have considered.
Fairness. People sometimes care about fairness and so may refuse to buy something because the price seems unfair to them. In one famous example, people were asked to imagine that they are on the beach and that a friend offers to buy a cold drink on their behalf.See Richard Thaler, “Mental Accounting and Consumer Choice, Marketing Science 4 (1985): 199–214. They are asked how much they are willing to pay for this drink. The answer to this question should not depend on where the drink is purchased. After all, they are handing over some money and getting a cold drink in return. Yet people are prepared to pay more if they know that the friend is going to buy the drink from a hotel bar rather than a local corner store. They think it is reasonable for hotels to have high prices, but if the corner store charged the same price as the hotel, people think that this is unfair and are unwilling to pay.
Altruism. People sometimes care not only about what they themselves consume but also about the well-being of others. Such altruism leads people to give gifts, to give to charity, to buy products such as “fair-trade” coffee, and so on.
Relative incomes. Caring about the consumption of others can take more negative forms as well. People sometimes care about whether they are richer or poorer than other people. They may want to own a car or a barbecue grill that is bigger and better than that of their neighbors.
More complicated preferences such as these are not irrational, but they require a more complex framework for decision making than we can tackle in a Principles of Economics book.We say more about some of these ideas in Chapter 13 "Superstars".
Key Takeaways
• The budget set consists of all combinations of goods and services that are affordable, and the budget line consists of all combinations of goods and services that are affordable if you spend all your income.
• The opportunity cost of an action (such as consuming more of one good) is what must be given up to carry out that action (consuming less of some other good).
• Your choices reflect the interaction between what you can afford (your budget set) and what you like (your preferences).
• Economists think that most people prefer having more to having less, are able to choose among the combinations in their budget set, and make consistent choices.
• Rational agents are able to evaluate their options and make choices that maximize their happiness.
Exercises
1. Suppose that all prices and income were converted into a different currency. For example, imagine that prices were originally in dollars but were then converted to Mexican pesos. Would the budget set change? If so, explain how. If not, explain why not.
2. Assume your disposable income is $100, the price of a music download is$2, and the price of a chocolate bar is \$5. Redo Table 4.2.1 "Spending on Music Downloads and Chocolate Bars". Find (or create) three combinations of chocolate bars and downloads that are on the budget line. Find a combination that is not affordable and another combination that is in the budget set but not on the budget line.
3. What is the difference between your budget set and your budget line? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/04%3A_Everyday_Decisions/4.02%3A_Individual_Decision_Making-_How_You_Spend_Your_Income.txt |
Learning Objectives
1. What is a demand curve, and what is the law of demand?
2. What is the decision rule for choosing how much to buy of two different goods?
3. What is the decision rule for choosing to buy a single unit of a good?
Now that we have a framework for thinking about your choices, we can now explain one of the most fundamental economic ideas: demand. Here we focus on the demand of a single individual.In Chapter 6 "eBay and craigslist", we develop the idea of the market demand curve, which combines the demands of many individuals. We use two different ways of thinking about your demand for a good or a service. One approach builds on the idea of the budget set. The other focuses on how much you would be willing to pay for a good or service. In combination, they give us a detailed understanding of how economic decisions are made.
Individual Demand for a Good
As you visit stores at different times, you undoubtedly notice that the prices of goods and services change. At the same time, your income may also change from one month to the next. So if we were to look at your budget set monthly, we would typically find it changing from one month to the next. We would then expect that you would choose different combinations of goods and services from one month to the next.
To keep things simple, suppose we are still in a world of two goods—downloads and chocolate bars—and that you do no saving. We will describe your demand for chocolate bars. (If you like, you can think of downloads as representing all the other goods and services you consume.) Given prices and your income, you pick the best point on the budget line. Look again at the “preferred” point in Figure 4.2.5 "Choosing a Preferred Point on the Budget Line". One way to interpret this point is that it tells us how many chocolate bars you will buy, given your income and given the price of a chocolate bar and other goods. Using this as a reference point, we now ask how your choice will change as income changes and then as the price of a chocolate bar changes.
Changes in Income
Imagine that your income increases. Figure 4.3.1 "An Increase in Income" shows what happens to the budget line. Higher income means that you can afford to buy more chocolate bars and more downloads, so the budget line shifts outward. The slope of the budget line is unchanged because there is no change in the price of a chocolate bar relative to downloads.
An increase in income shifts the budget line outward.
What happens to your consumption of chocolate bars? There are two possibilities ( Figure 4.3.2 "The Consequences of an Increase in Income"): the increase in income leads you to consume either more chocolate bars or fewer chocolate bars. Both are plausible, and either is possible. (Of course, you might also choose exactly the same amount as before.) We might think that the more normal case is that higher income would lead to higher chocolate bar consumption. If a good has a property that you will consume more of it when you have higher income, we call it a normal good.
Figure \(2\): The Consequences of an Increase in Income
In response to an increase in income, two things are possible: the consumption of chocolate bars may increase (a) or decrease (b).
Under some circumstances, higher income leads to lower consumption. For example, suppose you are surviving in college on a diet consisting of mostly instant noodles. When you graduate college and have higher income, you can afford better things to eat, so you will probably consume a smaller quantity of instant noodles. Economists call such products inferior goods. If a particular product exists in several qualities (cheap versus expensive cuts of meat, for example), we often find that the low-quality version is an inferior good. A good might be normal for one consumer and inferior for another. More precisely, therefore, we say that a good is inferior if, on average, higher income leads to lower consumption.
Economists make a further distinction among different kinds of normal goods. If you spend a larger fraction of your income on a particular good as your income increases, then we say that the good is a luxury good. Another way of saying this is that for a luxury good, the percentage increase in consumption is bigger than the percentage increase in income.
We can also define these ideas in terms of the income elasticity of demand, which is a measure of how sensitive demand is to changes in income. For an inferior good, the income elasticity of demand is negative: higher income leads to lower consumption. For a normal good, the income elasticity of demand is positive. And for a luxury good, the income elasticity of demand is greater than one.
Toolkit: Section 31.2 "Elasticity"
For more discussion of normal, inferior, and luxury goods, see the toolkit.
The distinctions among these different kinds of goods are crucial for managers of firms. To predict sales, managers need to know whether the products they are selling are normal, inferior, or luxury goods. Firms that sell inferior goods tend to do well when the economy as a whole is doing poorly and vice versa. By contrast, firms selling luxury goods will do particularly poorly when the economy as a whole is performing poorly.
Changes in Price
Now we look at what happens if there is a change in the price of a chocolate bar. Suppose the price decreases. First, let us analyze what this means in terms of our picture. Remember that the intercepts of the budget line tell you how much you can have of one good if you consume none of the other. If you consume no chocolate bars, then a decrease in the price of a chocolate bar has no effect on your consumption. You can consume exactly the same number of downloads as before. The intercept on the vertical axis therefore does not move. However, a decrease in the price of a chocolate bar means that, if you consume only chocolate bars, then you can have more than before. The intercept on the horizontal axis moves outward. One way to see this is to remember that this intercept is given by
Figure 4.3.3 "A Decrease in the Price of a Chocolate Bar" illustrates a decrease in the price of a chocolate bar. The new budget line lies outside the old budget line. Any bundle you could have bought at the old prices is still affordable now, and you can also get more. A decrease in the price of a chocolate bar, in other words, makes you better off. In addition, the slope of the budget line changes: it is flatter than before. The slope of the budget line reflects the way in which the market allows you to trade chocolate bars for other products. If you choose to consume fewer downloads, the reduction in the price of a chocolate bar means that you get relatively more chocolate bars in exchange.
A decrease in the price of a chocolate bar causes the budget line to rotate. The result is an increase in the quantity of chocolate bars consumed.
Figure 4.3.3 "A Decrease in the Price of a Chocolate Bar" also shows a new consumption point. In response to the decrease in the price of a chocolate bar, we see an increase in the consumption of chocolate bars. The idea that people almost always consume more of a good when its price decreases is one of the fundamental ideas of economics. Indeed, it is sometimes called the law of demand. It is certainly intuitive that lower prices lead people to consume more. There are two reasons why we expect to see this result.
First, if a good (for example, chocolate bars) decreases in price, it becomes cheaper relative to other goods. Its opportunity cost—that is, the amount of other goods you must give up to get a chocolate bar—has decreased. The lower opportunity cost means that there is a substitution effect away from other goods and toward chocolate bars. Second, a decrease in the price of a chocolate bar also means that you can afford more of everything, including chocolate bars. Provided chocolate bars are a normal good, this income effect will also lead you to want to consume more chocolate bars. If chocolate bars are inferior goods, the income effect leads you to want to consume fewer chocolate bars.
In Figure 4.3.3 "A Decrease in the Price of a Chocolate Bar", the substitution effect is reflected by the fact that the budget line changes slope. The flatter budget line tells us that the opportunity cost of chocolate bars in terms of downloads has decreased. The income effect shows up in the fact that the new budget set includes the old budget set. You can consume your previous bundle of goods and still have some income left over to buy more.
Based on the idea of the law of demand, we can construct your individual demand curve for chocolate bars. We do so by drawing the budget set for each different price of a chocolate bar, seeing how much you buy, and then plotting this data. For example, we might find that your purchases of chocolate bars look like those in Table 4.3.1 "Demand for Chocolate Bars". If we plot these points on a graph and then “fill in the gaps,” we get a diagram like Figure 4.3.4 "The Demand Curve". This is your demand curve for chocolate bars. It tells how many chocolate bars you would purchase at any given price. The law of demand means that we expect this curve to slope downward. If the price increases, you consume less. If the price decreases, you consume more.
Price per Bar (\$) Quantity of Chocolate Bars Bought
1 12
2 6
3 4
4 3
5 2.4
6 2
Table \(1\): Demand for Chocolate Bars
Figure \(4\): The Demand Curve
Table 4.3.1 "Demand for Chocolate Bars" contains an example of some observations on demand. At different prices from \$1 to \$6, we see the number of chocolate bars purchased. If we fill in the gaps, we obtain a demand curve.
Toolkit: Section 31.1 "Individual Demand"
The individual demand curve is drawn on a diagram with the price of a good on the vertical axis and the quantity demanded on the horizontal axis. It is drawn for a given level of income.
We must be careful to distinguish between movements along the demand curve and shifts in the demand curve. Suppose there is a change in the price of a chocolate bar. Then, as we explained earlier, the budget line shifts, and the quantity demanded of both chocolate bars and downloads will change. This appears in Figure 4.3.4 "The Demand Curve" as a movement along the demand curve. For example, if the price of a chocolate bar decreases from \$4 to \$3, then, as in Table 4.3.1 "Demand for Chocolate Bars", the quantity demanded increases from three bars to four bars. The demand curve does not change; we simply move from one point on the line to another.
If a change in anything other than the price of a chocolate bar causes you to change your consumption of chocolate bars, then there is a shift in the demand curve. For example, suppose you get a pay raise at your job, so you have more income. As long as chocolate bars are a normal good, this increase in income will cause your demand curve for chocolate bars to shift outward. This means that, at any given price, you will buy more of the good when income increases. In the case of an inferior good, an increase in income will cause the demand curve to shift inward. You will buy less of the good when income increases. We illustrate these two cases in Figure 4.3.5 "Shifts in the Demand Curve: Normal and Inferior Goods".
Figure \(5\): Shifts in the Demand Curve: Normal and Inferior Goods
(a) If income increases and chocolate bars are a normal good, then the individual demand curve will shift to the right. At every price, a greater quantity of chocolate bars is demanded. (b) If income increases and chocolate bars are inferior goods, then the individual demand curve will shift to the left. In the event of a decrease in income, the two cases are reversed.
Exceptions to the Law of Demand
The law of demand is highly intuitive and is supported by lots of research for all sorts of different goods and services. We can take it as a reliable fact that in almost all circumstances, the demand curve will indeed slope downward. Yet we might still wonder if there are any exceptions, any cases in which the demand curve slopes upward. There are indeed a few such exceptions.
• Giffen goods. We explained that the law of demand comes from both a substitution effect and—for normal goods—an income effect. But for inferior goods, the income effect acts in the opposite direction to the substitution effect: a decrease in price makes people better off, which is an incentive to consume less of the good. Theoretically, it is possible for this income effect to be stronger than the substitution effect. Although conceivable, Giffen goods are extremely rare; indeed, economists are unsure if they actually exist outside of textbooks. For the income effect to overwhelm the substitution effect, the good in question must form a very large part of the overall consumption bundle. This might arise in extremely poor economies where people spend a large part of their income on a staple food, as was found in a recent experiment conducted in rural China.See Robert Jensen and Nolan Miller, “Giffen Behavior: Theory and Evidence” (Harvard University, John F. Kennedy School of Government Working Paper RWP 07-030, July 2007). The researchers gave families subsidies to buy rice, making it cheaper, and found that consumption of rice did indeed decrease.
• Status goods. Some luxury products are purchased mainly for their status appeal—for example, Rolls-Royce automobiles, Louis Vuitton handbags, and Gucci shoes. The high prices of these goods contribute to their exclusivity. Price is an attribute of a good, so a higher price can make a good seem more, not less, attractive. Again, it is theoretically possible that this could lead the demand curve to slope upward, at least for some range of prices. Although high prices increase the appeal of status goods, it is rare for this effect to be strong enough to outweigh the more basic income and substitution effects.
• Judging quality by price. Implicitly, we have supposed that people are well informed about the products they buy. In many cases, though, we must purchase goods and services with only imperfect knowledge of their quality. In this situation, we may use price as an indicator of the quality of a good. Of course, marketers are well aware that we do this and will often try to use price as a signal of the quality of their brand or products. The upshot is that people may be more willing to buy at a higher price.
In these three situations, it is conceivable that we might observe a higher price being associated with a higher quantity of the good being purchased. You should not overestimate the significance of these cases, however, because (1) most products do not fall into any of these categories, and (2) the substitution effect is still in operation for all goods, as is the income effect for all normal goods.
Changes in Other Prices
So far, we have said that the number of chocolate bars you want to buy is affected by income and the price of a chocolate bar. Changes in the prices of other goods also have an impact. In general, an increase in a price of another good could cause the demand for chocolate bars to increase or decrease.
Goods are substitutes if an increase in the price of one good leads to increased consumption of the other good. CDs and music downloads are one example: if the price of CDs increases, you will obtain more music through downloads.
Goods are complements if an increase in the price of one good leads to decreased consumption of the other good. For example, DVDs and DVD players are complements. If the price of DVD players decreases, more people will buy DVD players. As a result, more people will want to buy DVDs.
Toolkit: Section 31.2 "Elasticity"
To learn more about substitutes and complements, see the toolkit for formal definitions. (These definitions are presented in terms of the cross-elasticity of demand, which is a measure of how responsive the quantity demanded is to changes in the price of another good.)
The Valuation Approach to Demand
There is another way of thinking about demand. Instead of focusing attention on the budget set and the budget line, we can think more directly about your preferences. Imagine you are asked the following question in an interview:
What is the maximum amount you would be willing to pay for one chocolate bar?
In answering this question, you should not worry about what would be a reasonable or fair price for a chocolate bar or even about the price at which this chocolate bar might actually be available. You should simply decide how much you want chocolate bars. For example, you might think that you would really like to have at least one chocolate bar, so you would be willing to pay up to \$12 for one bar—that is, you would be happier with one more chocolate bar and up to \$12 less in income. This is your valuation of one chocolate bar.
Now we ask you some more questions.
What is the maximum amount that you would be willing to pay for two chocolate bars? Three chocolate bars?…
Perhaps you decide you would be willing to pay \$18 for two bars, \$22 for three bars, and so on. If we kept asking such questions, we might get the first two columns of Table 4.3.2 "Valuation and Marginal Valuation". We can also plot this valuation (part [a] of Figure 4.3.6 "Valuation of a Good"). Your valuation is increasing; you always like having more chocolate bars because “more is better.”
Quantity of Chocolate Bars Bought Valuation (\$) Marginal Valuation (\$)
0 0.00
1 12.00 12.00
2 18.00 6.00
3 22.00 4.00
4 25.00 3.00
5 27.40 2.40
6 29.40 2.00
Table \(2\): Valuation and Marginal Valuation
Your valuation of a good is the maximum amount that you would be willing to pay, purely on the basis of your desire for the good.
Because you are willing to pay \$12 for one bar and \$18 for two bars, we know you would be willing to pay an additional \$6 for the second chocolate bar. Similarly, if you have two chocolate bars, you would be willing to pay an additional \$4 for a third bar. We call the change in your valuation your marginal valuation (see the third column of Table 4.3.2 "Valuation and Marginal Valuation", which is graphed in part [b] of Figure 4.3.6 "Valuation of a Good"). Notice that marginal valuation decreases as the quantity of chocolate bars increases. The change in your valuation gets smaller as you obtain more chocolate bars. We can see the same thing in part (a) of Figure 4.3.6 "Valuation of a Good" from the fact that the valuation curve gets flatter as the quantity of chocolate bars increases.
Toolkit: Section 31.1 "Individual Demand"
An individual’s valuation of some quantity of a product is the maximum amount the individual would be willing to pay to obtain that quantity. An individual’s marginal valuation of some good is the maximum amount the individual would be willing to pay to obtain one extra unit of that product.
It usually seems reasonable to think that marginal valuations will indeed decrease in this way. If you don’t have any chocolate bars, then the first bar is worth a lot to you—\$12 in our example. But if you already have five chocolate bars, then the sixth bar is worth only \$2 to you. As you obtain more and more of any given product, each additional unit is less and less valuable. For most people, we expect that most products will exhibit such diminishing marginal valuation.
Part (b) of Figure 4.3.6 "Valuation of a Good" may seem familiar. It is the demand curve for chocolate bars you saw previously in Figure 4.3.4 "The Demand Curve". This is not an accident or a coincidence. There is a simple decision rule to tell you how much you should buy: when your marginal valuation is greater than the price, you should buy more of the good, stopping only when the marginal valuation of the good has dropped to the level of the price. For example, suppose that chocolate bars are selling for \$3.99. You should definitely buy the first chocolate bar, because it is worth \$10 to you and will cost you only \$3.99. You should buy the second bar as well because it is worth an additional \$8 to you; likewise you should buy the third and fourth bars. You don’t buy the fifth bar because it is worth only \$3 to you, which is less than what it costs. Thus your decision rule is as follows:
• Buy until the marginal valuation of a good equals the price of the good.
Because the demand curve, by definition, tells you how much you buy at a given price, it is the same as the marginal valuation curve.
Combining the Two Approaches to Demand
We have presented two different ways of thinking about consumer decisions, but the underlying choice is the same. To see how the two approaches are linked, rewrite the decision rule for chocolate bars as buy until
You have a similar decision rule for downloads: buy until
Combining these two equations, we see that
which we can rearrange as
The ratio on the right-hand side of this expression should look familiar. Earlier, we found that the slope of the budget line is
So the marginal valuation of a chocolate bar divided by the marginal valuation of downloads equals minus the slope of the budget line.
What does this mean? The budget line tells us the rate at which the market allows you to trade off chocolate bars for downloads. If you consume one fewer chocolate bar, the number of dollars you will get is equal to the price of a chocolate bar. These dollars will buy you downloads. The ratio of marginal valuations describes how you view the trade-off between chocolate bars and downloads. If you are making good decisions about how to spend your money, then the rate at which you are happy to trade off chocolate bars for downloads equals the rate at which the market allows you to make such trades. If this were not true, then you could make yourself happier by choosing a different bundle on the budget line.
Making Decisions at the Margin
To make good decisions, you need to understand the trade-offs you are making. To put it another way, you need to recognize that every purchase has an opportunity cost, which is summarized by the budget line. If you want more chocolate bars, you must consume less of something else. You also need to find the right point on the budget line—the point that makes you happiest. Most of the time, economists simply assume that you are able to make this decision correctly on the basis of the three assumptions about your preferences that we introduced earlier.
You can also use this theory to help you think about the decisions you make. Suppose you are facing the budget line we discussed earlier and plan to buy 8 chocolate bars and 60 downloads (as in Figure 4.2.5 "Choosing a Preferred Point on the Budget Line"). In principle, you need to compare that bundle with every other combination on the budget line. In practice, it is enough—most of the time at least—to compare it with nearby bundles. For example, if you prefer this bundle to 7 chocolate bars and 65 downloads, and you also prefer this bundle to 9 chocolate bars and 55 downloads, then you can be reasonably confident that you have found the best bundle. If a small change won’t make you happier, then neither will a large change.
Unit Demand
So far we have considered situations where you might buy multiple units of a good—for example, 20 music downloads or 5 chocolate bars. To keep things simple, we also supposed that you could buy fractional amounts, such as 20.7 downloads, or 3.25 chocolate bars. This assumption gives a decision rule for purchase: buy until marginal valuation equals price.
Some purchase decisions are better thought of as “buy or don’t buy.” Large, infrequent purchases fall into this category. Think, for example, about the decision to buy a new car, a new microwave, or an expensive vacation. You won’t buy five microwaves because they are cheap. The decision rule for purchase is even easier in this case: buy if your valuation of the good exceeds the price of the good. In fact, this is really no different from our earlier decision rule. Because you are only ever thinking about buying one unit, your valuation and your marginal valuation are the same thing (look back at the first two rows of Table 4.3.2 "Valuation and Marginal Valuation"). And because in this case it does not make sense to suppose you can buy fractional amounts of the good, you cannot keep buying until your marginal valuation decreases all the way to the price.
If a buyer is interested in purchasing one and only one unit of a good, the unit demand curve tells us the price at which he is willing to buy. Below his valuation, he buys the good. Above his valuation, he does not buy the good. A unit demand curve is shown in Figure 4.3.7 "Unit Demand". In this example, the buyer’s valuation is \$3,000.
The buyer follows this decision rule: “Buy if the price is less than valuation.” If the price is greater than \$3,000, the buyer will not purchase. The quantity demanded is zero. If the price is less than \$3,000, the buyer will purchase one unit. No matter how low the price decreases, the buyer will not want more than a single unit. This is an example of unit demand.
To see where such a valuation could come from, look at Figure 4.3.8 "The Valuation of a Car". Suppose you are thinking about buying a car. The figure shows our standard downloads-and-chocolate-bar diagram, except that there are two budget lines. The outer budget line applies in the case where you do not buy the car. You have a preferred point in terms of downloads and chocolate bars (A). If you buy the car, you have less income to spend on everything else. The effect is to shift your budget line inward, in which case you have a new preferred point (B). The thought experiment here is to decrease your income and shift your budget line inward until you are equally happy with the two bundles. The change in your income—the amount by which the budget line must shift—is your valuation of the car. Your valuation, in other words, is the opportunity cost of the car: if you buy the car, you can only consume bundle B rather than bundle A.
If you don’t buy a car, your preferred mix of chocolate bars and downloads is at point A. If you buy a car, then you no longer have that income available to spend on chocolate bars and downloads. Your budget line shifts inward, and you consume at your preferred point B. Now imagine that you are equally happy at point A and point B. Then the difference in income is equal to your valuation of the car. Thus the valuation of a car is its opportunity cost in terms of other goods.
Budget Studies
Economists’ theories are all well and good. But we do not actually get to see people’s preferences or marginal valuations. We observe what people actually do. To see our theory in action, we can look at household budget studies. These are surveys where government statisticians interview households and ask them how they spend their income. For example, Table 4.3.3 "Budget Shares in the United States" contains data on US consumer expenditures for the years 2005, 2007, and 2009.
Year 2005 2005 (Under 25) 2007 2007 (Under 25) 2009 2009 (Under 25)
Income (before tax) 58,712 27,404 63,091 31,443 62,857 25,695
Spending 46,409 27,770 49,638 29,457 49,067 28,119
Category Percentage of Total Spending
Food 12.8 14.2 12.4 14.1 13.0 14.9
Alcohol 0.9 1.4 0.9 1.6 0.9 1.2
Housing 32.7 32.2 34.1 32.6 34.4 34.6
Apparel 4.1 5.7 3.8 5.0 3.5 5.0
Transportation 18.0 21.6 17.6 19.4 15.9 19.0
Health care 5.7 2.5 5.7 2.7 6.4 2.4
Entertainment 5.2 5.0 5.4 4.9 5.5 4.4
Personal care products and services 1.2 1.2 1.2 1.1 1.2 1.3
Reading 0.3 0.2 0.2 0.2 0.2 0.2
Education 2.0 4.9 1.9 6.1 2.2 6.8
Tobacco 0.7 1.1 0.7 1.0 0.8 1.2
Personal insurance and pensions 11.2 7.7 10.8 8.3 11.2 7.1
Other 5.3 2.3 5.3 3.0 4.8 1.9
Table \(3\): Budget Shares in the United States
Source: US Department of Labor, “Consumer Expenditures Survey,” table 47, http://www.bls.gov/cex/2005/share/age.pdf, http://www.bls.gov/cex/2007/share/age.pdf, and http://www.bls.gov/cex/2009/share/age.pdf, all accessed February 24, 2011.
You can see that, on average, households spend a little more than 45 percent of their income on food and housing. Insurance is also a large category, with about 11 percent of income being spent on it. Chapter 5 "Life Decisions" discusses why we buy insurance. Interestingly, the budget shares do not change much over the three years despite the differences in income and spending. From this we see that, although individual goods may be inferior or luxury goods, such differences are largely offset when we look at broad categories of goods or services.
The table also contains data for households under age 25.This is based on the age of the reference person in the household, who is the individual who owns or rents the property. We can compare the spending patterns of this group against all households. Not surprisingly, the younger group earns less than the average household. Also, this younger group often spends more than it earns, indicating that younger people are borrowing, on average. The younger group spends more on alcohol, transportation, and education and much less on health care and insurance than the average household. This makes sense given the health status of young individuals as well as their demand for education.
Table 4.3.4 "United Kingdom Budget Study" is a UK budget study for households headed by young people (under the age of 30) in 2009. It shows how these households allocated their expenditures over a week.The British source is as follows: Office for National Statistics, Family Spending, 2010, table A.11, accessed January 24, 2011, www.statistics.gov.uk/downloads/theme_social/family-spending-2009/familyspending2010.pdf. We can compare these figures against those for young people in the United States. (We need to be careful in making comparisons because the categories for spending are not exactly the same across surveys. Still, it is useful to explore these differences.) In the United Kingdom, spending on food and housing is much lower for these younger households than in the United States. Health also has a much lower expenditure share.
Category of Expenditure Spending Share (%)
Food and nonalcoholic drinks 9.2
Alcoholic beverages, tobacco, and narcotics 2.2
Clothing and footwear 4.3
Housing, fuel, and power 22.6
Household goods and services 4.4
Health 0.9
Transport 12.2
Communication 2.7
Recreation and culture 9.0
Education 4.5
Restaurants and hotels 8.0
Miscellaneous goods and services 7.1
Other expenditure items 13.0
Table \(4\): United Kingdom Budget Study
Source: Data from Office for National Statistics, Family Spending, 2010, table A.11, accessed January 24, 2011, www.statistics.gov.uk/downloads/theme_social/family-spending-2009/familyspending2010.pdf.
Key Takeaways
• The demand curve of an individual shows the quantity of a good or service demanded at different prices, given income and other prices.
• The law of demand—which holds for almost all goods and services—states that the demand curve slopes downward: as the price of a good decreases, the quantity demanded of that good will increase.
• When you are making an optimal choice between two goods, the rate at which you want to trade off the two goods—at the margin—should equal the rate at which the market allows you to trade off the two goods.
• You should buy one more unit of a good whenever your marginal valuation of the good is greater than the price.
• When you are willing to buy at most one unit of a good (unit demand), your valuation and your marginal valuation are identical, so you should purchase the good as long as your valuation of that good is greater than the price.
check your understanding
1. Think about your own preferences. Can you think of a good that—for you—is a substitute for a chocolate bar? Can you think of a good that is a complement?
2. Draw a version of Figure 4.3.1 "An Increase in Income" to show a decrease in income.
3. Create a version of Figure 4.3.2 "The Consequences of an Increase in Income" that shows music downloads as an inferior good. Why can’t you draw a version of the figure where both music downloads and chocolate bars are inferior goods? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/04%3A_Everyday_Decisions/4.03%3A_Individual_Demand.txt |
Learning Objectives
1. What is the time budget constraint of an individual?
2. What is the opportunity cost of spending your time on a particular activity?
3. What is the meaning of real wage?
4. What is the labor supply curve of an individual, and how does it depend on the real wage?
So far we have discussed how you choose to spend your money. There is another decision you make every day: how to spend your time. You have 24 hours each day in which to do all the different things you want to do: work, sleep, eat, study, watch television, surf the Internet, go to the movies, and so on. Time, like money, is scarce. Given that you have only 24 hours to allocate in every day, how do you decide which activities to spend your time on? This problem is very similar to the allocation of your budget, with one key difference: you cannot save or borrow time in the way that you can save or borrow money. There are exactly 24 hours in each day—no more, no less.
Choosing among Different Uses of Your Time
We begin with the most fundamental time allocation problem for all students: choosing between studying and sleeping. As before, we keep things simple by thinking about only two possible uses of your time. You are given 24 hours in the day to study and sleep. How should you allocate your time?
As with the allocation of your income, there are two aspects of this problem. First, there is a budget constraint—only now it is your time that is scarce, not money. Second, you have your own preferences about sleep and study time. Your ability to meet your desires is constrained by the scarcity of your time: you must trade off one activity for another.
The time budget constraint is the restriction that there are only 24 hours in the day. It is shown in Figure 4.4.1 "The Time Budget Constraint" and is the counterpart to the budget line in our earlier discussion. Any point in this figure represents a combination of sleep and study time. The sum of sleep and study time must equal 24 hours (remember we are supposing that these are the only ways you spend your time). Thus your allocation of your time must lie somewhere on this line.
The time allocation line shows your options for dividing your time between study and sleep.
Figure 4.4.1 "The Time Budget Constraint" also shows one possible choice that you might make: allocating 8 hours to sleep and 16 hours to studying. The choice of this point reflects your desires for sleep and study. As with the spending decision, we pass no judgment, as economists, on the actual decision you make. We suppose you typically make the choice that makes you the happiest.
At your preferred point, your choice to sleep for 8 hours means that your study time must equal 16 hours; equivalently, your choice to study for 16 hours means that you must sleep for 8 hours. Any increase in one activity must be met by a reduction in time for the other. The opportunity cost of each hour of sleep is an hour of study time, and the opportunity cost of each hour of study time is an hour of sleep. If you choose this point, you reveal that you are willing to “pay” (that is, give up) 8 hours of study time to obtain 8 hours of sleep, and you are willing to pay 16 hours of sleep to obtain 16 hours of study time.
As with consumption choices, it is often enough to look at small changes to evaluate whether or not you are making a good decision. The opportunity cost of a little more sleep is a little less study time. If you are making a good decision about the allocation of your time, then the extra sleep is not worth the extra study time. Suppose you are contemplating a particular point on the time budget line, and you want to know if it is a good choice. If a very small movement away from your chosen point will not make you happier, then—in most circumstances—neither will a big movement. By a very small movement, we mean sleeping a little less and studying a little more or studying a little less and sleeping a little more. If you are making a good decision, then your willingness to substitute sleep for study time is exactly the same as that allowed by the time constraint.
Individual Labor Supply
Sleeping and studying are uses of your time that are directly for your own benefit. Most people—perhaps including yourself—also spend time working for money. So let us now look at the choice between spending time working and enjoying leisure. Our goal is to determine how much labor you will choose to supply to the market—which is equivalently a choice about how much leisure time to enjoy, because choosing the number of working hours is the same as choosing the number of leisure hours. Your choice between the two is based on the trade-off between enjoying leisure and working to earn money that allows the purchase of goods.
Once again—to make it easy to draw diagrams—we suppose that these are the only uses of your time. Part (a) of Figure 4.4.2 "Choosing between Work and Leisure" presents the allocation of time between work and leisure. As with the sleep-study choice, there is a time budget constraint, and you have preferences between these two ways to allocate time. Your best choice satisfies the same property as before: you allocate time such that no other division of your time makes you happier.
What makes this different from the sleep-study choice is the valuation of your time. We can think of sleep as a good thing in that you generally prefer more to less. Likewise, we can think of study as a good thing in that—even if you don’t always enjoy it—you perceive a gain to spending time studying. So Figure 4.4.1 "The Time Budget Constraint" is like our earlier diagrams with downloads and chocolate bars: it has a good thing on each axis. Now, people presumably prefer more leisure to less: leisure is a “good,” like chocolate bars, blue jeans, or cans of soda. But we have drawn part of (a) Figure 4.4.2 "Choosing between Work and Leisure" as if work is also a good thing. Most people, however, see work time as a “bad” rather than as a “good.” Even people who like their work would almost always prefer to work a little less and have a little more leisure time.
(a) The time budget line shows your options for dividing your time between labor and leisure. However, we generally think of labor as a “bad” rather than as a “good.” (b) Now the choice is between consumption and leisure. For each hour of your time, you earn the nominal hourly wage. If you divide this by the price level, you get the real wage. The real wage tells you how many goods and services you can enjoy for one hour of work.
The gain from working, of course, is that you earn income, allowing you to purchase goods and services. Each extra hour of your work allows you to buy more goods and services. Conversely, if you want more leisure time, you must give up some goods and services. Thus the choice between labor and leisure is linked to the choice about how many chocolate bars and other goods you buy. The income we take as given in describing your budget set typically comes from your decision to supply labor time. (Of course, you may have other sources of income as well, such as loans or grants.)
Part (b) of Figure 4.4.2 "Choosing between Work and Leisure" takes the labor-leisure choice and converts it into a choice between leisure and consumption. Here, consumption refers to all the goods and services you consume. We lump together all the products you consume, just as we lump together all your different forms of leisure (sleep, study, watching television, and so on). As before, time is measured on the horizontal axis: there are 24 hours to the day, which must be split between leisure time and labor time. On the vertical axis, we measure consumption.
To get the budget constraint for this picture, we begin with the time budget constraint:
\[leisure\ hours\ +\ labor\ hours\ =\ 24.\]
The value of an hour of time in dollars is given by the wages at which you can sell your time. Multiplying the time budget constraint by the wage gives us a budget constraint in dollars:
\[(leisure\ hours\ ×\ wage)\ +\ wage\ income\ =\ 24\ ×\ wage.\]
Wage income is equal to the number of hours worked times the hourly wage. Because wage income is used to buy goods, we can replace it by total spending on consumption, which is the price level times the quantity of consumption goods purchased:
\[(leisure\ hours\ ×\ wage)\ +\ (price\ level\ ×\ consumption)\ =\ 24\ ×\ wage.\]
This is the budget constraint faced by an individual choosing between leisure and consumption. Think of it as follows: The individual first sells all her labor at the going wage, yielding the income on the right-hand side. With this income, she then “buys” back leisure and also buys consumption goods. The price of an hour of leisure represents the wage rate, and the price of a unit of consumption goods represents the price level.
Toolkit: Section 31.3 "The Labor Market"
The real wage is the relative price of labor in terms of consumption goods:
Dividing the time budget constraint by the price level, we get the budget in line in part (b) of Figure 4.4.2 "Choosing between Work and Leisure".
\[leisure\ hours\ ×\ real\ wage\ +\ consumption\ =\ 24\ ×\ real\ wage.\]
As you move along the budget line, you trade hours of leisure for consumption goods. The slope of the budget line is the negative of the real wage. If you give up an hour of leisure, you obtain extra consumption equal to the real wage. Put differently, the opportunity cost of an hour of leisure is the amount of consumption you give up by not working. Once we have worked out how much leisure you consume, we have equivalently worked out how much labor you supply:
\[labor\ hours\ =\ 24\ −\ leisure\ hours.\]
Part (a) of Figure 4.4.3 "The Effect of a Real Wage Increase on the Quantity of Labor Supplied" shows what happens when the real wage changes. When the real wage increases, the vertical intercept of the budget line is higher because the vertical intercept tells us how much consumption an individual could obtain if she worked for all 24 hours in the day. The horizontal intercept does not change as the real wage changes: if an individual does not work, then the level of consumption is zero regardless of wages. It follows that the budget line is steeper as the real wage increases. If an individual gives up an hour of leisure time, he or she gets more additional consumption when the real wage is higher. The opportunity cost of leisure in terms of forgone consumption is higher.
(a) An increase in the real wage causes the budget line to rotate. Income and substitution effects are both at work: the income effect encourages more leisure (less work), while the substitution effect encourages more work. The substitution effect generally dominates, so higher real wages lead to more work. This means that the labor supply curve slopes upward, as shown in (b).
Part (b) of Figure 4.4.3 "The Effect of a Real Wage Increase on the Quantity of Labor Supplied" shows the individual labor supply curve that emerges from the labor-leisure choice.
Toolkit: Section 31.3 "The Labor Market"
The individual labor supply curve shows the number of hours that an individual chooses to work at each value of the real wage.
In fact, there are conflicting incentives at work here. As the real wage increases, the opportunity cost of leisure is higher, so you are tempted to work more. But at a higher real wage, you can enjoy the same amount of consumption with fewer hours of work, so this tempts you to work less. This is another example of substitution and income effects. The substitution effect says that when something gets more expensive, we buy less of it. When the real wage increases, leisure is more expensive. The income effect says that as the real wage increases, you can buy more of the things you like, including leisure. We know from our study of demand that, for normal goods, the income and substitution effects act in the same direction. In the case of supply, however, income and substitution effects point in different directions. Consistent with this, most economic studies find that, though the labor supply curve slopes upward, hours worked are not very responsive to changes in the real wage.
Some jobs do not give you any control over the number of hours that you must work. Labor supply then becomes a “unit supply” decision, analogous to the unit demand decisions we considered previously. Should you take a job at all and, if so, what job? To the extent that you can choose among different jobs that offer different hours of work, your decision about whether or not to work will still reflect a trade-off between leisure and consumption.
Individuals and Households
We have discussed almost everything in this chapter in terms of an individual’s decision making. However, economists often think in terms of households rather than individuals. In part this is because—as we saw with the budget studies—much more economic data are collected for households than for individuals. Also, many of the decisions we have discussed are really made by a household as a whole, rather than by the individual members of that household.
For example, many households have two working adults. Their decisions about how much to work will usually be made jointly on the basis of the real wages they both face. To see some implications of this, consider a two-person household in which both are working. Now suppose that the real wage increases for one person in the household. One person will probably respond by increasing the number of hours worked. However, the other person may choose to work less. Imagine, for example, that there are household chores that either could do. By working less, one person can do more of these chores and thus compensate the other person for the extra hours worked.This is an application of an important economic idea called comparative advantage, which we discuss in more detail in Chapter 6 "eBay and craigslist". Most of the time, though, we do not need to worry about the distinction between the individual and the household, and we often use the terms interchangeably.
Time Studies
Table 4.4.1 "Allocation of Hours in a Day" shows the allocation of time to certain activities for individuals in three countries: the United States, the United Kingdom, and Mexico. It shows the time allocated on average per day for each of four activities: work, study, personal care, and leisure.
Country Age Work Study Personal Care Leisure
United States 15–24 2.65 2.2 9.95 5.46
United Kingdom 16–24 3.00 1.39 9.96 5.13
Mexico 20–29 4.49 0.72 10.37 3.1
Table \(1\): Allocation of Hours in a Day
For the United States and the United Kingdom, the average number of hours worked is between 2.65 and 3.00. This is an average: some people in this age group may work a full-time job, while others may be students who are not working for pay at all. The sample from Mexico differs from the US and UK samples. First, the group is slightly older. Second, Mexico is notably poorer than the United States and the United Kingdom. For these two reasons, individuals sampled in Mexico are more likely to be working and less likely to be studying and enjoying leisure—which is indeed what we see.
Combining Your Time and Spending Choices
So far we have looked at the allocation of your income separately from the allocation of your time. Yet these choices are linked. The allocation of your time influences the income you have to spend on goods and services. So a change in the wages you are paid will affect how you allocate your time and the goods and services you choose to buy.
In a similar fashion, the prices of goods and services you purchase will have an influence on your allocation of time. For example, if the price of a computer you want to buy decreases, you may respond by working a little more to earn extra income to purchase the computer. The reduction in the price of the computer raises your real wage, so you respond by working more.
Effects of Real Wages on Household Demand
If the real wage changes, there are changes in both consumption decisions and work choices. Figure 4.4.3 "The Effect of a Real Wage Increase on the Quantity of Labor Supplied" shows that an increase in the real wage means you can obtain more consumption for a given amount of work time. Further, as in Figure 4.3.1 "An Increase in Income", the budget set expands as income increases. Because an increase in the real wage will lead to an increase in hours worked (see Figure 4.4.3 "The Effect of a Real Wage Increase on the Quantity of Labor Supplied"), labor income will increase. So we can interpret the shift in the budget line in Figure 4.3.1 "An Increase in Income" as coming from this increase in labor income.
When income increases, you will generally consume more of all goods and services. An increase in the real wage leads to an outward shift in your demand curves for chocolate bars, downloads, and all other normal goods. Combining these figures, we can make the following predictions about the effects of an increase in the real wage:
• You will work more hours.
• You will have more income.
• You will consume more goods and services.
• You will be happier.
The last item in the list draws on Figure 4.3.1 "An Increase in Income" but is less direct than the other implications. As the real wage—and thus your income—increases, the set of bundles you can afford is larger. Moreover, every bundle you could afford when you had less income is still affordable now that you have more income. Thus we conclude that you will be happier. After all, you can always purchase the bundle you bought with lower income and still have some extra income to spend.
Effects of Prices on Time Allocation
Suppose the price of a chocolate bar increases. We saw from Figure 4.3.3 "A Decrease in the Price of a Chocolate Bar" that when this price increases, the budget set shrinks. We also saw from Figure 4.3.4 "The Demand Curve" that the demand for chocolate bars decreases when the price of a chocolate bar increases. But there are also implications for labor supply. Remember that the real wage is the nominal wage dividing by a price index representing a household’s cost of purchasing a bundle of goods and services. So when the price of a chocolate bar increases, the cost of purchasing the bundle will increase and the real wage will decrease. From Figure 4.4.3 "The Effect of a Real Wage Increase on the Quantity of Labor Supplied", labor supply will decrease as the real wage decreases. This is a movement along the labor supply curve.
Key Takeaways
• The time budget constraint states that the sum of the time spent on all activities each day must equal 24 hours.
• The opportunity cost of time spent on one activity is the time taken away from another.
• Decisions about how much to work depend on how much more you can purchase if you work a little more: that is, they depend on the real wage.
• The individual labor supply curve shows how much an individual will choose to work given the real wage.
• As the real wage increases, an individual will supply more labor if the substitution effect dominates the income effect.
Check your understanding
1. If you must sleep a minimum of five hours each day, how would you modify Figure 4.4.1 "The Time Budget Constraint" to indicate this necessity of life?
2. If both the nominal wage and the price level double, what will happen to your allocation of time and consumption? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/04%3A_Everyday_Decisions/4.04%3A_Individual_Decision_Making-_How_You_Spend_Your_Time.txt |
In Conclusion
We all make economic decisions every day, often without giving them very much thought. In this chapter, we highlighted two fundamental decisions: allocating income and allocating time. You (and everyone else) generally make choices over income and time allocations in a manner that makes you happy. Thus we predict that you will not throw income away. Further, whatever combinations of goods and services and time allocations you choose, economic theory presumes that these are the best ones available to you. Remember also that even though it is usually easier to focus on one decision at a time, your spending and time allocation decisions are interconnected. Changes in the prices of goods and services affect how you spend your time, and changes in the real wage affect your consumption choices. Chapter 8 "Why Do Prices Change?" has more to say on the connections among different markets in the economy.
Economics is often defined as the study of how we allocate scarce resources that have alternative uses. In this chapter, we saw this idea at work at the individual level. Your income is a scarce resource; you don’t have enough income to buy everything that you would like. Your income has alternative uses because there are lots of things you might want to buy.
Perhaps the most fundamental idea of this chapter is that of opportunity cost. Given that you have limited income to allocate across goods and services, the opportunity cost of consuming one good or service is the amount of another good or service you give up. Given that you have limited time to allocate across activities, the opportunity cost of spending time on one activity is the value of the time you could have spent on another. The budget and time budget constraints are graphical representations of this central economic principle. And the interaction between these budget constraints and people’s wants and desires is at the heart of the economic analysis of decision making.
Key Link
exercises
1. Which statements are prescriptive? Which statements are descriptive?
• The government should take care of the poor.
• If the real wage increases, households will be willing to supply more labor.
• When people’s incomes decrease, they consume more cheap cuts of meat.
• We ought to consume fewer resources to protect the planet.
• Young people should purchase medical insurance because it is cheaper for young people than for old people.
2. Draw a budget line assuming disposable income equals \$100, the price of a music download is \$1, and the price of a chocolate bar is \$5. On the same graph, draw another budget line assuming the same level of income but with the price of a music download equal to \$2 and the price of a chocolate bar equal to \$1. Explain how the budget sets differ. If you liked downloads but hated chocolate bars, which budget set would you prefer?
3. Consider a bundle consisting of 4 chocolate bars and 30 downloads (call it bundle A). Using the assumption that “more is better,” what bundles can we say are definitely preferred to bundle A? What bundles are definitely worse than bundle A? Show your answers on our usual kind of diagram (that is, a budget set diagram with chocolate bars and downloads on the axes).
4. If we observe that a household buys bundle A but not bundle B and we know that bundle B has more of every good than does bundle A, what can we say about the household’s preferences for bundle A and bundle B? What can we say about the household’s budget set?
5. (Advanced) Look at Table 4.5.1 "Preferences over Downloads and Chocolate Bars". The top part of the table lists four different bundles of downloads and chocolate bars. The bottom part of the table shows which bundle is preferred when we compare any two bundles. Look at bundle 1. The top part of the table tells us it contains 0 downloads and 20 chocolate bars. The first row of the bottom part of the table shows how this bundle compares to the other bundles. So this individual prefers bundle 1 to bundle 2 but also prefers both bundle 3 and bundle 4 to bundle 1. Do these preferences satisfy “more is better”? Are they consistent or can you find some contradictions?
Bundle Downloads Consumption Chocolate Bar Consumption
1 0 20
2 100 0
3 50 10
4 110 30
Bundle Which Bundle Is Preferred When Comparing Bundles?
Bundle 1 Bundle 2 Bundle 3 Bundle 4
1 1 3 4
2 1 2 4
3 3 2 3
4 4 4 3
TABLE \(1\): PREFERENCES OVER DOWNLOADS AND CHOCOLATE BARS
6. Suppose income increases by 10 percent, but the price of a chocolate bar and the price of downloads both increase by 5 percent. Will the budget line shift inward or outward? Will the slope of the budget line change?
7. We explained the household demand curve and the law of demand by focusing on how a change in the price of a chocolate bar influences the quantity of chocolate bars demanded. Redo this discussion and the figures to illustrate how a change in the price of downloads will affect the demand for downloads and the demand for chocolate bars.
8. In our example, we noted that it was not possible for both chocolate bars and music downloads to be inferior goods. Suppose there were three goods: chocolate bars, music downloads, and tuna sushi. Is it possible now that chocolate bars and music downloads are both inferior goods? Could all three be inferior goods?
9. (Advanced) Suppose the government imposes a tax on chocolate bars. Draw a diagram that shows what happens to the budget set. If chocolate bars and downloads are both normal goods, can you say whether the consumption of chocolate bars will increase or decrease? What about the consumption of downloads?
10. Explain why a price increase in movie tickets causes the demand curve for chocolate bars to shift.
11. Suppose you are thinking of buying chocolate bars. Your marginal valuation of the seventh chocolate bar is \$3. The price of a chocolate bar is \$4. Should you buy more or fewer than seven bars?
12. Explain how the law of demand works in the case of a unit demand curve.
13. Can preferences include altruism or a regard for fairness and still exhibit rationality?
14. Using the data in Table 4.3.4 "United Kingdom Budget Study", create a pie graph of expenditure shares. How might you explain the differences in spending between younger households in the United States and the United Kingdom? How might you explain the differences in spending in 2005 between younger households and average households?
15. (Advanced) In discussing labor supply, we did not allow an individual to decide not to work. Yet we observe many individuals who could work but choose not to. How would you have to amend the discussion to include the choice of working or not working?
16. If you face a big exam this week, how might this influence your time allocation choice in Figure 4.4.1 "The Time Budget Constraint"?
17. (Advanced) If there is a reduction in the price of a chocolate bar, what does our theory predict will happen to labor supply?
18. (Advanced) Suppose the government imposes a tax on labor. What will that tax do to the labor supply of a household and its demands for downloads and chocolate bars?
19. (Advanced) If one member of a two-person household gets a raise, what will that do to the hours worked by that person and to the other household member? Explain this using income and substitution effects. Could this raise cause the other household member not to work at all?
Economics Detective
1. Search the Internet to find the level of spending by Japanese households on food in a recent year. Convert this figure to dollars.
2. The data in Table 4.3.3 "Budget Shares in the United States" come from a survey. Who was surveyed? How frequently?
3. Go to the web page of the Office for National Statistics in the United Kingdom ( www.statistics.gov.uk/CCI/Nscl.asp?ID=5407&Pos=1&ColRank=1&Rank=16UK) and create a version of Table 4.3.4 "United Kingdom Budget Study" for different income groups. What differences do you see in spending patterns across income groups? How would you explain the differences in spending patterns as income changes?
4. Go to http://www.bls.gov/tus. Pick two years. Prepare a table to illustrate how the allocation of time has changed for one of two age groups over these two years. How might you explain these changes?
Spreadsheet Exercise
1. (Advanced) Create a spreadsheet to reproduce the graph of a budget constraint with two goods (chocolate bars and downloads) in Figure 4.2.4 "The Budget Line". In column A, put the quantity of chocolate bars (from 0 to 20). In column B, put the price of a chocolate bar (that is, each cell should contain a 5).This is the simplest but not the most elegant way to create this spreadsheet. If you are an experienced user of spreadsheets, you may know tricks that will allow you to create the spreadsheet in a more compact way. In column C, put the price of downloads. In column D, put income. Then write an equation to enter in each cell of column E, based on the budget line. This equation should calculate the quantity of downloads in terms of the prices, income, and the quantity of chocolate bars. Make sure that you allow only nonnegative quantities of the goods. Use this to graph the budget line. Now try changing the prices and the level of income and make sure you can explain how the budget line shifts as income and prices change. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/04%3A_Everyday_Decisions/4.05%3A_End-of-Chapter_Material.txt |
Thumbnail: https://pixabay.com/photos/startup-whiteboard-room-indoors-3267505/
05: Life Decisions
Some economic decisions, like how to spend your money and your time, are everyday decisions.See Chapter 4 "Everyday Decisions" for more discussion. There are also bigger and more difficult economic decisions that you confront only occasionally. In the months and years after graduation, you will face major life choices, such as the following:
• Upon graduation, which occupation should you choose?
• Should you go to graduate school?
• Should you purchase a new car?
• Should you purchase a house?
• How much of your income should you save?
• Should you purchase health insurance?
• Should you purchase insurance for your home or apartment?
• What should you do with the money you save?
These economic choices are more complicated than choosing how many chocolate bars to buy or how much time you should spend watching television today.
Two things make these decisions hard. First, there is the element of time—not the 24 hours in a day, but the fact that you must make decisions whose consequences will unfold over time. In choosing an occupation, deciding on graduate school, or picking a portfolio of financial assets, you must look ahead. Second, there is the element of uncertainty. Will you be healthy? Will you live to an old age? Will you succeed as a rock musician? The future is unknown, yet we cannot ignore it. The future is coming whether we like it or not.
We cannot tell you whether you should buy a new car or if you will be a rock star. But we can give you some tools that will help you when you are making decisions that involve time and uncertainty. In this chapter we tackle the following questions:
• How do we make decisions over time?
• How do we make plans for an uncertain future?
Road Map
The chapter is organized around the two themes of time and uncertainty. We begin with a brief review of the choice between two goods at a given time.This decision is analyzed at length in Chapter 4 "Everyday Decisions". Then we look at choices over time. Economists typically assume that individuals are capable of choosing consistently among the bundles of goods and services they might wish to consume. The ability to make such a choice is perhaps not too onerous in the case of simple choices at a given time (such as whether to go to a movie or go to dinner). It is more difficult when we consider choices over a broad range of goods from now into the future.
• There are goods and services that will be available to you in the future that you cannot imagine today. When people chose among different types of handheld calculators 30 years ago, they could not imagine that today they would be choosing among different types of tablet computers. Many products that we now consume simply did not exist in any form until comparatively recently, and when we make choices now, we do so in ignorance of future consumption possibilities.
• Your tastes may change. When you are 20 years old, it is difficult to predict what goods and services you will want to buy when you are 30, 40, or 50 years old. Your future self might regret past decisions.
We tackle time and uncertainty separately. To begin with, we will suppose that the future is known with certainty. This allows us to focus on including time in our analysis of economic decision making. We begin with a discussion of the choice between consumption and saving and explain how this decision is affected by changes in interest rates. We then look at problems such as how to choose an occupation. A major part of this analysis is an explanation of how to compare income that we receive in different years.
We then turn to uncertainty. We explain the idea of risk and then discuss the kinds of risks you cannot avoid in life. We explain how insurance is a way to cope with these risks. We also discuss uncertainties that we create in our lives—through occupational choice, portfolio choice, and gambling. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/05%3A_Life_Decisions/5.01%3A_Life_Choices.txt |
Learning Objectives
1. What is your lifetime budget constraint?
2. What factors influence your choice between consumption today and saving for the future?
3. What is the difference between real and nominal interest rates?
4. What are the effects of a change in the interest rate on consumption and saving?
Your choice at any given time between two goods—say, chocolate bars and music downloads—reflects the tension between your desires for chocolate bars and downloads and your income, as summarized by your budget line. The budget line shows us the bundles of goods and services that you can afford, given prices and your income, under the presumption that you do not throw any money away. For an individual choosing between two goods only (chocolate bars and music downloads), the budget line states that total spending is equal to spending on chocolate bars plus spending on downloads:
\[(number\ of\ chocolate\ bars\ ×\ price\ of\ a\ chocolate\ bar)\ +\ (number\ of\ downloads\ ×\ price\ of\ download)\ =\ disposable\ income.\]
Figure 5.2.1 "The Budget Line with Two Goods" displays the budget line for the choice between downloads and chocolate bars.
Toolkit: Section 31.1 "Individual Demand"
You can review the derivation and meaning of the budget line in the toolkit.
This diagram shows the budget line for an individual choosing between chocolate bars and music downloads. The slope of the budget line reflects the rate at which an individual can trade off the two goods.
The slope of the budget line is
As you move along the budget line, you are giving up downloads to get chocolate bars. If you give up one chocolate bar, you get an amount of money equal to the price of a chocolate bar. You can take this money and use it to buy music downloads. You have to divide this amount of money by the price of a download to determine how many downloads you can buy. The slope of the budget line reflects the opportunity cost of chocolate bars in terms of music downloads.
The Budget Line with Two Periods
Now think about what the budget line looks like when we are choosing between now and the future. Just as we find it easier to think about the choice between two goods rather than among 2,000 goods, so too is it easier to think about the choice over only two periods of time. We call these two periods “this year” and “next year.” There is nothing special about the two-period example beyond the fact that it makes it easy to draw diagrams and see what is going on. The principles that we uncover for this case also apply to decisions made with more than two time periods in mind.
We also do not worry about all the different goods and services that are available, preferring instead to talk in general about consumption this year and consumption next year. We aggregate together all the different products that we consume. Thus “consumption” means the bundle of goods and services people consume. This consumption also has an associated price, which we call the price level. Think of this as the average price of goods and services in the economy. If you find it easier, imagine there is a single good, like chocolate bars, that you consume, and think of the price level as simply being the price of a chocolate bar.
Saving and the Nominal Interest Rate
If you choose not to spend all your income on consumption this year, you are saving. When you save, you can put your money into a financial institution and earn interest on it. Suppose you have \$100 this year that you save by putting it in a bank. You are then lending to the bank—saving and lending are really the same thing. The bank acts as an intermediary, taking your \$100 and giving it to someone else who borrows from the bank.
The bank offers you interest on this loan—for example, it may pay a nominal interest rate of 5 percent per year. After a year, your bank account will contain your original \$100, plus an extra 5 percent. Because 5 percent of \$100 is \$5, you earn \$5 worth of interest. We talk about interest rates in percentage terms, but you should remember that a percentage is simply a number. For example, 5 percent is 0.05, and 20 percent is 0.2. The nominal interest rate is the interest rate at which individuals and firms in the economy can save or borrow.There are actually many different interest rates in an economy. Chapter 10 "Making and Losing Money on Wall Street" looks at some of these. Here, we simplify the process by supposing there is only one interest rate. It is called a nominal interest rate because it is measured in monetary terms. Most interest rates are quoted on an annual basis, meaning that they specify the amount earned per year.
Of course, if you put a \$100 in the bank for one year, then next year you will still have the original \$100 as well as the interest you earned. At an interest rate of 5 percent, \$100 this year is worth \$105 next year. To calculate the total amount of money that you can earn, we simply add one to the nominal interest rate, giving us the nominal interest factor:
\[nominal\ interest\ factor\ =\ 1\ +\ nominal\ interest\ rate.\]
The nominal interest factor is used to convert dollars today into dollars next year.
Toolkit: Section 31.6 "The Credit Market"
The nominal interest rate is the rate at which individuals and firms in the economy can save or borrow. The nominal interest factor is 1 + the nominal interest rate.
In this chapter, we typically use the nominal interest factor rather than the nominal interest rate because it makes the equations easier to understand. Just keep in mind that it is easy to move back and forth between the interest rate and the interest factor by adding or subtracting one.
If you have \$100 today, then tomorrow it will be worth \$100 × the nominal interest factor. In general,
\[z\ this\ year\ will\ be\ worth\ z\ times the\ nominal\ interest\ factor\ next\ year.\]
Armed with this idea of the nominal interest factor, we can graph the budget line for a two-period consumption-saving problem. Figure 5.2.2 "The Budget Line with Two Periods" shows consumption this year on the horizontal axis and consumption next year on the vertical axis. To discover what the budget line looks like, we first determine its slope and then its position.
This diagram shows the budget line for an individual choosing consumption over time. The slope of the budget line depends on the price level this year, the price level next year, and the nominal interest factor (= 1 + nominal interest rate). Suppose the price level this year is \$9, the price level next year is \$10, and the nominal interest rate is 20 percent. Then the slope of the budget line is −(9/10) × 1.2 = −1.08. This means that if you give up 1 unit of consumption this year, you can get 1.08 units next year.
The Slope of the Budget Line
The slope of the budget line tells you how much extra consumption you will get next year if you give up a unit of consumption this year. So to determine the slope of the budget line, we use the following thought experiment.
1. If you give up one unit of consumption this year, you get an amount of dollars equal to the price of consumption this year (the price level).
2. You can then save those dollars, so next year you will have a number of dollars equal to the price level this year × the nominal interest factor.
3. Next year, you can take these funds and purchase
units of consumption.
So the slope of the budget line is as follows:
We show the budget line in Figure 5.2.2 "The Budget Line with Two Periods".
The budget line has a negative slope because—as with the choice between chocolate bars and downloads—you must give one thing up to get another. If you want to consume more in the future, you must be willing to consume less right now. If you want to consume more now, you will have to sacrifice consumption in the future.
The slope of the budget line depends not only on the nominal interest factor but also on prices this year and next year. Suppose the price of a unit of consumption this year is \$100 and next year it is \$110. Economists call the percentage increase in the price level the inflation rate; it is calculated as follows:
Put differently, it is the rate of growth of the price level. In our example, the inflation rate is 10 percent.
Now suppose the nominal interest rate is also 10 percent, which means that the nominal interest factor is 1.1. Then
In this case, the price level increased by 10 percent, from 100 to 110. But the nominal interest rate also increased by 10 percent, which offset the increase in prices. We see that the slope of the budget line depends on both the nominal interest factor and the rate of inflation. In fact, it depends on the real interest factor:
\[slope\ of\ budget\ line\ =\ −(1\ +\ real\ interest\ rate)\ =\ −real\ interest\ factor.\]
Toolkit: Section 31.6 "The Credit Market"
The real interest rate is the rate of interest adjusted for inflation. It tells you how much you will get next year, in terms of goods and services, if you give up a unit of goods and services this year. The real interest factor allows you to convert units of goods and services this year into units of goods and services next year. The real interest factor is 1 + the real interest rate.
As you move along the budget line in Figure 5.2.2 "The Budget Line with Two Periods", you are giving up chocolate (consumption) this year for chocolate next year. So the slope of the budget line must be a number, not a dollar amount. Because this year’s price and next year’s price are both denoted in dollars, their ratio is a number. Likewise, the interest rate is a number, so the slope of the budget line is indeed a number.
An example may help you understand the difference between the nominal interest rate and the real interest rate. Suppose you go to your bank and get a one-year, \$20,000 loan to buy a car, with a nominal interest rate of 5 percent. Your contract with the bank thus stipulates that you must pay the bank \$21,000 at the end of the year. If the inflation rate is zero, then the cost of borrowing measured in terms of real goods and services is \$1,000, which is 5 percent of the amount that you borrowed. But if the inflation rate is 5 percent, then the \$21,000 you pay to the bank at the end of the loan buys the same amount of goods and services that the \$20,000 the bank lent to you. In this case, you are effectively able to borrow for free.
Good decisions about borrowing and lending are based on real interest rates rather than nominal interest rates. Your cost of borrowing to buy the car is not the monetary payments you make on the loan but rather the value of the goods and services you could have purchased with that money. So we need a way to convert from the commonly observed nominal interest rate to a measure of real interest rates. We do this by using a formula for the real interest rate that was discovered by a famous economist named Irving Fisher.
Toolkit: Section 31.8 "Correcting for Inflation"
The Fisher equation is a formula for converting from nominal interest rates to real interest rates, which is as follows:
\[real\ interest\ rate\ ≈\ nominal\ interest\ rate\ –\ inflation\ rate.\]
Equivalently,
\[real\ interest\ factor\ ≈\ nominal\ interest\ factor\ –\ inflation\ rate.\]
For example, suppose the nominal interest rate is 5 percent. If the rate of inflation is zero, then the real interest rate is 5 percent. But if the rate of inflation is 4 percent, the real interest rate is only 1 percent. The Fisher equation is a tool that tells us how to convert nominal interest rates—the interest rates you see in the newspapers and on television—into real interest rates, which are key for decision making.The precise formula is as follows:This equation is, to a very good approximation, the same as the one in the text.
The Position of the Budget Line
Whereas the slope of your budget line depends on the real interest rate, the position of your budget line depends on how much income you have. When you have more income, the budget line is further away from the origin. One way to determine the position of the budget line is by looking at its intercepts. The horizontal intercept is the amount you can consume this year if you spend all of this year’s income and borrow against your entire future income. The vertical intercept is the amount you can consume next year if you choose to consume nothing this year and save all of your current income.
It is easier and more instructive, however, to look at a different point on the budget line. Remember that the budget line is the bundles of consumption you can just afford. One bundle you can certainly afford is the bundle where you spend all of this year’s income on consumption this year and all of next year’s income on consumption next year. In other words, one available option is that you neither save nor borrow. In this case,
and
On the right-hand side of these equations, we divided dollar income by the price level to give us real income (that is, income measured in terms of purchasing power). We must do this to find out how much you can consume in terms of goods and services.
For example, suppose your nominal income this year is \$23,000, and your nominal income next year is \$24,200. Suppose the price level this year is \$10 and the price level next year is \$11. This means that
and
So one possible consumption choice, as shown in Figure 5.2.3 "Determining the Position of the Budget Line", is 2,300 units of consumption this year and 2,200 units of consumption next year. In this case, you are neither borrowing nor saving. Of course, you might choose some different point on the budget line. Figure 5.2.3 "Determining the Position of the Budget Line" shows that your real income this year and next year does indeed pick out a point on the budget line. And because we already know the slope of the budget line, we are done; we can now draw the budget line.
The position of the budget line depends on income this year and next year. We know that one possible choice of consumption is where the consumer neither saves nor borrows. This means that the budget line must pass through this point.
Adding Income and Consumption Spending over Two Periods
Your budget line describes the condition that total spending equals total income. This is true for the choice about the consumption of downloads and chocolate bars, and it is also true for the choice over time. But once we move to two periods, we must be careful about measuring both total income and total spending.
Adding Nominal Income over Two Periods
Suppose you earn some income this year (say, \$23,000) and will earn some more next year (say \$24,200). What is your income for these two years together? Your first instinct is probably to add the income in the two years and say \$47,200. Superficially this makes sense—after all, income is measured in dollars in both years. Unfortunately, this is not a very good way to add money over time. It is flawed because it views income in two different years as if they are the same thing. In fact, money this year and money next year are not the same.
Imagine that a friend asks to borrow \$1,000 from you today, promising to pay you back the \$1,000 twenty years from now. Would you be likely to agree to this? Even if you trust your friend completely, the answer is surely no. After all, you could take your \$1,000 and put it in the bank for twenty years, and the bank will pay you interest on your money—that is, the bank is willing to pay you for the privilege of using your money. Over twenty years, you could earn quite a bit of interest. By contrast, your friend is asking for a zero-interest loan in which no interest is paid on the money that you lend.
Positive interest rates mean that a dollar today and a dollar in the future are not worth the same. Adding dollars in one year to dollars in another year makes no more sense than adding apples and oranges. We need to convert dollars next year into their value right now. Remember that
\[z\ this\ year\ will\ be\ worth\ z\ ×\ the\ nominal\ interest\ factor\ next\ year.\]
We can turn this around. If the interest rate is 5 percent, then \$105 next year will be worth only \$100 this year. A dollar next year is worth dollars this year. This is the most you would be willing to give someone this year if he or she promised to give you a dollar next year. You would not give them more than this because you would lose money relative to the alternative of putting the dollar in the bank and earning interest. More generally,
Toolkit: Section 31.5 "Discounted Present Value"
Unless the interest rate is zero, a dollar this year is not the same as a dollar a year from now. To avoid this problem, economists use discounted present value as a device for measuring flows that occur over time. Discounted present value tells you the value of something you will receive in the future, discounted back to the present.
For example, if we want to add income in dollars over two years, the discounted present value of such a two-year flow of income is given by the following formula:
This is the income term that we need for the budget line in our two-year example. Go back to our earlier example, where income this year is \$23,000 and income next year is \$24,200, and the nominal interest factor is 1.1. Then
Even though income next year is higher in dollar terms, it is lower in terms of present value: \$24,200 next year is worth only \$22,000 today. Notice that when we measure the discounted value of a flow of nominal income, we still end up with a nominal value—the value of the income flow in terms of this year’s dollars.
Table 5.2.1 "Discounted Present Value of Income" provides another illustration: it shows the calculation of the discounted present value of income when this year’s income is \$100 and next year’s income is \$200. You can see that, as the interest rate increases, the discounted present value of income decreases.
Nominal Income This Year (\$) Nominal Income Next Year (\$) Discounted Present Value of Nominal Income Flow (\$)
Nominal Interest Rate
0% 5% 10%
100 200 300.00 290.47 281.82
250 500
Table \(1\): Discounted Present Value of Income
Adding Nominal Consumption over Two Periods
When we want to add consumption spending this year and next year, measured in dollars, we use exactly the same logic as we did when adding income. Nominal consumption this year and next are given as follows:
\[nominal\ consumption\ this\ year\ =\ price\ level\ this\ year\ ×\ consumption\ this\ year\]
and
\[nominal\ consumption\ next\ year\ =\ price\ level\ next\ year\ ×\ consumption\ next\ year.\]
(Again, if you find it easier, just think of this as chocolate: total spending is the number of chocolate bars purchased times the price per bar. When we talk about “consumption,” we mean something measured in real units, such as chocolate bars. When we talk about “nominal consumption,” we are referring to a value measured in dollars.) Just as it is incorrect to add this year’s and next year’s income, so too should we not add together nominal consumption. Instead, we must calculate a discounted present value, exactly as we did before.
As with income, the discounted present value of nominal consumption is measured in this year’s dollars.
Which Interest Factor Should You Use?
Earlier, we emphasized that people think about the real interest factor when they are comparing this year and next year. Yet in calculating the discounted present value of income and consumption spending, we are using the nominal interest factor. What is going on?
The rule for determining which interest factor to use in a discounted present value calculation is simple. If you are converting nominal values, then you should use the nominal interest factor. If you are converting real values, then you should use the real interest factor. So if you want to know how much a given number of dollars in the future will be worth in dollars today, you should use the nominal interest factor. This is the normal case for most calculations that you would do. However, if you want to calculate a discounted present value for variables that have already been corrected for inflation, you must use the real interest factor. In this case, the answer you get is also a real quantity.
The Two-Period Budget Line Revisited
The tool of discounted present value gives us another way of thinking about the two-period budget line—the condition that
discounted present value of two-year flow of nominal consumption = discounted present value of two-year flow of nominal income.
Remember that both sides of this equation are measured in terms of this year’s dollars. If we were to divide both sides of this equation by this year’s price level, then we would get the equivalent expression in real terms:
\[discounted\ present\ value\ of\ two-year\ flow\ of\ consumption = discounted\ present\ value\ of\ two-year\ flow\ of\ real\ income.\]
In this case, as we just explained, the discounting must be done using the real interest factor instead of the nominal interest factor.
Income, Consumption, and Saving
Given your budget line, we suppose you choose a combination of consumption this year and next year that makes you as well off as possible. An example of such a preferred point is indicated in Figure 5.2.4 "The Preferred Point".
The consumer’s preferred point must lie somewhere on the budget line. In this example, the consumer is choosing to consume in excess of his income this year. The consumer must borrow against future income, which means that consumption next year will be below next year’s income.
The choice of a preferred point reflects two ideas. Whatever your tastes between consumption in the two years, we presume that you will not throw any income away. As a result, your choice will be on, not inside, the budget line. Further, if you choose well, according to your preferences, then you will pick the best combination of consumption; there is no other point on the budget line that you prefer.
Saving and Borrowing
Your preferred point implies a choice about how much saving or borrowing you do. Figure 5.2.5 "Consumption and Saving" shows two possible cases. In part (a) of Figure 5.2.5 "Consumption and Saving", you are a saver: you are consuming less than your income this year. The difference between your income and your consumption is the amount of your savings. Those savings, plus interest, are available to you next year, so next year you can consume in excess of your income. In part (b) of Figure 5.2.5 "Consumption and Saving", you are a borrower: you are consuming more than your income this year. When you borrow this year, you must repay the loan with interest next year, so your consumption next year is less than your income.
(a) The individual is a saver this year. (b) The individual is a borrower this year.
The budget line tells you the rate at which the market allows you to substitute goods between this year and next year. This is distinct from your personal tastes about consuming this year or next year. The saver in part (a) of Figure 5.2.5 "Consumption and Saving" is a relatively patient person: she is willing to give up a lot of consumption this year to be able to consume more next year. The borrower in part (b) of Figure 5.2.5 "Consumption and Saving" is a relatively impatient person: he wants to consume a lot this year and is willing to sacrifice a great deal of future consumption.
You will sometimes hear discussions of how much individuals like to “discount the future.” This is a statement about their tastes. Someone who discounts the future a great deal is impatient. Such a person wants to consume right away, so he will give up a lot of future consumption to have more today. Someone who discounts the future only a little is patient. Such a person is willing to give up consumption today even if she gets only a little extra consumption in the future. Economists pass no judgment on whether it is better to be impatient or thrifty. These are matters of personal preference.
The Timing of Income
Interestingly, the timing of your income turns out not to matter for your choice of consumption, which is illustrated in Figure 5.2.6 "The Timing of Income".
The timing of income is irrelevant to the consumption choice. Here, one individual has low income this year and high income next year, while the opposite is true for the other individual. However, the discounted present value of income is the same in both cases. If they both have the same tastes, they will choose the same consumption point.
Suppose that the nominal interest rate is 10 percent and that the price level is \$10 in both periods. This means that the inflation rate is zero, so—from the Fisher equation—the real interest rate is also 10 percent. Now imagine that there are two individuals who have identical tastes. One of them earns income of \$40,000 this year and \$22,000 next year, so real income (nominal income divided by the price level) is therefore 4,000 this year and 2,200 next year. The other person earns \$20,000 this year and \$44,000 next year, yielding a real income of 2,000 this year and 4,400 next year. Both of these individuals share the same budget line (see Figure 5.2.6 "The Timing of Income"). This is because the discounted present value of their nominal income is the same: \$60,000. (Check to make sure you understand why this is true.) For example, suppose that the preferred point of both individuals is to consume the same amount in each year. Then they can both consume approximately 3,143 units of consumption in each period.
Let us see how this works. Because the price level is \$10, this amount of consumption costs \$31,430 in each period. The first individual takes her income of \$40,000 and saves \$8,570 by putting it in the bank. This saving earns 10 percent interest, so she gets an additional \$857. She thus has income in the following year equal to \$22,000 + \$8,570 + \$857 = \$31,427. This allows her to buy 3,142.7 units of consumption goods. The second individual needs to borrow \$11,430 to add to his income this year. Next year, he must repay this amount plus 10 percent interest (that is, another \$1,143). So his income next year is \$44,000 − \$11,430 − \$1,143 = \$31,427. So one individual must save to reach her preferred consumption bundle, while the other must borrow to reach his. Yet because they have the same discounted present value of income and the same tastes, they will consume the same bundle of goods.
Keep in mind that our discussion so far ignores uncertainty. We assumed that both individuals know their current and future income with certainty. Just as importantly, we have supposed that a bank is confident that the borrower will have sufficient income next year to repay the loan. In a world of uncertainty, we do not know for sure how much money we will have next year, and lenders worry about the possibility that people might not make good on their loans. Later in the chapter, we explain more about decision making in an uncertain world.
Lifetime Budget Constraint
So far, we have worked everything out in terms of a two-period example. The two-period budget constraint tells us how income and consumption are linked over time. In reality, of course, you make these decisions with longer time horizons, and you can save or borrow for multiple years. But the same fundamental insight holds. If you save this year, then you will have extra resources to spend at some future date. If you borrow this year, then you will have to repay that loan sometime in the future, at which time you will have fewer resources to spend.
Toolkit: Section 31.4 "Choices over Time"
Individuals face a lifetime budget constraint. They can save in some periods of their lives and borrow (not save) in other periods. Over the course of any individual’s lifetime, however, income and consumption spending must balance. (If you begin life with some assets [for example, a bequest], we count this as part of income. If you leave a bequest when you die, we count this as part of consumption.) The lifetime budget constraint is as follows:
\[discounted\ present\ value\ of\ lifetime\ consumption\ =\ discounted\ present\ value\ of\ lifetime\ income.\]
Again, it is important to be consistent in calculating the discounted present values in this expression. We have written the equation in terms of (real) consumption and (real) income, which means that the real interest factor must be used for discounting. An alternative is to measure both consumption and income in nominal terms and then use the nominal interest factor for discounting. There is a useful special case where real interest rates are zero, in which case it is legitimate simply to add income and consumption in different years. Thus the lifetime budget constraint becomes
\[total\ lifetime\ consumption\ =\ total\ lifetime\ income.\]
Although the principles of decision making are the same whether we are thinking about 2 months, 2 years, or an entire lifetime, it is obviously harder to make decisions over a 30-year horizon than over a 30-day horizon. One reason is that, over longer time horizons, we are more likely to face uncertainty. We don’t know what our income will be 30 years from now, and we don’t know our tastes. But even without that uncertainty, we may not always make good decisions.
In particular, economists and psychologists have discovered that we do not view choices involving the near future the same way as we view distant choices. For example, suppose an individual is given a choice between 1 cookie today or 2 cookies tomorrow. If he is impatient (or hungry), he is likely to choose the single cookie today. But if the same individual is given a choice between 1 cookie in 30 days or 2 cookies in 31 days, he or she may very well choose the 2-cookie option. Yet after 30 days have gone by, that person will be confronting the earlier decision, wishing that he or she could have the 2 cookies today.
Another way of saying this is that our decisions are not always consistent over time: our future selves may wish that our current selves had displayed more self-control. For example, we may choose to consume a lot today—instead of saving—and then regret that decision when we are older. Indeed, people often engage in tricks to get around their lack of self-control. For example, some people have a separate bank account for their savings, so they are less tempted to spend that money. Governments also take actions that compensate for our lack of self-control. Social security is in some ways a “forced saving” scheme: the government takes money from us when we are working but pays us money when we are retired.
There is a new and exciting field of economics called “neuroeconomics” that tries to understand the processes in the brain that underlie economic decision making. This field, while still very much in its infancy, promises to help us understand why the economic theory of how we make choices often works well, and why it sometimes does not. Some recent research suggests that different brain processes may deliver conflicting messages when making choices over time. Some processes are deliberative, in line with the economic model, while others are more impulsive. It is likely that the next two decades will bring a much deeper understanding of how the brain makes decisions, perhaps leading to a richer theory of economic decision making.
Changes in Interest Rates
Whenever the real interest rate changes, then the relative price of consumption this year and next year changes. As we already know, changes in the real interest rate can come from two different sources: changes in the nominal interest rate and changes in the inflation rate. (Look back at the Fisher equation for a reminder of this.) Figure 5.2.7 "An Increase in the Real Interest Rate" shows the effect of an increase in the real interest rate on your budget line. The budget line becomes steeper because the opportunity cost of consumption this year increases. Notice, though, that the point at which you just consume your income in each period is still on the budget line. This is the point at which you are neither saving nor borrowing. Thus no matter what the interest rate, this point is always available to you.
A change in the real interest rate changes the slope of the budget line. At any real interest rate, however, it is possible to consume exactly one’s income. So the point corresponding to no saving or borrowing is always available, no matter what the real interest rate. An increase in the real interest rate therefore causes the budget line to become steeper and rotate through the income point.
Changes in relative prices lead to income and substitution effects. To understand the effect of an increase in the real interest rate, we must look at both effects.
• Substitution effect. An increase in the real interest rate makes consumption next year look more attractive relative to consumption this year. This encourages saving and discourages borrowing.
• Income effect. The income effect is somewhat more complicated. Look again at Figure 5.2.7 "An Increase in the Real Interest Rate". Savers are made better off by an increase in interest rates because, to the left of the income point, the new budget line lies outside the old budget set. This encourages savers to increase consumption this year and next year. Because income this year hasn’t changed, but there is an incentive to consume more this year, we can see that the income effect discourages saving. Borrowers, meanwhile, are worse off by the increase in interest rates. To the right of the income point, the new budget line lies inside the old budget set. This encourages borrowers to decrease consumption this year and next year. This incentive to consume less tells us that the income effect discourages borrowing. In sum, the income effect gives an incentive for savers to save less and for borrowers to borrow less.
Combining the income and substitution effects and following an increase in the interest rate, borrowers have an incentive to borrow less. The substitution effect encourages saving, while the income effect discourages saving. The overall effect is ambiguous.
The evidence suggests that most people are like the individual in Figure 5.2.8 "Individual Loan Supply". For this person, the substitution effect dominates: the amount of saving increases as the real interest rate increases. Because an individual’s savings represent funds that can be lent out to others in the economy, we call them the individual loan supply.
Toolkit: Section 31.6 "The Credit Market"
Individual loan supply is the amount of saving carried out by an individual at different values of the real interest rate. It is illustrated in a diagram with the real interest rate on the vertical axis and the supply of loans on the horizontal axis.
For savers in the economy, the effects of an increase in the real interest rate are ambiguous. The substitution effect encourages saving, but the income effect discourages saving. The evidence suggests that, on balance, the substitution effect dominates, so that savings increase. (a) In this two-period diagram, an increase in interest rates causes consumption this year to decrease. Because income this year is unchanged, savings increases. (b) The same diagram is applied to an individual supply of loans.
As the real interest rate changes, the response of individual saving is a movement along the loan supply curve. What might cause the whole curve to shift? If an individual has a higher income in the current year, this will cause the budget line to shift outward, and the person will consume more goods in the current year and more goods in the future. To consume more in the future, the person will have to save more. In this case, the supply of savings shifts outward as current income increases. This is shown in Figure 5.2.9 "A Shift in an Individual’s Supply of Savings".
Figure \(9\): A Shift in an Individual’s Supply of Savings
An increase in this year’s income means that an individual will save more at any given interest rate. This means that the loan supply curve for the individual shifts outward.
Key Takeaways
• Over the course of an individual’s lifetime, the discounted present value of spending equals the discounted present value of income.
• Households save to consume more in the future.
• Unless the interest rate is zero, a dollar today does not have the same value as a dollar tomorrow.
• The nominal interest rate is expressed in dollar terms, while the real interest rate is expressed in terms of goods and services. Economists think that households and firms make decisions on the basis of real interest rates.
check your understanding
1. Fill in the missing values in Table 5.2.1 "Discounted Present Value of Income".
2. If the interest rate increases, what will happen to the amount saved by a household? How does this answer depend on whether the household is a lender (saving is positive) or a borrower (saving is negative)? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/05%3A_Life_Decisions/5.02%3A_Consumption_and_Saving.txt |
Learning Objectives
1. When should you use the tool of discounted present value?
2. How does an increase in the interest rate affect the discounted present value of a flow of income?
Section 5.2 "Consumption and Saving" introduced a valuable technique called discounted present value. You can use this technique whenever you need to compare flows of goods, services, or currencies (such as dollars) in different periods of time. In this section, we look at some of the big decisions you make during your life, both to illustrate discounted present value in action and to show how a good understanding of this idea can help you make better decisions.
Choosing a Career
A decision you typically make around the time that you graduate is your choice of a career. What makes the choice of a career so consequential is the fact that it can be very costly to switch from one career to another. For example, if you have trained as an engineer and then decide you want to be a lawyer, you will have to give up your engineering job (and give up your salary as well) and go to law school instead.
Suppose you are choosing among three careers: a lawyer, an insurance salesperson, or a barista. To make matters simple, we will work out an example with only two years. Table 5.3.1 "Which Career Should You Choose?" shows your earnings in each year at each occupation. In the first year in your career as a lawyer, we suppose that you work as a clerk, not earning very much. In the second year, you join a law firm and enjoy much higher pay. Selling insurance pays better than the legal career in the first year but worse in the second year. Working as a barista pays less than selling insurance in both years.
Career First-Year Income (\$) Second-Year Income (\$)
Lawyer 5,000 60,000
Insurance salesperson 27,000 36,000
Barista 18,000 20,000
Table \(1\): Which Career Should You Choose?
It is obvious that, if you care about the financial aspect of your career, you should not be a barista. (You would choose that career only if it had other benefits—such as flexible working hours and lack of stress—that outweighed the financial penalty.) It is less obvious whether it is better financially to work as a lawyer or as an insurance salesperson. Over the two years, you earn \$65,000 as a lawyer and \$63,000 as an insurance seller. But as we have already explained, simply adding your income for the two years is incorrect. The high salary you earn as a lawyer comes mostly in the second year and must be discounted back to the present.
To properly compare these careers, you should use the tool of discounted present value. With this tool, you can compare the income flows from the different occupations. Table 5.3.2 "Comparing Discounted Present Values of Different Income Streams" shows the discounted present value of the two-year flow of income for each career, assuming a 5 percent interest rate (that is, an interest factor equal to 1.05). Look, for example, at the lawyer’s income stream:
Similarly, the discounted present value of the income stream is \$61,286 for the insurance salesperson and \$37,048 for the barista. So if you are choosing your career on the basis of the discounted present value of your income stream, you should pick a career as a lawyer.
Career First-Year Income (\$) Second-Year Income (\$) Discounted Present Value at 5% Interest Rate (\$)
Lawyer 5,000 60,000 62,143
Insurance salesperson 27,000 36,000 61,286
Barista 18,000 20,000 37,048
Table \(2\): Comparing Discounted Present Values of Different Income Streams
This conclusion, however, depends on the interest rate used for discounting. Table 5.3.3 "Discounted Present Values with Different Interest Rates" adds another column, showing the discounted present values when the interest rate is 10 percent. You can see two things from this table: (1) The higher interest rate reduces the discounted present value for all three professions. If the interest rate increases, then future income is less valuable in present value terms. (2) The higher interest rate reverses our conclusion about which career is better. Selling insurance now looks better than being a lawyer because most of the lawyer’s earnings come in the future, so the discounting has a bigger effect.
Career First-Year Income (\$) Second-Year Income(\$) Discounted Present Value at 5% Interest Rate (\$) Discounted Present Value at 10% Interest Rate (\$)
Lawyer 5,000 60,000 62,143 59,545
Insurance salesperson 27,000 36,000 61,286 59,727
Barista 18,000 20,000 37,048 36,182
Table \(3\): Discounted Present Values with Different Interest Rates
Of course, what you might really like to do is to sell insurance for the first year and work as a lawyer in the second year. This evidently would have higher income. Sadly, it is not possible: it is almost impossible to qualify for a high-paying lawyer’s job without investing a year as a law clerk first. Changing occupation can be very costly or even impossible if you don’t have the right skills. So choosing a career path means you must look ahead.
Going to College
If you are like most readers of this book, you have already made at least one very important decision in your life. You have chosen to go to college rather than taking a job immediately after graduating from high school. Ignoring the pleasures of going to college—and there are many—there are direct financial costs and benefits of a college education.
Think back to when you were deciding whether to go to college or to start work immediately. To keep our example from being too complicated, we again look at a two-year decision. What if you could obtain a college degree in one year, at a tuition cost of \$13,000, and the interest rate is 5 percent annually? Your earnings are presented in Table 5.3.4 "Income from Going to College versus Taking a Job". In your year at college, you would earn no income, and you have to pay the tuition fee. In the following year, imagine that you can earn \$62,143 working as a lawyer. Alternatively, you could bypass college and go to work as a barista, earning \$10,000 in the first year and \$37,048 in the second year. (We are assuming, as before, that you know these figures with certainty when you are making your decision.)
Career Income in the Year at College (\$) Income in the Year after College (\$)
College −13,000 62,143
Barista 10,000 37,048
Table \(4\): Income from Going to College versus Taking a Job
Going to college is an example of an investment decision. You incur a cost in the year when you go to college, and then you get a benefit in the future. There are two costs of going to college: (1) the \$13,000 tuition you must pay (this is what you probably think of first when considering the cost of going to college) and (2) the opportunity cost of the income you could have earned while working. In our example, this is \$10,000. The explicit cost and the opportunity cost together total \$23,000, which is what it costs you to go to college instead of working in the first year.
By the way, we do not think about living expenses as a cost of going to college. You have to pay for food and accommodation whether you are at college or working. Of course, if these living expenses are different under the two scenarios, then you should take this into account. For example, if your prospective college is in New York City and has higher rental costs than in the city where you would work, then the difference in the rent should be counted as another cost of college.
The benefit of going to college is the higher future income that you enjoy. In our example, you will earn \$62,143 in the following year if you go to college, and \$37,048 if you do not. The difference between these is the benefit of going to college: \$62,143 − \$37,048 = \$25,095. Even though this is greater than the \$23,000 cost of going to college, we cannot yet conclude that going to college is a good idea. We have to calculate the discounted present value of this benefit. Suppose, as before, that the interest rate is 5 percent. Then
We can conclude that, with these numbers, going to college is a good investment. It is worth \$900 more in discounted present value terms.
We could obtain this same conclusion another way. We could calculate the discounted value of the two-year income stream for the case of college versus barista, as in Table 5.3.5 "Income Streams from Going to College versus Taking a Job". We see that the discounted value of the income stream if you go to college is \$46,184, compared to \$45,284 if you work as a barista. The difference between these two is \$900, just as before.
Career Income in the Year at College (\$) Income in the Year after College (\$) Discounted Present Value at 5% Interest Rate (\$)
College −13,000 62,143 46,184
Barista 10,000 37,048 45,284
Table \(5\): Income Streams from Going to College versus Taking a Job
You might have noticed that the figures we chose as “income in the year after college” in Table 5.3.4 "Income from Going to College versus Taking a Job" are the same as the numbers that we calculated in Table 5.3.2 "Comparing Discounted Present Values of Different Income Streams". The numbers in Table 5.3.2 "Comparing Discounted Present Values of Different Income Streams" were themselves the result of a discounted present value calculation: they were the discounted present value of a two-year income stream. When we compare going to college with being a barista, we are therefore calculating a discounted present value of something that is already a discounted present value. What is going on?
To understand this, suppose you are deciding about whether to go to college in 2012. If you do go to college, then in 2013 you will decide whether to be a lawyer, an insurance salesman, or a barista. If you decide on the legal career, then you will be a law clerk in 2013, and you will earn the high legal salary in 2014. Our analysis in Table 5.3.2 "Comparing Discounted Present Values of Different Income Streams" is therefore about the choice you make in 2013, thinking about your income in 2013 and 2014. Table 5.3.2 "Comparing Discounted Present Values of Different Income Streams" gives us the discounted present value in 2013 for each choice. If we then take those discounted present values and use them as “income in the year after college,” as in Table 5.3.5 "Income Streams from Going to College versus Taking a Job", we are in fact calculating the discounted present value, in 2012, of the flow of income you receive in 2012, 2013, and 2014.
If you think carefully about this, you will realize that
This is the same answer that we got before. As this example suggests, you can calculate discounted present values of long streams of income, including income you will receive many years in the future.The toolkit gives a more general formula for calculating the discounted present value. (See the more formal presentation of discounted present value at the end of Chapter 5 "Life Decisions", Section 5.4 "Embracing Risk".)
Economists have worked hard to measure the return on investment from schooling: “Alan B. Krueger, an economics professor at Princeton, says the evidence suggests that, up to a point, an additional year of schooling is likely to raise an individual’s earnings about 10 percent. For someone earning the national median household income of \$42,000, an extra year of training could provide an additional \$4,200 a year. Over the span of a career, that could easily add up to \$30,000 or \$40,000 of present value. If the year’s education costs less than that, there is a net gain.”Anna Bernasek, “What’s the Return on Education?” Economic View, Business Section, New York Times, December 11, 2005, accessed February 24, 2011, http://www.nytimes.com/2005/12/11/business/yourmoney/11view.html. Notice several things from this passage. First, the gains from education appear as an increase in earnings each year. So even if a 10 percent increase in earnings does not seem like a lot, it can be substantial once these gains are added over one’s lifetime. Second, Krueger is careful to use the term present value. Third, the number given is an average. Some people will benefit more; others will benefit less. Equally, some forms of schooling will generate larger income gains than others. Fourth, Krueger correctly notes that the present value must be compared with the cost of education, but you should remember that the cost of education includes the opportunity cost of lost income.
Table 5.3.6 "Return on Education" provides some more information on the financial benefits of schooling.US Census Bureau, “Income, Earnings, and Poverty from the American Community Survey,” 2010, table 5, accessed February 24, 2011, www.census.gov/hhes/www/poverty/publications/acs-01.pdf. The table shows average income in 2004. There is again evidence of a substantial benefit from schooling. Male college graduates, on average, earned more than \$21,000 (68 percent) more than high school graduates, and female college graduates earned more than \$16,000 (78 percent) more than high school graduates. The table shows that women are paid considerably less than men and also that the return on education is higher for women.
Schooling Median Annual Income (Men) Median Annual Income (Women)
High school graduate 31,183 19,821
Some college 37,883 25,235
College graduate 52,242 35,185
Table \(6\): Return on Education
Source: US Census Bureau, “Income, Earnings, and Poverty From the 2004 American Community Survey,” August 2005, table 5, page 10, accessed March 14, 2011, www.census.gov/hhes/www/poverty/publications/acs-01.pdf.
The presence of such apparently large gains from education helps explain why economists often suggest that education is one of the most important ingredients for the development of poorer countries. (In poorer countries, we are often talking not about the benefit of going to college but about the benefit of more years of high school education.) Moreover, the benefits from education typically go beyond the benefits to the individuals who go to school or college. There are benefits to society as a whole as well.
However, you should be careful when interpreting numbers such as these. We cannot conclude that if you randomly selected some high school graduates and sent them to college, then their income would increase by \$17,000. As we all understand, individuals decide whether to go to college. These decisions reflect many things, including general intelligence, the ability to apply oneself to a task, and so on. People who have more of those abilities are more likely to attend—and complete—college.
One last point: we conducted this entire discussion “ignoring the pleasures of going to college.” But those pleasures belong in the calculations. Economics is about not only money but also all the things that make us happy. This is why we occasionally see people 60 years old or older in college. They attend not as an investment but simply because of the pleasure of learning. This is not inconsistent with economic reasoning or our discussion here. It is simply a reminder that your calculations should not only be financial but also include the all the nonmonetary things you care about.
The Effects of Interest Rates on Labor Supply
After you have decided whether or not to go to college and have chosen your career, you will still have plenty of decisions to make involving discounted present value. Remember that you have a lifetime budget constraint, in which the discounted present value of your income, including labor income, equals the discounted present value of consumption.
Your labor income is partly under your control. If you have some choice about how many hours to work, then your individual labor supply curve depends on the real wage, as shown in Figure 5.10 "Individual Labor Supply". Chapter 4 "Everyday Decisions" explains the individual supply of labor. The labor supply curve illustrates the fact that as the real wage increases, you are likely to work more. Labor supply, like the supply of loans that we considered previously, is driven by substitution and income effects. As the real wage increases,
• the opportunity cost of leisure increases, so you have an incentive to work more (substitution effect); and
• you have more income to spend on everything, including leisure, so you have an incentive to consume more leisure and work less (income effect).
Toolkit: Section 31.3 "The Labor Market"
The toolkit contains more information if you want to review the labor supply curve.
An increase in the real wage encourages an individual to work more. The labor supply curve slopes upward.
When you are making a decision about how much to work over many periods of time, your choice is more complicated. How much you choose to work right now depends not only on the real wage today but also on the real wage in the future and on the real interest rate. This is because you work both today and in the future to earn the income that goes into your lifetime budget constraint. If you think it is likely to be harder to earn money in the future, then you will probably decide to work more today. If you think it will be easier to earn money in the future, then you might well decide to work less today.
It is easiest to see how this works with an example. Suppose you are a freelance construction worker in Florida in the aftermath of a hurricane. There is lots of work available, and construction firms are paying higher than usual wages. You realize that you can earn much more per hour of work right now compared to your likely wage a few months in the future. A natural response is to work harder now to take advantage of the unusually high wages.
We can understand your decision in terms of income and substitution effects. The higher wage leads to the usual substitution effect. But because the change in the wage is only temporary, and because you are thinking about your wages over your lifetime, it does not have a large income effect. In this case, therefore, we expect the substitution effect to strongly outweigh the income effect.
Interest rates may also influence your decision about how hard to work. If interest rates increase, then the gains from working today increase as well. If you save money at high interest rates, you can enjoy more consumption in the future. High interest rates, like temporarily high current wages, increase the return to working today compared to working in the future, so you are likely to work more today.
The Demand for Durable Goods
Some of the products we purchase, such as milk or a ticket to a football game, disappear as soon as they are consumed. Other goods last for a long time and are, in effect, consumed over and over. Some examples are a bicycle, a car, and a microwave oven.
Goods that last over many uses are called durable goods, while those that do not last very long are called nondurable goods. There is no hard-and-fast distinction between durable and nondurable goods. Many everyday items, such as plates, books, T-shirts, and downloaded music, are used multiple times. In economic statistics, however, the term durable is reserved for larger items that are bought only occasionally and that typically last for many years. Cars and kitchen appliances are classified as durable goods, but blue jeans and haircuts are not, even though they are not consumed all at once.
Because durable goods last a long time, making decisions about purchasing a durable good requires thinking about the future as well as the present. You must compare the benefits of the durable good over its entire lifetime relative to the cost you incur to pay for the durable now. A durable good purchase is typically a unit demand decision—you buy either a single unit or nothing. For unit demand, your decision rule is simple: buy if your valuation of the good exceeds the price of the good. (Remember that your valuation is the maximum you would be willing to pay for the good.) In the case of durable goods, there is an extra twist: your valuation needs to be a discounted present value.
Toolkit: Section 31.1 "Individual Demand"
You can review valuation and unit demand in the toolkit.
The idea is that you obtain a flow of services from a durable good. You need to place a valuation on that flow for the entire lifetime of the durable good. Then you need to calculate the discounted present value of that flow of services. If this discounted present value exceeds the price of the good, you should purchase it.
Suppose you are thinking of buying a new car that you expect to last for 10 years. You need to place a valuation on the flow of services that you get from the car each year: for example, you might decide that you are willing to pay \$3,000 each year for the benefit of owning the car. To keep life really simple, let us think about a situation where the real interest rate is zero; this is the special case where it is legitimate to add these flows. So the car is worth \$30,000 (= \$3,000 per year × 10 years) to you now. This means you should be willing to buy the car if it costs less than \$30,000, and you should not buy it otherwise.What if you think you might sell the car before it wears out? In this case, the value of the car has two components: (1) the flow of services you obtain while you own it, and (2) the price you can expect to obtain when you sell it. When you buy a durable good, you are purchasing an asset: something that yields some flow of benefits over time and that you can buy and sell. In general, the value of an asset depends on both the benefits that it provides and the price at which it can be traded. We examine these ideas in much more detail in Chapter 10 "Making and Losing Money on Wall Street".
If real interest rates are not zero, then spending on durable goods will depend on interest rates. As interest rates increase, the future benefits of the durable good become smaller, in terms of discounted present value. This means that durable goods become more expensive relative to nondurable goods. Thus the demand for durable goods decreases as interest rates increase.
One way to understand this is to realize that it is often easy to defer the purchase of a durable good. New durable goods are frequently bought to replace old goods that are wearing out. People buy new cars to replace their old cars or new washing machines to replace their old ones. If interest rates are high, you can often postpone such replacement purchases; you decide whether you can manage another year with your old car or leaking washing machine. As a result, spending on durable goods tends to be very sensitive to changes in interest rates.
These examples of discounted present value illustrate one key point: whenever you are making economics decisions about the future—be it what career to follow, when it is best to work hard, or if you should buy a new car—your decisions depend on the rate of interest. Whenever the rate of interest is high, future costs and benefits are substantially discounted and are therefore worth less in present value terms. High interest rates, in other words, mean that you put a lot of weight on the present relative to the future. When the rate of interest decreases, the future should play a larger role in your decisions.
Key Takeaways
• You should use discounted present value whenever you need to compare flows of income and expenses in different periods of time.
• The higher the interest rate, the lower the discounted present value of a flow.
check your understanding
1. List five goods that are durable and five services that are nondurable. Is it possible to have a service that is durable?
2. Calculate the appropriate values in Table 5.3.2 "Comparing Discounted Present Values of Different Income Streams" assuming an interest rate of 8 percent.
3. If interest rates are lower, would you expect people to invest more or less in their health? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/05%3A_Life_Decisions/5.03%3A_Using_Discounted_Present_Values.txt |
Learning Objectives
1. What is the definition of probability?
2. How can I calculate an expected value?
3. What is risk aversion?
4. How do individuals and firms deal with risk?
5. How does insurance work?
In life, there are many uncertainties. So far, we have ignored them all, but you will have to face them. In our various discussions of discounted present value, we pretended that you knew your future income—and your future tastes—with certainty. In real life, we must decide how much to save without knowing for sure what our future income will be. We must pick a career without knowing how much we will enjoy different jobs or how much they will pay. We must decide whether or not to go to college without knowing what kind of job we will be able to get, and so on. How can we deal with all these uncertainties?
Some of the uncertainties we face are forced on us with no choice of our own, such as the following:
• Accidents involving you, your automobile, your house, and so on
• Layoffs resulting in spells of unemployment
• Your health
As you know, one way to deal with these uncertain events is through insurance. Insurance is a way of trying to remove some of the risk that we face. We explain how it works later in this section.
Other risks are more under our control. We accept jobs that entail certain risks. We drive our cars even though we know that there is a risk of accident. We put our savings into risky stocks rather than safe assets. In these cases, we trade off these risks against other benefits. We drive faster, accepting the greater risk of accident to save time. Or we take a risky job because it pays well.
There are yet other kinds of risk that we actually seek out rather than avoid. We play poker or bet on sporting events. We climb mountains, go skydiving, and engage in extreme sports. In these cases, the risks are apparently something good that we seek out, rather than something bad that we avoid.
Risk and Uncertainty
Let us begin by making sure we understand what risk and uncertainty mean. (Here we will use the terms more or less interchangeably, although people sometimes reserve the term uncertainty for cases where it is hard to quantify the risks that we face.) Probably the simplest example of risk is familiar to us all: the toss of a coin. Imagine flipping a coin five times. Each time, the outcome will be either a head or a tail. Table 5.4.1 "Coin-Flipping Experiment" shows an example of such an experiment. In this experiment, the outcome was three heads and two tails. For each flip of the coin, there was uncertainty about the outcome. We did not know ahead of time whether there would be heads or tails. The outcome reported in Table 5.4.1 "Coin-Flipping Experiment" is only one example. If you were to carry out this experiment right now, you would almost certainly end up with a different outcome.
Flip 1 2 3 4 5
Outcome Heads Heads Tails Heads Tails
Table \(1\): Coin-Flipping Experiment
Coin tosses are special because the flips of the coin are independent of each other (that is, the history of previous tosses has no effect on the current toss of a coin). In Table 5.4.1 "Coin-Flipping Experiment", the coin was not more likely to come up tails on the third toss because the previous tosses were both heads. Even if you have 100 heads in a row, this does not affect the outcome of the 101st toss of the coin. If you think that the coin is “fair,” meaning that heads and tails are equally likely, then the 101st toss is still just as likely to be heads as tails. By contrast, the likelihood that it will be raining an hour from now is not independent of whether or not it is raining at this moment.
Financial Risk and Expected Value
Some of the risks that we confront are nonfinancial. An example of nonfinancial uncertainty is the risk that you might break your ankle playing basketball or the possibility that your favorite sporting team will win a big game and make you happy. Here, we will focus on financial uncertainty, by which we mean situations where there is money at stake. In other words, we are thinking about risks where you can measure the implications in monetary terms. An obvious example is the money you could win or lose from buying a lottery ticket or playing poker. Another is the money you would have to pay for repairs or medical expenses following a car accident. Another is the gains or losses from buying stocks, government bonds, or other financial assets. Another is the income you would lose if you were laid off from your job.
When we evaluate risky situations, we must have a way of describing the kinds of gambles that we confront. In general, we do this by listing all the possible outcomes together with the likelihood of each outcome. For example, Table 5.4.2 "Outcomes and Probabilities from a Coin Toss" lists the outcomes and the probability (that is, the likelihood of each outcome) for the experiment of tossing a coin one time.
Outcome Probability
Heads
Tails
Table \(2\): Outcomes and Probabilities from a Coin Toss
Toolkit: Section 31.7 "Expected Value"
Probability is the percentage chance that something will occur. For example, there is a 50 percent chance that a tossed coin will come up heads. We say that the probability of getting the outcome “heads” is 0.5.
There are five things to know about probability:
1. The list of outcomes must be complete.
2. The list of outcomes must not overlap.
3. If an outcome is certain to occur, it has probability of 1.
4. If an outcome is certain not to occur, it has probability of 0.
5. If we add the probabilities for all the possible outcomes, the total must equal 1.
Think about rolling a normal six-sided die one time and describing outcomes and probabilities.
• We must make sure that we include every outcome. We cannot list as possible outcomes “less than or equal to 2” and “greater than or equal to 4.” Such a list ignores the possibility of rolling a 3.
• We cannot list as possible outcomes “less than or equal to 4” and “greater than or equal to 3.” These categories overlap because a roll of a 3 or a 4 would show up in both categories.
• The outcome “less than or equal to 6” has a probability of 1 because it is certain.
• The outcome “9” has a probability of 0.
• Provided we have a complete list of outcomes (for example “less than or equal to 4” and “greater than or equal to 5”), the probabilities of all the outcomes will always sum to 1. (In this case, the probability of the first outcome is 2/3, and the probability of the second outcome is 1/3.)
Now suppose you are playing a gambling game based on a toss of a coin. If the coin comes up heads, you win \$1. If it comes up tails, you win \$0. When we look at a situation such as this, we are often interested in how much you would get, on average, if you played the game many times. In this example, it is easy to guess the answer. On average, you would expect to win half the time, so half the time you get \$1, and half the time you get nothing. We say that the expected value of each flip of the coin is 50 cents.
Toolkit: Section 31.7 "Expected Value"
The expected value of a situation with financial risk is the measure of how much you would expect to win (or lose) on average, if the situation were to be replayed a large number of times. Expected value is calculated as follows:
1. For each outcome, multiply the probability of that outcome by the amount you will receive.
2. Add these amounts over all the possible outcomes.
Table 5.4.3 "Outcomes and Probabilities from Investment in Internet Venture" gives another example of expected value. Suppose a friend is planning on establishing a small Internet business and asks you to invest \$1,000. He tells you (and you believe him) that there is a 50 percent chance that the business will fail, so you will lose your money. There is a 40 percent chance that the business will just break even, so you will get your \$1,000 back but nothing more. And there is a 10 percent chance that the business will be very successful, so you will earn \$16,000.
Outcome Probability Amount You Will Receive (\$)
Failure 0.5 0
Break even 0.4 1,000
Success 0.1 16,000
Table \(3\): Outcomes and Probabilities from Investment in Internet Venture
In this case, the expected value of the investment is given by the following:
\[expected\ value\ =\ (0.5\ ×\ \$0)\ +\ (0.4\ ×\ \$1,000)\ +\ (0.1\ ×\ \$16,000)\ =\ \$2,000.\]
Thus for your investment of \$1,000, you could expect to get \$2,000 back on average. This seems like a good investment. It is important to remember, though, what “on average” means. You will never actually get \$2,000. You will receive either \$16,000, \$1,000, or nothing. Even though this is a good investment on average, you might still decide that you don’t want any part of it. Yes, you might get the big net gain of \$15,000. But there’s also a 50 percent chance that you will be out \$1,000. The gamble might seem too risky for you.
Coin tosses are special because it is relatively easy to determine the probability of a head or a tail. This is not the case for all the types of uncertainty you might face. In some cases, financial instruments—such as the mortgage-backed securities that played a big role in the financial crisis of 2007–2009—are so complex that investors find it difficult to assess the probabilities of various outcomes.
We often do a bad job of estimating probabilities. One reason for this is because we are unduly influenced by things that we can easily bring to mind. Psychologists call this the “availability heuristic.” For example, we tend to overestimate certain causes of death, such as car accidents, tornadoes, and homicides, and underestimate others, such as diabetes, stroke, and asthma.See Paul Slovic, Baruch Fischoff, and Sarah Lichtenstein, “Facts versus Fears: Understanding Perceived Risk,” in Judgment under Uncertainty: Heuristics and Biases, ed. Daniel Kahneman, Paul Slovic, and Amos Tversky (Cambridge, MA: Cambridge University Press, 1982), 463–89. We also often do a poor job at using probabilities; in particular, we often put too much emphasis on small probabilities. For example, consider two drugs that are equally effective in treating a disease, but suppose the older drug has a 1 in 10 million chance of having a certain side effect and the newer drug has a 1 in a 100 million chance of having the same side effect. Consumers might view the new drug as much more appealing, even though the side effect was already highly improbable with the older drug.
Diversification of Risk
In many cases, we would like to find some way of getting rid of—at least to some degree—the risks that we face. One way we eliminate risk is through insurance. Sometimes we purchase insurance on the market. Sometimes our employer provides us with insurance. Sometimes the government provides us with insurance. In the following subsections, we look at many different kinds of insurance, including property insurance, unemployment insurance, and deposit insurance.We do not discuss health insurance here. In Chapter 16 "A Healthy Economy", we discuss the provision of health care and the problems of health insurance in detail.
First, though, we need to understand how and why insurance works. Suppose you have a bicycle worth \$1,000, and (for some reason) you cannot purchase insurance. You think that, in any given year, there is about a 1 percent chance that your bike will have to be replaced (because it is either stolen or written off in an accident).
Now, in expected value terms, this may not look too bad. Your expected loss from an accident is \$0.01 × \$1,000 = \$10. So on average, you can expect to lose \$10 a year. But the problem is that, if you are unlucky, you are stuck with a very big expense. Most of us dislike this kind of risk.
You are complaining about this to a friend, and she sympathizes, saying that she faces exactly (and we mean exactly) the same problem. She also has a bike worth \$1,000 and thinks there is a 1 percent chance each year that she will need to replace it. And that’s when you have the brilliant idea. You can make an agreement that, if either one of you has to replace your bikes, you will share the costs. So if you have to replace your bike, she will pay \$500 of your costs, and if she has to replace her bike, then you will pay \$500 of her costs. It is (almost exactly) twice as likely that you will have to pay something, but if you do, you will only have to pay half as much. With this scheme, your expected loss is unchanged. But you and your friend prefer this scheme because it is less risky; it is much less likely that you will have to make the big \$1,000 payout.
We are implicitly assuming here that your chances of having to replace your bike are independent of the chance that she will have to replace her bike. (If you are likely to crash into her, or both of your bikes are stolen, then it is a different story.) There is also still a chance that you will both experience the unlucky 1-in-100 chance, in which case you would both still have to pay \$1,000. But the likelihood of this happening is now tiny. (To be precise, the probability of both of you having an accident in the same year is 1 in 10,000 [that is, 0.0001]). This is because the probability that two independent events occur equals the probability of one multiplied by the probability of the other.)
But why stop here? If you can find two more friends with the same problem, then you can make it almost certain that you will have to pay out no more than \$250. It is true that you would be even more likely to have to make a payment because you will have to pay if you or one of your friends has to replace his or her bike. But because the payment is now being shared four ways, you will have to pay only 25 percent of the expenses. This is an example of diversification, which is the insight that underlies insurance: people share their risks, so it is less likely that any single individual will face a large loss.
Diversification and insurance don’t prevent bad stuff from happening. We live in a world where bicycles are stolen; where houses are destroyed by floods, fires, or storms; where people have accidents or become ill; and so on. There is not a lot we can do about the fact that bad things happen. But we can make the consequences of these bad things easier to deal with. Insurance is a means of sharing—diversifying—these risks.
Continuing with our bicycle insurance example, suppose you could find thousands of friends who would agree to be part of this arrangement. As more and more people join the scheme, it becomes increasingly likely that you have to make a payment each year, but the amount you would have to pay becomes smaller and smaller. With a very large number of people, you would end up very close to a situation where you pay out \$10 with certainty each year. Of course, organizing thousands of your friends into such a scheme would present all sorts of practical problems. This is where insurance companies come in.
Insurance companies charge you a premium (an annual payment). In return, they promise to pay you an indemnity in the event you suffer a loss. The indemnity is usually not the full amount of the loss. The part of the loss that is not covered is called the deductible. In our example, there is no deductible, and the indemnity is \$1,000. An insurance company would charge you a premium equal to the expected loss of \$10 plus a little extra. The extra payment is how the insurance company makes money. You and everyone else are willing to pay this extra amount in return for the removal of risk.
The idea of diversification can also be applied to investment.We discuss this in Chapter 10 "Making and Losing Money on Wall Street". Think back to our example of your friend with the Internet venture. You might not want to invest \$1,000 in his scheme because it seems too risky. But if you had 100 friends with 100 similar (but independent) schemes, you might be willing to invest \$10 in each. Again, you would be diversifying your risk.
Risk Aversion
The preceding discussion of insurance and diversification is based on the presumption that people typically wish to avoid risk whenever possible. In our example, you have a 1 percent chance of suffering a \$1,000 loss. Your expected loss is therefore \$10. Now imagine we give you a choice between this gamble and a certain loss of \$10. If you are just as happy in either case, then we say you are risk-neutral. But if you are like most people, then you would prefer a certain loss of \$10 to the gamble whereby you have a 1 percent chance of losing \$1,000. In that case, you are risk-averse.
Toolkit: Section 31.7 "Expected Value"
Suppose you are presented with the following gamble:
• Lose nothing (99 percent probability)
• Lose \$1,000 (1 percent probability)
How much would you pay to avoid this gamble? If you are risk-neutral, you would be willing to pay only \$10, which is the expected loss. If you are risk-averse, you would be willing to pay more than \$10. The more risk-averse you are, the more you would be willing to pay.
It is risk aversion that allows insurance companies to make money. Risk-averse people prefer a sure thing to a gamble that has the same expected value. In fact, they will prefer the sure thing to a gamble with a slightly lower expected value. Because it can diversify risk, the insurance company cares only about the expected value. Thus an insurance company behaves as if it were risk-neutral.
Different Kinds of Insurance
There are many different kinds of insurance available to you. We briefly discuss some of the most important.
Property Insurance
Many forms of property are insured: houses, cars, boats, the contents of your apartment, and so on. Indeed, some insurance is often mandatory. People purchase insurance because there are risks associated with owning property. Houses burn down, cars are stolen, and boats are wrecked in storms. In an abstract sense, these risks are just like a coin flip: heads means nothing happens; tails means there is a fire, a robbery, or a storm.
Let us look at home insurance in more detail. Suppose you own a house that is worth \$120,000. You might pay \$1,000 per year as a premium for an insurance policy. If your house burns down, then the insurance company will pay you some money to recover part of the loss. If the deductible on the policy is \$20,000, you would receive an indemnity of \$100,000. You lose \$20,000 when the house burns down because the insurance company does not fully cover your loss.
Thus, if your house burns down, the insurance company loses the indemnity minus the premium—a total of \$99,000. You lose the deductible and the premium—a total of \$21,000. Your joint loss is \$120,000—the lost value of the house. This serves to remind us again that insurance is not some magic way of preventing bad things from happening. When the house does not burn down, the insurance company earns the \$1,000 premium, and you pay the \$1,000 premium. Your joint loss is zero in this case.
You may wonder why insurance companies typically insist on a deductible as part of an insurance contract. After all, you would probably prefer to be covered for the entire loss. Deductibles exist because insurance policies can have the effect of altering how people behave. We have assumed that the probability of a bad thing happening was completely random. But if you are fully insured, you might not be so careful about how you look after your house. You might worry less about turning off the stove, ensuring that you have put out the fire in the fireplace, falling asleep while smoking, and so on. Deductibles make sure that you still have a big incentive to take care of your property.
Unemployment Insurance
Not everyone who wants to work actually has a job. Some people are unemployed, meaning that they are actively looking for work but do not have jobs. The unemployment rate is the number of unemployed individuals divided by the sum of the number employed and the number unemployed.
Toolkit: Section 31.3 "The Labor Market"
If you want to learn more details about the definition and measurement of unemployment, refer to the toolkit.
Since 1960, the unemployment rate in the United States has averaged slightly under 6 percent. This means that for every 100 people in the labor force (either working or looking for a job), 94 of them are working, and the other 6 are looking for jobs. The labor market is fluid so that, over time, unemployed workers find jobs, while some employed workers lose jobs and become unemployed. The unemployed find jobs, and others lose them and go through spells of unemployment.
If you are laid off from your job and become unemployed, you obviously still need to spend money for food and rent. During a spell of unemployment, you have several possible sources of income. If you have an existing stock of accumulated savings, then you can draw on these. If you are a member of a union, you may receive some support from the union. You may receive some severance pay when you lose your job. You might be able to rely on the support of your family and friends. And, most relevant for this chapter, you may be eligible to receive income from the government, called unemployment insurance.
Unemployment insurance is similar in some ways to health and property insurance. There is an unlucky event called unemployment, and the government provides insurance. Perhaps you think this is great news: after graduation, you can claim unemployment, collect from the government, and enjoy your leisure. Of course, life is not quite that good. First, to qualify for unemployment insurance, you have to hold a job for some period of time. The details of these regulations differ across countries and also across states within the United States. Second, unemployment benefits do not last forever, nor do they completely compensate for all of your lost income. Again, the details depend on the country or state in which you work.
Why is the government in the business of providing insurance? To answer this, look back at our example of home insurance. The typical insurance company will have many policies with many different households. Over the course of a year, some households will make a claim on their insurance, but most will not. As long as the insurance company has lots of policies in many locations, then, on average, the number of insurance claims will be nearly constant each year. Although individual households face risk, the insurance company is able to diversify almost all of this risk.
Unemployment is different. When the economy is doing well, unemployment is low, and few households need this form of insurance. When the economy is not doing well, then the unemployment rate can be very high. In such times, many people want to claim unemployment insurance at the same time. So unlike insurance policies for homeowners, there is no easy way to balance out the risks of unemployment. The risk of unemployment is not independent across all individuals.
If an individual insurance company tried to offer unemployment insurance, it might be unable to survive: during a period of low economic activity, the demands for insurance would be so severe that the insurance company might not be able to meet all the claims. The government has the ability to tax people and borrow as needed. This puts it in a much better position to offer unemployment insurance. So in many countries, the government raises revenue by taxing firms and workers and uses these funds to provide unemployment insurance.
Deposit Insurance
In the United States and in some other countries, deposits that you place in the bank are insured by the government. In the United States, the government provides insurance, up to \$250,000 per deposit, to you in the event your bank closes.You can find details at FDIC, “Your Insured Deposits,” accessed March 14, 2011, www.fdic.gov/deposit/deposits/insured/basics.html. Deposit insurance in the United States dates from the time of the Great Depression in the 1930s. In this period many banks had insufficient funds on hand to meet the demands of their depositors and so went bankrupt. When this occurred, depositors lost the money they had put in the bank. After the Great Depression, the US federal government instituted deposit insurance. Similar programs exist in most other countries.
The argument for why the government should provide deposit insurance is similar to the argument for government provision of unemployment insurance. During periods of financial turbulence, many banks are prone to failure. If there were a private insurance company providing deposit insurance, it would probably be unable to meet all the claims. In addition, there is considerable social value to deposit insurance. It gives people greater confidence in the bank and in the banking system, which in turn makes bank failures less likely. Because bank failures put a great deal of stress on the financial system, government has an interest in insuring deposits.
In the summer of 2007, the British bank Northern Rock entered a financial crisis. Savers who had put their money in this institution started to worry that the bank would go bust, in which case they would lose their money. The British government, like the US government, provides deposit insurance. However, the amount of this insurance was limited to a maximum of about \$70,000, so some people were still concerned about their savings. As lines started to form outside Northern Rock branches, the British government—concerned that the possible failure of Northern Rock would put other banks at risk—ended up guaranteeing all of its deposits.
Key Takeaways
• The probability of a particular outcome is the percentage chance that the outcome will occur.
• An expected value is calculated by multiplying the probability of each outcome by the value of that outcome and then adding these numbers for all outcomes.
• Risk aversion means a preference for a sure thing rather than a gamble with the same expected value.
• We face many types of risks in our lives, and we can often buy insurance as a way to deal with these risks.
• Insurance companies provide a way for individuals to diversify their individual risks.
check your understanding
1. Imagine you have a die that is fair: the probability of rolling each number is ⅙. Each time you roll the die, it is independent of the previous roll. Suppose you roll the die 10 times, and you roll a 5 each time. What is the probability of getting a 5 on the next roll of the die? Relate your answer to the common analysis of sportscasters who say that a baseball hitter who normally bats 0.300 “is due” when that batter has no hits in his last 20 at bats.
2. List some risks that you face that are not fully covered by insurance. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/05%3A_Life_Decisions/5.04%3A_Avoiding_Risk.txt |
Learning Objectives
1. Why do people sometimes take on risks instead of avoiding them?
2. What are compensating wage differentials?
Insurance allows us to remove some risks from our lives, either partially or completely. There are other risks that we accept or even embrace. In some cases, we are willing to take on risks because we are compensated in some way for them. We discuss two examples here: job choice and investment in the stock market. In other cases, we actively seek risk, such as when we gamble, buy lottery tickets, or engage in extreme sports.
Job Choice
We have already discussed how your choice of career should be based on discounted present value, taking into account the fact that it can be costly to move from one job to another. Your choice of career also reflects how you feel about risk and uncertainty. There are numerous kinds of jobs that differ in many dimensions. When choosing a job, we pay particular attention to wages or salaries, vacation plans, health coverage, and other benefits. We also take into account the job’s riskiness.
The most severe risk is, of course, the risk of death. Every year in the United States several thousand workers suffer fatal work injuries. For most of the last decade, this number has been between about 5,000 and 6,000, or the equivalent of roughly 4 deaths for every 100,000 workers. Figure 5.5.1 "Work Fatalities in the United States" shows data on work-related deaths in the United States for 2006–9.The data come from Occupational Safety and Health Administration, “Census of Fatal Occupational Injuries,” accessed February 24, 2011, http://stats.bls.gov/iif/oshwc/cfoi/cfch0008.pdf. The Occupational Safety and Health Administration (OSHA) is the federal agency that monitors workplace safety. The fatality rate has generally been declining over time. In the early 1990s, the fatality rate was in excess of 5 deaths for every 100,000 workers; in 2009, the fatality rate was 3.3.
Source: US Department of Labor, Occupational Safety and Health Administration, http://stats.bls.gov/iif/oshwc/cfoi/cfch0008.pdf.
The fatality rate in the United States is high relative to many other developed countries. For example, the corresponding rate in England in 2006 was 0.8 per 100,000 workers.See Health and Safety Executive, “Fatal Injury Statistics,” accessed March 14, 2011, http://www.hse.gov.uk/statistics/fatals.htm. Care must be taken when comparing international data because they are not always exactly comparable. Most importantly, European Union statistics exclude road traffic accidents, which account for about 43 percent of US deaths. Correcting for this, the US figures are similar to the European Union average. Figure 5.5.2 "Work Fatalities in Europe" shows the work-related fatalities for countries in the European Union. Most importantly for the current discussion, the fatality rate varies significantly across jobs. In the United States, “Agriculture and mining recorded the highest fatal work injury rates among the major industry sectors in 2005—32.5 fatalities per 100,000 workers for agriculture and 25.6 fatalities per 100,000 workers for mining.” In the European Union, construction, agriculture, and transportation are the most dangerous sectors.See US Department of Labor Bureau of Labor Statistics, “National Census of Fatal Occupational Injuries in 2005,” accessed March 14, 2011, http://www.bls.gov/iif/oshwc/cfoi/cfnr0012.txt and Health and Safety Executive, “European Comparisons,” accessed March 14, 2011, http://www.hse.gov.uk/statistics/european/fatal.htm.
In the European Union, the average work-related fatality rate is lower than in the United States, although some countries—most notably Portugal—have higher rates. The lowest rate in the European Union is in Great Britain.
Source: Health and Safety Executive, Great Britain: http://www.hse.gov.uk/statistics/european/fatal.htm.
The risk of death is not the only job risk. Jobs also differ in terms of their risk of injury. In some cases, these injuries can have a severe impact on a person’s quality of life; in other cases, they may prevent an individual from working in the future. Professional athletes and other performers face the risk of injuries that can end their careers. These individuals sometimes buy insurance to help mitigate some of these risks. In 2006, for example, pop star Mariah Carey purchased a $1 billion insurance policy on her legs after signing up for an advertising campaign (“Legs of a Goddess”) with the Gillette shaving company. Bruce Springsteen’s voice is insured for$5.6 million.See starpulse.com, “Mariah Carey Takes Out $1 Billion Insurance Policy For Her Legs,” accessed March 14, 2011, www.starpulse.com/news/index.php/2006/05/30/mariah_carey_takes_out_1_billion_insuran for an account of Ms. Carey’s insurance policy; Paul Bannister, “World's Biggest Insurer Takes on All Risks,” accessed March 14, 2011, http://www.bankrate.com/brm/news/insurance/old-lloyds1.asp, details a number of unusual insurance policies. Riskier jobs generally pay more. A firm that exposes workers to more risk must compensate them for that risk. A compensating wage differential is any difference in pay received by identical workers doing different jobs. (By “identical” we mean workers with comparable education, skills, experience, and so on.) Jobs that are unpleasant or dangerous will typically pay higher wages to compensate workers for the negative aspects of their jobs. To the extent workers do not like to face risks, jobs that are viewed as riskier tend to pay more on average. For example, a recent study found that nurses who were more likely to be exposed to the AIDS virus (HIV) received higher wages than comparable nurses who were less likely to be exposed.Jeff DeSimone and Edward J. Schumacher, “Compensating Wage Differentials and AIDS Risk” (NBER Working Paper No. 10861, November 2004), accessed March 14, 2011, http://www.nber.org/papers/w10861. Asset Portfolio Choice Young people’s portfolios of assets are usually very simple: a typical college student might have only a checking account and a savings account. As you grow older, though, you will typically acquire a broader portfolio. Even if you do not directly purchase assets such as stocks and bonds, you may own them indirectly when you sign up for a pension plan. Because the return on stocks (and other assets) is uncertain, owning these assets is another type of risk you choose to take. Owning a stock is somewhat like buying a lottery ticket. You pay some money to buy a share of the stock of some company. In return, you may be paid some dividends; at some time in the future, you may sell the stock. But at the time you buy the stock, you don’t know the payments you will receive in the future and you don’t know the future price of the stock. So by purchasing a stock, you are gambling. Whether the gamble is favorable or not depends on the price of the stock, the chance it will pay dividends in the future, and the future price. Choosing how to allocate the assets in a portfolio is a type of gamble we all make. We cannot completely avoid this kind of gamble. Perhaps you think that putting cash in your mattress would be a way to avoid this risk, but that is not the case. Ultimately you care about what that money can buy in terms of goods and services. The real value of the money held in your mattress depends on the future prices of goods and services, which are not known to you today. The benefit of holding cash depends on the unknown inflation rate. Buying a Lottery Ticket Some people, at some times, are eager and willing to engage in risky activities. People engage in extreme sports, where the danger appears to be part of the attraction. People go to Las Vegas or to Monaco to gamble. In many countries, citizens can purchase a wide variety of lottery tickets sold by their governments. This is a form of gambling: you buy a ticket and if you have the lucky number, then you get a (sometimes large) prize. If you do not have the lucky number, your money is gone. The existence of lotteries and other kinds of gambling seems like a puzzle. If people are risk-averse, then they are supposed to want to get rid of risk. The purchase of a lottery ticket is the exact opposite: you give up a sure thing (the price of the ticket) for an uncertain outcome. Unlike the purchase of insurance, which is a way to avoid risk, buying a lottery ticket is a demand for a gamble. Why do so many people buy lottery tickets? Why do governments sell them? Do lottery tickets have an expected value that exceeds the cost of the ticket? If the difference is big enough, then even a risk-averse person might want to buy a ticket. Consider a very simply lottery. Suppose there is one fixed prize, and there is a probability that you win the prize. Then your expected gain is just the probability of winning times the prize: $expected\ gain = probability\ of\ winning \times value\ of\ prize.$ Using this equation, you can determine whether the price for a lottery ticket is high or low. If the price of the ticket exceeds the expected gain from buying the ticket, then the ticket is not a good deal. But if the price is low relative to the expected gain, then you may want to accept the risk and buy the ticket. Let us look at an example. One US lottery is called Powerball. On February 18, 2006, the prize was worth$365 million to the winner. The chance of getting the jackpot was 1 in 988,172,368.This is based on five balls selected ranging from 1 to 55 and a powerball ranging 1 to 42. See the Powerball site ( http://www.usamega.com/powerball-howtoplay.htm) for details on this game. See also the odds calculator at CSGNetwork.com, “The Ultimate Lottery Games Odds Calculator,” accessed March 14, 2011, http://www.csgnetwork.com/oddscalc.html. The expected value of a ticket at that time was the value of the prize times the probability of winning: far less than the dollar price of the ticket. Despite the huge prize, the price of a ticket far exceeded its expected value.
Another perspective on the lottery is from the viewpoint of the government selling these tickets. Consider the Texas lottery.Texas Lottery home page, accessed March 14, 2011, http://www.txlottery.org/export/sites/default/index.html. The proceeds from the sale of tickets primarily support education. In 2005, about 60 percent of the income from the lottery went to payment for prizes and 28 percent went to a school fund. From the perspective of the Texas state government, selling lottery tickets is a way to fund programs. If the government is to make money on lottery tickets, then those buying the tickets must, on average, be losing money.
In fact, as this discussion suggests, the expected value of a lottery ticket is less—often substantially less—than the cost of the ticket. Why, then, do people buy lottery tickets? One possibility is that they simply enjoy gambling. This means that, at least with respect to these types of gambles, they are risk-loving rather than risk-averse. The pleasure of a lottery ticket is, among other things, the license to dream. Another possibility is that individuals overestimate their chances of winning.
Key Takeaways
• One reason that people take on risks is because they enjoy gambling.
• Some jobs are riskier than others and pay more to compensate people for the risks they face.
check your understanding
1. Suppose you take a job as an engineer at an oil company. There are two places where you can work. One is Houston, where you will live in the suburbs and commute to work. The other is on an oil rig in the North Sea (between Scotland and Norway), where you will spend most of your time on the rig. If the jobs are otherwise identical, which do you expect will pay more? Explain why. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/05%3A_Life_Decisions/5.05%3A_Embracing_Risk.txt |
In Conclusion
Many decisions involve a trade-off between now and the future. Whenever we invest our time or money, we are giving up something today to obtain something in the future. So by saving some of our income, we give up consumption now for consumption in the future. When we go to a university, we give up income and leisure time today to get more consumption (through higher income) in the future.
Once you start thinking about trade-offs over time, it is difficult to avoid the reality that many of these decisions are made in the face of great uncertainty. When we save, we are not certain of the return on our saving. When we go to school, we are not guaranteed a job in the future nor are we guaranteed a specific salary. We have provided some insights into the nature of these uncertainties and how to deal with them. Discounted present value and expected value are techniques that are worthwhile to master, as they will help you make better decisions throughout your life.
Key Links
exercises
1. Explain why an increase in the interest rate reduces the discounted present value of income.
2. What incentives exist for people to repay loans on education? On cars?
3. Suppose the nominal interest rate is 20 percent, the price level in the first year is 50, and the price level in the second year is 60. What is the real interest rate? How could you alter this example so that the real interest rate is 0?
4. Can the nominal interest rate ever be less than the real interest rate? If the real interest rate is negative, what happens to the slope of the budget line with two periods discussed in Chapter 5 "Life Decisions", Section 5.1 "Consumption and Saving"?
5. Do households sometimes borrow and lend simultaneously? Why might that happen? Is the interest rate they borrow at usually higher or lower than the interest rate they receive, say in the form of bank deposits?
6. In describing how changes in income influence the supply of loans, we assumed that the increase in income occurs this year. Suppose instead that the increase in income will occur next year even though everyone in the economy knew it would happen today. How would the news of a future increase in income influence the current loan supply curve?
7. When the government changes taxes, do you know if it is permanent or temporary?
8. (Advanced) One way that real wages received by workers can change is through a change in income taxes. Considering the information in this chapter, would you except temporary tax changes to have a bigger or a smaller impact on labor supply than a permanent tax change? What if the tax change is not through a change in the tax rate but rather through a fixed payment to households? What would that policy do to labor supply?
9. Look back at Table 5.3.1 "Which Career Should You Choose?" in the section “Choosing a Career.” How would you edit the income entries in the table so that the insurance salesperson had a higher discounted present value than the lawyer even when the interest rate is 5 percent?
10. Look back at Table 5.3.1 "Which Career Should You Choose?" in the section “Choosing a Career.” Explain why an increase in the interest rate makes it less attractive to be a lawyer.
11. Besides discounted present values of income, what other factors are important in choosing a career? How do you balance these with differences in the discounted present value of income?
12. What are the risks associated with choosing a particular career? How do those risks depend on whether the skills you learn at your job can be used in other jobs?
13. Show the calculation of the discounted present value from work in Table 5.3.5 "Income from Going to College versus Taking a Job". Redo the comparison of college and work assuming an interest rate of 20 percent.
14. (Advanced) Look back at Table 5.3.1 "Which Career Should You Choose?" in the section “Choosing a Career.” Suppose the income of a lawyer increases by 20 percent each year after year 2 and the income of the insurance salesperson increases by \$10,000 each year. Extend Table 5.3.1 "Which Career Should You Choose?" to 5 years. Which is a better profession?
15. Create your own version of Table 5.4.1 "Coin-Flipping Experiment" by flipping a coin 10 times. Imagine that each time the result is a head, you earn \$1,000, and each time it is a tail, you lose \$1,000. After you flip the coin 10 times, calculate how much you won (or lost). Now do this same experiment 20 times. Each time you flipped the coin 10 times, record how much you won (or lost), which will result in 20 numbers. What is the average of these 20 numbers? What is the expected value of how much money you will earn in each coin-flipping experiment??
16. Many products, such as computers, come with the option of an extended warranty. Suppose you are buying a computer with a one-year warranty. Thereafter, you can purchase an extended warranty for one more year, at a cost of \$50. The warranty will repair or replace your computer in the event of breakdown. Suppose the average cost to the manufacturer of repairing or replacing the computer is \$1,000. If the manufacturer is making no money from this warranty, what is the implied probability that the computer will need repair?
17. We wrote “As long as the insurance company has lots of policies in many locations, then, on average, the number of insurance claims will be nearly constant each year.” Why did we include the statement about many locations?
18. Why is it difficult to diversify job risk? Is it possible to do some diversification within a family?
19. In the United States, the provision of unemployment insurance is partly at the state level and partly at the federal level. For your state, find out what the benefits are and what federally funded unemployment insurance might be available to you.
Economics Detective
1. Study the insurance policy you can buy when you purchase a new cell phone. Exactly what does this insurance protect you against? Given the price of the insurance and the coverage, what is the implied probability that you will make a claim for a new phone under the insurance? Is there a deductible? Why is it part of the policy?
2. Look at the insurance policy (if you have one) for the place where you are living. What is the deductible? List the ways in which you take actions to reduce the risk of fire where you live.
3. Our example of homeowners’ insurance did not use real numbers. Find a homeowners’ policy and determine the coverage, the premium, and the deductible.
4. One form of insurance occurs when you rent a car. Using the Internet or phoning local insurance agents, find out the kinds of insurance that are available when you rent a car. What is the cost per day? Exactly what risks do these policies protect you against? Given the price of the insurance and the coverage, what is the implied probability that you will have an accident and make a claim under the insurance? Does this probability seem reasonable to you?
5. What is the average price of a house in the United States? In your hometown?
6. What does it cost to insure a \$100,000 house in your city? What does it cost to insure a \$1,000,000 house in your city? Explain the differences in the insurance costs.
7. Pick a state in the Unites States. Suppose you work there and earn \$2,000 each week as a manager. One day, the firm tells you that you are no longer needed. What unemployment insurance could you collect? Would you qualify for unemployment insurance? How much would the benefits be? How long would the benefits last?
8. Go to your local bank and see if there are any signs that indicate deposit insurance is provided. Ask about details of the program.
9. Use the Internet to find out about deposit insurance programs in the United States and in another country. How do these programs compare?
10. For the state in which you live, does the government sponsor a lottery? If so, how are the funds used?
11. In the financial crisis of 2008–9, was deposit insurance provided in the United States? In other countries?
12. In the state you live in, find out about the unemployment insurance program. How long do you receive benefits and how generous are the benefits?
Spreadsheet Exercises
1. Write a spreadsheet program to create a version of Table 5.4.1 "Coin-Flipping Experiment" for any combination of income flows and interest rates.
2. (Advanced) Create a spreadsheet program to simulate the flipping of a coin. Do T experiments with 5 flips per experiment. For each experiment, calculate the mean of the outcome. When you are finished, you will have T means. What does the distribution of the T means look like? What is the mean of that distribution? What happens as T gets very large? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/05%3A_Life_Decisions/5.06%3A_End-of-Chapter_Material.txt |
Thumbnail: https://pixabay.com/photos/ecommerce-selling-online-2140604/
06: eBay and craigslist
eBay is one of the most famous sites on the Internet ( www.ebay.com; Figure 6.1.1 "The eBay Home Page"). It was founded in 1995 and is now a very large company, with \$60 billion in sales in 2009 and over 90 million active users worldwide.See eBay Inc., “Who We Are,” accessed February 24, 2011, http://www.ebayinc.com/who. One of the many ways in which the Internet is changing the world is that there are now ways of buying and selling—such as eBay—that were completely unavailable to people 20 years ago.
Figure \(1\): The eBay Home Page
In or around the second and third centuries BCE, the island of Delos, in Greece, was a major center of trade—both of goods and slaves. At its height of activity, Delos, an island of five square kilometers, had a population of about 25,000 people.MyKonos Web, “History of Delos,” accessed January 25, 2011, http://www.mykonos-web.com/mykonos/delos_history.htm. This means Delos was about as densely populated as modern-day cities such as Istanbul, London, Chicago, Rio de Janeiro, or Vancouver. Visitors today see different things when they visit the ruins of Delos. Some see dusty pieces of shattered rock; others see the remains of a great culture. An economist sees the ruins of a trading center: a place where people such as the trader shown in Figure 6.1.2 "A Trader in Delos" were, in a sense, the eBay of their times.
Delos and eBay are separated by almost two and a half millennia of history, yet both are founded on a basic human activity: the trading of goods and services. How basic? Consider the following.
• Children learn to trade at an early age. First graders may be trading Pokémon cards before they have even learned the meaning of money.
• In prisoner-of-war camps during World War II, prisoners would receive occasional parcels from the Red Cross, containing items such as chocolate bars, cigarettes, jam, razor blades, writing paper, and so on. There was extensive trading of these items. In some cases, cigarettes even started to play the role of money. For the classic discussion of trade in a prisoner-of-war camp, see R. A. Radford, “The Economic Organisation of a P.O.W. Camp,” Economica (New Series) 12, no. 48 (1945): 189–201.
• In Nazi concentration camps, where people lived close to starvation in conditions of extreme danger and deprivation, the prisoners traded with each other. They traded scraps of bread, undergarments, spoons, basic medicines, and even tailoring services.Jill Klein, “Calories for Dignity: Fashion in the Nazi Concentration Camp,” Advances in Consumer Research 15 (2003): 34–37.
Trade has played a central role in determining where many of us live today.
• In England, you will find the town of Market Harborough; in Germany, you can find Markt Isen; in Sweden, Lidköping. Markt and köping both mean market. These towns, and many others like them, date from the medieval period and, as their names suggest, owe their existence to the markets that were established there.
• Many of the great cities of the world developed in large part as ports, where goods were imported and exported. London, New Orleans, Hong Kong, Cape Town, Singapore, Amsterdam, and Montreal are a few examples.
Much of economics is about how we interact with each other. We are not alone in the economic world. We buy goods and services from firms, retailers, and each other. We likewise sell goods and services, most notably our labor time. In this chapter, we investigate different kinds of economic interactions and answer two of the most fundamental questions of economics:
1. How do we trade?
2. Why do we trade?
Road Map
The chapter falls naturally into two parts corresponding to these two questions. We begin by thinking about the ways in which individuals exchange goods and services.
In modern economies, most trade is highly disintermediated. You usually don’t buy a good from its producer. Perhaps the producer sells the good to a retail store that then sells to you. Or perhaps the good is first sold to a wholesaler who then sells to a retailer who then sells to you. Goods are often bought and sold many times before you get the opportunity to buy them.Such transactions are the focus in Chapter 7 "Where Do Prices Come From?" and Chapter 8 "Why Do Prices Change?". For the moment, however, we have a different emphasis. We do not yet get into the details of retailing in the economy but instead focus on trade among individuals—the kind of transaction that you can carry out on eBay and craigslist.
Specifically, we want to understand how potential buyers and sellers are matched up. We also want to know what determines the prices at which people exchange goods and services. Broadly speaking, prices can be established in the following ways.
• Some prices are the result of bargaining and negotiation. If you buy a car or a house, you will engage in a one-on-one negotiation with the seller in which there will typically be several rounds of offers and counteroffers before a final price is agreed on. Similarly, if you go to street markets in many countries in the world, you will not find posted prices but will have to bargain and haggle.
• Some prices are determined by auction, such as trinkets sold on eBay and antiques sold by Christie’s. Auctions are a type of bargaining that must follow some preset rules.
• Some prices are chosen by the seller: she simply displays a price at which she is willing to sell a unit of the good or service. Even this is a very simple type of bargaining called the “take-it-or-leave-it offer.” The seller posts a price (an “offer”), and prospective buyers then have a simple choice: either they buy at that price (they “take it”) or they do not buy (they “leave it”).
Take-it-or-leave-it offers are the most common form of price-setting in retail markets. The prices displayed in your local supermarket can be thought of as thousands of take-it-or-leave-it offers that the supermarket makes to you and other shoppers. Whenever you go to the supermarket, you reject most of these offers (meaning you don’t buy most of the goods on display), but you accept some of them. Take-it-or-leave-it offers also occur when individuals trade. Classified advertisements in newspapers or on Internet sites like craigslist typically involve take-it-or-leave-it offers.
Once we understand how individuals trade with one another, we turn to an even more basic question: why do we trade? Whether we are talking about first graders swapping Pokémon cards, the purchase of a camera on eBay, the auction of a Renoir painting at Sotheby’s, or traders in the Mediterranean islands over two millennia ago, there is one reason for trade: I have something you want, and you have something I want. (In many cases, one of these “somethings” is money. Keep in mind, though, that people don’t want money for its own sake; they want money to buy goods and services.)
We therefore explain how differences in what we have and what we want provide a motive for trade and how such trade creates value in the economy. Then we go deeper. In a modern economy, trade is an essential part of life. We consume a large number of goods and services, but we play a role in the production of very few. Put differently, modern economies exhibit a great deal of specialization. We carefully investigate how specialization lies right at the heart of the gains from trade. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/06%3A_eBay_and_craigslist/6.01%3A_Buying_on_the_Internet.txt |
Learning Objectives
1. What are the gains from trade?
2. How does a market with take-it-or-leave-it offers work?
3. How are the gains from trade split between buyers and sellers?
4. What is economic efficiency?
To begin our investigation of why and how we trade, let us examine craigslist ( http://www.craigslist.org), an Internet site devoted to exchange. The craigslist site is very similar to the classified advertisements in a newspaper except that the advertisements are online. It is local, in the sense that there is a different site for different places. You can find craigslist sites for cities and states throughout the United States, and—at the time of this writing—for 14 cities and 54 countries around the world. If you visit the craigslist website, you will see there are many types of goods and services listed. For now, we focus on the purchase of a good. Later, we will consider the purchase and even the exchange of services.
Pricing on craigslist commonly takes a take-it-or-leave-it form. The seller posts a price and then buyers and sellers communicate through (anonymous) e-mails. Of course, the buyer always has the option of trying to turn this take-it-or-leave-it scenario into back-and-forth bargaining by making a counteroffer. Once they have agreed to trade, the buyer and seller must find a way to consummate the transaction—delivering the good and making payment.
The Gains from Trade from a Single Transaction
Suppose you are interested in buying a car. You go to craigslist in your area and search through offers to sell cars. These offers typically provide lots of information about the product, usually including photos and a price. If you want to inquire about a particular car, you can contact the seller. If you want to buy the car, you can accept the seller’s offer. If you want to negotiate, you can do so as well. To get at the heart of this kind of exchange, let us first take a simple case where there is a single seller and a single buyer.
Economists generally think that individuals make decisions in their own self-interests. If a seller is willing to sell a good at a given price, and a buyer is willing to buy at that price, our presumption is that this exchange makes them both better off. This deceptively simple idea is the very heart of economics: voluntary trade makes both participants better off. The word voluntary matters here. We are supposing that both people freely enter into this trade. If two people make a deal of their own free will and if they are rational, in the sense that they can make decisions in their own best interests, then the deal must make them both better off.
The demand for a car is an example of a unit demand curve because you are deciding whether or not to buy at all rather than how much you should buy.See Chapter 4 "Everyday Decisions" for more discussion. The buyer has a valuation for the good, which represents the most he would be willing to pay for it. For example, suppose you see a used car on craigslist, and your valuation of this car is \$3,000. This means that you would be equally happy either having the car and forfeiting \$3,000 worth of other goods and services or not having the car. Figure 6.2.1 "The Buyer’s Valuation" shows what your demand curve looks like in this case. You are choosing to buy either zero units or one unit, so if the price is above your valuation, you do not buy the good, whereas if the price is below your valuation, you buy the car.
Toolkit: Section 31.1 "Individual Demand"
You can review unit demand and valuation in the toolkit.
The buyer follows the decision rule: “Buy if the price is less than the valuation.”
If your valuation were \$3,000, then you would, of course, prefer to pay much less. If the car is for sale for \$2,990, then it is true that you would be better off buying the car than not, but you won’t get much out of the deal. You would be happier only to the tune of \$10 (more precisely, \$10 worth of goods and services). If the car is for sale for \$2,400, then you will be happier by an amount equivalent to \$600 worth of goods and services. On the other hand, if the car were for sale for \$3,001, you definitely would not want to buy at that price. Buying the car would actually make you slightly less happy.
The seller also has a valuation of the car. The seller is not willing to sell it at any price. For example, if her valuation is \$2,000, she is equally happy keeping the car or not having the car and having an extra \$2,000 worth of goods and services. If she can sell the car for more than \$2,000, she will be better off. She won’t sell the car for less than \$2,000 because then she would be less happy than before. We can show the seller’s willingness to sell in a way analogous to the buyer’s willingness to buy. Figure 6.2.2 "The Seller’s Valuation" shows that she will not sell the car at a price less than \$2,000, but she will sell once the price is greater than \$2,000.
By analogy to unit demand, we call this the unit supply curve. It tells us the price at which she is willing to sell. Below her valuation, she is unwilling to supply to the market. Above her valuation, she is willing to sell the good. Whereas the buyer’s valuation is the absolute maximum that the buyer is willing to pay, the seller’s valuation is the absolute minimum that the seller is willing to accept.
Figure \(2\): The Seller’s Valuation
The seller follows the decision rule: “Sell if the price is greater than the valuation.”
The buyer’s valuation in our example is larger than the seller’s valuation. This means it is possible to make both the buyer and the seller better off. The mere fact of transferring a good from someone who values it less to someone who values it more is an act that creates value in the economy. We say that there are gains from trade available here.
Toolkit: Section 31.10 "Buyer Surplus and Seller Surplus"
Total surplus is a measure of the gains from trade. In a single transaction,
\[total\ surplus\ =\ buyer’s\ valuation\ −\ seller’s\ valuation.\]
In this example, therefore, the total surplus is \$1,000. This is the value created in the economy by the simple fact of transferring the car from a seller who values it less to a buyer who values it more. Figure 6.2.3 "Buyer and Seller Valuations" shows this graphically by combining the unit demand curve and the unit supply curve.
The total surplus from a transaction is equal to the buyer’s valuation minus the seller’s valuation. Graphically, total surplus can be represented as a rectangle. The height of the rectangle is the difference in the valuations. The base of the rectangle is 1 because only one unit is being traded.
The buyer wants the price to be as low as possible, whereas the seller wants the price to be as high as possible. If both agree on a price of \$2,100, for example, the buyer gets most of the surplus, and the seller does not get very much. If they agree on a price of \$2,900, the situation is reversed: most of the benefit goes to the seller. The distribution of the value created depends on the price. Either way, though, they are both made better off by the trade, and in both cases the total surplus is the same ( Figure 6.2.4 "The Distribution of Total Surplus").
Toolkit: Section 31.10 "Buyer Surplus and Seller Surplus"
The buyer surplus is a measure of how much the buyer gains from a transaction, and the seller surplus is a measure of how much the seller gains from a transaction:
\[buyer\ surplus\ =\ buyer’s\ valuation\ −\ price\]
and
\[seller\ surplus\ =\ price\ −\ seller’s\ valuation.\]
The total surplus is the sum of the buyer surplus and the seller surplus.
The distribution of surplus between the buyer and the seller depends on the price. A low price means that the buyer will get most of the surplus, while a high price means that the seller will get most of the surplus. The total surplus, however, is the same no matter what the price.
Economic Efficiency
When the buyer purchases the car from the seller, there is a reallocation of society’s resources. Dollars have gone from the buyer to the seller, and the car has gone from the seller to the buyer. Economists have developed a specific criterion, called efficiency, for evaluating the way in which resources are allocated in a society.
It is actually easier to understand efficiency by looking at its opposite. Economists say that an allocation of resources is inefficient if there is some way to reallocate those resources that will make some people better off (that is, happier) without making anyone else worse off. For example, think about the situation where the buyer and seller have not traded the car. This allocation is inefficient. The buyer places a greater value on the car than does the seller, so it is inefficient for the car to remain with the seller. Any rearrangement of resources that makes some people better off without making anyone else worse off is welfare improving.
Toolkit: Section 31.11 "Efficiency and Deadweight Loss"
Efficiency is the basis that economists use for judging the allocation of resources in an economy. Resources are allocated efficiently if there is no way to reallocate them to make someone better off without making anybody else worse off.
Before the buyer and the seller trade, the allocation of resources is inefficient. However, there are many different trades that make both the buyer and the seller better off. In fact, any trade between a price of \$2,000 and a price of \$3,000 is welfare improving. The only thing that matters for economic efficiency is that a trade takes place, so the gains from trade can be realized. No matter how the surplus is distributed between the buyer and the seller, the outcome is efficient as long as the trade occurs.
Determining a Price on craigslist
We now know that as long as the buyer’s valuation for a good exceeds the seller’s valuation, there are potential gains from trade. We have not yet explored the mechanisms that allow trade to occur, nor have we explained what determines the price at which trades occur. To begin with, we ignore the possibility of bargaining. Then there are only two steps for selling an item on craigslist:
1. The seller of an item posts a price (makes a take-it-or-leave-it offer).
2. The buyer either accepts or rejects the offer.
If the buyer accepts the seller’s offer, then an exchange is made. But what offer will the seller make? The answer depends on how much the seller knows about the buyer’s valuation of the good. There are two cases to consider:
1. The seller knows the buyer’s valuation. The seller would like her surplus to be as large as possible. If she knows the buyer’s valuation, what should she do? To answer this question, she must put herself in the buyer’s shoes. If she sets a price that is greater than the buyer’s valuation, then the buyer will reject the offer. But as long as the price is less than the buyer’s valuation, the buyer will accept the offer. With this in mind, the seller will set a price slightly less than the buyer’s valuation to capture almost the entire surplus. In our example, the seller should put the car on sale for \$2,999. The seller gets \$999 worth of surplus, and the buyer gets \$1. (Does it matter if the buyer also knows the seller’s valuation? As a matter of pure economic theory, the answer is no. The buyer should be willing to buy provided he is getting some surplus—even if it is very little. After all, something is better than nothing. However, if the buyer knows that the seller is getting a lot of surplus, he may perceive this as unfair and might even choose not to buy out of spite. In reality, sellers often set a lower price, “giving away” some of the surplus to the buyer, to avoid this possibility.Technically, a take-it-or-leave-it offer is an example of an ultimatum game, which is discussed in Chapter 13 "Superstars".)
2. The seller does not know the buyer’s valuation. This case is more likely and also much harder. The seller must trade off two different concerns. If she picks too high a price, then there is a risk of not making a sale at all. But the lower the price, the less surplus she gets in the event of a sale. There is no simple rule to know what price she should set. An economist looking from the outside finds this case more worrying than the first because it is possible that the gains from trade will be missed. If the seller offers a price that is greater than the buyer’s valuation, then—under a take-it-or-leave-it offer—no trade takes place.
The knowledge of the buyer also matters. Suppose that the buyer knows the seller’s valuation. Then he knows that there are possible gains from trade. In this case, it is natural to think that the buyer will try to negotiate with the seller, rather than just accept or reject the seller’s offer. Indeed, if the buyer knows the seller’s valuation, then we have the reverse of the first case. If the buyer offers a price slightly above the seller’s valuation, then the buyer should be able to capture the entire surplus. We summarize this in Figure 6.2.5 "The Outcomes from a Take-It-or-Leave-It Offer".
In practice, the buyer is also likely to try to negotiate if the seller’s price leaves the buyer with very little surplus. Thus even though craigslist is apparently based on take-it-or-leave-it offers, a great deal of bargaining does in fact take place.
Key Takeaways
• If the seller’s valuation of an object is less than the buyer’s valuation of the same object, then there are gains to trade.
• One mechanism to reap the gains from trade when valuations are known is for the seller to post a price and the buyer to decide to purchase the good or not—that is, the seller makes a take-it-or-leave it offer.
• The way the gains to trade are split between the buyer and the seller depends on the way the bargaining occurs and the information the parties have about each other.
• An allocation is efficient if there is no way to make someone better off without also making somebody else worse off.
check your understanding
1. In this discussion, we assumed that the seller’s valuation was less than the buyer’s valuation. What would happen if that were not true?
2. Suppose the seller’s valuation is less than the buyer’s but that the buyer, not the seller, sets the price. What price would the buyer set? Would there still be gains from trade? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/06%3A_eBay_and_craigslist/6.02%3A_craigslist_and_the_Gains_from_Trade.txt |
Learning Objectives
1. What are the economics of an eBay auction?
2. How should I bid on eBay?
3. How are gains to trade determined and shared when there are multiple buyers?
4. What is the winner’s curse?
So far we have supposed that there is only a single buyer and a single seller. If you are thinking about selling a good on craigslist, however, there are many potential buyers of your good. In addition, you probably don’t know very much about the valuations of the different buyers. You might then like to find some way to make your buyers compete with each other. In other words, you might consider auctioning off the good instead.
You have probably at least visited the eBay site, and you may even have bought or sold an item on eBay. If so, you know it can be a convenient and efficient way to buy and sell goods. But what exactly is eBay? We answer this question by looking at the site from the perspective of participants. First we review how eBay works and look at it from the point of view of both a buyer and a seller. Then we bring some economic analysis to bear to better understand what is taking place on eBay and in other auctions.
Buying on eBay
Suppose you want to purchase something, such as a leather jacket, some cycling gloves, or a cell phone; the list of things that might interest you is endless. On the eBay page, you can search for the exact item you want to buy. Your search must be specific: if you search for “cell phone,” you will find thousands of products. You need to know the exact model of phone you want, and even then you may find multiple items for sale.
Auctions on eBay have several characteristics, including the identity of the seller, the time limit on the auction, the acceptable means of payment, the means of delivery, and the reserve price.
• Seller identity. Unlike when you purchase from a store, you do not get to see the seller on eBay, and you cannot simply walk away with the good. This may concern you. After all, how do you know the seller will actually ship you the good after you have paid? How do you know if the product will work? This is a worry for you, but it is also a worry for any reputable seller. Sellers want you to trust them, so there are mechanisms to allow you to find out about sellers. On the eBay page, you can find detailed information about the seller, including a number—called a feedback score—that indicates the number of positively rated sales by that seller. If you dig a bit deeper, you can even find reviews of the performance of the seller.
• Time remaining in the auction. Online auctions have a fixed time limit. When you go to the auction site for a particular good, you will see the amount of time left in the auction. Much of the action in an auction often comes very near the end of the bidding.
• Means of payment. When you buy a good on eBay, you are not able to simply give the seller some cash. The means of payment accepted by the seller are indicated in the auction information. In many cases, sellers use an electronic payment system, such as PayPal.
• Means of delivery. The seller must have a way of shipping the good to you—perhaps via FedEx or another package delivery service. The auction specifies who pays the cost of shipping.
• Reserve price. The seller will frequently specify a minimum price, called a reserve price. As a potential buyer, however, you will not see the actual reserve price; the only information you will see is whether or not the reserve price has been reached. A natural reserve price for the seller is her valuation of the good. (More precisely, the reserve price would also include the fee that the seller must pay to eBay in the event of a sale. The only reason for a seller to set a higher valuation is if she thinks she might do better trying to auction the good again at some point in the future rather than settling for a low price in the current auction.)
You participate as a buyer in an eBay auction by placing a bid. For some products, you also have an option of clicking “Buy It Now,” where you can purchase the good immediately. In other words, sellers sometimes make a take-it-or-leave it offer as well as offer an auction. To understand the details of the bidding process, look first at the description of how to bid on eBay:
Once you find an item you’re interested in, it’s easy to place a bid. Here’s how:
1. Once you’re a registered eBay member, carefully look over the item listing. Be sure you really want to buy this item before you place a bid.
2. Enter your maximum bid in the box at the bottom of the page and then click the Place Bid button.
3. Enter your User ID and password and then click the Confirm Bid button. That’s it! eBay will now bid on your behalf up to the maximum amount you’re willing to pay for that item.
You’ll get an email confirming your bid. At the end of the listing, you’ll receive another email indicating whether you’ve won the item with an explanation of next steps.eBay Inc., “Help: How to Bid,” accessed March 14, 2011, pages.ebay.com/help/new/contextual/bid.html.
Because participants in an eBay auction are not all present to bid at the same time, eBay bids for you. All you have to do is to tell it how much you are willing to pay, and eBay takes over. This is known as “proxy bidding” or “automatic bidding.”
The exact way in which eBay bids for you is not transparent from this description. It works as follows. Once you input your maximum bid, eBay compares this to the highest existing bid. If your maximum bid is higher than the existing highest bid, then eBay raises the bid by an increment on your behalf. Unless someone bids more, you will win the auction. If someone does bid more (the maximum bid exceeds the highest bid), then you, by proxy, will respond. In this way, the highest bid increases. This process ends with the item going to the bidder with the highest maximum bid. However, the buyer does not pay the amount of the maximum bid. The buyer pays the amount of the next highest bid, plus the increment.
Let us see how this works through an example. Suppose there are two buyers who put in maximum bids of \$100 and \$120 for a cell phone. Suppose that the increment is \$1 and the bidding starts at \$50. Because the maximum bids exceed \$50, the highest bid will increase by increments of \$1 until reaching \$100. At this point, the higher of the two maximums, \$120, will cause the highest bid to increase by another increment to \$101. After this, there is no further action: the other bidder effectively drops out of the auction. The item goes to the buyer who bid \$120, and he pays a price of \$101 (provided this exceeds the seller’s reserve price).
A Decision Rule for Bidding on eBay
Now that you understand how the auction works, you must decide how to bid. Suppose there is only one auction for the good you want (rather than multiple sellers of similar goods). In this case, there is a remarkably simple decision rule to guide your bidding.
1. Decide on your valuation of the good—that is, the most you would be willing to pay for it.
2. Bid that amount.
This seems surprising. Your first reaction might well be that it is better to bid less than your valuation. But here is the key insight: the amount you actually pay if you win the auction doesn’t depend on your bid. Your bid merely determines whether or not you win the auction.
If you pursue this strategy and win the auction, you will gain some surplus: the amount you pay will be less than the valuation you place on the good. If you don’t win the auction, you get nothing. So winning the auction is better than not winning. If you bid more than your valuation, then there is a chance that you will have to pay more than your valuation. In particular, if the second-highest bidder puts in a bid that exceeds your valuation, then you will lose surplus. So this does not seem like a good strategy. Finally, if you bid less than your valuation, there is a chance that you won’t win the auction even though you value the good more highly than anyone else. Therefore, you will lose the chance of getting some surplus. This is also not a good strategy.
Figure 6.3.1 "Why You Should Bid Your Valuation in an eBay Auction" illustrates one way of thinking about this. There are two possibilities: either your valuation is bigger than the highest competing bid or your valuation is smaller than the highest competing bid. We don’t have to know anything about how other bidders are making their decisions. Part (a) of Figure 6.3.1 "Why You Should Bid Your Valuation in an eBay Auction" shows the first case. Here, there is a risk that you will lose out on surplus that you could have received. If you bid below the competing bid, you will lose the auction and hence lose out on the surplus. The surplus is the difference between your valuation and the competing bid, minus the increment.
These illustrations show why you should always bid your valuation on eBay.
Part (b) of Figure 6.3.1 "Why You Should Bid Your Valuation in an eBay Auction" shows the case where your valuation is less than the competing bid. Here the risk is that you will win the auction and then regret it. If you bid an amount greater than the competing bid, then you will win the auction, but the amount you will have to pay exceeds your valuation. Your loss is the difference between the competing bid and your valuation, plus the increment.
Although automatic bidding by proxy sounds very fancy, the eBay auction is really the same as “English auctions” that are familiar from television and movies. In an English auction, an auctioneer stands at the front of the room and invites bids. Bidding increases in increments until all but one bidder drops out. The winning bidder pays the amount of his bid. The winning bidder therefore pays an amount equal to the highest competing bid, plus the increment, just as in the eBay auction. The amount that she wins is her valuation minus the price she pays, just as in the eBay auction.
The bidding in an English auction can be exciting to watch; you can also have the excitement of seeing how bids evolve on eBay (at least if you are willing to keep logging on and hitting the “refresh” button). But we could also imagine that eBay could do something simpler. It could carry out a “Vickrey auction,” which is named after its inventor, the Nobel-prize-winning economist William Vickrey. In a Vickrey auction, the auctioneer (1) collects all the bids, (2) awards victory in the auction to the highest bidder, and (3) makes this person pay an amount equal to the second-highest bid.
The Vickrey auction sometimes goes by the more technical name of a second-price sealed-bid auction. Most people think this kind of auction sounds very odd when they first hear of it. Why make the winner pay the second-highest bid? Yet it is almost exactly the same as the eBay auction or the English auction. In those auctions, as in the Vickrey auction, the winner is the person with the highest bid, and the winner pays the amount of the second-highest bid (plus the increment). The only difference is that there is no increment in the Vickrey auction; because the increment is typically a very small sum of money, this is a minor detail.
Selling on eBay
Sellers on eBay typically provide information on the product being sold. This is often done by creating a small web page that describes the object and includes a photograph. Sellers also pay a listing fee to eBay for the right to sell products. They also specify the costs for shipping and handling. After the sale is completed, the buyer and the seller communicate about the shipping, and the buyer makes a payment. Then the seller ships the product, pays eBay for the right to sell, and pockets the remainder.
As we mentioned previously, the buyer can provide feedback on the transaction with the seller. This feedback is important to the seller because transactions require some trust. A seller who has built a reputation for honesty will be able to sell more items, potentially at a higher price.
An Economic Perspective on Auctions
As an individual participating in an auction, you have two concerns: (1) whether or not you win and (2) how much you have to pay. As economists observing from outside, there are other perspectives. Auctions play a very valuable role in the economy. They represent a leading way in which goods are bought and sold—that is, they represent a mechanism for trade.
As we have already stated, voluntary trade is a good thing because it creates value in the economy. Every transaction allows a good or service to be transferred from someone who values it less to someone who values it more. The English auction, such as on eBay, is attractive to economists because it does something more. It ensures that the good or the service goes to the person who values it the most—that is, it ensures that the outcome is efficient. It also has the fascinating feature that it induces people to reveal their valuations through their bids.
eBay is just one example of the many auctions you could participate in. There are auctions for all types of goods: treasury securities, art, houses, the right to broadcast in certain ranges of the electromagnetic spectrum, and countless others. These auctions differ not only in terms of the goods traded but also in their rules. For example, firms competing for a contract to improve a local road may submit sealed bids, with the contract going to the lowest bidder to minimize the costs of the project. Of course, other elements of the bid, including the reputation of the bidder, may also be taken into account.
Complications
The eBay auction sounds almost too good to be true. It is easy to understand, brings forth honest bids, and allocates the good to the person who values it the most. Are there any problems with this rosy picture?
Multiple Sellers
Suppose you have a video-game system for sale. You can put it up for auction on eBay, but you must be aware that many other people could be listing the identical item. What will happen?
First, your potential buyers will most likely look (and bid) at multiple auctions, not only your auction. Second, potential buyers will not be eager to bid in your auction. After all, if they don’t win your auction, they can always hope for better luck in another auction. It follows that buyers may decide it is no longer such a good strategy to bid their valuations. Buyers who bid their valuations might end up paying a high price if they win an auction where someone else placed a relatively high bid. Such buyers might be more successful taking the chance of losing one auction and winning another in which the bidding is lower. As buyers monitor other auctions, they will also start to get a sense of how much other people are willing to pay and will adjust their bidding accordingly.
Unfortunately, we can’t give you such simple advice about what to do as a buyer in these circumstances. It is not easy to develop the best bidding strategy. In fact, problems like this can be so hard that even expert auction theorists have not fully worked them out.
Tacit Collusion
Another concern is that bidders might want to find some way to collude. As a simple example, suppose there are three bidders for a good with an increment of \$1. One bidder has a valuation of \$50, one has a valuation of \$99, and one has a valuation of \$100. In an eBay auction, the winning bid would be \$100, but the winner would end up with no surplus (because he would pay \$99 plus the \$1 increment). Now suppose that the two high-value bidders make an agreement. As soon as the third bidder drops out, they toss a coin. If it comes up heads, Mr. \$99 drops out. If it comes up tails, Ms. \$100 drops out.
This means that with 50 percent probability, Ms. \$100 wins, pays \$51, and gets a surplus of \$49. With 50 percent probability Mr. \$99 wins, pays \$51, and gets a surplus of \$48. Both buyers prefer this. It’s certainly better for Mr. \$99, who had no chance of winning before. It is also better for Ms. \$100 because even though she may no longer win the auction, she stands to get some surplus if she does win. Of course, the seller wouldn’t like this arrangement at all. And the dispassionate economist observing from afar doesn’t like it either because sometimes the good may not go to the person who values it the most.
Explicit collusion of this type may very well be illegal, and it is also very hard to carry out. Yet it may be possible for buyers to collude indirectly, and there is speculation that such collusion is sometimes observed on eBay.
The Winner’s Curse
We have been supposing throughout that potential buyers know their own valuations of the good being auctioned. In most circumstances, this seems reasonable. Valuations are typically a personal matter that depend on the tastes of the individual buyer.
Occasionally, however, a good with an objective monetary value that is unknown to potential buyers may be auctioned. A classic example is the drilling rights to an oilfield. There is a certain amount of oil in the ground, and it will earn a certain price on the market. However, bidders do not know these values in advance and must make their best guess.
It is easiest to see what can happen here with a numerical example. Suppose the true (but unknown) value of an oilfield is \$100 million. Suppose there are five bidders, whose guesses as to the value of the oilfield are summarized in Table 6.3.1 "Valuations of Different Bidders in a Winner’s Curse Auction". Notice that these bidders are right on average, but two overestimate the value of the field, and two underestimate it. Imagine that the bidders decide to follow the strategy that we recommended earlier and bid up to their best guess. Bidder E will win. He will have to pay the second-highest bid of \$105 million, which is more than the oilfield is worth. He will lose \$5 million.
Bidder A Bidder B Bidder C Bidder D Bidder E
Valuation (\$ million) 90 95 100 105 110
Table \(1\): Valuations of Different Bidders in a Winner’s Curse Auction
The problem here is that the person who will win the auction is the person who makes the worst overestimate of the value of the field. Evidently it is not a good strategy in this auction to bid your best guess. You should recognize that your best guess may be inaccurate, and if you overestimate badly, you may win the auction but lose money. This phenomenon is known as the winner’s curse. Your best strategy is therefore to bid less than you actually think the oilfield is worth. But how much less should you bid? That, unfortunately, is a very hard question for which there is no simple answer. It depends on how accurate you think your guess is likely to be and how accurate you think other bidders’ guesses will be.
Key Takeaways
• On eBay, the best strategy is to bid your true valuation of the object.
• Auctions, like eBay, serve to allocate goods from sellers to buyers.
• If the winner’s curse if present, then you will want to bid less than your estimate of the value of the object.
check your understanding
1. Suppose you bid less than your valuation on eBay. Explain how you could do better by bidding a little more.
2. Why didn’t the winner’s curse have an effect on your bidding in eBay? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/06%3A_eBay_and_craigslist/6.03%3A_eBay.txt |
Learning Objectives
1. What is the outcome of an auction with a large number of buyers and sellers?
2. What is the market demand curve?
3. What is the market supply curve?
4. What is the equilibrium of perfectly competitive markets?
An auction mechanism such as eBay is a natural thing for a seller to use if there are a large number of potential buyers for a good. But what happens if there is also a large number of potential sellers? In this section, we consider what might happen when we have a large number of potential buyers and a large number of potential sellers of a good.
We have already explained that it is very difficult to analyze what would happen on eBay when there are multiple buyers and sellers, but we can make a better guess about what will happen on a site like craigslist. As a buyer, you will look for the lowest price out there, bargain with sellers who post high prices, or both. As a seller, you would look at the prices posted by others and realize that you probably should set your price fairly close to those prices. In addition, we have some evidence that can help us understand the likely outcome in a world of many buyers and many sellers. It comes from looking at “double oral auctions.” “Double” refers to the fact that there are a large number of buyers and sellers. “Oral” refers to the way in which the auction is conducted.
Double Oral Auctions
In a double oral auction, there is a large number of buyers, each of whom potentially has a different valuation of the good. There is also a large number of sellers, each of whom potentially has a different valuation of the good. Buyers and sellers negotiate with each other, one on one. If they cannot agree to a deal, either party can move on at any time and try to find someone else to bargain with.
Until quite recently, auctions such as this were common in many financial markets and commodity markets. These markets sometimes go by the name pit markets because buyers and sellers meet in a frenzy of activity in a trading area called the pit. Traders can hear and see the negotiations of others and often have access to the prices at which deals have been done. This means that both buyers and sellers have lots of information about what price is prevailing in the market. Chapter 10 "Making and Losing Money on Wall Street" has much more to say about these markets.
Economists have also conducted experiments in which they have put people in simulated pit markets to find out how they behave. The result is quite remarkable, but before we explain what happens, we need a framework to help us think about such markets.
Demand: Many Buyers
Suppose we are considering the purchase of a gaming console by a group of buyers. Each potential buyer has his own valuation. Some might be willing to pay as much as \$700. Others might be willing to spend much less. After all, how much you are willing to pay for a gaming console depends on your income, how much you like playing, what equipment you currently own, and so on.
Each potential buyer has a unit demand curve like the one we saw in Figure 6.2.1 "The Buyer’s Valuation". We can add these unit demand curves together to get a picture of demand in the entire market: the market demand curve. For example, suppose only one person is willing to buy if the price is \$700. However, suppose there is another buyer with a valuation of \$660. If consoles were on sale for \$660, then both individuals would want to purchase. At \$660, in other words, the quantity demanded is 2. Perhaps the buyer with the next-highest valuation is willing to pay \$640. If the price is \$640, the quantity demanded is 3. Figure 6.4.1 "Obtaining the Market Demand Curve" shows what happens when we add together all these unit demand curves. The result is a downward sloping relationship that shows us how many units would be demanded at any given price.
Toolkit: Section 31.9 "Supply and Demand"
The market demand curve tells us how many units of a good or a service will be demanded at any given price. The market demand curve is obtained by adding together the individual demand curves in the economy and obeys the law of demand: as the price decreases, the quantity demanded increases.
We can add together the unit demand curves of different individuals in the economy to get the market demand curve.
Supply: Many Sellers
We saw earlier that each potential seller has a unit supply curve. If the price is less than a seller’s valuation, she will not sell the good, but when the price becomes greater than her valuation, she will be willing to sell. Just as we added together the unit demand curves to get the market demand curve, so too can we add together the unit supply curves to get the market supply curve.
Toolkit: Section 31.9 "Supply and Demand"
The market supply curve tells us how many units of a good or a service will be supplied at any given price. The market supply curve is obtained by adding together the individual supply curves in the economy and typically slopes upward: as the price increases, the quantity supplied to the market increases.
In Figure 6.4.2 "Obtaining the Market Supply Curve", we see that the lowest valuation in the market is \$150. There is one seller willing to sell a console at that price. As the price increases, more and more sellers will find the price attractive and will want to sell. For example, there are 11 potential sellers with a valuation less than \$350. Thus, at this price, 11 consoles will be supplied to the market.
We can add together the unit supply curves of different individuals in an economy to get the market supply curve.
Equilibrium
Figure 6.4.1 "Obtaining the Market Demand Curve" and Figure 6.4.2 "Obtaining the Market Supply Curve" tell us the number of buyers willing to buy and the number of sellers willing to sell at each price.
Figure 6.4.3 "Market Equilibrium" shows what happens if we combine the demand curve and the supply curve on the same diagram. One point jumps out at us: the place where the demand and supply curves meet. In our example, this is at \$480 and a quantity of 21 units. At this point, the number of buyers with a valuation greater than the price is the number of sellers with a valuation less than the price. If buyers and sellers were presented with this price, none would find themselves unable to transact. At this price, there is an exact match between the number of buyers and sellers.
Figure \(3\): Market Equilibrium
In this figure, we combine the demand and supply curves to find the equilibrium price and quantity in the market.
Toolkit: Section 31.9 "Supply and Demand"
Equilibrium in a market refers to an equilibrium price and an equilibrium quantity and has the following features:
• Given the equilibrium price, sellers supply the equilibrium quantity.
• Given the equilibrium price, buyers demand the equilibrium quantity.
Equilibrium is not only a point on a graph. It is a prediction about a possible outcome in a situation where a large number of buyers and sellers meet with the possibility of trading. It seems plausible that in a situation where a large number of buyers and sellers can meet and trade with each other, most will end up trading at or near the equilibrium price.
The equilibrium outcome is plausible because, at any other price, there will be a mismatch of buyers and sellers. Imagine, by contrast, that the buyers and sellers of our example are currently trading at \$600, well above the equilibrium price of \$480. At this high price, many more people want to sell than want to buy. Buyers would rapidly realize that they are in a strong bargaining position: if many sellers want your business, you can make them compete with each other and force price decreases. In fact, whenever the price is above equilibrium, the mismatch of buyers and sellers will tend to decrease prices.
By similar reasoning, a price of, say, \$400 would also result in a mismatch between buyers and sellers. In this case, though, there are more people who want to buy than sell. Sellers can make buyers compete with each other, leading to price increases. At any price below the equilibrium price, prices will tend to increase.
Perfectly Competitive Markets
Economists formalize the intuition we have just developed with the most famous framework in all of economics: supply and demand.The definition is repeated and discussed in more detail in Chapter 8 "Why Do Prices Change?"; we make extensive use of it in other chapters.
Toolkit: Section 31.9 "Supply and Demand"
Supply and demand is a framework we use to explain and predict the equilibrium price and quantity of a good. This framework illustrates the willingness to sell (market supply) and buy (market demand) on a graph with price on the vertical axis and units of the good or the service on the horizontal axis. A point on the market supply curve shows the quantity that suppliers are willing to sell for a given price. A point on the market demand curve shows the quantity that demanders are willing to buy for a given price. The intersection of supply and demand determines the equilibrium price and quantity that will prevail in the market. A basic supply-and-demand framework is shown in Figure 6.4.4 "Supply and Demand".
When we have a large number of buyers and sellers of an identical good or service, the equilibrium price and quantity are determined by the intersection of the supply and demand curves.
The position of the demand curve depends on many things, such as income and the prices of other goods. A change in any of these will cause the entire demand curve to shift. Likewise, the position of the supply curve depends on factors such as a supplier’s costs. A change in these will cause the entire supply curve to shift. When one (or both) of the curves shifts, the equilibrium price and quantity change.
Experience with double oral auctions, both in the laboratory and in actual pit markets, tells us that trading will typically settle down close to the equilibrium price within a relatively short period of time. In a situation where there is a large number of people buying and selling an identical good, we say that we have a competitive market. We expect that most trades will take place at or close to the equilibrium price, and the quantity traded will be approximately equal to the equilibrium quantity. In fact, even when the number of participants in the auction is relatively small, we often find that a double oral auction still gets close to this equilibrium price and quantity. This is the remarkable finding that we mentioned earlier: in a double oral auction, the number of transactions and the prices of these transactions are usually very close to the equilibrium predicted by supply and demand.
Toolkit: Section 31.9 "Supply and Demand"
Suppose a market has the following two characteristics:
1. There are many buyers and many sellers, all of whom are small relative to the market.
2. The goods being traded are perfect substitutes.
In this case we say that we have a competitive market (sometimes called a perfectly competitive market). Buyers and sellers both take the price as given. This means that they think their actions have no effect on the price in the market, which in turn means we can employ the supply-and-demand framework.
The Gains from Trade in Equilibrium
Suppose all the transactions in Figure 6.4.3 "Market Equilibrium" take place at the equilibrium price of \$480. What can we say about the surplus received by buyers and sellers? Each individual transaction looks like those we examined in Chapter 6 "eBay and craigslist", Section 6.2 "eBay". The total surplus from any given transaction is equal to the difference between the buyer’s valuation and the seller’s valuation. The buyer surplus is the difference between his valuation and \$480. The seller surplus is the difference between the price and her valuation. For example, Figure 6.4.5 "The Gains from Trade in a Single Transaction in Market Equilibrium" shows the gains from trade if a buyer with a valuation of \$630 matches up with a seller whose valuation is \$230:
\[buyer\ surplus\ =\ \$630 − \$480 = \$150,\ seller\ surplus\ =\ \$480 − \$230 = \$250,\]
and
\[total\ surplus\ =\ \$150 + \$250 = \$400.\]
The transaction generates \$400 worth of surplus: \$150 goes to the buyer, and \$250 goes to the seller.
Each transaction in the market generates surplus.
We could draw exactly the same diagram for all 21 transactions in the market. If we combine them, we would end up with Figure 6.4.6 "Surplus in Equilibrium". The total surplus accruing to the buyers is equal to the area below the demand curve and above the price. The total surplus accruing to the sellers is equal to the area above the supply curve and below the price. The total surplus—that is, the total gains from trade in this market—is the sum of the buyer surplus in the market and the seller surplus in the market. The total surplus is therefore the area between the supply curve and the demand curve.
Figure \(6\): Surplus in Equilibrium
If we add the surplus from all trades in the market, supposing that they all take place at \$480, we obtain the total surplus in the market.
If you look at Figure 6.4.6 "Surplus in Equilibrium", something else may become apparent to you. All the gains from trade have been exhausted in the market. If buyers and sellers trade at the market price, then they manage to achieve all the gains from trade that are possible in this market because
• every transaction that has been carried out has created surplus;
• any further transaction would generate negative surplus.
The first statement is true because all trades are voluntary. We can see that the second statement is true by imagining trying to match up another buyer and seller. All the buyers with valuations greater than \$480 have now made a purchase. So every remaining potential buyer has a valuation less than \$480. All the sellers with valuations less than \$480 have now made a sale. So every potential seller has a valuation greater than \$480. It follows that there is no mutually beneficial transaction to be carried out.
This is a truly remarkable result. A market where all potential buyers and sellers take as given the equilibrium price allows all the possible gains from trade to be realized. Thus a market is a very effective mechanism for generating an efficient allocation of resources. This is why economists place so much emphasis on markets and “market solutions” to economic problems. Markets allow buyers and sellers to come together to make mutually beneficial trades. Economists believe that, as far as possible, we should create circumstances in which people can meet and carry out voluntary transactions.
Although this argument for markets is very powerful, we must be careful. Buyers and sellers may benefit from trading, but sometimes other people not involved in the transaction may also be affected. For example, suppose you fill up your car with gas at your local gas station. Presumably, you benefit from this transaction—otherwise you wouldn’t have bought the gas. Likewise, the gas station owner benefits from the transaction—otherwise the owner wouldn’t have sold it to you. But your purchase will contribute to smog and air pollution when you drive the car, affecting other people in the vicinity. To the extent that you make a contribution to global climate change, your little transaction has the potential to have an effect—a very tiny effect but an effect nonetheless—on everyone else on the planet. As a more positive example, going to college is presumably a mutually beneficial transaction between you and your school. But many others may eventually benefit from your education as well. In Chapter 14 "Cleaning Up the Air and Using Up the Oil", we consider such uncompensated costs and benefits in detail.
Key Takeaways
• In a perfectly competitive market, buyers and sellers take the prices as given.
• In the equilibrium of a perfectly competitive market, there are no further gains to trade.
• The outcome of a double oral auction and the supply-and-demand framework are the same.
check your understanding
1. Look at Figure 6.4.3 "Market Equilibrium". How could the equilibrium price be greater than \$480?
2. Suppose there are two buyers. The first has a demand curve given by quantity = 5 − 0.5 × price. The second one has a demand curve of quantity = 15 − 1.5 × price. What is the market demand at \$1? Suppose there is a total supply of 10 units in this market. What is the equilibrium price? How is the surplus allocated? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/06%3A_eBay_and_craigslist/6.04%3A_Supply_and_Demand.txt |
Learning Objectives
1. Where do the gains from trade come from?
2. What determines who produces which good?
So far we have discussed several different ways in which individuals trade with one another, including individual bargaining and Internet sites such as eBay and craigslist. We have considered situations with one seller and one buyer, one seller and many buyers, and many sellers and buyers. But why do we trade so much? Why is trade so central to our lives and indeed to the history of the human race?
On a typical craigslist website, many services are offered for sale. They are listed under categories such as financial, legal, computer, beauty, and so on. If you click on one of these headings and follow one of the offers, you typically find that someone is willing to provide a service, such as legal advice, in exchange for money. Sometimes there are offers to barter: to exchange a service for some other service or for some specific good. For example, we found the following offers listed on craigslist.These are actual offers that we found on craigslist, edited slightly for clarity.
Hello, I am looking for a dentist/oral surgeon who is willing to remove my two wisdom teeth in exchange for furniture repair and refinishing. If preferred, I’ll come to your office and show you my teeth beforehand. Take a look at some of the work I have posted on my web page…quality professional furniture restoration. Bring new life to your antiques!
We are new to the area and are looking for a babysitter for casual or part-time help with our three little girls. My husband is a chiropractor and offers adjustments, and I am a vegan and raw foods chef offering either culinary classes or prepared food in exchange for a few hours of babysitting each week.
I have a web design company,…I figure I’d offer to barter in this slow economy. If you got something you’d be willing to trade for a website, let me know and maybe we can work something out!
These offers provide a glimpse into why people trade. Some people are relatively more productive than others in the production of certain goods or services. Hence it makes sense that people should perform those tasks they are relatively good at and then in some way exchange goods and services. These offers reveal both a reason for trade and a mechanism for trade.
As individuals, we are involved in the production of a very small number of goods and services. The person who cuts your hair is probably not a financial advisor. It is unlikely that your economics professor also moonlights as a bouncer at a local nightclub. By contrast, we buy thousands of goods and services—many more goods and services than we produce. We specialize in production and generalize in consumption. One motivation for trade is this simple fact: we typically don’t consume the goods we produce, and we certainly want to consume many more goods than we produce. Yet that prompts the question of why society is organized this way. Why do we live in such a specialized world?
To address this question, we leave our modern, complicated world—the world of eBay, craigslist, and the Internet—behind and study some very simple economies instead. In fact, we begin with an economy that has only one individual. This allows us to see what a world would look like without any trade at all. Then we can easily see the difference that trade makes.
Production Possibilities Frontier for a Single Individual
Inspired by the craigslist posts that we saw earlier, imagine an economy where people care about only two things: web pages and vegan meals. Our first economy has a single individual—we call him Julio—who has 8 hours a day to spend working. Julio can spend his time in two activities: web design and preparing vegan meals. To be concrete, suppose he can produce 1 web page per hour or 2 vegan meals per hour. Julio faces a time allocation problem: how should he divide his time between these activities?We study the time allocation problem in Chapter 4 "Everyday Decisions".
The answer depends on both Julio’s productivity and his tastes. We start by looking at his ability to produce web pages and vegan meals in a number of different ways. Table 6.5.1 "Julio’s Production Ability" shows the quantity of each good produced per hour of Julio’s time. Julio can produce either 2 vegan meals or 1 web page in an hour. Put differently, it takes Julio half an hour to prepare a meal and 1 hour to produce a web page. These are the technologies—the ways of producing output from inputs—that are available to Julio.
Toolkit: Section 31.17 "Production Function"
A technology is a means of producing output from inputs.
Vegan Meals per Hour Web Pages per Hour
2 1
Table \(1\): Julio’s Production Ability
We could write these two technologies as equations:
\[quantity\ of\ vegan\ meals\ =\ 2\ ×\ hours\ spent\ cooking\]
and
\[quantity\ of\ web\ pages\ =\ hours\ spent\ on\ web\ design.\]
Or we can draw these two technologies ( Figure 6.5.1 "Julio’s Production Ability"). The equations, the figure, and the table are three ways of showing exactly the same information.
These figures show Julio’s technologies for producing vegan meals and producing web pages.
When we add in the further condition that Julio has 8 hours available each day, we can construct his different possible production choices—the combinations of web pages and vegan cuisine that he can produce given his abilities and the time available to him. The first two columns of Table 6.5.2 "Julio’s Production Possibilities" describe five ways Julio might allocate his 8 hours of work time. In the first row, Julio allocates all 8 hours to preparing vegan meals. In the last row, he spends all of his time in web design. The other rows show what happens if he spends some time producing each service. Note that the total hours spent in the two activities is always 8 hours.
The third and fourth columns provide information on the number of vegan meals and web pages that Julio produces. Looking at the first row, if he works only on vegan meals, then he produces 16 meals and 0 web pages. If Julio spends all of his time designing web pages, then he produces 0 vegan meals and 8 web pages.
Time Spent Producing Goods Produced
Vegan Meals Web Pages Vegan Meals Web Pages
8 0 16 0
2 6 12 2
4 4
6 2
0 8 0 8
Table \(2\): Julio’s Production Possibilities
We can also illustrate this table in a single graph ( Figure 6.5.2 "Julio’s Production Possibilities") that summarizes Julio’s production possibilities. The quantity of vegan meals is on the horizontal axis, and the quantity of web pages is on the vertical axis. To understand Figure 6.5.2 "Julio’s Production Possibilities", first consider the vertical and horizontal intercepts. If Julio spends the entire 8 hours of his working day on web design, then he will produce 8 web pages and no vegan meals (point A). If Julio instead spends all his time cooking vegan meals and none on web design, then he can produce 16 vegan meals and 0 web pages (point B).
Figure \(2\): Julio’s Production Possibilities
Julio’s production possibilities frontier shows the combinations of meals and web pages that he can produce in an 8-hour day.
The slope of the graph is −1/2. To see why, start at the vertical intercept where Julio is producing only web pages. Suppose that he reduces web-page production by 1 page. This means he will produce only 7 web pages, which requires 7 hours of his time. The hour released from the production of web design can now be used to prepare vegan meals. This yields 2 vegan meals. The resulting combination of web pages and vegan meals is indicated as point C. Comparing points A and C, we can see why the slope is −1/2. A reduction of web-page production by 1 unit (the rise) yields an increase in vegan meals production of 2 (the run). The slope—rise divided by run—is −1/2.
Given his technology and 8 hours of working time, all the combinations of vegan meals and web pages that Julio can produce lie on the line connecting A and B. We call this the production possibilities frontier. Assuming that Julio equally likes both web design and vegan meals and is willing to work 8 hours, he will choose a point on this frontier.All of this may seem quite familiar. The production possibility frontier for a single individual is the same as the time budget line for an individual. See Chapter 4 "Everyday Decisions" for more information.
Toolkit: Section 31.12 "Production Possibilities Frontier"
The production possibilities frontier shows the combinations of goods that can be produced with available resources. It is generally illustrated for two goods.
What is the cost to Julio of cooking one more meal? To cook one more meal, Julio must take 30 minutes away from web design. Because it takes 30 minutes to produce the meal, and Julio produces 1 web page per hour, the cost of producing an additional vegan meal is half of a web page. This is his opportunity cost: to do one thing (produce more vegan meals), Julio must give up the opportunity to do something else (produce web pages). Turning this around, we can determine the opportunity cost of producing an extra web page in terms of vegan meals. Because Julio can produce 1 web page per hour or cook 2 meals per hour, the opportunity cost of 1 web page is 2 vegan meals. The fact that Julio must give up one good (for example, web pages) to get more of another (for example, vegan meals) is a direct consequence of the fact that Julio’s time is scarce.
Could Julio somehow produce more web pages and more vegan meals? There are only two ways in which this could happen. First, his technology could improve. If Julio were able to become better at either web design or vegan meals, his production possibilities frontier would shift outward. For example, if he becomes more skilled at web design, he might be able to produce 3 (rather than 2) web pages in 2 hours. Then the new production possibilities frontier would be as shown in part (a) of Figure 6.5.3 "Two Ways of Shifting the Production Possibilities Frontier Outward".
There are two ways in which Julio could produce more in a day: he could become more skilled, or he could work harder.
Alternatively, Julio could decide to work more. We have assumed that the amount of time that Julio works is fixed at 8 hours. Part (b) of Figure 6.5.3 "Two Ways of Shifting the Production Possibilities Frontier Outward" shows what the production possibilities frontier would look like if Julio worked 10 hours per day instead of 8 hours. This also has an opportunity cost. If Julio works longer, he has less time for his leisure activities.
We have not yet talked about where on the frontier Julio will choose to allocate his time. This depends on his tastes. For example, he might like to have 2 vegan meals for each web page. Then he would consume 4 web pages and 8 meals, as in Figure 6.5.4 "Julio’s Allocation of Time to Cooking Meals and Producing Web Pages".
Figure \(4\): Julio’s Allocation of Time to Cooking Meals and Producing Web Pages
If Julio likes to consume pages and meals in fixed proportions (2 vegan dishes for every web page), he will allocate his time to achieve the point shown in the figure.
The Production Possibilities Frontier with Two People
If this were the end of the story, we would not have seen the advertisements on craigslist to trade vegan meals or web pages. Things become more interesting and somewhat more realistic when we add another person to our economy.
Hannah has production possibilities that are summarized in Table 6.5.3 "Production Possibilities for Julio and Hannah". She can produce 1 vegan meal in an hour or produce 1.5 web pages in an hour. Hannah, like Julio, has 8 hours per day to allocate to production activities. In Table 6.5.3 "Production Possibilities for Julio and Hannah" we have also included their respective opportunity costs of producing web pages and vegan meals.
Vegan Meals per Hour Web Pages per Hour Opportunity Cost of Vegan Meals (in Web Pages) Opportunity Cost of Web Pages (in Vegan Meals)
Julio 2 1 1/2 2
Hannah 1 1.5 3/2 2/3
Table \(3\): Production Possibilities for Julio and Hannah
Table 6.5.3 "Production Possibilities for Julio and Hannah" reveals that Hannah is more productive than Julio in the production of web pages. By contrast, Julio is more productive in vegan meals. Hannah’s production possibilities frontier is illustrated in Figure 6.5.5 "Hannah’s Production Possibilities Frontier". It is steeper than Julio’s because the opportunity cost of vegan meals is higher for Hannah than it is for Julio.
Figure \(5\): Hannah’s Production Possibilities Frontier
Hannah’s production possibilities frontier is steeper than Julio’s.
Economists use the ideas of absolute advantage and comparative advantage to compare the productive abilities of Hannah and Julio.
Toolkit: Section 31.13 "Comparative Advantage"
Comparative advantage and absolute advantage are used to compare the productivity of people (or firms or countries) in the production of a good or a service. A person has an absolute advantage in the production of a good if that person can produce more of that good in a unit of time than another person. A person has a comparative advantage in the production of one good if the opportunity cost, measured by the lost output of the other good, is lower for that person than for another person.
Both absolute and comparative advantage are relative concepts because they compare two people. In the case of absolute advantage, we compare the productivity of two people for a given good. In the case of comparative advantage, we compare two people and two goods because opportunity cost is defined across two goods (web pages and vegan meals in our example). Comparing Hannah and Julio, we see that Hannah has an absolute advantage in the production of web pages. She is better at producing web pages than Julio. By contrast, Julio has an absolute advantage in the production of vegan meals. Therefore, it is not surprising that Hannah also has a comparative advantage in the production of web pages—the opportunity cost of web pages is lower for her than it is for Julio—whereas Julio has a comparative advantage in vegan meals.
It is entirely possible for one person to have an absolute advantage in the production of both goods. For example, were Hannah’s productivity in both activities to double, she would be better both at both web design and vegan meals. However, her opportunity cost of web pages would be unchanged. Julio would still have a comparative advantage in vegan meals. In general, one person always has a comparative advantage in one activity, while the other person has a comparative advantage in the other activity (the only exception is the case where the two individuals have exactly the same opportunity costs).
Suppose that Hannah’s tastes for vegan meals and web pages are the same as Julio’s: like Julio, Hannah wants to consume 2 meals for every web page. Acting alone, she would work for 2 hours in web design and spend 6 hours cooking, ending up with 3 web pages and 6 meals. But there is something very odd going on here. Julio, who is good at preparing meals, spends half his time on web design. Hannah, who is good at web design, spends three-quarters of her time cooking. Each has to spend a lot of time doing an activity at which he or she is unproductive.
This is where we see the possibility of gains from trade. Imagine that Julio and Hannah join together and become a team. What is their joint production possibilities frontier? If both Julio and Hannah devote their 8 hours of time to the production of web pages, then the economy can produce 20 web pages (8 from Julio and 12 from Hannah). At the other extreme, if both Julio and Hannah devote their 8 hours to cooking vegan meals, then the economy can produce 24 meals (16 from Julio and 8 from Hannah). These two points, which represent specialization of their two-person economy in one good, are indicated by point A and point D in Figure 6.5.6 "Julio and Hannah’s Joint Production Possibilities Frontier".
Julio and Hannah’s joint production possibilities frontier.
To fill in the rest of their joint production possibilities frontier, start from the vertical intercept, where 20 web pages are being produced. Suppose Julio and Hannah jointly decide that they would prefer to give up 1 web page to have some vegan meals. If Hannah were to produce only 11 web pages, she could free up 2/3 of an hour for vegan meals. She would produce 2/3 of a meal. Conversely, if Julio produced 1 fewer web page, that would free an hour of his time (because he is less efficient than Hannah at web design), and he could create 2 vegan meals. Evidently, it makes much more sense for Julio to shift from web design to cooking (see point B in Figure 6.5.6 "Julio and Hannah’s Joint Production Possibilities Frontier").
The most efficient way to substitute web design production for vegan meals production, starting at point A, is to have Julio switch from producing web pages to producing vegan meals. Julio should switch because he has a comparative advantage in cooking. As we move along the production possibilities frontier from point A to point B to point C, Julio continues to substitute from web pages to meals. For this segment, the slope of the production possibilities frontier is −1/2, which is Julio’s opportunity cost of web pages.
At point C, both individuals are completely specialized. Julio spends all 8 hours on vegan meals and produces 16 meals. Hannah spends all 8 hours on web design and produces 12 web pages. If they would like to have still more vegan meals, it is necessary for Hannah to start producing that service. Because she is less efficient at cooking and more efficient at web design than Julio, the cost of extra vegan meals increases. Between point A and point C, the cost of vegan meals was 1/2 a webpage. Between point C and point D, the cost of a unit of vegan meals is 1.5 web pages. The production possibilities frontier becomes much steeper. If you look carefully at Figure 6.5.4 "Julio’s Allocation of Time to Cooking Meals and Producing Web Pages", Figure 6.5.5 "Hannah’s Production Possibilities Frontier", and Figure 6.5.6 "Julio and Hannah’s Joint Production Possibilities Frontier", the joint production possibilities frontier is composed of the two individual frontiers joined together at point C.
Gains from Trade Once Again
Figure 6.5.7 "Julio and Hannah’s Preferred Point" again shows the production possibilities frontier for the Julio-Hannah team: all the combinations of web pages and vegan meals that they can produce in one day, using the technologies available to them.
Julio and Hannah can benefit from joining forces.
Julio and Hannah have a great deal to gain by joining forces. We know that Julio, acting alone, produces 4 web pages and 8 vegan meals. Hannah, acting alone, produces 3 web pages and 6 vegan meals. The joint total is 7 web pages and 14 vegan meals. In Figure 6.5.7 "Julio and Hannah’s Preferred Point", we have labeled this as “Total production of Julio and Hannah if they do not form a team.” But look at what they can achieve if they work together: they can produce 9 web pages and 18 vegan meals.
Evidently they both can be better off when they work together. For example, each could get an additional web page and 2 vegan meals. Julio could have 5 web pages and 10 vegan meals (instead of 4 and 8, respectively), and Hannah could have 4 web pages and 8 vegan meals (instead of 3 and 6, respectively).
How do they do this? Julio specializes completely in vegan meals. He spends all 8 hours of his day cooking, producing 16 vegan meals. Hannah, meanwhile, gets to spend most of her time doing what she does best: designing web pages. She spends 6 hours on web design, producing 9 web pages, and 2 hours cooking, producing 2 vegan meals.
The key to this improvement is that we are no longer requiring that Julio and Hannah consume only what they can individually produce. Instead, they can produce according to their comparative advantage. They each specialize in the production of the good that they produce best and then trade to get a consumption bundle that they are happy with. The gains from trade come from the ability to specialize.
It is exactly such gains from trade that people are looking for when they place advertisements on craigslist. For example, the first ad we quoted was from someone with a comparative advantage in fixing furniture looking to trade with someone who had a comparative advantage in dental work. Comparative advantage is one of the most fundamental reasons why people trade, and sites like craigslist allow people to benefit from trade. Of course, in modern economies, most trade does not occur through individual barter; stores, wholesalers, and other intermediaries mediate trade. Although there are many mechanisms for trade, comparative advantage is a key motivation for trade.
Specialization and the History of the World
Economics famously teaches us that there is no such thing as a free lunch: everything has an opportunity cost. Paradoxically, economics also teaches us the secret of how we can make everyone better off than before simply by allowing them to trade—and if that isn’t a free lunch, then what is?
This idea is also the story of why the world is so much richer today than it was 100 years, 1,000 years, or 10,000 years ago. The ability to specialize and trade is a key to prosperity. In the modern world, almost everybody is highly specialized in their production, carrying out a very small number of very narrow tasks. Specialization permits people to become skilled and efficient workers. (This is true, by the way, even if people have similar innate abilities. People with identical abilities will still usually be more efficient at producing one good rather than two.) Trade means that even though people specialize in production, they can still generalize in consumption. At least in the developed world, we enjoy lives of luxury that were unimaginable even a couple of centuries ago. This luxury would be impossible without the ability to specialize and trade.
The story of Julio and Hannah is therefore much more than a textbook exercise. One of the first steps on the ladder of human progress was the shift from a world where people looked after themselves to a world where people started producing in hunter-gatherer teams. Humans figured out that they could be more productive if some people hunted and others gathered. They also started to learn the benefits of team production—hunting was more efficient if a group of hunters worked together, encircling the prey so it could not escape. Such hunting teams are perhaps the first example of something that looks like a firm: a group of individuals engaged jointly in production.
Production Possibilities Frontier for a Country
Before we finish with this story, let us try to get a sense of how we can expand it to an entire economy. We begin by adding a third individual to our story: Sergio. Sergio is less efficient than both Julio and Hannah. He has no absolute advantage in anything; he is no better at web design than Hannah, and he is no better preparing vegan meals than Julio. Remarkably, Julio and Hannah will still want to trade with him.
Vegan Meals per Hour Web Pages per Hour Opportunity Cost of Web Pages (in Vegan Meals) Opportunity Cost of Vegan Meals (in Web Pages)
Julio 2 1 1/2 2
Hannah 1 1.5 3/2 2/3
Sergio 1 1 1 1
Table \(4\): Production Possibilities for Julio, Hannah, and Sergio
We begin by constructing the production possibilities frontier for these three individuals. The logic is the same as before. Start from the position where the economy produces nothing but web pages (see Figure 6.5.8 "The Production Possibilities Frontier with Three People", point A). Together, Julio, Hannah, and Sergio can produce a total of 28 web pages in a day. Then we first shift Julio to cooking because he has the lowest opportunity cost of that activity. As before, the slope of this first part of the frontier is −1/2, up to point B. At point B, Julio is producing nothing but vegan meals, and Hannah and Sergio are devoting all of their time to producing web pages. At point B, the economy produces 20 web pages and 16 vegan meals.
Here we show a production possibilities frontier with three individuals. Notice that it is smoother than the production possibilities frontier for two people.
If they want more vegan meals, who should switch next? The answer is Sergio because his opportunity cost of vegan meals is lower than Hannah’s. As Sergio starts shifting from web design to vegan meals, the frontier has slope −1, and we move from point B to point C. At point C, Sergio and Julio cook meals, and Hannah produces web pages. The number of web pages produced is 12, and there are 24 vegan meals. Finally, the last segment of the frontier has slope −3/2, as Hannah also shifts from web design to vegan meals. At point D, they all cook, with total production equal to 32 meals.
Let us suppose that Sergio, like the others, consumes in the ratio of 2 vegan meals for every web page. If the economy is at point C, the economy can produce 12 web pages and 24 vegan meals. Earlier, we saw that Hannah and Julio could together produce 9 web pages and 18 vegan meals, so bringing in Sergio allows for an extra 3 web pages and 6 vegan meals, which is more than Sergio could produce on his own. Even though Sergio is less efficient than both Julio and Hannah, there are still some gains from trade. The easiest way to see this is to note that it would take Sergio 9 hours to produce 3 web pages and 6 vegan meals. In 8 hours he could produce almost 3 web pages and over 5 vegan meals.
Where do the gains from trade come from? They come from the fact that, relative to Hannah, Sergio has a comparative advantage in vegan meals. Previously, Hannah was devoting some of her time to vegan meals, which meant she had to divert time from web design. This was costly because she is good at web design. By letting Sergio do the vegan meals, Hannah can specialize in what she does best. The end result is that there are extra web pages and vegan meals for them all to share.
Comparing Figure 6.5.7 "Julio and Hannah’s Preferred Point" and Figure 6.5.8 "The Production Possibilities Frontier with Three People", you can see that the frontier becomes “smoother” when we add Sergio to the picture. Now imagine that we add more and more people to the economy, each with different technologies, and then construct the frontier in the same way. We would get a smoother and smoother production possibilities frontier. In the end, we might end up with something like Figure 6.5.9 "The Production Possibilities Frontier with a Large Number of People".
Figure \(9\): The Production Possibilities Frontier with a Large Number of People
As we add more and more people to the economy, the production possibilities frontier will become smoother.
It is easy enough to imagine that Julio, Hannah, and Sergio could all get together, agree to produce according to the principle of comparative advantage, and then share the goods that they have produced in a way that makes them all better off than they would be individually. Exactly how the goods would be shared would involve some kind of negotiation and bargaining among them. Once we imagine an economy with a large number of people in it, however, it is less clear how they would divide up the goods after they were produced. And that brings us full circle in the chapter. It is not enough that potential gains from trade exist. There must also be mechanisms, such as auctions and markets, that allow people to come together and realize these gains from trade.
Key Takeaways
• Gains in trade partly come from the fact that individuals specialize in production and generalize in consumption.
• The efficient way to organize production is by looking at comparative advantage.
• Gains to trade emerge when individuals produce according to comparative advantage and then trade goods and services with one another.
check your understanding
1. Fill in the missing values in Table 6.5.2 "Julio’s Production Possibilities". | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/06%3A_eBay_and_craigslist/6.05%3A_Production_Possibilities.txt |
In Conclusion
This chapter is our first look at how individuals exchange. We have emphasized two points:
1. How individuals trade. You have seen that some very familiar things, such as eBay and craigslist, provide mechanisms to facilitate trade.
2. Why individuals trade. These gains may simply arise from differences in how people value items, as in Chapter 6 "eBay and craigslist", Section 6.3 "eBay". Or, as in Chapter 6 "eBay and craigslist", Section 6.6 "End-of-Chapter Material", these gains may reflect the fact that people differ in their abilities to produce different goods and services.
In reality, individuals differ across these two dimensions and more. Chapter 10 "Making and Losing Money on Wall Street" explores two further reasons for trade: differences in information and differences in attitudes toward risk.
Auctions such as eBay, newspaper classified advertisements, and sites such as craigslist are all means by which individuals in an economy can trade with one another. Of course, these are not the only forms of trade. Our discussion, by design, has ignored other common forms of trade in the economy, such as individuals buying goods and services from a firm (perhaps through a retailer) and individuals selling their labor services to firms.Such exchanges are discussed in Chapter 7 "Where Do Prices Come From?" and Chapter 8 "Why Do Prices Change?".
The biggest insight you should take away from this chapter is the fact that exchange is a means of creating value. When a seller sells a good or a service to a buyer, there is a presumption that both become better off. We have such a presumption because people enter into trades voluntarily: nobody forces a buyer to buy; nobody forces a seller to sell. The fact that voluntary exchange creates value is one of the most powerful ideas in economics.
Key Links
exercises
1. Would you expect to get an item for less by buying it through craigslist rather than a regular store? If so, why?
2. (Advanced) Suppose the government imposed a tax on trading through craigslist, so the seller had to pay 5 percent of the price to the government. What might be the impact on trade in this market? What might happen to prices?
3. If you are a seller on craigslist, what would be the cost of setting a very high price?
4. If the price of an item traded increases, can both the surplus to the buyer and the surplus of the seller increase simultaneously?
5. If the owner of a car values it at \$5,000 and there is a prospective buyer who is willing to pay \$7,000 for that car, what does efficiency dictate about the price the buyer should pay for the car?
6. What are the differences between buying an item on eBay and buying that same item on craigslist?
7. In what settings do you have to be aware of the winner’s curse?
8. In what way does a double oral auction differ from craigslist? From eBay?
9. If more people come into an auction, how should that affect your bidding in a winner’s curse situation? Should you bid more or less? Why?
10. Suppose that instead of producing 2 vegan meals each hour, Julio can produce 3 vegan meals each hour. Draw his production possibilities frontier. What is his opportunity cost of web pages in terms of vegan meals with this alternative technology?
11. Suppose that Julio can produce 3 vegan meals each hour but requires 2 hours to design a web page. Draw his production possibilities frontier.
12. If Julio had a choice between the technology in Table 6.5.1 "Julio’s Production Ability" and the one described in question 10, which would he prefer? Explain why.
13. What would the production possibilities frontier look like if, starting from point A in Figure 6.3.1 "Why You Should Bid Your Valuation in an eBay Auction", we first shifted Hannah rather than Julio to vegan meal production?
14. Show how the production possibilities frontier shifts if Hannah becomes more productive in producing web pages.
15. (Advanced) Suppose that both Julio and Hannah like each of the goods in a ratio of 6 vegan meals to 1 web page. Show that there are still gains to trade using the technologies described in Table 6.3.1 "Valuations of Different Bidders in a Winner’s Curse Auction".
16. Explain what it means to “specialize in production and generalize in consumption.” How many jobs do people usually have at a point in time? How many items does a food shopper usually have in his or her basket at the store?
17. Explain the connection between opportunity cost and comparative advantage.
Economics Detective
1. Find an auction to buy or sell the following items: a house, a car, a government bond, and licenses for the electromagnetic spectrum. What do you have to do to become a bidder at one of these auctions? How is the auction conducted?
2. Suppose you want to purchase a painting at Sotheby’s, a famous English auction house. How would you do so? How would the auction operate? In what ways would it differ from buying art on eBay or craigslist?
Spreadsheet Exercise
1. (Advanced) Create a spreadsheet to input data like that in the first two columns of Table 6.5.3 "Production Possibilities for Julio and Hannah". Suppose there are two people who can produce two goods. Enter into the spreadsheet how much of each good they can produce in an hour.
1. Calculate the opportunity costs, as in the last two columns of Table 6.5.3 "Production Possibilities for Julio and Hannah".
2. Assuming each has 8 hours a day to work, use the spreadsheet to calculate the total amount of each good each individual could produce if they produced only that good.
3. Use this information to graph the production possibilities frontier for each person.
4. Use this information to graph the production possibilities frontier for the two people combined.
5. As you input different levels of output per hour per person, watch how these graphs change.
6. Where do you see comparative advantage coming into play? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/06%3A_eBay_and_craigslist/6.06%3A_End-of-Chapter_Material.txt |
Thumbnail: https://pixabay.com/vectors/shopping-edit-money-price-1724299/
07: Where Do Prices Come From
If you walk down the aisles of a supermarket, you will see thousands of different goods for sale. Each one will have a price displayed, telling you how much money you must give up if you want the good in question. On the Internet, you can find out how much it would cost you to stay in a hotel in Lima, Peru, or how much you would have to pay to rent a four-wheel drive vehicle in Nairobi, Kenya. On your television every evening, you can see the price that you would have to pay to buy a share of Microsoft Corporation or other companies.
Prices don’t appear by magic. Every price posted in the supermarket or on the Internet is the result of a decision made by one or more individuals. In the future, you may find yourself trying to make exactly such a decision. Many students of economics have jobs in the marketing departments of firms or work for consulting companies that provide advice on what prices firms should charge. To learn about how managers make such decisions, we look at a real-life pricing decision.
In 2003, a major pharmaceutical company was evaluating the performance of one of its most important drugs—a medication for treating high blood pressure—in a Southeast Asian country. (For reasons of confidentiality, we do not reveal the name of the company or the country; other than simplifying the numbers slightly, the story is true.) Its product was known as one of the best in the market and was being sold for \$0.50 per pill. The company had good market share and income in the country. There was one major competing drug in the market that was selling at a higher price and a few less important drugs.
In pharmaceutical companies, one individual often leads the team for each major drug that the company sells. In this company, the head of the product team—we will call her Ellie—was happy with the performance of the drug. Nonetheless, she wondered whether her company could make higher profits by setting a higher or lower price. In many countries, the prices of pharmaceutical products are heavily regulated. In this particular country, however, pharmaceutical companies were largely free to set whatever price they chose. Together with her team, therefore, Ellie decided to review the pricing strategy for her product. In this chapter, we therefore tackle the following question:
How should a firm set its price?
Road Map
Price-setting in retail markets typically takes the form of a take-it-or-leave-it offer. The seller posts a price, and prospective customers either buy or don’t buy at that price. The prices you encounter every day in a supermarket, a coffee shop, or a fast-food restaurant, for example, are all take-it-or-leave-it offers that the retailer makes to you and other customers. Chapter 6 "eBay and craigslist" has more discussion.
In this chapter, we put you in the place of a marketing manager who has been given the job of determining the price that a firm should charge for its product. We first discuss the goals of this manager: what is she trying to achieve? We then show what information she needs to make a good decision. Finally, we derive some principles that allow her to set the right price. The chapter is built around two ideas:This chapter and Chapter 6 "eBay and craigslist" are linked because they are both about mechanisms that allocate goods and services. In Chapter 6 "eBay and craigslist" we explain how eBay, craigslist, and newspapers are ways in which individuals exchange goods and services. In this chapter, we study how goods and services are allocated from firms to households. At the end of this chapter, we show that the supply-and-demand framework introduced in Chapter 6 "eBay and craigslist" is also a useful framework when the same product is produced by a large number of firms. In particular, we show that our ideas about pricing also allow us to understand the foundations of supply.
1. The law of demand. Each firm faces a demand curve for its product. This demand curve obeys the law of demand: if a firm sets a higher price, it must be willing to sell a smaller quantity; if a firm wishes to sell a larger quantity, it must set a lower price.
2. Profit accounting. Firms earn income from selling their goods and services, but they also incur costs from producing those goods and services. These costs include the costs of raw materials, the wages paid to the firm’s workers, and so on. The difference between a firm’s revenues and its costs is the firm’s profits.
The choice of price, via the demand curve, determines the amount of output a firm sells. The amount of output determines a firm’s revenues and costs. Together, revenues and costs determine the profits of a firm. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/07%3A_Where_Do_Prices_Come_From/7.01%3A_The_Price_of_a_Pill.txt |
learning objective
1. What is the goal of a firm?
Firms devote substantial resources to their decisions about pricing. Large firms often have individuals or even entire departments whose main job is to make pricing decisions. Consulting firms specialize in providing advice to firms about the prices that they should charge. Some companies, such as airlines, have dedicated software to help them make these decisions. It isn’t hard to understand why firms pay so much attention to the prices they charge. More than anything else, price determines the profits that a firm earns.
Economists are prone to talk about the decisions and objectives of a firm, and we often use the same shorthand. A firm, though, is just a legal creation—a collection of individuals who use some kind of technology. A firm takes labor, raw materials, and other inputs and turns them into products that people want to buy. Some of the people in a firm—the managers—decide how many workers it should hire, what prices it should set, and so on.
To understand pricing, we begin with the goal of a firm (that is, its managers). If a firm’s managers are doing their jobs well, they should be making decisions to serve the interests of the owners of that firm. The owners of a firm are its shareholders. If you buy a share in a firm, then you own a fraction (your share) of the firm, which gives you the right to a fraction of the firm’s earnings. Shareholders, for the most part, have one reason for buying and owning shares: to earn income. So the managers, if they are doing their jobs well, want a firm to make as much money as possible. We need to be careful, though. What matters is not the total amount of money received by a firm, but how much is available to be distributed to its owners. The owners of a firm hope to earn as high a return as possible on their shares.
Toolkit: Section 31.15 "Pricing with Market Power"
The money that is available for distribution to the shareholders of a firm is called a firm’s profits. A firm pays money for raw materials, energy, and other supplies, and it pays wages to its workers. These expenses are a firm’s costs of production. When it sells the product(s) it has produced, a firm earns revenues. Accountants analyze these revenues and costs in more detail, but in the end all the monies that flow in and out of a firm can be classified as either revenues or costs. Thus
\[profits\ = revenues\ −\ costs.\]
Consider, then, a marketing manager who wants to set the best price for a product—such as Ellie choosing the price for her company’s blood pressure medication. She wants to find the price that will yield the most profits to her company. In an ideal world, a marketing manager might have access to a spreadsheet table, such as Figure 7.2.1 "A Spreadsheet That Would Make Pricing Decisions Easy", which displays a firm’s monthly profits for different possible prices that it might set. Then Ellie’s job would be easy: she would just have to look at the table, find the cell in column B with the highest number, and set the corresponding price. In this case, she would set a price of \$15.
Figure \(1\): A Spreadsheet That Would Make Pricing Decisions Easy
But the reality of business is different. It is very difficult and expensive—perhaps even impossible—to gather information such as that in Figure 7.2.1 "A Spreadsheet That Would Make Pricing Decisions Easy". You might imagine that a firm could experiment, trying different prices and seeing what profits it earned. Unfortunately, this would be very costly because most of the time a firm would earn much lower profits than it could. Experimenting might even generate losses. For example, suppose that, one September, Ellie chose to try a price of \$2 per pill. The firm would lose nearly \$6 million—the equivalent of about six months’ profits even at the very best price. Ellie would rapidly find herself looking for another job.
It is clear that trial and error—choosing different prices at random and seeing how much profit you get—could lead to costly mistakes, and there is no guarantee that you would ever find the best price. By adding some structure to a trial-and-error process, though, there is a simple strategy for finding the best price: begin by slightly raising the firm’s price. If profits increase, then you are on the right track. Keep raising the price, little by little, until profits stop increasing. On the other hand, if profits decrease when you raise the price, then you should try lowering the price instead. If profits increase, then keep lowering the price little by little.
Figure 7.2.2 "A Change in Price Leads to a Change in Profits" shows how a change in price translates into a change in profits. A change in a firm’s price leads to a change in the quantity demanded. As a result, the revenues and costs of a firm change, as do its profits. Figure 7.2.3 "The Profits of a Firm" shows the profits a firm will earn at different prices. Our pricing strategy simply says the following. You are trying to get to the highest point of the profit hill in Figure 7.2.3 "The Profits of a Firm", and you will get there eventually if you always walk uphill. At the very top of the hill, the change in profits is zero.
Figure \(2\): A Change in Price Leads to a Change in Profits
If a firm changes its price, then there will be a change in demand. This then leads to changes in revenues and costs, which changes in the profits of a firm.
We could end the chapter right here. But we want to dig deeper and uncover some principles that tell us more about how pricing works. Then we can learn what information Ellie and other managers like her need to make better pricing decisions—and how they can make these decisions effectively. Our starting point is our earlier observation that
\[profits\ =\ revenues\ −\ costs.\]
key takeaway
• The objective of a firm is to maximize its profits, defined as revenues minus costs.
check your understanding
1. If the manager of a firm chose a price to maximize sales, what would that price be? What would profits be at that price?
2. Explain in words why the profit function has the shape shown in Figure 7.2.3 "The Profits of a Firm". | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/07%3A_Where_Do_Prices_Come_From/7.02%3A_The_Goal_of_a_Firm.txt |
learning objectives
1. What is the demand curve faced by a firm?
2. What is the elasticity of demand? How is it calculated?
3. What is marginal revenue?
A firm’s revenues are the money that it earns from selling its product. Revenues equal the number of units that a firm sells times the price at which it sells each unit:
\[revenues\ =\ price\ ×\ quantity.\]
For example, think about a music store selling CDs. Suppose that the firm sells 25,000 CDs in a month at \$15 each. Then its total monthly revenues are as follows:
\[revenues\ =\ 15 × 25,000 = \$375,000.\]
There are two ways in which firms can obtain higher revenues: sell more products or sell at a higher price. So if a firm wants to make a lot of revenue, it should sell a lot of its product at a high price. Then again, you probably do not need to study economics to figure that out. The problem for a manager is that her ability to sell a product is limited by what the market will bear. Typically, we expect that if she sets a higher price, she will not be able to sell as much of the product:
Equivalently, if she wants to sell a larger quantity of product, she will need to drop the price:
This is the law of demand in operation ( Figure 7.3.1 "A Change in the Price Leads to a Change in Demand").
An increase in price leads to a decrease in demand. A decrease in price leads to an increase in demand.
The Demand Curve Facing a Firm
There will typically be more than one firm that serves a market. This means that the overall demand for a product is divided among the different firms in the market. We have said nothing yet about the kind of “market structure” in which a firm is operating—for example, does it have a lot of competitors or only a few competitors? Without delving into details, we cannot know exactly how the market demand curve will be divided among the firms in the market. Fortunately, we can put this problem aside—at least for this chapter.We look at market structure in Chapter 15 "Busting Up Monopolies". For the moment, it is enough just to know that each firm faces a demand curve for its own product.
When the price of a product increases, individual customers are less likely to think it is good value and are more likely to spend their income on other things instead. As a result—for almost all products—a higher price leads to lower sales.
Toolkit: Section 31.15 "Pricing with Market Power"
The demand curve facing a firm tells us the price that a firm can expect to receive for any given amount of output that it brings to market or the amount it can expect to sell for any price that it chooses to set. It represents the market opportunities of the firm.
An example of such a demand curve is
\[quantity\ demanded\ =\ 100 − (5 × price).\]
Table 7.3.1 "Example of the Demand Curve Faced by a Firm" calculates the quantity associated with different prices. For example, with this demand curve, if a manager sets the price at \$10, the firm will sell 50 units because 100 − (5 × 10) = 50. If a manager sets the price at \$16, the firm will sell only 20 units: 100 − (5 × 16) = 20. For every \$1 increase in the price, output decreases by 5 units. (We have chosen a demand curve with numbers that are easy to work with. If you think that this makes the numbers unrealistically small, think of the quantity as being measured in, say, thousands of units, so a quantity of 3 in this equation means that the firm is selling 3,000 units. Our analysis would be unchanged.)
Price (\$) Quantity
0 100
2 90
4 80
6 70
8 60
10 50
12 40
14 30
16 20
18 10
20 0
Table \(1\): Example of the Demand Curve Faced by a Firm
Equivalently, we could think about a manager choosing the quantity that the firm should produce, in which case she would have to accept the price implied by the demand curve. To write the demand curve this way, first divide both sides of the equation by 5 to obtain
Now add “price” to each side and subtract “ ” from each side:
For example, if the manager wants to sell 70 units, she will need a price of \$6 (because 20 − 70/5 = 6). For every unit increase in quantity, the price decreases by 20 cents.
Either way of looking at the demand curve is perfectly correct. Figure 7.3.2 "Two Views of the Demand Curve" shows the demand curve in these two ways. Look carefully at the two parts of this figure and convince yourself that they are really the same—all we have done is switch the axes.
There are two ways that we can draw a demand curve, both of which are perfectly correct. (a) The demand curve has price on the horizontal axis and quantity demanded on the vertical axis (b). The demand curve has price on the vertical axis, which is how we normally draw the demand curve in economics.
The firm faces a trade-off: it can set a high price, such as \$18, but it will be able to sell only a relatively small quantity (10). Alternatively, the firm can sell a large quantity (for example, 80), but only if it is willing to accept a low price (\$4). The hard choice embodied in the demand curve is perhaps the most fundamental trade-off in the world of business. Of course, if the firm sets its price too high, it won’t sell anything at all. The choke price is the price above which no units of the good will be sold. In our example, the choke price is \$20; look at the vertical axis in part (b) of Figure 7.3.2 "Two Views of the Demand Curve".A small mathematical technicality: the equation for the demand curve applies only if both the price and the quantity are nonnegative. At any price greater than the choke price, the quantity demanded is zero, so the demand curve runs along the vertical axis. A negative price would mean a firm was paying consumers to take the product away.
Every firm in the economy faces some kind of demand curve. Knowing the demand for your product is one of the most fundamental necessities of successful business. We therefore turn next to the problem Ellie learned about the demand curve for her company’s drug.
The Elasticity of Demand: How Price Sensitive Are Consumers?
Marketing managers understand the law of demand. They know that if they set a higher price, they can expect to sell less output. But this is not enough information for good decision making. Managers need to know whether their customers’ demand is very sensitive or relatively insensitive to changes in the price. Put differently, they need to know if the demand curve is steep (a change in price will lead to a small change in output) or flat (a change in price will lead to a big change in output). We measure this sensitivity by the own-price elasticity of demand.
Toolkit: Section 31.2 "Elasticity"
The own-price elasticity of demand (often simply called the elasticity of demand) measures the response of quantity demanded of a good to a change in the price of that good. Formally, it is the percentage change in the quantity demanded divided by the percentage change in the price:
When price increases (the change in the price is positive), quantity decreases (the change in the quantity is negative). The price elasticity of demand is a negative number. It is easy to get confused with negative numbers, so we instead use
which is always a positive number.
• If −(elasticity of demand) is a large number, then quantity demanded is sensitive to price: increases in price lead to big decreases in demand.
• If −(elasticity of demand) is a small number, then quantity demanded is insensitive to price: increases in price lead to small decreases in demand.
Throughout the remainder of this chapter, you will often see −(elasticity of demand). Just remember that this expression always refers to a positive number.
Calculating the Elasticity of Demand: An Example
Go back to our earlier example:
\[quantity\ demanded\ =\ 100 − 5 × price.\]
Suppose a firm sets a price of \$15 and sells 25 units. What is the elasticity of demand if we think of a change in price from \$15 to \$14.80? In this case, the change in the price is −0.2, and the change in the quantity is 1. Thus we calculate the elasticity of demand as follows:
1. The percentage change in the quantity is (4 percent).
2. The percentage change in the price is (approximately −1.3 percent).
3. −(elasticity of demand) is
The interpretation of this elasticity is as follows: when price decreases by 1 percent, quantity demanded increases by 3 percent. This is illustrated in Figure 7.3.3 "The Elasticity of Demand".
When the price is decreased from \$15.00 to \$14.80, sales increase from 25 to 26. The percentage change in price is −1.3 percent. The percentage change in the quantity sold is 4. So −(elasticity of demand) is 3.
One very useful feature of the elasticity of demand is that it does not change when the number of units changes. Suppose that instead of measuring prices in dollars, we measure them in cents. In that case our demand curve becomes
\[quantity\ demanded\ = 100 − 500 × price.\]
Make sure you understand that this is exactly the same demand curve as before. Here the slope of the demand curve is −500 instead of −5. Looking back at the formula for elasticity, you see that the change in the price is 100 times greater, but the price itself is 100 times greater as well. The percentage change is unaffected, as is elasticity.
Market Power
The elasticity of demand is very useful because it is a measure of the market power that a firm possesses. In some cases, some firms produce a good that consumers want very much—a good in which few substitutes are available. For example, De Beers controls much of the world’s market for diamonds, and other firms are not easily able to provide substitutes. Thus the demand for De Beers’ diamonds tends to be insensitive to price. We say that De Beers has a lot of market power. By contrast, a fast-food restaurant in a mall food court possesses very little market power: if the fast-food Chinese restaurant were to try to charge significantly higher prices, most of its potential customers would choose to go to the other Chinese restaurant down the aisle or even to eat sushi, pizza, or burritos instead.
Ellie’s company had significant market power. There were a relatively small number of drugs available in the country to treat high blood pressure, and not all drugs were identical in terms of their efficacy and side effects. Some doctors were loyal to her product and would almost always prescribe it. Some doctors were not very well informed about the price because doctors don’t pay for the medication. For all these reasons, Ellie had reason to suspect that the demand for her drug was not very sensitive to price.
The Elasticity of Demand for a Linear Demand Curve
The elasticity of demand is generally different at different points on the demand curve. In other words, the market power of a firm is not constant: it depends on the price that a firm has chosen to set. To illustrate, remember that we found −(elasticity of demand) = 3 for our demand curve when the price is \$15. Suppose we calculate the elasticity for this same demand curve at \$4. Thus imagine that that we are originally at the point where the price is \$4 and sales are 80 units and then suppose we again decrease the price by 20 cents. Sales will increase by 1 unit:
1. The percentage change in the quantity is (1.25 percent).
2. The percentage change in the price is (5 percent).
3. −(elasticity of demand) is
The elasticity of demand is different because we are at a different point on the demand curve.
When −(elasticity of demand) increases, we say that demand is becoming more elastic. When −(elasticity of demand) decreases, we say that demand is becoming less elastic. As we move down a linear demand curve, −(elasticity of demand) becomes smaller, as shown in Figure 7.3.4 "The Elasticity of Demand When the Demand Curve Is Linear".
Figure \(4\): The Elasticity of Demand When the Demand Curve Is Linear
The elasticity of demand is generally different at different points on a demand curve. In the case of a linear demand curve, −(elasticity of demand) becomes smaller as we move down the demand curve.
Measuring the Elasticity of Demand
To evaluate the effects of her decisions on revenues, Ellie needs to know about the demand curve facing her firm. In particular, she needs to know whether the quantity demanded by buyers is very sensitive to the price that she sets. We now know that the elasticity of demand is a useful measure of this sensitivity. How can managers such as Ellie gather information on the elasticity of demand?
At an informal level, people working in marketing and sales are likely to have some idea of whether their customers are very price sensitive. Marketing and sales personnel—if they are any good at their jobs—spend time talking to actual and potential customers and should have some idea of how much these customers care about prices. Similarly, these employees should have a good sense of the overall market and the other factors that might affect customers’ choices. For example, they will usually know whether there are other firms in the market offering similar products, and, if so, what prices these firms are charging. Such knowledge is much better than nothing, but it does not provide very concrete evidence on the demand curve or the elasticity of demand.
A firm may be able to make use of existing sales data to develop a more concrete measure of the elasticity of demand. For example, a firm might have past sales data that show how much they managed to sell at different prices, or a firm might have sales data from different cities where different prices were charged. Suppose a pricing manager discovers data for prices and quantities like those in part (a) of Figure 7.3.5 "Finding the Demand Curve". Here, each dot marks an observation—for example, we can see that in one case, when the price was \$100, the quantity demanded was 28.
(a) This is an example of data that a manager might have obtained for prices and quantities. (b) A line is fit to the data that represents a best guess at the underlying demand curve facing a firm.
The straight-line demand curves that appear in this and other books are a convenient fiction of economists and textbook writers, but no one has actually seen one in captivity. In the real world of business, demand curves—if they are available at all—are only a best guess from a collection of data. Economists and statisticians have developed statistical techniques for these guesses. The underlying idea of these techniques is that they fit a line to the data. (The exact details do not concern us here; you can learn about them in more advanced courses in economics and statistics.) Part (b) of Figure 7.3.5 "Finding the Demand Curve" shows an example. It represents our best prediction, based on available data, of how much people will buy at different prices.
If a firm does not have access to reliable existing data, a third option is for it to generate its own data. For example, suppose a retailer wanted to know how sensitive customer demand for milk is to changes in the price of milk. It could try setting a different price every week and observe its sales. It could then plot them in a diagram like Figure 7.3.5 "Finding the Demand Curve" and use techniques like those we just discussed to fit a line. In effect, the store could conduct its own experiment to find out what its demand curve looks like. For a firm that sells over the Internet, this kind of experiment is particularly attractive because it can randomly offer different prices to people coming to its website.
Finally, firms can conduct market research either on their own or by hiring a professional market research firm. Market researchers use questionnaires and surveys to try to discover the likely purchasing behavior of consumers. The simplest questionnaire might ask, “How much would you be willing to pay for product x?” Market researchers have found such questions are not very useful because consumers do not answer them very honestly. As a result, research firms use more subtle questions and other more complicated techniques to uncover consumers’ willingness to pay for goods and services.
Ellie decided that she should conduct market research to help with the pricing decision. She hired a market research firm to ask doctors about how they currently prescribed different high blood pressure medications. Specifically, the doctors were asked what percentage of their prescriptions went to each of the drugs on the market. Then they were asked the effect of different prices on those percentages. Based on this research, the market research firm found that a good description of the demand curve was as follows:
\[quantity\ demanded\ =\ 252 − 300 × price.\]
Remember that the drug was currently being sold for \$0.50 a pill, so
\[quantity\ demanded\ =\ 252 − 300 × 0.5 = 102.\]
The demand curve also told Ellie that if she increased the price by 10 percent to \$0.55, the quantity demanded would decrease to 87 (252 − 300 × 0.55 = 87). Therefore, the percentage change in quantity is From this, the market research firm discovered that the elasticity of demand at the current price was
How Do Revenues Depend on Price?
The next step is to understand how to use the demand curve when setting prices. The elasticity of demand describes how quantity demanded depends on price, but what a manager really wants to know is how revenues are affected by price. Revenues equal price times quantity, so we know immediately that a firm earns \$0 if the price is \$0. (It doesn’t matter how much you give away, you still get no money.) We also know that, at the choke price, the quantity demanded is 0 units, so its revenues are likewise \$0. (If you sell 0 units, it doesn’t matter how high a price you sell them for.) At prices between \$0 and the choke price, however, the firm sells a positive amount at a positive price, thus earning positive revenues. Figure 7.3.6 "Revenues" is a graphical representation of the revenues of a firm. Revenues equal price times quantity, which is the area of the rectangle under the demand curve. For example, at \$14 and 30 units, revenues are \$420.
The revenues of a firm are equal to the area of the rectangle under the demand curve.
We can use the information in Table 7.3.1 "Example of the Demand Curve Faced by a Firm" to calculate the revenues of a firm at different quantities and prices (this is easy to do with a spreadsheet). Table 7.3.2 "Calculating Revenues" shows that if we start at a price of zero and increase the price, the firm’s revenues also increase. Above a certain point, however (in this example, \$10), revenues start to decrease again.
Price(\$) Quantity Revenues (\$)
0 100 0
2 90 180
4 80 320
6 70 420
8 60 480
10 50 500
12 40 480
14 30 420
16 20 320
18 10 180
20 0 0
Table \(2\): Calculating Revenues
Marginal Revenue
Earlier we suggested that a good strategy for pricing is to experiment with small changes in price. So how do small changes in price affect the revenue of a firm? Suppose, for example, that a firm has set the price at \$15 and sells 25 units, but the manager contemplates decreasing the price to \$14.80. We can see the effect that this has on the firm’s revenues in Figure 7.3.7 "Revenues Gained and Lost".
If a firm cuts its price, it sells more of its product, which increases revenues, but sells each unit at a lower price, which decreases revenues.
The firm will lose 20 cents on each unit it sells, so it will lose \$5 in revenue. This is shown in the figure as the rectangle labeled “revenues lost.” But the firm will sell more units: from the demand curve, we know that when the firm decreases its price by \$0.20, it sells another unit. That means that the firm gains \$14.80, as shown in the shaded area labeled “revenues gained.” The overall change in the firm’s revenues is equal to \$14.80 − \$5.00 = \$9.80. Decreasing the price from \$15.00 to \$14.80 will increase its revenues by \$9.80.
Look carefully at Figure 7.3.7 "Revenues Gained and Lost" and make sure you understand the experiment. We presume throughout this chapter that a firm must sell every unit at the same price. When we talk about moving from \$15.00 to \$14.80, we are not supposing that a firm sells 25 units for \$15 and then drops its price to \$14.80 to sell the additional unit. We are saying that the manager is choosing between selling 25 units for \$15.00 or 26 units for \$14.80
If a manager has an idea about how much quantity demanded will decrease for a given increase in price, she can calculate the likely effect on revenues.
Figure 7.3.8 "Calculating the Change in Revenues" explains this idea more generally. Suppose a firm is originally at point A on the demand curve. Now imagine that a manager decreases the price. At the new, lower price, the firm sells a new, higher quantity (point B). The change in the quantity is the new quantity minus the initial quantity. The change in the price is the new price minus the initial price (remember that this is a negative number). The change in the firm’s revenues is given by
\[change\ in\ revenues\ =\ (change\ in\ quantity\ ×\ new\ price)\ +\ (change\ in\ price\ ×\ initial\ quantity).\]
The first term is positive: it is the extra revenue from selling the extra output. The second term is negative: it is the revenue lost because the price has been decreased. Together these give the effect of a change in price on revenues, which we call a firm’s marginal revenue.
Toolkit: Section 31.15 "Pricing with Market Power"
Marginal revenue is the change in revenue associated with a change in quantity of output sold:
We can write this asFor the derivation of this expression, see the toolkit.
Marginal Revenue and the Elasticity of Demand
Given the definitions of marginal revenue and the elasticity of demand, we can write
It may look odd to write this expression with two minus signs. We do this because it is easier to deal with the positive number: −(elasticity of demand). We see three things:
1. Marginal revenue is always less than the price. Mathematically, Suppose a firm sells an extra unit. If the price stays the same, then the extra revenue would just equal the price. But the price does not stay the same: it decreases, meaning the firm gets less for every unit that it sells.
2. Marginal revenue can be negative. If –(elasticity of demand) < 1, then and When marginal revenue is negative, increased production results in lower revenues for a firm. The firm sells more output but loses more from the lower price than it gains from the higher sales.
3. The gap between marginal revenue and price depends on the elasticity of demand. When demand is more elastic, meaning −(elasticity of demand) is a bigger number, the gap between marginal revenue and price becomes smaller.
These three ideas are illustrated in Figure 7.3.9 "Marginal Revenue and Demand". The demand curve shows us the price at any given quantity. The marginal revenue curve lies below the demand curve because of our first observation: at any quantity, marginal revenue is less than price.When a demand curve is a straight line, the marginal revenue curve is also a straight line with the same intercept, but it is twice as steep. The marginal revenue curve intersects the horizontal axis at 50 units: when output is less than 50 units, marginal revenue is positive; when output exceeds 50, marginal revenue is negative. We explained earlier that a linear demand curve becomes more inelastic as you move down it. When the demand curve goes from being relatively elastic to relatively inelastic, marginal revenue goes from being positive to being negative.
The marginal revenue curve lies below the demand curve because at any quantity, marginal revenue is less than price.
Earlier, we showed that when a firm sets the price at \$15, −(elasticity of demand) = 3. Thus we can calculate marginal revenue at this price:
What does this mean? Starting at \$15, it means that if a firm decreases its price—and hence increase its output—by a small amount, there would be an increase in the firm’s revenues.
When revenues are at their maximum, marginal revenue is zero. We can confirm this by calculating the elasticity of demand at \$10. Consider a 10 percent increase in price, so the price increases to \$11. At \$10, sales equal 50 units. At \$11, sales equal 45 units. In other words, sales decrease by 5 units, so the decrease in sales is 10 percent. It follows that
Plugging this into our expression for marginal revenue, we confirm that
At \$10, a small change in price leads to no change in revenue. The benefit from selling extra output is exactly offset by the loss from charging a lower price.
Figure \(10\): Marginal Revenue and the Elasticity of Demand
The demand curve can be divided into two parts: at low quantities and high prices, marginal revenue is positive and the demand curve is elastic; at high quantities and low prices, marginal revenue is negative and the demand curve is inelastic.
We can thus divide the demand curve into two parts, as in Figure 7.3.10 "Marginal Revenue and the Elasticity of Demand". At low quantities and high prices, a firm can increase its revenues by moving down the demand curve—to lower prices and higher output. Marginal revenue is positive. In this region, −(elasticity of demand) is a relatively large number (specifically, it is between 1 and infinity) and we say that the demand curve is relatively elastic. Conversely, at high quantities and low prices, a decrease in price will decrease a firm’s revenues. Marginal revenue is negative. In this region, −(elasticity of demand) is between 0 and 1, and we say that the demand curve is inelastic. Table 7.3.3 represents this schematically.
−(Elasticity of Demand) Demand Marginal Revenue Effect of a Small Price Decrease
• > –(elasticity of demand) > 1 Relatively elastic Positive Increase revenues
−(elasticity of demand) = 1 Unit elastic Zero Have no effect on revenues
1 > –(elasticity of demand) > 0 Relatively inelastic Negative Decrease revenues
Table \(3\)
Maximizing Revenues
The market research company advising Ellie made a presentation to her team. The company told them that if they increased their price, they could expect to see a decrease in revenue. At their current price, in other words, marginal revenue was positive. If Ellie’s team wanted to maximize revenue, they would need to recommend a reduction in price: down to the point where marginal revenue is \$0—equivalently, where −(elasticity of demand) = 1.
Some members of Ellie’s team therefore argued that they should try to decrease the price of the product so that they could increase their market share and earn more revenues from the sale of the drug. Ellie reminded them, though, that their goal wasn’t to have as much revenue as possible. It was to have as large a profit as possible. Before they could decide what to do about price, they needed to learn more about the costs of producing the drug
key takeaways
• The demand curve tells a firm how much output it can sell at different prices.
• The elasticity of demand is the percentage change in quantity divided by the percentage change in the price.
• Marginal revenue is the change in total revenue from a change in the quantity sold.
check your understanding
1. Earlier, we saw that the demand curve was
\[quantity\ demanded\ =\ 252 − 300 × price.\]
• Suppose Ellie sets the price at \$0.42. What is the quantity demanded?
• Suppose Ellie sets a price that is 10 percent higher (\$0.462). What is the quantity demanded?
• Confirm that −(elasticity of demand) = 1 when the price is \$0.42.
1. If a firm’s manager wants to choose a price to maximize revenue, is this the same price that would maximize profits?
2. If a demand curve has the same elasticity at every point, does it also have a constant slope? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/07%3A_Where_Do_Prices_Come_From/7.03%3A_The_Revenues_of_a_Firm.txt |
learning objectives
1. What is marginal cost?
2. What costs matter for a firm’s pricing decision?
The goods and services that firms put up for sale don’t appear from nowhere. Firms produce these goods and incur costs as a result. When a marketing manager is thinking about the price that she sets, she must take into account that different prices lead to different levels of production and hence to different costs for the firm.
Your typical image of a firm probably involves a manufacturing process. This could be very simple indeed. For example, there are firms in Malaysia that produce palm oil. A firm in this context is little more than a big piece of machinery in the middle of a jungle of palm trees. The production process is hot, noisy, and very straightforward: (1) laborers harvest palm nuts from the trees surrounding the factory; (2) these palm nuts are crushed, heated, and pressed to extract the oil; and (3) the oil is placed into barrels and then sold. If you wanted to run a palm oil production business in Malaysia, you would need to purchase the following:
• Machine for extracting the oil
• Truck to transport the oil to market
• Generator to power the machinery
• Fuel to power the generator
• Gasoline for the truck
• Labor time from workers—to harvest the nuts, run the machinery, and transport the oil to market
That’s it. It is not difficult to become a palm oil entrepreneur! In this case, it is quite easy to list the main costs of production for the firm.
In other businesses, however, it is much more difficult. Imagine trying to make a similar list for Apple Computer, with all its different products, production plants in different countries, canteens for their workers, pension plans, and so on. Of course, Apple’s accountants still need to develop a list of Apple’s expenses, but they keep their jobs manageable by grouping Apple’s expenditures into various categories. If this were an accounting textbook, we would discuss these categories in detail. Our task here is simpler: we only need to determine how these costs matter for pricing decisions.
Marginal Cost
Earlier, we showed how a firm’s revenues change when there is a change in quantity that the firm produces. If we also know how a firm’s costs change when there is a change in output, we have all the information we need for good pricing decisions. As with revenues, we scale this change by the size of the change in quantity. Figure 7.4.1 "Marginal Cost" shows how marginal cost fits into our road map for the chapter.
Toolkit: Section 31.14 "Costs of Production"
Marginal cost is the change in cost associated with a change in quantity of output produced:
When a firm sets a higher price, it sells a smaller quantity and its costs of production decrease.
Output Total Costs Marginal Cost (\$)
0 50
10
1 60
10
2 70
10
3 80
10
4 90
10
5 100
Table \(1\): Marginal Cost
Table 7.4.1 "Marginal Cost" shows an example of a firm’s costs. It calculates marginal cost in the last column. We have presented this table with marginal cost on separate rows to emphasize that marginal cost is the cost of going from one level of output to the next. In our example, marginal cost—the cost of producing one more unit—is \$10. If you want to produce one unit, it will cost you \$60. If you want to produce two units, your must pay an additional \$10 in costs, for a total of \$70. If you want to produce three units, you must pay the \$70 to produce the first two units, plus the additional marginal cost of \$10, for a total cost of \$80, and so on. Graphically, marginal cost is the slope of the cost line, as shown in Figure 7.4.2 "An Example of a Cost Function".
This graph illustrates the cost function for a firm. In this case, the cost function has the equation cost = 50 + 10 × quantity. The cost of producing each additional unit (the marginal cost) is \$10.
To emphasize again, only those costs that change matter for a firm’s pricing decision. When a firm considers producing extra output, many of its costs do not change. We can completely ignore these costs when thinking about optimal pricing. This is not to say that other costs don’t matter; quite the contrary. They are critical for a different decision—whether the firm should be in business at all.See Chapter 9 "Growing Jobs". But as long as we are interested in pricing, we can ignore them.
The costs for developing pharmaceutical products are typically quite high. The drug that Ellie was responsible for was first developed in research laboratories, then tested on animals, and then run through a number of clinical studies on human patients. These studies were needed before the Food and Drug Administration in the United States, and equivalent drug safety organizations in other countries, would approve the drug for sale. But these development costs have no effect on marginal cost because they were all incurred before a single pill could be sold.
Surprisingly, this means that even though the drug was very expensive to develop, Ellie’s team—quite correctly—paid no attention to that fact. In determining what price to set, they looked at the price sensitivity of their customers and at marginal cost. They understood that the development costs of the drug were not relevant to the pricing decision. In fact, Ellie’s team had only a very vague idea how much the drug had cost to develop: after all, that development had been carried out by a completely different arm of the company in other parts of the world.
You will often hear the opposite argument. It is common for people to say that pharmaceutical companies charge high prices because it costs so much to develop their drugs. This argument is superficially appealing, but it is completely backward. Pharmaceutical companies don’t charge high prices because they incur large development costs. They are willing to incur large development costs because they can charge high prices.
Estimating Marginal Cost
Estimating marginal cost is generally much easier than estimating demand because the cost side of the business is largely under the control of the firm. The firm’s costs depend on its technology and the decisions made about using that technology. In most medium- or large-sized firms, there is an “operations department” that takes care of the production process. The marketing manager ought to be able to consult with her colleagues in operations and learn about the costs of the firm. Most importantly, even if it is unreasonable to expect an operations manager to know the firm’s entire cost function, the operations manager should have a good idea about marginal cost (that is, should know how much it would cost per unit to scale up operations by a small amount). And that is the information the marketing manager needs for her pricing decisions.
key takeaways
• Marginal cost measures the additional costs from producing an extra unit of output.
• It is only the change in costs—marginal cost—that matter for a firm’s pricing decision.
checking your understanding
If the marginal cost in Table 7.4.1 "Marginal Cost" were \$20, what would be the cost of producing 10 units of the good? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/07%3A_Where_Do_Prices_Come_From/7.04%3A_The_Costs_of_a_Firm.txt |
learning objectives
1. What is the optimal price for a firm?
2. What is markup?
3. What is the relationship between the elasticity of demand and markup?
Let us review the ideas we have developed in this chapter. We know that changes in output lead to changes in both revenues and costs. Changes in revenues and costs lead to changes in profits (see Figure 7.5.1 "Changes in Revenues and Costs Lead to Changes in Profits"). We have a measure of how much revenues change if output is increased—called marginal revenue, which you can calculate if you know price and the elasticity of demand. We also have a measure of how much costs change if output is increased—this is called marginal cost. Given information on current marginal revenue and marginal cost, a marketing manager can then decide if a firm should change its price. In this section, we derive a rule that tells us how a manager should make this decision.
When a firm changes its price, this leads to changes in revenues and costs. The change in a firm’s profit is equal to the change in revenue minus the change in cost—that is, the change in profit is marginal revenue minus marginal cost. When marginal revenue equals marginal cost, the change in profit is zero, so a firm is at the top of the profit hill.
In the real world of business, firms almost always choose the price they set rather than the quantity they produce. Yet the pricing decision is easier to analyze if we think about it the other way round: a firm choosing what quantity to produce and then accepting the price implied by the demand curve. This is just a matter of convenience: a firm chooses a point on the demand curve, and it doesn’t matter if we think about it choosing the price and accepting the implied quantity or choosing the quantity and accepting the implied price ( Figure 7.5.2 "Setting the Price or Setting the Quantity").
It doesn’t matter if we think about choosing the price and accepting the implied quantity or choosing the quantity and accepting the implied price
Suppose that a marketing manager has estimated the elasticity of demand, looked at the current price, and used the marginal revenue formula to discover that the marginal revenue is \$5. This means that if the firm increases output by one unit, its revenues will increase by \$5. The marketing manager has also spoken to her counterpart in operations, who has told her that the marginal cost is \$3. This means it would cost an additional \$3 to produce one more unit. From these two pieces of information, the marketing manager knows that an increase in output would be a good idea. An increase in output leads to a bigger increase in revenues than in costs. As a result, it leads to an increase in profits: specifically, profits will increase by \$2. This tells the marketing manager that it is a good idea to increase output. From the law of demand, she should think about decreasing the price.
To the left of the point marked “profit-maximizing quantity,” marginal revenue exceeds marginal cost so increasing output is a good idea. The opposite is true to the right of that point.
Figure 7.5.3 "Optimal Pricing" shows this idea graphically. To the left of the point marked “profit-maximizing quantity,” marginal revenue exceeds marginal cost. Suppose a firm is producing below this level. If it increases its output, the extra revenue it obtains will exceed the extra cost. We see that an increase in output yields extra revenue equal to the areas A + B and extra costs equal to B. The increase in output yields extra profit, which is equal to A. Increasing its output is thus a good idea. Conversely, to the right of the profit-maximizing point, marginal revenue is less than marginal cost. If a firm reduces its output, the decrease in costs (C + D) exceeds the decrease in revenue (D). Decreases in output lead to increases in profit.
Profits are greatest when
\[marginal\ revenue\ =\ marginal\ cost.\]
This is the point where a change in price leads to no change in profits, so we are at the very top of the profit hill that we drew in Figure 7.2.3 "The Profits of a Firm". See also Figure 7.5.2 "Setting the Price or Setting the Quantity".
The Markup Pricing Formula
Think about Ellie’s company. If it became more expensive for the company to produce each pill, it seems likely they would respond by raising their costs. Also, we said earlier that their customers are not very sensitive to changes in the price, which should allow them to set a relatively high price. In other words, the profit-maximizing price is related to the elasticity of demand and to marginal cost. These are the two critical ingredients of the pricing decision.
Toolkit: Section 31.15 "Pricing with Market Power"
Firms should set the price as a markup over marginal cost: This expression comes from combining the formula for marginal revenue and the condition that marginal revenue equals marginal cost. See the toolkit for more details.
and
There are three facts about markup:
1. Markup is greater than or equal to zero—that is, the firm never sets a price below marginal cost.
2. Markup is smaller when demand is more elastic.
3. Markup is zero when the demand curve is perfectly elastic: −(elasticity of demand) = •.
Ellie’s team looked at their numbers. At the current price, −(elasticity of demand) = 1.47. They learned that the marginal cost was \$0.28 per pill, and they were charging \$0.50 per pill. Their current markup, in other words, was about 79 percent: 0.5 = (1+ 0.79) × 0.28. But if they applied the markup pricing formula based on the current elasticity of demand, they could charge a markup of 1/0.47 = 2.12—that is, more than a 200 percent markup, leading to a price of \$0.87. It was clear that they could do better by increasing their price
A Pricing Algorithm
To summarize, a manager needs two key pieces of information when determining price:
1. Marginal cost. We have shown that the profit-maximizing price is a markup over the marginal cost of production. If a manager does not know the magnitude of marginal cost, she is missing a critical piece of information for the pricing decision.
2. Elasticity of demand. Once a manager knows marginal cost, she should then set the price as a markup over marginal cost. But this should not be done in an ad hoc manner; the markup must be based on information about the elasticity of demand.
Given these two pieces of information, a manager can then use the markup formula to determine the optimal price. Be careful, though. The markup formula looks deceptively simple, as if it can be used in a “plug-and-play” manner—given marginal cost and the elasticity of demand, plug them into the formula and calculate the optimum price. But if you change the price, both marginal cost and the elasticity of demand are also likely to change. A more reliable way of using this formula is in the algorithm shown in Figure 7.5.4 "A Pricing Algorithm", which is based on our earlier idea that you should find your way to the top of the profit hill. The five steps are as follows:
1. At your current price, estimate marginal cost and the elasticity of demand.
2. Calculate the optimal price based on those values.
3. If the optimal price is greater than your actual price, increase your price. Then estimate marginal cost and the elasticity again and repeat the process.
4. If the optimal price is less than your actual price, decrease your price. Then estimate marginal cost and the elasticity again and repeat the process.
5. If the current price is equal to this optimal price, leave your price unchanged.
This pricing algorithm shows how to get the best price for a product.
Ellie’s team members were aware that, even though demand for the drug was apparently not very sensitive to price, they should not immediately jump to a much higher markup. They had found that based on current marginal cost and elasticity, the price could be raised. But as they raised the price, they knew that the elasticity of demand would probably also change. Looking more closely at their market research data, they found that at a price of \$0.56 (a 100 percent markup), the elasticity of demand would increase to about 2. An elasticity of 2 means that the markup should be 100 percent to maximize profits. Thus—at least if their market research data were reliable—they knew that a price of \$0.56 would maximize profits. Ellie recommended to senior management that the price of the drug be raised by slightly over 10 percent, from \$0.50 per pill to \$0.56 per pill.
Shifts in the Demand Curve Facing a Firm
So far we have looked only at movements along the demand curve—that is, we have looked at how changes in price lead to changes in the quantity that customers will buy. Firms also need to understand what factors might cause their demand curve to shift. Among the most important are the following:
• Changes in household tastes. Starting around 2004 or so, low-carbohydrate diets started to become very popular in the United States and elsewhere. For some companies, this was a boon; for others it was a problem. For example, companies like Einstein Bros. Bagels or Dunkin’ Donuts sell products that are relatively high in carbohydrates. As more and more customers started looking for low-carb alternatives, these firms saw their demand curve shift inward.
• Business cycle. Consider Lexus, a manufacturer of high-end automobiles. When the economy is booming, sales are likely to be very good. In boom times, people feel richer and more secure and are more likely to purchase a luxury car. But if the economy goes into recession, potential car buyers will start looking at cheaper cars or may decide to defer their purchase altogether. Many companies sell products that are sensitive to the state of the business cycle. Their demand curves shift as the economy moves from boom to recession.
• Changes in competitors’ prices. In a business setting, this is a critical concern. If a competitor decreases its price, this means that the demand curve you face will shift inward. For example, suppose that British Airways decides to decrease its price for flights from New York to London. American Airlines will find that its demand curve for that route has shifted inward. Ellie certainly has to worry about this because her company’s product has only a small number of competitors. A change in price of a competing blood pressure drug might make a big difference in the sales and profits of Ellie’s product.
If the demand curve shifts, should a firm change its price? The answer is yes if the shift in the demand curve also leads to a change in the elasticity of demand. In practice, this is likely to be the case, although it is certainly possible for a demand curve to shift without a change in the elasticity of demand. The correct response to a shift in the demand curve is to reestimate the elasticity of demand and then decide if a change in price is appropriate.
Complications
Pricing is a difficult and delicate job, and there are many factors that we have not yet considered:We address some of them in other chapters of the book; others are topics for more advanced classes in economics and business strategy.
• By far the most important problem that we have neglected is as follows: When making pricing decisions, firms may need to take into account how other firms will respond to their decisions. For example, a manager might estimate her firm’s elasticity of demand and marginal cost and determine that she could make more money by decreasing price. That calculation presumes that competing firms keep their prices unchanged. In markets with a small number of competitors, it is instead quite likely that other firms would respond by decreasing their prices. This would cause a firm’s demand curve to shift inward and probably leave it worse off than before.
• We have assumed throughout that a firm has to charge the same price for every unit that it sells. In many cases, this is an accurate description of pricing behavior. When a grocery store posts a price, that price holds for every unit on the shelf. But sometimes firms charge different prices for different units—by either charging different prices to different customers or offering individual units at different prices to the same customer. You have undoubtedly encountered examples. Firms sometimes offer quantity discounts, so the price is lower if you buy more units. Sometimes they offer discounts to certain groups of customers, such as cheap movie tickets for students. We could easily fill an entire chapter with other examples—some of which are remarkably sophisticated.
• Firms can have pricing strategies that call for the price to change over time. For example, firms sometimes engage in a strategy known as penetration pricing, whereby they start off by charging a low price in an attempt to develop or expand the market. Imagine that Kellogg’s develops a new breakfast cereal. It might decide to offer the cereal at a low price to induce people to try the product. Only after it has developed a group of loyal customers would it start setting their prices according to the markup principle.
• Pricing plays a role in the overall marketing and branding strategy of a firm. Some firms position themselves in the marketplace as suppliers of high-end offerings. They may choose to set high prices for their products to ensure that customers perceive them appropriately. Consider a luxury hotel that is contemplating setting a very low price in the off-season. Even though such a strategy might make sense in terms of its profits at that time, it might do long-term damage to the hotel’s reputation. For various reasons, customers often use the price of a product as an indicator of that product’s quality, so a low price can adversely affect a firm’s image.
• Psychologists who study marketing have found that demand is sensitive at certain price points. For example, if a firm increases the price of a product from \$99.98 to \$99.99, there might be very little effect on demand. But if the price increases from \$99.99 to \$100.00, there might be a much bigger effect because \$100.00 is a psychological barrier. Such consumer behavior does not seem completely rational, but there is little doubt that it is a real phenomenon.
• Throughout this chapter, we have said that there is no difference between a firm choosing its price and taking as given the implied quantity or choosing its quantity and taking as given the implied price. Either way, the firm is picking a point on the demand curve. This is true, but there is a footnote that we should add. A firm’s demand curve depends on what its competitors are doing and, oddly enough, it does make a difference if those competitors are choosing quantities or prices.See Chapter 15 "Busting Up Monopolies" for discussion of this. We should also note that firms often do not know their demand curves with complete certainty. Suppose, for example, that the true demand curve for a firm’s product is actually further outward than a firm expects. If the firm sets the price, it will end up with an unexpectedly large quantity being demanded. If the firm sets the quantity, it will end up with an unexpectedly high price.
• We have focused our attention on the market power of firms as sellers, as reflected in the downward-sloping demand curves they face. Firms can also have market power as buyers. Walmart is such an important customer for many of its suppliers that it can use its position to negotiate lower prices for the goods it buys. Governments are also often powerful buyers and may be able to influence the prices they pay for goods and services. For example, government-run health-care systems may be able to negotiate favorable prices with pharmaceutical companies.
key takeaways
• At the profit-maximizing price, marginal revenue equals marginal cost.
• Markup is the difference between price and marginal cost, as a percentage of marginal cost.
• The more elastic the demand curve faced by a firm, the smaller the markup.
check your understanding
1. We said that markup is always greater than zero. Look at the formula for markup. If markup is greater than zero, what must be true about −(elasticity of demand)? Can you see why this must be true? Look back at Figure 7.3.10 "Marginal Revenue and the Elasticity of Demand" for a hint.
2. If price is a markup over marginal cost, then how does marginal revenue influence the pricing decision of a firm?
3. Starting at the profit-maximizing price, if a firm increases its price, could revenue increase? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/07%3A_Where_Do_Prices_Come_From/7.05%3A_Markup_Pricing-_Combining_Marginal_Revenue_and_Marginal_Cost.txt |
learning objectives
1. What is a perfectly competitive market?
2. In a perfectly competitive market, what does the demand curve faced by a firm look like?
3. What happens to the pricing decision of a firm in a perfectly competitive market?
In this chapter, we have paid a great deal of attention to demand, but we have not spoken of supply. There is a good reason for this: a firm with market power does not have a supply curve. A supply curve for a firm tells us how much output the firm is willing to bring to market at different prices. But a firm with market power looks at the demand curve that it faces and then chooses a point on that curve (a price and a quantity). Price, in this chapter, is something that a firm chooses, not something that it takes as given. What is the connection between our analysis in this chapter and a market supply curve?
Perfectly Competitive Markets
If you produce a good for which there are few close substitutes, you have a great deal of market power. Your demand curve is not very elastic: even if you charge a high price, people will be willing to buy the good. On the other hand, if you are the producer of a good that is very similar to other products on the market, then your demand curve will be very elastic. If you increase your price even a little, the demand for your product will decrease a lot.
The extreme case is called a perfectly competitive market. In a perfectly competitive market, there are numerous buyers and sellers of exactly the same good. The standard examples of perfectly competitive markets are those for commodities, such as copper, sugar, wheat, or coffee. One bushel of wheat is the same as another, there are many producers of wheat in the world, and there are many buyers. Markets for financial assets may also be competitive. One euro is a perfect substitute for another, one three-month US treasury bill is a perfect substitute for another, and there are many institutions willing to buy and sell such assets.
Toolkit: Section 31.9 "Supply and Demand"
You can review the market supply curve and the definition of a perfectly competitive market in the toolkit.
An individual seller in a competitive market has no control over price. If the seller tries to set a price above the going market price, the quantity demanded falls to zero. However, the seller can sell as much as desired at the market price. When there are many sellers producing the same good, the output of a single seller is tiny relative to the whole market, and so the seller’s supply choices have no effect on the market price. This is what we mean by saying that the seller is “small.” It follows that a seller in a perfectly competitive market faces a demand curve that is a horizontal line at the market price, as shown in Figure 7.6.1 "The Demand Curve Facing a Firm in a Perfectly Competitive Market". This demand curve is infinitely elastic: −(elasticity of demand) = ∞. Be sure you understand this demand curve. As elsewhere in the chapter, it is the demand faced by an individual firm. In the background, there is a market demand curve that is downward sloping in the usual way; the market demand and market supply curves together determine the market price. But an individual producer does not experience the market demand curve. The producer confronts an infinitely elastic demand for its product.
Figure \(1\): The Demand Curve Facing a Firm in a Perfectly Competitive Market
The demand curve faced by a firm in a perfectly competitive market is infinitely elastic. Graphically, this means that it is a horizontal line at the market price.
Everything we have shown in this chapter applies to a firm facing such a demand curve. The seller still picks the best point on the demand curve. But because the price is the same everywhere on the demand curve, picking the best point means picking the best quantity. To see this, go back to the markup formula. When demand is infinitely elastic, the markup is zero:
so price equals marginal cost:
\[price\ =\ (1 + markup) × marginal\ cost\ =\ marginal\ cost.\]
This makes sense. The ability to set a price above marginal cost comes from market power. If you have no market power, you cannot set a price in excess of marginal cost. A perfectly competitive firm chooses its level of output so that its marginal cost of production equals the market price.
We could equally get this conclusion by remembering that
marginal revenue = marginal cost
and that when −(elasticity of demand) is infinite, marginal revenue equals price. If a competitive firm wants to sell one more unit, it does not have to decrease its price to do so. The amount it gets for selling one more unit is therefore the market price of the product, and the condition that marginal revenue equals marginal cost becomes
price = marginal cost.
For the goods and services that we purchase regularly, there are few markets that are truly perfectly competitive. Often there are many sellers of goods that may be very close substitutes but not absolutely identical. Still, many markets are close to being perfectly competitive, in which case markup is very small and perfect competition is a good approximation.
The Supply Curve of a Firm
Table 7.6.1 "Costs of Production: Increasing Marginal Cost" shows the costs of producing for a firm. In contrast to Table 7.4.1 "Marginal Cost", where we supposed marginal cost was constant, this example has higher marginal costs of production when the level of output is greater.Total cost in Table 7.6.1 "Costs of Production: Increasing Marginal Cost" is 50 + 10 × quantity + 2 × quantity2.
Output Total Costs (\$) Marginal Cost (\$)
1 22 12
2 38 16
3 58 20
4 82 24
5 110 28
Table \(1\): Costs of Production: Increasing Marginal Cost
Figure 7.6.2 "The Supply Curve of an Individual Firm" shows how we derive the supply curve of an individual firm given such data on costs. The supply curve tells us how much the firm will produce at different prices. Suppose, for example, that the price is \$20. At this price, we draw a horizontal line until we reach the marginal cost curve. At that point, we draw a vertical line to the quantity axis. In this way, you can find the level of output such that marginal cost equals price. Looking at the figure, we see that the firm should produce 3 units because the marginal cost of producing the third unit is \$20. When the price is \$30, setting marginal cost equal to price requires the firm to produce 5.5 units. When the price is \$40, setting marginal cost equal to price requires the firm to produce 8 units.
The supply curve shows us the quantity that a firm will produce at different prices. Figure 7.6.2 "The Supply Curve of an Individual Firm" reveals something remarkable: the individual supply curve of the firm is the marginal cost curve. They are the same thing. As the price a firm faces increases, it will produce more. Note carefully how this is worded. We are not saying that if a firm produces more, it will charge a higher price. Firms in a competitive market must take the price as given. Instead, we think about the response of a firm to a change in the price.The individual firm’s supply curve is an exact counterpart to something we show in Chapter 4 "Everyday Decisions", where we derive the demand curve for an individual. We show that an individual buys a good up to the point where marginal valuation equals price. From this we can conclude that the demand curve for an individual is the same as the individual’s marginal valuation curve. In Chapter 8 "Why Do Prices Change?", we use an individual firm’s supply curve as the basis for the market supply curve. Likewise, we use the individual demand curve as the basis for the market demand curve. By combining these curves, we obtain the supply-and-demand framework, which we can use to understand changing prices in an economy.
The firm chooses its quantity such that price equals marginal cost, which implies that the marginal cost curve of the firm is the supply curve of the firm.
key takeaways
• A perfectly competitive market has a large number of buyers and sellers of exactly the same good.
• In a perfectly competitive market, an individual firm faces a demand curve with infinite elasticity.
• In a perfectly competitive market, the firm does not set a price but chooses a level of output such that marginal cost equals the market price.
check your understanding
1. Explain why the demand curve a firm faces in a perfectly competitive market is horizontal even though the market demand curve is not horizontal.
2. Why is the cost of one unit \$60 in Table 7.4.1 "Marginal Cost" but only \$22 in Table 7.6.1 "Costs of Production: Increasing Marginal Cost"? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/07%3A_Where_Do_Prices_Come_From/7.06%3A_The_Supply_Curve_of_a_Competitive_Firm.txt |
In Conclusion
Choosing the right price is one of the hardest problems that a manager faces. It is also one of the most consequential: few other decisions have such immediate impact on the health and success of a firm. It is hardly surprising that firms devote considerable resources to deciding on the price to set. Even though firms operate in many different market settings, our analysis of markup pricing is very general: it applies to firms in all sorts of different circumstances. It is thus a powerful tool for understanding the behavior of firms in an economy.
One goal of this textbook is to help you make good decisions, both in your everyday life and in your future careers. In this chapter, we have set out the principles of how prices should be set, assuming that the goal of a manager is to make as much profit for a firm as possible. It does not necessarily follow, however, that this is how managers actually behave in real life. Does this chapter just describe a make-believe world of economists or does it also describe how prices are set in the real business world?
The answer is a bit of both. Managers must think carefully about costs and demand when setting prices. Market research firms routinely investigate consumers’ price sensitivities and estimate elasticities. At the same time, pricing decisions are sometimes more haphazard than this chapter might suggest. In practice, managers often use rules of thumb or standard markups that are not necessarily solidly based on the elasticity of demand.
There is one reason to think that managers do not stray too far from the prices that maximize their firms’ profits, however. Business is a competitive affair, and firms that make poor decisions will often not survive in the marketplace. If a firm consistently sets the wrong price, it will make less money than its competitors and will probably be forced out of business or taken over by another firm that can do a better job of management. The marketplace imposes a harsh discipline on badly managed firms, but the end result is—usually at least—a more efficient and better-functioning economy.
exercises
1. We suggested that a grocery store could conduct an experiment to find a demand curve by charging a different price each week for some product.
1. Do you think that technique would be more accurate for a perishable good, such as milk, or for a nonperishable good, such as canned tuna? Why?
2. Do you think the technique would be more accurate if the firm announced the price each week in advance or if it just let customers discover the different prices when they came to the store? Why?
2. Extend Table 7.6.1 "Costs of Production: Increasing Marginal Cost" for output levels 6–10. What does Table 7.6.1 "Costs of Production: Increasing Marginal Cost" look like if the fixed cost is \$100?
3. Suppose your company is selling a product that is an inferior good. What do you think will happen to the demand curve facing your firm when the economy goes into recession?
4. Suppose you are a producer of DVDs and imagine that producers of DVD players decrease their prices. What do you think will happen to the demand curve you face?
5. If you were running a fast-food restaurant, what factors would you take into account in setting a price for burgers?
6. Suppose a monopolist could produce an extra unit at zero marginal cost and, at the current price, faces a demand curve with an −(elasticity of demand) of 2. Should the monopolist raise or lower its price to make more profit?
7. Suppose that instead of maximizing profit, the monopolist in Question 6 wants to maximize revenues. Would it behave any differently? What if the marginal cost was positive?
8. If the price of steak is \$25.00 a pound and the −(elasticity of demand) is 2, what decrease in price would lead the quantity sold to increase by 4 percent?
9. Explain why marginal revenue must be less than the price when a firm faces a downward-sloping demand curve.
10. A monopolist is maximizing profit. Perhaps due to an innovation in some other product line, he finds that the elasticity of demand for his product is lower. What will this change in the elasticity of demand due to the profit of the monopolist? How will the monopolist respond to this change?
11. The following is an excerpt from an article in the Singaporean newspaper, the Straits Times:
Singaporeans with a sweet tooth could soon find themselves paying more for their favourite treats, as bakers and confectioners buckle under soaring sugar prices.
Since March last year, the price of white sugar has shot up by 70 per cent, according to the New York Board of Trade. As if that didn’t make life difficult enough for bakers, butter and cheese prices have also risen, by 31 per cent and 17 per cent respectively.
The increases have been caused by various factors: a steep drop in Thailand’s sugarcane production due to drought, higher sea freight charges, increasing demand from China’s consumers for dairy products and the strong Australian and New Zealand dollar.
For the consumer in Singapore, what this may eventually boil down to is a more expensive bag of cookies, with prices at some bakeries expected to rise between 10 and 20 per cent.
[The owner of a Singapore bakery, Mr. Leong Meng Pock], said that he intends to raise prices possibly as early as next month. A sugared doughnut at his shop sells for 50 cents [about US\$0.30] and a slice of Black Forest cake for \$1.80 [about US\$1.13], prices that have remained unchanged since 1990. Next month, the doughnuts may go up to 60 cents and the Black Forest cake to \$2.
Said Mr Leong: “In Singapore, you have bread and cake prices that are at least 10 years old. This is especially true for the HDB [government-subsidized housing] neighborhoods, where customers are very price-sensitive.”See http://straitstimes.asia1.com.sg.
1. Do you think bakers face a demand curve that is relatively elastic or relatively inelastic? Why?
2. What has happened to their marginal cost?
12. Explain the difference between a shift in the demand curve and movement along a demand curve.
13. If you observe the price of a product, then you can infer the marginal cost of the product if and only if the market is competitive. Explain.
Spreadsheet Exercise
1. Suppose that the cost function for a product is given by total costs = 100 + 2,000 × quantity. Create a spreadsheet to calculate the costs for different levels of output and use it to produce a graph like Figure 7.5.1 "Changes in Revenues and Costs Lead to Changes in Profits".
Economics Detective
1. What prices are your local gas stations currently charging for gas? Do the stations generally have the same price for gas? If not, what would explain the differences in prices they set? Do the stations charge the same price all the time or does the price change? When the price changes, what might be the reason for that change?
2. Think about the college you are attending. What determines the profit of the college—what are its revenues and what are its costs? What is tuition at your college? Would you advocate an increase or a decrease in tuition rates to increase revenue at your college? What factors determine the elasticity of demand faced by your college? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/07%3A_Where_Do_Prices_Come_From/7.07%3A_End-of-Chapter_Material.txt |
Thumbnail: https://www.pexels.com/photo/photo-of-discount-sign-2529787/
08: Why Do Prices Change
Here are two recent headlines. The first discusses beer prices in England.
Price of a Pint “Could Rise 60%”
The average price of a pint of beer could hit £4 [about \$8]…
Scottish & Newcastle today forecast “material price increases” next year. The brewer, which sells three of the top 10 beer brands in Europe including Kronenbourg and Foster’s, is also reviewing its supply chain in a bid to cut costs.
Industry experts say the cost of an average pint will rise by at least 15p, although some are now predicting rises of up to 60%.…
“It is a bleak time for everyone,” said Iain Lowe, research and information manager at Camra [The Campaign for Real Ale]. “These price rises have been predicted for a long time.”Teena Lyons, “The Price of a Pint Could Rise 60%,” Guardian Unlimited, November 20, 2007, accessed January 27, 2011, http://www.guardian.co.uk/business/2007/nov/20/fooddrinks.foodanddrink?gusrc=rss&feed=networkfront.
The second concerns sales of baseball merchandise in Detroit at the start of the 2010 season.
Tigers’ Merchandise Off to Roaring Start
Opening Day is still a day away for Detroit’s baseball fans, but its impending arrival already is generating its share of Detroit Tiger retail hits.
Thousands of fans have flooded Comerica Park’s pro shop and other Metro Detroit sporting outlets in anticipation of Friday afternoon’s home game against the Cleveland Indians, snapping up Tigers jerseys, T-shirts and hats bearing the surnames Cabrera, Verlander and Damon, even Granderson—Tigers old and new.
Though it’s too soon to tell which Tigers will prove most popular at the checkout line, former players have been relegated to the discount bin.
“Retailers take a pretty aggressive stand,” Powell said. Most shops have marked down jerseys and T-shirts branded with ex-Tigers between 25 and 50 percent.
“Granderson and Polanco—we discount the price,” said Brian King, owner of Sports Authentics in Rochester Hills. “Unfortunately, you can’t take the names off the back.”“Tigers’ Merchandise off to Roaring Start,” The Detroit News, April 8, 2010, accessed January 27, 2011, http://www.detnews.com/article/20100408/BIZ/4080349/1129/Tigers-merchandise-off-to-roaring-start.
We could have picked thousands of other examples. If you search Google’s news aggregator on any day with a string such as “an increase in the price of” you will find dozens, perhaps hundreds, of recent news articles that contain this phrase. Our task in this chapter is to see where all these price changes come from and what they imply for other economic variables, such as the quantity of these goods traded.
To see how good you are at this, think about these two stories. Can you explain why the price of beer increased? Can you explain why “Granderson” T-shirts are being sold at discounted prices? What do you think happened to the quantity of beer sold as the price increased? What do you think happened to the quantity of T-shirts sold as the price decreased?
Understanding the sources and consequences of changing prices in the economy is one of the most important tasks of an economist. There is an almost endless list of such analyses in economics. In fact, most of the applications in this textbook ultimately come down to understanding, explaining, and predicting changes in prices. The question that motivates this chapter is so important that we have chosen it as the title:
Why do prices change?
Road Map
All prices in the economy are ultimately chosen by someone. Sometimes they are chosen by marketing or pricing managers in big companies. Sometimes they are chosen by bidders in an auction. Sometimes they are agreed on by the buyer and the seller after bargaining. We discuss these choices in Chapter 6 "eBay and craigslist" and Chapter 7 "Where Do Prices Come From?". Yet we can often make good predictions about prices without looking closely at the individual decision making of buyers and sellers by summarizing their decisions with demand curves and supply curves. Building on the ideas of the individual demand curve and a firm’s supply curve for a good or service, we develop the ideas of supply and demand for an entire market. Individual demand and supply curves are introduced in Chapter 4 "Everyday Decisions" and Chapter 7 "Where Do Prices Come From?". In this chapter, we look at the trade that occurs between firms and households or among different firms in the economy. In the business world, these are called business-to-consumer (B2C) and business-to-business (B2B) trade, respectively. The market demand and supply curves that we derive allow us to predict what will happen to prices and quantities traded when there are changes that influence the market. Chapter 6 "eBay and craigslist" also looks at supply and demand in the context of trade between individuals.
An old joke says that you can ask an economist any question, and he will always give the same answer: supply and demand. Yet—strictly speaking—we are supposed to use the supply-and-demand framework only when we are talking about a competitive market—a market in which a homogeneous good is traded by a large number of buyers and sellers. In practice, economists and others use the framework all the time in settings where these assumptions do not hold. Perhaps surprisingly, this can be a completely reasonable thing to do, and we explain why.
Once we understand why prices change, we consider the implications of these price changes for the functioning of the economy. Prices convey information to both producers and consumers. When the price of a good or a service increases, it encourages consumers to consume less and producers to produce more. As we will see, this means that prices play a crucial role in allocating resources in the economy.
We finish this chapter by looking at three very significant markets in the economy: the labor market, the credit market, and the foreign exchange market. Understanding how these three markets work is necessary for a good understanding of both microeconomics and macroeconomics. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/08%3A_Why_Do_Prices_Change/8.01%3A_Prices_in_the_News.txt |
learning objectives
1. How is the market demand curve derived?
2. What is the slope of the market demand curve?
3. How is the market supply curve derived?
4. What is the slope of the market supply curve?
5. What is the equilibrium of a perfectly competitive market?
We begin the chapter with the individual demand curve—sometimes also called the household demand curve—that is based on an individual’s choice among different goods. (In this chapter, we use the terms individual and household interchangeably.) We show how to build the market demand curve from these individual demand curves. Then we do the same thing for supply, showing how to build a market supply curve from the supply curves of individual firms. Finally, we put them together to obtain the market equilibrium.
Market Demand
Figure 8.2.1 "The Demand Curve of an Individual Household" is an example of a household’s demand for chocolate bars each month. Taking the price of a chocolate bar as given, as well as its income and all other prices, the household decides how many chocolate bars to buy. Its choice is represented as a point on the household’s demand curve. For example, at \$5, the household wishes to consume five chocolate bars each month. The remainder of the household income—which is its total income minus the \$25 it spends on chocolate—is spent on other goods and services. If the price decreases to \$3, the household buys eight bars every month. In other words, the quantity demanded by the household increases. Equally, if the price of a chocolate bar increases, the quantity demanded decreases. This is the law of demand in operation.
One way to summarize this behavior is to say that the household compares its marginal valuation from one more chocolate bar to price. The marginal valuation is a measure of how much the household would like one more chocolate bar. The household will keep buying chocolate bars up to the point where
\[marginal\ valuation\ =\ price.\]
Toolkit: Section 31.1 "Individual Demand"
You can review the foundations of individual demand and the idea of marginal valuation in the toolkit.
The household demand curve shows the quantity of chocolate bars demanded by an individual household at each price. It has a negative slope: higher prices lead people to consume fewer chocolate bars.
Price (\$) Household 1 Demand Household 2 Demand Market Demand
1 17 10 27
3 8 3 11
5 5 2 7
7 4 1.5 5.5
Table \(1\): Individual and Market Demand
In most markets, many households purchase the good or the service traded. We need to add together all the demand curves of the individual households to obtain the market demand curve. To see how this works, look at Table 8.2.1 "Individual and Market Demand" and Figure 8.2.2 "Market Demand". Suppose that there are two households. Part (a) of Figure 8.2.2 "Market Demand" shows their individual demand curves. Household 1 has the demand curve from Figure 8.2.1 "The Demand Curve of an Individual Household". Household 2 demands fewer chocolate bars at every price. For example, at \$5, household 2 buys 2 bars per month; at \$3, it buys 3 bars per month. To get the market demand, we simply add together the demands of the two households at each price. For example, when the price is \$5, the market demand is 7 chocolate bars (5 demanded by household 1 and 2 demanded by household 2). When the price is \$3, the market demand is 11 chocolate bars (8 demanded by household 1 and 3 demanded by household 2). When we carry out the same calculation at every price, we get the market demand curve shown in part (b) of Figure 8.2.2 "Market Demand".
Toolkit: Section 31.9 "Supply and Demand"
You can review the market demand curve in the toolkit.
Market demand is obtained by adding together the individual demands of all the households in the economy.
Because the individual demand curves are downward sloping, the market demand curve is also downward sloping: the law of demand carries across to the market demand curve. As the price decreases, each household chooses to buy more of the product. Thus the quantity demanded increases as the price decreases. Although we used two households in this example, the same idea applies if there are 200 households or 20,000 households. In principle, we could add together the quantities demanded at each price and arrive at a market demand curve.
There is a second reason why demand curves slope down when we combine individual demand curves into a market demand curve. Think about the situation where each household has a unit demand curve: that is, each individual buys at most one unit of the product. As the price decreases, the number of individuals electing to buy increases, so the market demand curve slopes down.See Chapter 4 "Everyday Decisions" and Chapter 6 "eBay and craigslist" for discussions of unit demand. In general, both mechanisms come into play.
• As price decreases, some households decide to enter the market; that is, these households buy some positive quantity other than zero.
• As price decreases, households increase the quantity that they wish to purchase.
When the price decreases, there are more buyers, and each buyer buys more.
Market Supply
In a competitive market, a single firm is only one of the many sellers producing and selling exactly the same product. The demand curve facing a firm exhibits perfectly elastic demand, which means that it sets its price equal to the price prevailing in the market, and it chooses its output such that this price equals its marginal cost of production.At the end of Chapter 7 "Where Do Prices Come From?", we derive the supply curve of a firm in a competitive market. If it were to try to set a higher price, it could not sell any output at all. If it were to set a lower price, it would be throwing away profits. Thus, for a competitive firm, the quantity produced satisfies this condition:
\[price\ =\ marginal\ cost.\]
Toolkit: Section 31.2 "Elasticity"
For more information on elasticity, see the toolkit.
We typically expect that marginal cost will increase as a firm produces more output. Marginal cost is the cost of producing one extra unit of output. The cost of producing an additional unit of output generally increases as firms produce a larger and larger quantity. In part, this is because firms start to hit constraints in their capacities to produce more product. For example, a factory might be able to produce more output only by running extra shifts at night, which require paying higher wages.
If marginal cost is increasing, then we know the following:
• Given a price, there is only one level of output such that price equals marginal cost.
• As the price increases, a firm will produce more.
Indeed, the supply curve of an individual firm is the same as its marginal cost curve.
Figure 8.2.3 "The Supply Curve of an Individual Firm" illustrates the supply curve for a firm. A firm supplies seven chocolate bars at \$3 and eight chocolate bars at \$5. From this we can deduce that the marginal cost of producing the seventh chocolate bar is \$3. Similarly, the marginal cost of producing the eighth chocolate bar is \$5.
A firm’s supply curve, which is the same as its marginal cost curve, shows the quantity of chocolate bars it is willing to supply at each price.
Just as the market demand curve tells us the total amount demanded at each price, the market supply curve tells us the total amount supplied at each price. It is obtained analogously to the market demand curve: at each price we add together the quantity supplied by each firm to obtain the total quantity supplied at that price. If we perform this calculation for every price, then we get the market supply curve. Figure 8.2.4 "Market Supply" shows an example with two firms. At \$3, firm 1 produces 7 bars, and firm 2 produces 3 bars. Thus the total supply at this price is 10 chocolate bars. At \$5, firm 1 produces 8 bars, and firm 2 produces 5 bars. Thus the total supply at this price is 13 chocolate bars.
The market supply curve is increasing in price. As price increases, each firm in the market finds it profitable to increase output to ensure that price equals marginal cost. Moreover, as price increases, firms who choose not to produce and sell a product may be induced to enter into the market.A similar idea is in Chapter 6 "eBay and craigslist", where we show how to add together unit supply curves to obtain a market supply curve.
Figure \(4\): Market Supply
Market supply is obtained by adding together the individual supplies of all the firms in the economy.
In general, both mechanisms come into play. The market supply curve slopes up for two reasons:
1. As the price increases, more firms decide to enter the market—that is, these firms produce some positive quantity other than zero.
2. As the price increases, firms increase the quantity that they wish to produce.
When the price increases, there are more firms in the market, and each firm produces more.
Market Equilibrium
In a perfectly competitive market, we combine the market demand and supply curves to obtain the supply-and-demand framework shown in Figure 8.2.5 "Market Equilibrium". The point where the curves cross is the market equilibrium.The definition of equilibrium is also presented in Chapter 6 "eBay and craigslist". At this point, there is a perfect match between the amount that buyers want to buy and the amount that sellers want to sell. The term equilibrium refers to the balancing of the forces of supply and demand in the market. At the equilibrium price, the suppliers of a good can sell as much as they wish, and demanders of a good can buy as much of the good as they wish. There are no disappointed buyers or sellers.
Toolkit: Section 31.9 "Supply and Demand"
You can review the definition and meaning of equilibrium in the supply-and-demand framework in the toolkit.
Figure \(5\): Market Equilibrium
In a competitive market, the equilibrium price and the equilibrium quantity are determined by the intersection of the supply and demand curves.
Because the demand curve has a negative slope and the supply curve has a positive slope, supply and demand will cross once. Both the equilibrium price and the equilibrium quantity will be positive. (More precisely, this is true as long as the vertical intercept of the demand curve is larger than the vertical intercept of the supply curve. If this is not the case, then the most that any buyer is willing to pay is less than the least any seller is willing to accept and there is no trade in the market.)
Price (\$) Market Supply Market Demand
1 5 95
5 25 75
10 50 50
20 100 0
Table \(2\): Market Equilibrium: An Example
Table 8.2.2 "Market Equilibrium: An Example" shows an example of market equilibrium with market supply and market demand at four different prices. The equilibrium occurs at \$10 and a quantity of 50 units. The table is based on the following equations:
\[market\ demand\ =\ 100 − 5 × price\]
and
\[market\ supply\ = 5 × price.\]
Equations such as these and diagrams such as Figure 8.2.5 "Market Equilibrium" are useful to economists who want to understand how the market works. Keep in mind, though, that firms and households in the market do not need any of this information. This is one of the beauties of the market. An individual firm or household needs to know only the price that is prevailing in the market.
Reaching the Market Equilibrium
Economists typically believe that a perfectly competitive market is likely to reach equilibrium for several reasons.
• If the prevailing price is different from the equilibrium price, then there will be an imbalance between demand and supply, which gives buyers and sellers an incentive to behave differently. For example, if the prevailing price is less than the equilibrium price, demand will exceed supply. Disappointed buyers might start bidding the price up, or sellers might realize they could charge a higher price. The opposite is true if the prevailing price is too high: suppliers might be tempted to try decreasing prices, and buyers might look for better deals. These are informal stories because the supply and demand curves are based on the idea that firms and consumers take prices as given. Still, the idea that there will be pressure on prices away from equilibrium is a plausible one.
• There is strong support for market predictions in the evidence from experimental markets.In Chapter 6 "eBay and craigslist", we explain that a double oral auction, in which buyers and sellers meet individually and bargain over prices, typically yields results very close to the market outcome in Figure 8.2.5 "Market Equilibrium".
• The supply-and-demand framework generally provides reliable predictions about the movement of prices.
key takeaways
• The market demand curve is obtained by adding together the demand curves of the individual households in an economy.
• As the price increases, household demand decreases, so market demand is downward sloping.
• The market supply curve is obtained by adding together the individual supply curves of all firms in an economy.
• As the price increases, the quantity supplied by every firm increases, so market supply is upward sloping.
• A perfectly competitive market is in equilibrium at the price where demand equals supply.
check your understanding
1. In Table 8.2.2 "Market Equilibrium: An Example", market supply was equal to 5 × price. Suppose instead that market supply = 15 × price. Would the equilibrium price still be \$10? If not, construct a new column in the table and find the new equilibrium price.
2. Explain why supply and demand cross only once. Do they always cross at a positive price? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/08%3A_Why_Do_Prices_Change/8.02%3A_Market_Supply_and_Market_Demand.txt |
learning objectives
1. Why do market prices increase and decrease?
2. How can I predict what is going to happen to prices?
Economists are often asked to make predictions about the effects of events on economic outcomes. They do so by using the supply-and-demand framework. To use this framework, we must first distinguish between those things that we take as given (exogenous variables) and those that we seek to explain (endogenous variables).
Toolkit: Section 31.16 "Comparative Statics"
An exogenous variable is something that comes from outside a model and is not explained in our analysis. An endogenous variable is one that is explained within our analysis. When using the supply-and-demand framework, price and quantity are endogenous variables; everything else is exogenous.
A Shift in Supply: Beer Prices in Britain
Figure \(1\): A Shift in the Supply Curve of an Individual Firm
An increase in marginal cost leads a firm to produce less output at any given price. This means that a firm’s supply curve shifts upward and to the left.
When we quoted the British newspaper article about beer prices in the chapter introduction, we omitted some sentences. The first sentence reads, in full: “The average price of a pint of beer could hit £4 [pounds sterling] after poor weather forced up the price of hops.” A few sentences later the article states: “Hop farmers have not seen any price rises for years, but the appalling summer has finally forced the prices up.” According to the article, the price of beer is increasing because the price of hops has increased.
This makes intuitive sense, but it is worth understanding the exact chain of reasoning here. Hops are a key ingredient in the production of beer. An increase in the price of hops means an increase in the cost of producing beer. More precisely, the marginal cost of producing beer increases. The typical beer producer decides how much to produce by observing this decision rule:
\[price = marginal\ cost.\]
If marginal cost increases, then, at the existing price, the producer will find that price is now less than marginal cost. To bring price back in line with marginal cost, the producer will have to produce a smaller quantity. In fact, at any given price, an increase in marginal cost leads to a reduction in output ( Figure 8.3.1 "A Shift in the Supply Curve of an Individual Firm"). The supply curve of an individual firm shifts to the left.
The increase in the price of hops affects all firms in the market. Each firm sees an increase in its marginal cost of production, so each firm produces less output at a given price: the shift in supply shown in Figure 8.3.1 "A Shift in the Supply Curve of an Individual Firm" applies to all firms in the market. Figure 8.3.2 "A Shift in Market Supply" shows the outcome in the market. Because all the individual supply curves shift to the left, the market supply curve likewise shifts to the left. At any given price, firms supply less beer to the market. From the figure, we see that the higher price of hops leads to an increase in the price of beer and a reduction in the quantity of beer produced and sold.
An increase in the price of hops causes all beer producers to produce less at any given price. This means that the market supply curve shifts to the left. The consequence is an increase in the equilibrium price and a decrease in the equilibrium quantity.
For the individual producer, what does this mean? The producer sees an increase in marginal cost. In the new equilibrium, the producer also obtains a higher price. However, the increase in price is not as big as the increase in marginal cost. Because the producer sets price equal to marginal cost, each individual brewer still produces less. We show this in Figure 8.3.3 "The New Equilibrium from the Perspective of an Individual Firm".
1. The price of hops, an input into beer production, has increased, which increases the marginal cost of producing beer.
2. At each given price, beer producers want to supply less beer: the firm supply curve shifts to the left.
3. Because all the individual supply curves shift to the left, the market supply curve also shifts to the left.
4. The beer market reaches a new equilibrium with a higher price and smaller quantity of beer produced and consumed.
Following the increase in the price of hops, the equilibrium price of beer increases. An individual firm ends up with higher marginal cost but also receives a higher price for beer. Because the increase in price is smaller than the increase in marginal cost, beer production still decreases.
Comparative Statics
The approach that we used here is an illustration of a general technique used by economists to explain changes in prices and quantities and to make predictions about what will happen to market prices.
Toolkit: Section 31.16 "Comparative Statics"
Comparative statics is a technique that allows us to describe how market equilibrium prices and quantities depend on exogenous events. As such, much of economics consists of exercises in comparative statics. In a comparative statics exercise, you must do the following:
1. Begin at an equilibrium point where the quantity supplied equals the quantity demanded.
2. Based on the description of the event, determine whether the change in the exogenous factor shifts the market supply curve or the market demand curve.
3. Determine the direction of this shift.
4. After shifting the curve, find the new equilibrium point.
5. Compare the new and old equilibrium points to predict how the exogenous event affects the market.
The most difficult part of a comparative statics exercise is to determine, from the description of the economic problem, which curve to shift—supply or demand. Once you determine which curve is shifting, then it is only a matter of using the supply-and-demand framework to find the new equilibrium. The final step is to compare the new equilibrium point (the new crossing of supply and demand) with the original point. With this comparison, you can predict what will happen to equilibrium prices and quantities when something exogenous changes.
A Shift in Demand
Let us try this technique again. Recall the second story from the chapter introduction about Detroit Tiger merchandise. In that story, we learned that “most shops have marked down jerseys and T-shirts branded with ex-Tigers between 25 and 50 percent.” Figure 8.3.4 "Shifts in Household Demand" shows the demand of a typical Detroit household’s demand for Granderson shirts. Now that Granderson has left the Tigers for the New York Yankees, the household’s marginal valuation for these shirts is lower. At any given price, a household wants to purchase fewer shirts, so the household’s demand curve shifts to the left.
A decrease in the marginal valuation of Granderson T-shirts leads a household to demand a smaller quantity at any given price. This means that a household’s demand curve shifts to the left.
We would expect that this shift in demand would apply to most households that contain Detroit Tigers fans. If we now add all the demand curves together, we get the market demand curve. The market demand curve shifts to the left ( Figure 8.3.5 "Shifts in Market Demand"). The end result is that we expect to see a decrease in the price of T-shirts—that is, the retailers put them in the discount bins—and also a decrease in demand.
Figure \(5\): Shifts in Market Demand
The decrease in demand causes both the equilibrium price and the equilibrium quantity of T-shirts to decrease.
Learning about the Slopes of the Supply and Demand Curves
Comparing our beer and T-shirt examples, we see that the quantity demanded decreased in both examples. In the first case, price increased; in the second case, price decreased. We can understand the difference by using the supply-and-demand framework. In the Detroit Tigers example, there is a decrease in the price of shirts and in the quantity sold. This might seem like a violation of the law of demand, which tells us that when price decreases, the quantity demanded increases. The explanation comes directly from Figure 8.3.5 "Shifts in Market Demand".
• Market demand is downward sloping and obeys the law of demand.
• Both equilibrium price and equilibrium quantity decrease after the departure of Granderson to the New York Yankees.
Curtis Granderson’s move leads to a shift in the demand curve and a movement along the supply curve. The law of demand, by contrast, applies to the movement along a demand curve.
Shifts in a Curve versus Movements along a Curve
Understanding the distinction between moving along a curve (either supply or demand) and shifting a curve is the hardest part about learning to use the supply-and-demand framework. Journalists and others frequently are confused about this—and no wonder. It requires practice to learn how to use supply and demand properly.
Let’s look at another example. An article in the British newspaper the Guardian reported about sales of beef when the news came out that eating beef might carry a risk of bovine spongiform encephalopathy (BSE), better known as mad cow disease. On November 1, 2000, the newspaper wrote, “Beef sales did drop after the link between BSE and deaths in humans was circumstantially established in 1996, but they have recovered as prices have fallen.”“First Beef—Now Lamb to the Slaughter?” Analysis, Guardian, November 1, 2000, accessed February 4, 2011, http://www.guardian.co.uk/uk/2000/nov/01/bse?INTCMP=SRCH.
The exogenous event here is the medical news about beef and mad cow disease. Presumably, this primarily affects the demand for beef: consumers decide to eat less beef and more of other products—such as chicken and pork. The demand curve for beef shifts to the left. As we saw in the T-shirt example, a leftward shift of the demand curve has two consequences: price decreases, and the quantity demanded and supplied also decreases. Thus the conclusion that the news should lead to a decrease in beef sales is perfectly consistent with our supply-and-demand analysis, as well as with common sense.
But what about the second part of the sentence? The article claims that beef sales “have recovered as prices have fallen.” This is not consistent with our supply-and-demand analysis. The decrease in prices is intimately connected with the decrease in quantity: both were caused by the health news. They are two sides of the same coin, so it does not make sense to use the decrease in prices to explain a recovery in beef sales.
In fact, you should be able to convince yourself that an increase in beef sales together with a decrease in prices (as asserted by the article) would require a rightward shift of the supply curve. (Draw a diagram to make sure you understand this.) It seems unlikely that health concerns about beef led cattle farmers to increase their production of beef. It is hard to escape the conclusion that the journalist became confused about shifts in the demand curve and movements along the curve.
Estimating Demand and Supply Curves
Comparative statics allows us to make qualitative predictions about prices and quantities. Given an exogenous shock in a market, we can determine whether (1) the price is likely to increase or decrease and (2) the quantity bought and sold is likely to increase or decrease. Often, though, we would like to be able to do more. We would like to be able to make some predictions about the magnitudes of the changes.
Figuring out what will happen to equilibrium prices and quantities requires economists to know the shapes of supply and demand. When the supply curve shifts, we need to know about the slope of the demand curve to predict the impact on price and quantity. When the demand curve shifts, we need to know about the slope of the supply curve to predict the impact on price and quantity. More precisely, we need measures of the elasticity of demand and of supply.
How do economists learn about these elasticities? The answer, perhaps surprisingly, is through the logic of comparative statics. For example, suppose the supply curve does not move, but the demand curve shifts around a lot. As the demand curve shifts, we observe different combinations of prices and quantities. Part (a) of Figure 8.3.6 "Finding the Elasticities of the Supply and Demand Curves" shows this in a supply-and-demand diagram. The different points that we observe are points on the supply curve. If the demand curve shifts but the supply curve does not, we eventually gather data on the supply curve. We can use these data to come up with estimates of the price elasticity of supply.
Toolkit: Section 31.2 "Elasticity"
The price elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in price.
Economists estimate the elasticities of supply and demand curves by looking for situations in which one curve is relatively stable while the other one is moving. What we actually observe are the equilibrium points. Movements in the demand curve (a) mean that the equilibrium points trace out the supply curve; movements in the supply curve (b) allow us to observe the demand curve. In most real-life cases, both curves move, and economists use sophisticated statistical techniques to tease apart shifts in supply from shifts in demand.
Part (b) of Figure 8.3.6 "Finding the Elasticities of the Supply and Demand Curves" shows the opposite case, where demand is stable and the supply curve is shifting. In this case, the data that we observe are different points on the demand curve. We can use this information to estimate the price elasticity of demand, which is the percentage change in the quantity demanded divided by the percentage change in price. It is important to note that we are speaking here about the elasticity of the market demand curve, not the elasticity of the demand curve facing an individual firm.
This sounds straightforward in theory, but it is difficult in practice. Economic data are messy. Typically, both the demand curve and the supply curve are shifting simultaneously. If economists had access to controlled environments, perhaps like a biochemist does, we could “shift the demand curve” and see what happens in the laboratory. Occasionally, we get lucky. Sometimes we can isolate a particular event that we know is likely to shift only one of the curves. This is sometimes called a natural experiment. Most of the time, however, we are not so lucky. Economists and statisticians have come up with sophisticated statistical techniques to disentangle shifts in demand and supply in these circumstances. Chapter 7 "Where Do Prices Come From?" discusses how a firm can use a similar technique to learn about the demand curve that it faces. Chapter 11 "Raising the Wage Floor" discusses the difficulties of measuring the demand curve for labor.
key takeaways
• Changes in prices come from shifts in market supply, market demand, or both.
• Economists use comparative statics to predict changes in prices. This technique explains how changes in exogenous variables cause shifts in supply and/or demand curves, which lead to changes in prices.
check your understanding
1. Suppose coffee crops in Brazil are destroyed by inclement weather. What happens to the supply curve for coffee? What happens to the price of coffee and the equilibrium quantity of coffee?
2. The discussion of the Detroit Tigers states that “it’s too soon to tell which Tigers will prove popular at the checkout line.” Suppose that Miguel Cabrera has an excellent season and breaks the home run record. What do you expect will happen to the price and quantity of T-shirts with his name on the back?
3. In our discussion of the demand for beef and mad cow disease, we said that an increase in quantity and a decrease in price require a rightward shift of the supply curve. Draw a diagram to illustrate this case. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/08%3A_Why_Do_Prices_Change/8.03%3A_Using_the_Supply-and-Demand_Framework.txt |
learning objectives
1. Are price changes good for the economy?
2. How is information conveyed among households and firms in an economy?
Think back to our story of increasing beer prices. In Figure 8.3.1 "A Shift in the Supply Curve of an Individual Firm", we saw that an increase in the marginal cost of beer production led to an increase in the price and a decrease in the quantity supplied. In that explanation, we focused on what was happening to supply. But as the supply curve shifted, we moved along the demand curve to a new equilibrium. What was happening to the quantity demanded as the quantity supplied decreased? The answer is that as firms started decreasing their supply, the price in the market began to increase. Consumers of beer, confronted by these higher prices, bought less beer. Perhaps they switched to wine or spirits instead. The higher prices induced the quantity demanded to decrease in line with the decline in supply.
Something remarkable is happening in this story, however. Bad weather has affected the hops harvest, making beer more expensive to produce, relative to other goods and services. Because it is more expensive to make beer, it makes sense—from the point of view of society as a whole—to shift resources away from the production of beer and toward the production of other goods. And it makes sense—from the point of view of society as a whole—for people to consume less of the expensive-to-produce beer and more of other goods and services. If we imagine an all-knowing, all-powerful central planner, whose job is to allocate resources in the economy, we would expect this person to respond to the decrease in the hops harvest by ordering the production and consumption of less beer.
But this is exactly what happens in an economy, simply through the mechanism of supply and demand. The automatic adjustment of prices, resulting from shifts in supply and demand, brings about desirable shifts in production and consumption. Nobody orders producers to produce less or consumers to consume less. These outcomes result from the working of supply and demand.
Similarly, think about our T-shirt example. Consumers decide that they would like to consume fewer Granderson T-shirts. This change in their preferences shows up in the market as a shift in the demand curve, which causes the price of T-shirts to decrease. This decrease in the price encourages producers in the economy to adjust their behavior to fit the changed tastes of households. Firms stop producing Granderson shirts. Again, this is not because anyone has instructed them to do so. The changed tastes of households generate the price signal that induces firms to produce less.
So far, we have answered the question of the chapter by saying that prices change because of shifts in supply and/or demand. This answer is correct. But we could give a different answer from another perspective: prices change in order to provide signals to firms and households about what to produce and what to consume. In a market economy, households and firms decide what to consumer by considering the prices they face. Prices change in response to changes in costs and tastes, and these changes lead firms and households to adjust their decisions in line with the new economic reality.
It is fair to ask whether we should trust prices to play this role. Economics provides a very direct answer to this question: when markets are competitive, the price system delivers an efficient allocation of resources. In the following subsections, we develop the idea that markets deliver efficient outcomes by looking at a single market.
Buyer Surplus
Consider the market for chocolate bars, as shown in Figure 8.2.5 "Market Equilibrium". At the market clearing price, suppliers and demanders of chocolate bars trade the equilibrium quantity of chocolate bars. Imagine first that each household purchases no more than a single chocolate bar at the equilibrium price. For example, if 200 chocolate bars are sold, then 200 separate households bought a chocolate bar. Not all these households are alike, however: some like chocolate bars more than others. Most of them would have, in fact, been willing to pay more than the equilibrium price for the chocolate bar. Their valuation of a chocolate bar is greater than the price.
Any household that would have been willing to pay more than the equilibrium price gets a good deal. For example, suppose the equilibrium price is \$5, but a household would have been willing to pay \$7. Then that household receives a buyer surplus of \$2.See Chapter 6 "eBay and craigslist" for more discussion. This logic extends to the case where households consume more than one unit. The demand curve of a household indicates the maximum amount that a person would pay for each successive unit of a good. The demand curve shows the household’s marginal valuation of a good. The individual household’s demand curve slopes downward because the household is willing to pay less and less for each successive unit—the marginal unit—as the total quantity consumed increases.
In general, we know that a household purchases chocolate bars up to the point where
\[marginal\ valuation\ =\ price.\]
The household receives no surplus on the very last bar that it purchases because the marginal valuation of that bar equals price. But it receives surplus on all the other bars because its marginal valuation exceeds price for those bars. Diminishing marginal valuation means that the household obtains surplus from all the chocolate bars except the very last one.
Table 8.4.1 "Calculating Buyer Surplus for an Individual Household" gives an example of a household facing a price of \$5. The first column is the quantity, the second is the price, the third is the marginal valuation (the extra value from the last chocolate), the fourth column measures the marginal surplus, and the last column is the total surplus.
Quantity (Bars) Price Marginal Valuation Surplus for Marginal Unit Total Surplus
1 5 10 5 5
2 5 8 3 8
3 5 5 0 8
4 5 3 –2 6
Table \(1\): Calculating Buyer Surplus for an Individual Household
The household is willing to buy three chocolate bars because the marginal value of the third bar is exactly equal to the price of \$5. (In fact, the household would be equally happy buying either two or three bars. It makes no substantive difference to the discussion, but it is easier if we suppose that the household buys the last bar even though it is indifferent about making this purchase.) The household would not buy four bars because the marginal valuation of the last unit is less than the price, which means the surplus from a fourth chocolate bar would be negative.
The household obtains surplus from the first and second bars that it purchases. The household would have been willing to pay \$10 for the first bar but only had to pay \$5. It gets \$5 of surplus from this first bar. The household would have been willing to pay \$8 for the second bar but only had to pay \$5. It gets \$3 of surplus for this second bar. It gets no surplus from the third bar. So the total buyer surplus for this household is \$5 + \$3 = \$8. Notice that by following the rule “buy until marginal valuation equals price,” the household maximizes its total surplus from the purchase of chocolate bars.
More generally, the buyer surplus for this household is measured by the area under its demand curve ( Figure 8.4.1 "Buyer Surplus for an Individual Household"). For each unit, the vertical difference between the price actually paid for each unit and the price the household would have been willing to pay measures the surplus earned for that unit. If we add the surplus over all units, we get the area between the demand curve and the price.
The buyer surplus is equal to the area between the demand curve and the price.
Seller Surplus
Sellers as well as buyers obtain surplus from trade. Suppose you won a used bicycle that you value at \$20. If you can sell that bicycle for \$30, you receive a seller surplus of \$10—the difference between the price and your valuation of the good. It is worth your while to sell as long as the price is greater than your valuation. When a firm is producing a good for sale, the situation is analogous. If a firm can produce one more unit of a good at a marginal cost of \$20, then the firm’s valuation of the good is effectively equal to \$20. If the firm can sell that unit for \$30, it will receive a surplus of \$10. The seller surplus earned by a firm for an individual unit is the difference between price and the marginal cost of producing that unit.
Given the price prevailing in a market, an individual firm in a competitive market will supply output such that the marginal cost of producing the last unit equals the price. The firm follows the rule: increase production up to the point where
\[price = marginal\ cost.\]
The example in Table 8.4.2 "Calculating Seller Surplus for an Individual Firm" gives the marginal cost of production for each unit and the surplus earned by a firm from producing that unit. If the firm produced only one unit, it would incur a marginal cost of \$1, sell the unit for \$5, and obtain a surplus of \$4. The second unit costs \$3 to produce, providing the firm with a surplus of \$2. The third unit provides surplus of \$1. The fourth unit costs \$5 to produce, so the firm earns no surplus on this final unit. So the firm produces four units and obtains a total seller surplus of \$7.
Quantity Price Marginal Cost Marginal Surplus Total Surplus
1 5 1 4 4
2 5 3 2 6
3 5 4 1 7
4 5 5 0 7
5 5 6 –1 6
Table \(2\): Calculating Seller Surplus for an Individual Firm
This difference between the price of a good and the marginal cost of producing the good is the basis of the seller surplus obtained by a firm. Exactly analogously to a household’s buyer surplus, we measure the seller surplus by looking at the benefit a firm gets from selling each unit, and then we add them together. For each unit, the seller surplus is the difference between the price and the supply curve (remember that the supply curve and the marginal cost curve are the same thing). When we add the surplus for all units, we obtain the area above the supply curve and below the price ( Figure 8.4.2 "Seller Surplus for an Individual Firm").
Figure \(2\): Seller Surplus for an Individual Firm
The seller surplus is the area between the equilibrium price and the firm’s supply curve.
Toolkit: Section 31.1 "Individual Demand" and Section 31.10 "Buyer Surplus and Seller Surplus"
You can review the concepts of valuation, marginal valuation, buyer surplus, and seller surplus in the toolkit.
Buyer Surplus and Seller Surplus for the Entire Market
So far we have considered the buyer surplus and seller surplus for an individual household and an individual firm. Because the market demand and supply curves are obtained by adding together the individual demand and supply curves, the same result holds if we look at the entire market. We illustrate this in Figure 8.4.3 "Surplus in the Market Equilibrium", which shows the total surplus flowing to all households and firms in the market equilibrium. The area below the market demand curve and above the price level is the total buyer surplus. The area above the market supply curve and below the price is the total seller’s (producer’s) surplus.There is one slightly technical footnote we should add. In some circumstances, the seller surplus may not all go to the firm. Instead, it may be shared between the firm and its workers (or other suppliers of inputs to the firm). Specifically, this occurs when increases in the market supply are large enough to cause input prices to change.
The total surplus generated in a market is the sum of the buyer surplus and the seller surplus. It is therefore equal to the area below the demand curve and above the supply curve.
Markets and the Gains from Trade
The buyer surplus and the seller surplus tell us something remarkable about market outcome. If we add together the surplus for all buyers and sellers, we obtain the total surplus (gains from trade) in the market. In a competitive market, this is the maximum amount of surplus that it is possible to obtain—that is, exchange in a competitive market exhausts all the gains from trade.
There are two ways of seeing why this is true. First, we can ask what level of output would give us the largest total surplus. You might be able to see by looking at Figure 8.4.3 "Surplus in the Market Equilibrium", where the equilibrium quantity yields the largest total surplus. Figure 8.4.4 "Surplus Away from the Market Equilibrium" explains why in more detail. If there are fewer trades, then some surplus goes unrealized: some transactions that would yield positive surplus do not take place. To put it another way, there are buyers whose marginal valuation exceeds the marginal cost of production but who are unable to purchase the good. By contrast, if there are more trades than the equilibrium quantity, then some trades generate a negative surplus. The marginal cost of producing output beyond the competitive level is less than the goods are worth to consumers.
Second, the following things are true at the market equilibrium:
• For each household, the marginal valuation for the last unit equals the price.
• For each firm, price equals the marginal cost for the last unit.
Combining these two pieces of information, we know that each household’s marginal valuation of the last unit is the marginal cost of producing that unit. As quantity increases, marginal valuation decreases and marginal cost increases. Therefore, if more of the good were produced, the marginal cost of the extra units would be higher than the marginal valuation. By the same argument, if fewer units were produced, the reduction in the household’s valuation would be higher than the reduction in cost. So producing one unit more or one unit less would not be beneficial to households and producers. Remember that it is the adjustment of prices that ensures that an economy trades at the point where supply and demand are equal. Price adjustment allows buyers and sellers to obtain all the gains from trade.
Figure \(4\): Surplus Away from the Market Equilibrium
If the quantity traded is less than the equilibrium quantity (a), then some gains from trade go unrealized. If the quantity traded is greater than the equilibrium quantity (b), then some trades generate negative surplus.
Why Markets?
We have been highlighting one of the principal messages in economics: markets are a mechanism to achieve the gains from trade. But are there other ways of achieving the same result? We previously introduced the fiction of an all-knowing, all-powerful central planner. Such a planner tells everyone what they should produce, takes all those goods, and distributes them throughout the economy. The planner tells everybody how much to work at each technology and decides exactly how to distribute all the goods and services that the economy produces.
Should we take this idea seriously or is it only a device to help us think about our theory? The answer is a bit of both. No economy has ever literally been run by a central planner. Historically, though, there have been many examples of so-called planned economies, where government bureaucracies played a major role in deciding what goods and services should be produced. For much of the 20th century, the economy of the Soviet Union operated under such a regime. China also used to be a largely planned economy. North Korea still operates as a largely planned economy.
Neither the Soviet Union nor China enjoyed much economic success under this system. The collapse of the Soviet Union’s economy was a key reason why the country itself collapsed. China eventually changed its system of economic organization to one that gives more primacy to markets. Today, there are very few economies that operate under central planning and none that are significant in global economic terms. However, there are still several economies in which the government plays a significant role in the allocation of resources; so the analysis of the planner remains relevant.
Why were planned economies so unsuccessful? Books have been written on this topic, but there is one key insight. In order to make good decisions—decisions in the interest of individuals in the economy—the planner would need a lot of information. It is simply inconceivable that a planner could have sufficient knowledge about the abilities and skills of different individuals to make good decisions about where and how much they should work. Moreover, the planner also needs to know the tastes of everyone in the economy. Without that knowledge, the planner might instruct them to produce too many chocolate bars or not enough beer. If we think of an economy with millions of inhabitants, all with their own preferences and abilities, it is surely impossible that a planner could be sufficiently well informed to make decisions that are in the interest of all an economy’s inhabitants.
key takeaways
• The response of prices and quantities to exogenous events is key for the efficient allocation of resources in the economy.
• Information about the tastes of households and the costs of production for a firm is conveyed through the price system.
• Through price adjustments in competitive markets, all potential gains from trade are realized.
check your understanding
1. If the demand for a good increases but the price is fixed, what gains from trade are lost?
2. Where in this section did we use the assumption of competitive markets? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/08%3A_Why_Do_Prices_Change/8.04%3A_Another_Perspective_on_Changing_Prices.txt |
learning objectives
1. How do the tools of comparative statics extend to other markets, such as the market for credit or labor?
2. How do markets interact with one another?
In other chapters in this book, we use the supply-and-demand framework to look at how goods and services are traded.We focus on labor in Chapter 9 "Growing Jobs" and Chapter 11 "Raising the Wage Floor". Chapter 10 "Making and Losing Money on Wall Street" looks at both the loan/credit market and the foreign exchange market. Here we give a brief overview of these markets.
Credit Market
The credit market (or loan market)—we use the terms loans and credit interchangeably—is where suppliers and demanders of credit meet and trade ( Figure 8.5.1 "Credit Market Equilibrium"). On the supply side are households and firms that, for various reasons, have chosen to save some of their current income. On the demand side are other households, firms, and (in some cases) the government. Households buy houses and cars, so they often need to borrow funds to finance those purchases. Firms seek credit to finance investment, such as the construction of a new production plant. Finally, governments borrow to finance some of their expenditures.
This diagram represents the loan or credit market.
The price of credit is the real interest rate, which is a measure of the value of the interest charged on a loan, adjusted for inflation. There are many different markets for credit because there are different kinds of loans in the economy. Chapter 10 "Making and Losing Money on Wall Street" discusses these. Associated with these different credit markets are different interest rates. For simplicity, though, we often suppose that there is a single market for credit.
Toolkit: Section 31.6 "The Credit Market"
You can review the credit market and the real interest rate in the toolkit.
The demand for credit decreases as the real interest rate increases. When it becomes more expensive to borrow, households, firms, and even governments want fewer loans. The supply of credit by households increases with the real interest rate. When the return on savings increases, households and firms will typically save more and so supply more loans to the market.The response of savings to changes in the real interest rate is discussed more fully in Chapter 5 "Life Decisions".
The news is filled with stories about interest rates increasing and decreasing. You can always use some version of Figure 8.5.1 "Credit Market Equilibrium" to understand why interest rates are changing. Ultimately, any change in the interest rate is due to a shift in either the supply of credit or the demand for credit. For example, if construction firms anticipate high future demand for housing, they will think that building new homes is a good use of investment funds. They will borrow to finance such construction. The increased demand for credit will shift the demand curve in Figure 8.5.1 "Credit Market Equilibrium" outward, and interest rates will increase. As another example, if individuals in other countries wish to increase their investment in US assets, this will shift the supply of credit outward, and interest rates will decrease.
Two of the most important players in the credit market are the government and the monetary authority. If the US federal government borrows more, this shifts the demand for credit outward and increases the interest rate. (The government is such a big player in this market that its actions affect the interest rate.) The monetary authority, meanwhile, buys and sells in credit markets to influence the real interest rate in the economy.The actions of the Federal Reserve and other monetary authorities are studied in detail in macroeconomics courses.
Foreign Exchange Market
If you travel abroad, you need to acquire the currency used in that region of the world. If you take a trip to Finland, Russia, and China, for example, you will undoubtedly buy euros, rubles, and yuan along the way. To do so, you need to participate in the foreign exchange market, trading one currency for another. Foreign exchange markets operate like other markets in the economy. The price—which in this case is called the exchange rate—is determined by the interaction of supply and demand.
Toolkit: Section 31.20 "Foreign Exchange Market"
The foreign exchange market is the market where currencies are traded. The price in this market is the price of one currency in terms of another and is called the exchange rate.
Figure 8.5.2 "Foreign Exchange Market Equilibrium" shows an example of a foreign exchange market—the market in which US dollars are exchanged for euros. On the horizontal axis, we show the number of euros bought and sold on a particular day. On the vertical axis is the exchange rate: the price of euros in dollars. This market determines the dollar price of euros just like the gasoline market in the United States determines the dollar price of gasoline.
Figure \(2\): Foreign Exchange Market Equilibrium
This diagram represents the foreign exchange market in which euros are bought and sold with US dollars.
On the demand side, there are traders (households and firms) who want to buy European goods and services. To do so, they need to buy euros. This demand for euros expressed in dollars need not come from US households and firms. Anyone holding dollars is free to purchase euros in this market. On the supply side, there are also traders (households and firms) who are holding euros and who wish to buy US goods and services. They need to sell euros to obtain US dollars.
There is another source of the demand for and the supply of different currencies. Households and, more importantly, firms often hold assets denominated in different currencies. You could, if you wish, hold some of your wealth in Israeli government bonds, in shares of a South African firm, or in Argentine real estate. But to do so, you would need to buy Israeli shekels, South African rand, or Argentine pesos. Likewise, many foreign investors hold US assets, such as shares in Dell Computer or debt issued by the US government. Thus the demand and the supply for currencies are influenced by the portfolio choices of households and firms. In practice, the vast majority of trades in foreign exchange markets are conducted by banks and other financial institutions that are adjusting their asset allocation.
In addition to households and firms, monetary authorities also participate in foreign exchange markets. For example, the US Federal Reserve Bank monitors the value of the dollar and may even intervene in the market, buying or selling dollars in an attempt to influence the exchange rate.
If you open a newspaper or browse the Internet, you can quickly find the current price of euros. This price changes all the time in response to changes in the currency’s demand and supply. For example, if you read that the euro is getting stronger, this means that the euro is becoming more expensive: you must give up more dollars to buy a euro. This increase in the price of the euro could reflect either an outward shift in the demand for euros, say as US households demand more goods from Europe, or an inward shift of the euro supply curve if holders of euros are not as willing to sell them for dollars.
Labor Market
In the markets for goods and services, the supply side usually comes from firms. In some cases, buyers are other firms (businesspeople call these B2B transactions), whereas in other cases buyers are households (often called B2C transactions). For the most part, though, households are not on the supply side of these markets. In the labor market, by contrast, firms and households switch roles: firms demand labor and households supply it.
Supply and demand curves for labor are shown in Figure 8.5.3 "Labor Market Equilibrium". Here the price of labor is the real wage. The real wage measures how much in the way of goods and services an individual can buy in exchange for an hour’s work. It equals the nominal wage (the wage in dollars) divided by the general price level.
Toolkit: Section 31.3 "The Labor Market"
You can review the labor market and the real wage in the toolkit.
The demand for labor comes from the fact that workers’ time is an input into the production process. This demand curve obeys the law of demand: as the price of labor increases, the demand for labor decreases. The supply of labor comes from households that allocate their time between work and leisure activities. In Figure 8.5.3 "Labor Market Equilibrium", the supply of labor is upward sloping. As real wage increases, households supply more labor. There are two reasons for this: (1) higher wages induce people to work longer hours, and (2) higher wages induce more people to enter the labor force and look for a job. Chapter 11 "Raising the Wage Floor" explains more about nominal wages and real wages, and we study the individual demand for labor in Chapter 9 "Growing Jobs". The decisions underlying labor supply are explained more fully in Chapter 4 "Everyday Decisions".
Figure \(3\): Labor Market Equilibrium
The equilibrium real wage is the price where supply equals demand in the labor market.
As with the other markets, we can use Figure 8.5.3 "Labor Market Equilibrium" to study comparative statics. For example, if an economy enters a boom, firms see more demand for their products, so they want to buy more labor to produce more product. This shifts the labor demand curve outward, with the result that real wages increase and employment is higher.
Multiple Markets
You have now seen equilibrium in a wide variety of markets: goods (chocolate), loans, foreign exchange, and labor. Actual economies contain hundreds of thousands of markets. Analyzing a single market would be enough if the markets in an economy were not connected, but markets are interrelated in many ways:A topic in advanced studies of economics is the simultaneous equilibrium of all markets. Because all markets are linked, it is necessary to find prices for all goods and services and all inputs simultaneously such that supply equals demand in all markets. This is an abstract exercise and uses lots of mathematics. The bottom line is good news: we can usually expect an equilibrium for all markets.
• Factors that shift the demand in one market may affect other markets as well. For example, an increase in energy costs will raise the marginal costs of firms in all sectors of an economy.
• The demand for one good depends on the prices of others. In the market for coffee, for example, the demand curve depends on the price of goods that are complements to coffee, such as milk, and the prices of goods that are substitutes for coffee, such as tea.
• The supply curve for most goods depends on the prices of inputs, such as labor. The real wage—the price of labor—is determined by the supply and demand for labor. Thus the outcome of the labor market influences the position of the supply curve in almost every other market.
• The income level of households affects the position of the demand curve for most goods and services. But the level of income comes, in part, from the labor market outcome because labor income is part of the income households have to spend.
The following newspaper story from the Singaporean newspaper the Straits Times nicely illustrates linkages across markets.
Singaporeans with a sweet tooth could soon find themselves paying more for their favourite treats, as bakers and confectioners buckle under soaring sugar prices.
Since March last year, the price of white sugar has shot up by 70 per cent, according to the New York Board of Trade. As if that didn’t make life difficult enough for bakers, butter and cheese prices have also risen, by 31 per cent and 17 per cent respectively.
The increases have been caused by various factors: a steep drop in Thailand’s sugarcane production due to drought, higher sea freight charges, increasing demand from China’s consumers for dairy products and the strong Australian and New Zealand dollar.See http://straitstimes.asia1.com.sg. We also discuss this quote in Chapter 6 "eBay and craigslist".
Look at the last paragraph. First, we are told that a drought has caused a drop in sugarcane production in Thailand. Part (a) of Figure 8.5.4 "The Sugar Market in Thailand and the Butter Market in Australia" shows this market. We can see that a decrease in sugar production will increase the price of sugar. In this picture we are showing the market in Thailand, so the price is measured in Thai baht.
Figure \(4\): The Sugar Market in Thailand and the Butter Market in Australia
(a) The market for sugar in Thailand is affected by a drought, which has decreased the sugar supply, causing an increase in sugar prices measured in Thai baht. (b) In the Australian butter market, increased demand from China causes the demand curve to shift outward, increasing the price of butter measured in Australian dollars.
We are also told that there has been increased demand for dairy products coming from China. Australia and New Zealand are the major suppliers of dairy products in Southeast Asia. Part (b) of Figure 8.5.4 "The Sugar Market in Thailand and the Butter Market in Australia" shows the market for butter in Australia. Increased demand from China shifts the demand curve outward, leading to an increase in the price of butter. For this market, we measure the price in Australian dollars.
From the perspective of Singapore bakers, both of these price changes show up as increases in their marginal cost. Moreover, the article reveals that these changes are exacerbated by other factors. Shipping costs have increased, so it also costs more to obtain sugar from Thailand and butter from Australia. And the Australian dollar has appreciated relative to the Singapore dollar, making goods imported from Australia even more expensive.
These are examples of B2B transactions. In fact, there is likely a whole chain of such transactions between, say, the Australian dairy farmer and the Singaporean baker. Farmers sell milk to butter producers, butter producers sell to wholesalers, and wholesalers sell to Singaporean importers and bakeries.
This story also illustrates again the powerful way in which market prices provide information that helps us understand the efficient allocation of resources. Drought in Thailand has reduced the amount of sugar available in the world. Through the magic of a series of prices, one of the results is that people in Singapore are less likely to eat cake for dessert.
key takeaways
• The supply-and-demand framework can be used to understand the markets for labor, credit, and foreign currency.
• Comparative statics can be used to study price and quantity changes in these markets.
• As markets interact with one another, sometimes comparative statics requires us to look at effects across markets.
exercises
1. Figure 8.5.2 "Foreign Exchange Market Equilibrium" shows the market where euros are bought and sold using dollars. We could equivalently think of this as the market where dollars are bought and sold using euros. Draw the graph for this market. How are the supply and demand curves in the two markets related to each other?
2. Using supply and demand, explain how an increase in Chinese demand for Australian butter might be a factor that causes the Australian dollar to appreciate.
3. What might be the effect of the financial crisis in the United States in 2008–9 on the income of lawyers? How does your answer depend on the specialization of the lawyer? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/08%3A_Why_Do_Prices_Change/8.05%3A_Three_Important_Markets.txt |
learning objective
1. How can I predict what will happen to prices when markets are not competitive?
Everything that we have discussed in this chapter applies, strictly speaking, only to perfectly competitive markets. Yet the conditions for perfect competition are quite stringent. For a market to be perfectly competitive, there must be a large number of sellers of an identical product. There also must be a large number of buyers. Each buyer and seller must be “small” relative to the market, meaning that they cannot influence market price.
There are certainly some markets that fit these criteria. Markets for commodities, such as wheat or gold, are one example. Markets for certain financial assets are another. Such examples notwithstanding, the vast majority of markets are not perfectly competitive. In most markets, firms possess some market power, meaning that the demand curve they face is not perfectly elastic.
You might think this greatly weakens the usefulness of the supply-and-demand framework. A firm with market power chooses a point on the demand curve that it faces. It sets a price as a markup over marginal cost and then produces enough to meet demand at that price.We explain how firms set these prices in Chapter 7 "Where Do Prices Come From?". A firm with market power does not take the price as given and then determine a quantity to supply. In fact—strictly speaking—there is no such thing as a supply curve when a firm has market power.
Economists understand this very well. Yet suppose you ask an economist to predict the likely effect of a worsening conflict in the Middle East on oil prices. The mental model she will use is almost certainly to imagine a supply curve for oil shifting to the left. Based on this model, she will predict higher prices and lower consumption. If you were to ask another economist to predict the effects of an economic recession on purchases of automobiles, he would imagine a demand curve shifting to the left and thus predict lower prices and lower output.
The first economist would use a supply-and-demand framework even though oil producers have market power. The second economist would use a supply-and-demand framework even though not all cars are identical. Although economists understand that many markets do not satisfy the strict conditions of perfect competition, they also know that the intuition from comparative statics carries over to more general market structures.
To see why, let us go back to our beer example again. We all know that not all beer is the same, and the beer companies spend a lot of money to convince us of this fact. Different beers have different tastes, and there are customers who are loyal to different beer brands. Breweries possess market power, meaning that we cannot—strictly speaking—draw a supply curve for individual beer producers or for the market as a whole.
Yet our comparative statics story, which supposes that the beer market is competitive, gives us an answer that makes sense. When the price of hops increases, this increases the marginal cost of production for all beer producers. Because they set prices based on a markup over marginal cost, the price of beer will increase, and less will be consumed. Output will be lower for all producers, and prices will be higher. Our comparative statics technique gives the right answer. Let us go through this more formally, first for a change in production costs and then for a change in demand.
Shifts in the Marginal Cost of Production
Figure 8.6.1 "Finding the Profit-Maximizing Price and Quantity When a Firm Has Market Power" shows how a firm with market power sets its price.This figure is explained more fully in Chapter 7 "Where Do Prices Come From?". To maximize its profits, a firm wants to produce the quantity where marginal revenue equals marginal cost. It sets the appropriate price as a markup over marginal cost.
Toolkit: Section 31.15 "Pricing with Market Power"
You can review the details of pricing with market power, including marginal revenue and markup, in the toolkit.
Figure \(1\): Finding the Profit-Maximizing Price and Quantity When a Firm Has Market Power
A firm with market power faces a downward-sloping demand curve and earns maximum profit at the point where marginal revenue equals marginal cost.
Now what happens if marginal cost increases? Think of a single beer producer and then imagine that the price of hops increases, so the marginal cost of producing an extra unit of output increases. This change in the marginal cost of production leads the brewer to decrease production ( Figure 8.6.2 "An Increase in Marginal Cost"). Marginal cost decreases and marginal revenue increases until the two are again equal.
In response to an increase in marginal cost, a firm now finds it optimal to set a higher price and produce a smaller quantity of beer.
Although Figure 8.6.2 "An Increase in Marginal Cost" is drawn for a single seller, it captures the common experience and response of all sellers. The increase in the price of hops causes the marginal cost to increase for all brewers, and they all respond by producing less and increasing the price of beer. And this is exactly what we predicted about prices and quantities when we considered an increase in marginal cost in a perfectly competitive market.
Shifts in Demand
Now reconsider the T-shirt example. There may be only a small number of producers who are licensed to produce Detroit Tigers T-shirts. Although there are many different kinds of replica sporting shirts in the world—at least one for each major team in most of the sports you can imagine—these shirts are not all the same. So the market for replica T-shirts—and certainly the market for Granderson T-shirts—is not competitive. The producers of Granderson shirts for the Tigers choose quantities and set prices (see Figure 8.6.1 "Finding the Profit-Maximizing Price and Quantity When a Firm Has Market Power").
Figure 8.6.3 "Shifts in Demand and Marginal Revenue" shows the market as seen by one of these producers. Granderson’s move from the Tigers shifts the demand curve inward for the shirts that they produce. This shift in the demand curve also shifts the marginal revenue curve inward. In response, the firm adjusts its output so that marginal revenue again equals marginal cost, choosing its price to match the point on the demand curve at the new quantity produced. Output and price both fall. Again, this is the same prediction that we obtained from the comparative statics of a competitive market.
A decrease in demand causes marginal revenue to shift to the left. Marginal cost and marginal revenue intersect at a lower level of output. This lower level of output means marginal cost is lower, so the firm will also decrease its price.
When Is Using Supply and Demand Misleading?
Even when markets are not perfectly competitive, the supply-and-demand framework is usually a good device for predicting what will happen to prices and quantities in a market following a shock. Even if firms have market power, an increase in marginal cost will typically lead to an increase in the price and a decrease in the quantity supplied, just as supply and demand predict. Similarly, an increase in demand will typically lead to an increase in the price and an increase in the quantity supplied, again as predicted by basic supply-and-demand reasoning.
Although the supply-and-demand framework can be used for most situations where markets are not perfectly competitive, we still need to know when it might mislead us.
• Though unlikely, it is possible that an increase in demand will lead to an increase in the price and a decrease in the quantity supplied. This is because it is possible, though unlikely, that an increase in demand will cause marginal revenue to decrease.
• It is possible that an increase in demand will lead to an increase in quantity but a decrease in the price. There are two ways this could happen, both stemming from the fact that a firm sets its price as a markup over marginal cost. First, even if demand is greater, the elasticity of demand could change so as to make the optimal markup. Second, some firms with market power may have decreasing marginal cost.
We also need to recognize that while we may be able to use supply-and-demand intuition for qualitative predictions, it is more difficult to make quantitative predictions when markets are not competitive. We cannot determine supply and demand elasticities as easily when firms have market power. The reason is that one firm’s decisions depend on what other firms are doing. Consider, for example, an increase in marginal cost in the beer industry. We have said that each firm in the market will respond by increasing its price and decreasing its quantity ( Figure 8.6.2 "An Increase in Marginal Cost"). For example, Miller in the United States will set higher prices in response to an increase in the price of hops. But when markets are not perfectly competitive, the story does not stop there. Firms also look at the prices set by their competitors. Miller’s decisions on pricing depend also on the price chosen by Budweiser. If Budweiser sets a higher price as well, then Miller may want to increase its price still further, and so on.How exactly this plays out is a complicated problem, requiring some of the ideas that we introduce in Chapter 15 "Busting Up Monopolies" and Chapter 17 "Cars".
To sum up, the supply-and-demand framework can occasionally mislead when markets are not perfectly competitive. Yet most economists still begin with supply and demand when trying to explain a change in prices or quantities. Then they consider if there are reasons to expect either changes in the elasticity of demand or decreasing marginal cost. If neither of these seems likely, then the simple intuition of supply and demand will almost certainly give the right answer.
key takeaways
• Even if markets are not competitive, the qualitative predictions from comparative statics in a competitive market remain.
• The prediction of the supply-and-demand framework could be misleading if a shift of the demand curve does not lead the marginal revenue curve to shift in the same direction.
check your understanding
1. Suppose there is a decrease in marginal cost in some industry. What will happen to price and quantity if the industry is competitive? What will happen to price and quantity if firms set the price as a markup over marginal cost? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/08%3A_Why_Do_Prices_Change/8.06%3A_Beyond_Perfect_Competition.txt |
In Conclusion
The supply-and-demand framework is the most powerful framework in the economist’s toolkit. Armed with an understanding of this framework, you can make sense of much economic news, and you can make intelligent predictions about future changes in prices.
A true understanding of this framework is more than just an ability to shift curves around, however. It is an understanding of how markets and prices are one of the main ways in which the world is interlinked. Markets are, quite simply, at the heart of economic life. Markets are the means by which suppliers and demanders of goods and services can meet and exchange their wares. Because exchange creates value—it makes both buyers and sellers better off—markets are the means by which our economy can prosper. Markets are the means by which economic activity is coordinated in our economy, allowing us to specialize in what we do best and buy other goods and services.
Economists wax lyrical about these features of markets, but this should not blind us to the fact that markets can go wrong. There are many ways in which market outcomes may not be the most desirable or efficient. In other chapters, we look in considerable detail at all the ways that markets can fail us as well as help us.
exercises
1. Fill in the missing values in Table 8.7.1 "Individual and Market Demand". What can you say about the missing price in the table?
Price of Chocolate Bars (\$) Household 1 Demand Household 2 Demand Market Demand
1 7 22
2 11 16
10 0.5 3 3.5
0.75 4 4.75
TABLE \(1\): INDIVIDUAL AND MARKET DEMAND
2. If the income levels of all households increase, what happens to the individual demand curves? What happens to market demand?
3. Suppose the price of coffee increases. Household 1 always eats chocolate bars while drinking coffee. What will happen to household 1’s demand for chocolate bars when the price of coffee increases? Household 2 either has coffee or a chocolate bar for dessert. What happens to household 2’s demand for chocolate bars when the price of coffee increases? What happens to the market demand for chocolate bars when the price of coffee increases?
4. In Figure 8.2.4 "Market Supply", list the factors that would imply that firm 1 produces fewer chocolate bars than firm 2 when the price is \$5. The figure is drawn so that firm 1 produces less than firm 2 at all prices. Does this have to be the case? Could the firms’ supply curves cross?
5. (Advanced) Draw a version of Figure 8.6.3 "Shifts in Demand and Marginal Revenue" if there is an outward shift in demand but no shift in marginal revenue. What would happen to the market price?
6. Consider the operation of a café. Describe the types of trades in terms of whether they are B2C or B2B. In what ways do you think that B2B trades are different from B2C trades?
7. Economists often say that individual decisions are “made at the margin.” How do you see that in the determination of market supply and market demand?
8. If there are fewer sellers in a market, what will happen to total output? What will happen to the output of each seller?
9. Explain why an increase in the mortgage rate, which reduces the demand for new houses, can teach researchers about the elasticity of the supply curve.
10. (Advanced) Using the credit market, show how governmental borrowing increases interest rates. Could governmental borrowing also lead to an outward shift in the supply of credit as households save more to pay off the future debt? How would you show this in a supply-and-demand diagram?
11. If the US Federal Reserve Bank takes actions to lower interest rates in the United States relative to other countries, what will happen to the euro price of the dollar? Explain.
12. Draw a figure showing an outward shift in a demand curve along with a reduction in marginal revenue. Explain what is going on in the diagram and how a monopolist would respond to the situation.
Spreadsheet Exercise
1. Using a spreadsheet, construct a version of Table 8.2.2 "Market Equilibrium: An Example" assuming that market demand = 50 − 5 × price. Fill in all the prices from 1 to 100. What is the equilibrium price and the equilibrium quantity in the market? How would you explain the difference between this equilibrium and the one displayed in Table 8.2.2 "Market Equilibrium: An Example"?
Economics Detective
1. Find a newspaper article that describes a price change for a good or service. Why did the price change? What happened to the quantities produced and sold? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/08%3A_Why_Do_Prices_Change/8.07%3A_End-of-Chapter_Material.txt |
The supply-and-demand framework can be analyzed with algebra. We start with supply and demand and then talk about market equilibrium. This presentation uses some notation rather than only words:
• p is the price of a chocolate bar.
• I measures the income of individuals in a market.
• qd is the quantity demanded.
• qs is the quantity supplied.
• A measures the technology of chocolate bar production.
Market Demand
With this notation, we represent the demand curve as follows:
$q^{d}=a_{d}-\beta_{d} p+\mathrm{V}_{d} I$
αd, βd, and γd are constants that characterize the effects of prices and income on the quantity demanded. With the restriction that βd > 0, the demand curve is downward sloping because an increase in p implies a reduction in the quantity demanded. It is natural to assume γd > 0, so an increase in income leads to an increase in the quantity demanded. This is represented as a shift in the demand curve.
Market Supply
With this notation, we represent the supply curve as follows:
$q^{5}=a_{s}-\beta_{s} p+\mathrm{Y}_{s} \mathcal{A}$
αs, βs, and γs are constants that characterize the effects of prices and income on the quantity demanded. With the restriction that βs > 0, the supply curve is upward sloping because an increase in p leads to an increase in the quantity supplied by all firms. It is natural to assume γs > 0, so an increase in the productivity of the current technology leads to an increase in the quantity produced at a given price. This is represented as a shift in the supply curve.
Market Equilibrium
The market is in equilibrium if there is a price and quantity combination, denoted (p*, q*) such that at the price p*, the quantity demanded, and the quantity supplied equal q*. Equilibrium is the simultaneous solution of supply and demand and can be found using the substitution method outlined in the toolkit.
Using $q^{s} = q^{d} = q^{*}$, we can substitute Equation 8.8.2 into Equation 8.8.1 yielding:
$a_{d}-\beta_{d} p^{*}+\mathrm{Y}_{d} I=a_{s}-\beta_{s} p^{*}+\mathrm{Y}_{s} \mathcal{A}$
This is a single equation in a single unknown, p*. Solving the equation for p* implies
Equation 8.4
The denominator is positive because we have assumed that both βd and βs are positive. The numerator is positive as long as the vertical intercept of the demand curve is greater than the vertical intercept of the supply curve: $\left(a_{d}+\mathrm{y}_{s} I\right)>\left(a_{s}+\mathrm{Y}_{d} A\right)$ This condition, combined with the restrictions on the slopes of supply and demand, is sufficient to guarantee that an equilibrium price exists in the market.
Using this calculation of p* in, say, the supply curve, we find
Equation 8.5
Grouping the terms into a constant, γdI and γsA, this becomes
Equation 8.6
Looking at Equation 8.4 and Equation 8.6, these expressions determine the equilibrium price and the equilibrium quantity depending on the two (exogenous) factors that impact supply and demand: income level I and state of technology A. Though income influences only the position of the demand curve, variations in income influence both the equilibrium price and the equilibrium quantity. The same is true for variations in technology that shift only the supply curve. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/08%3A_Why_Do_Prices_Change/8.08%3A_Appendix-_Algebraic_Presentation_of_Supply_and_Demand.txt |
Figure \(1\): Walmart Fact Sheet
Figure 9.1.1 "Walmart Fact Sheet" is a fact sheet from Walmart. The fact sheet tells you—if you didn’t know already—that Walmart is everywhere. It has over 7,000 retail units in the world, with over 3,000 outside the United States. Walmart employs about 1.36 million people in the United States alone, which is about 1 percent of the total number of workers employed in the United States. It seems that Walmart means jobs.
Figure \(2\): Walmart: Growing Jobs?
Source: This image is taken from en.Wikipedia.org/wiki/Image:Walmartbizarro.png. The image is copyright Dan Piraro 2006.
Despite the fact that Walmart provides so many jobs, the announcement of a new Walmart store is often greeted with trepidation or outright opposition. There are websites and even a film ( http://www.walmartmovie.com) dedicated to criticism of Walmart. It is true that the arrival of Walmart in a town will mean the creation of new jobs, including checkout clerks, shelf packers, and many other positions. Yet the arrival of Walmart will also mean that its competitors will lose jobs. The overall effect on jobs is unclear.
The arrival of a Walmart in a town has implications beyond the effects on jobs. Consumers are likely to face a different menu of goods. Walmart will bring some goods that were previously unavailable, while at the same time other goods sold by unsuccessful specialty stores will disappear. The shopping experience will change for consumers because shopping in a Walmart is not like shopping in a series of small stores. Consumers will face different and—for the most part—lower prices: Walmart is able to obtain goods more cheaply from suppliers and also has a very efficient distribution system that decreases costs. As fewer consumers visit the smaller shops, other nearby businesses, such as local restaurants, may suffer a decline in demand. The patterns of life in the town will change in numerous yet subtle ways.
This scenario has played out in many countries with many different stores. In France, there are hypermarkets such as Carrefour that likewise have had major effects on local businesses and sometimes encounter opposition. In England, the same is true of the Asda supermarket chain. In this chapter, we look at the economics that lies behind a firm’s decision to enter new markets (that is, open new stores) and exit from markets (that is, close down and go out of business). Although we begin here with Walmart, we tell a story that is about much more. Over the course of every year, jobs are created when existing firms expand and new firms enter. At the same time, jobs are lost when firms contract their workforces or close down completely.
A job is created when either an existing firm or a new firm hires workers. Jobs are destroyed when a firm fires some of its workers, some workers quit, or a firm exits a market. Figure 9.1.3 "US Net Job Creation from 2000 to 2009" provides data on net job creation in the United States from 2000 to 2009. By net job creation, we mean the number of new jobs created minus the number of jobs destroyed. For example, if some firms expand their employment by 200 workers and other firms reduce their workforce by 150 workers, we say that 200 jobs are created, 150 are destroyed, and the net job creation is 50.
Job creation and destruction take place all the time. Within an industry, and sometimes even within a firm, we see job creation and destruction occurring simultaneously. The Bureau of Labor Statistics now regularly produces quarterly job creation and destruction rates for the US economy.See Bureau of Labor Statistics, Business Employment Dynamics, “Table 3. Private sector gross job gains and losses, as a percent of employment, seasonally adjusted,” accessed March 1, 2011, http://www.bls.gov/web/cewbd/table3_1.txt. For the US private sector over the period 1990–2010, the average quarterly job creation and destruction rates were 7.5 percent and 7.3 percent, respectively. To put it another way, if you looked at 1,000 typical private sector jobs right now, then 75 of them didn’t exist last quarter, and 73 won’t exist next quarter. This implies that about 15 percent of jobs are either destroyed or created in a given quarter. Steven Davis, John Haltiwanger, and Scott Schuh, who were perhaps the first economists to study these processes in detail, call this job reallocation because it reflects the reshuffling of jobs across production locations. Sometimes a car produced at one particular automobile factory is selling well, so new jobs are created there. In the same quarter, another automobile factory may be shut down because the models produced there are not selling. The picture you should take away from these numbers is one of a very fluid labor market. One of our goals in this chapter is to understand how this labor market works.
One way that jobs can be created is by expanding an existing plant or firm. Another way that jobs are created is by the entry of a new plant or firm. The situation is analogous for job destruction. Some jobs are lost when existing plants contract (such as a plant eliminating a shift). Others are lost through the exit of a plant or a firm. The Davis, Haltiwanger, and Schuh data suggest that, each quarter, 11.5 percent of the jobs destroyed come from plants closing. An additional 20 percent of jobs are destroyed when plants undertake large workforce adjustments of more than 50 percent. On the entry side, about 8.4 percent of jobs created in a quarter are due to start-ups. Of course, if these start-ups are successful, then they create more jobs in later years. Ultimately, we want to answer the following question:
What are the economic forces driving job creation and destruction?
Road Map
The first part of this chapter examines labor demand by firms. We begin by looking at the decision of how many hours to hire. Then we turn to the entry and exit decisions of firms. We find the decision rules that govern these decisions.
After that, we consider a different way of looking at the labor market by examining the process of search and bargaining. We look at how workers who supply labor and firms that demand labor actually interact. Finally, we examine the effects of various government policies on labor market outcomes. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/09%3A_Growing_Jobs/9.01%3A_Changing_Jobs.txt |
Learning Objectives
1. What is a production function?
2. How does a firm decide how much to produce?
3. What factors determine a firm’s labor demand?
When economists are asked to explain the creation and destruction of jobs in an economy, they will typically begin with a diagram of supply and demand in the labor market. In the labor market, the real wage (on the vertical axis) and the total number of hours worked (on the horizontal axis) are determined by the interaction of labor supply and labor demand. As shown in Figure 9.2.1 "Labor Market Equilibrium", equilibrium in the labor market occurs at the wage and employment level such that the number of hours supplied and demanded is equal.
The equilibrium real wage in the labor market is the price where supply equals demand.
Toolkit: Section 31.3 "The Labor Market"
See the toolkit for more discussion on the labor market.
The upward-sloping supply curve tells us that households will want to supply more labor time as wages increase.Labor supply is discussed in Chapter 4 "Everyday Decisions".
• As the wage increases, some people find it worthwhile to enter the labor force and look for a job.
• As the wage increases, some of those with jobs will find it worthwhile to work more hours.
Labor demand slopes downward for two analogous reasons:
• As the wage increases, some firms find that they are no longer profitable and close down.
• As the wage increases, those firms that are in business choose to hire fewer hours of labor.
Thus an increase in wages will induce job destruction, and a decrease in wages will induce job creation.
The Decisions of a Firm
Firms hire labor to help them produce output. The amount of labor that a firm needs depends on the amount of output that it wants to produce. At the same time, its decision about how much to produce depends on its costs of production, which include the cost of labor. Our task here is to combine these ideas. The decision about how much labor to hire is only one of a large number of choices made by a firm’s managers. Of these, the most fundamental decisions are the following:
• Should a firm be in business at all?
• How much should a firm produce, and what price should its managers set?
• How should a firm produce its desired level of output?
A firm’s managers should actually answer these questions in the reverse order:
1. Managers should first determine the best way to produce output.
2. Then managers need to make a price/output decision. A firm is fundamentally constrained by the desires of the market. If managers choose the price of output, they must accept whatever sales are demanded by consumers at that price. If they choose the level of output, they can only charge the price that the market will bear for that quantity. In other words, a firm’s managers must choose a point on the demand curve facing a firm.
3. Then, and only then, can a firm’s managers decide if it is worth being in business at all. An existing firm can stay in the market or exit, thus destroying jobs. Potential new firms can enter the market and create jobs.
We follow this logic in our discussion.
Toolkit: Section 31.15 "Pricing with Market Power"
You can review the demand curve facing a firm and the details of pricing with market power in the toolkit.
The Production Function
A firm possesses a means of turning inputs into outputs. For example, Starbucks produces, among other things, grande vanilla low-fat decaf lattes. This drink is an example of a Starbucks output. The list of inputs that Starbucks needs to produce this product is much too long to write out in full but includes the following:
• Water, coffee beans, milk, vanilla syrup, paper cups, lids, and electricity
• An espresso machine
• The time of the barista—the person making the drink
• Starbucks’ “blueprints” (that is, the instructions for how to make a grande vanilla low-fat decaf latte)
This list doesn’t include any of the “back office” aspects of Starbucks’ operations, such as accounting, payroll, or the logistics of sourcing coffee beans and delivering them to individual stores. Other firms, of course, would have a very different list of inputs. So if we want to talk in abstract terms about the production of a firm, we need a description of production that could apply not only to Starbucks but also to General Motors, IKEA, your local computer repair store, and a manufacturer of paper clips. Therefore, we group inputs into broad categories called factors of production.
Toolkit: Section 31.17 "Production Function"
Economists group the inputs of any firm into a small number of general categories: raw materials, capital, and labor. We call these inputs a firm’s factors of production.
You can think of raw materials as the things that are transformed in the production process. In our Starbucks example, these include milk, coffee beans, and electricity. Labor refers to the time of the employees who work at a firm, so the time put in by a Starbucks’ barista counts as labor. Capital refers to goods that are used to help with production but are not used up in the process. The espresso machine is one of Starbucks’ capital goods; others are the tables and chairs in the café.
Starbucks’ technology—which we also think of as a factor of production—is the knowledge that allows it to take all these inputs and turn them into an output—the final product that people actually want to buy. It is this knowledge that ultimately lies behind Starbucks’ existence as a firm. Included in the technology are the managerial skills that allow Starbucks to operate effectively.
The production function combines a firm’s physical capital stock, labor, raw materials, and technology to produce output. Technology is the knowledge (the blueprints) that a firm possesses, together with managerial skills.
We represent the production process of a firm schematically in Figure 9.2.2 "The Technology of a Firm". Our description is quite general and can apply to nearly any kind of firm—for example, a lawyer’s office, Walmart, a university, and a child’s lemonade stand. Most people find it easiest to visualize a production function in terms of physical manufacturing, such as a production line for automobiles. Think of a firm’s capital as factory buildings and machinery; its labor as the workers on the production line; and its raw materials as the steel, plastic, and glass that it purchases.
A Production Function That Uses Only Labor
We summarize the technological possibilities of a firm using a production function, which is a description of how much output a firm can produce as it varies its inputs. Even though a typical firm’s production function contains many different inputs, we can understand most of the key features of the production function using an example where labor is the only factor of production. Although there are few goods or services that literally require no inputs other than labor, there are many services that are highly labor intensive, such as babysitting, housecleaning, and personal training at a gym.
To be concrete, think about housecleaning and suppose it has the following production function:
$output\ =\ productivity\ ×\ hours\ of\ labor\ input,$
where we think of productivity as just some number. If output measures clean houses, and if it takes 5 hours of labor to produce one clean house, then productivity is 0.2, and the production function is
$output\ =\ 0.2 ×\ hours\ of\ labor\ input.$
The production function tells us the level of output of a firm for given levels of labor input. Labor input is the total hours of labor time used by a firm. At this point, we are not distinguishing between hours worked per person and the number of people working, so a firm with 8 employees each working 20 hours per week has the same weekly labor input as a firm with 4 employees each working 40 hours per week. Table 9.2.1 "Production Function for Housecleaning" lists the amount of output that a housecleaning firm can obtain from various levels of input. We call this a linear production function because its graph is a straight line, as shown in Figure 9.2.3 "A Linear Production Function".
Labor Input (Hours) Output (Clean Houses)
0 0
1 0.2
2 0.4
3 0.6
4 0.8
5 1
10 2
15 3
20 4
25 5
30 6
35 7
40 8
Table $1$: Production Function for Housecleaning
Figure $3$: A Linear Production Function
A production function shows the maximum amount of output produced, given a level of labor input.
The marginal product of labor is the amount of extra output produced from one extra hour of labor input and is defined as
When the production function is linear, the marginal product of labor is constant. It is equal to the number we labeled productivity in our original production function.
In most cases, the marginal product of labor is not constant. To understand why, imagine you are managing a Starbucks outlet. You already have the machines to produce espresso, and you have lots of coffee beans on hand. You also have 500 square feet of space for making coffee and charging customers. But you still need labor. If you have no barista to operate the espresso machine, then you will have no output. If you hire one worker, you will be able to serve coffee to people. Adding the first worker will increase output considerably. However, that person must not only make the coffee but also clear the tables and handle the cash register. Adding a second worker to help with the register and clear tables will increase output even more. Now suppose you keep increasing the number of workers in the 500 square feet of space. After the third or fourth worker, they will start to bump into each other, and the barista will start to be very annoyed and unproductive. In other words, because one of your inputs—the amount of available space—is fixed, each additional worker contributes less and less to output. We call this the diminishing marginal product of labor.
Table 9.2.2 "Production Function for Coffee with a Diminishing Marginal Product of Labor" is an example of a production function with a diminishing marginal product of labor. In creating this table, the labor input is changed while holding all other inputs (the size of the café, the number of espresso machines, etc.) fixed.
Labor Input (Hours) Output (Cups of Coffee) Marginal Product of Labor
0 0
1 10 10
2 14.1 4.1
3 17.3 3.2
4 20 2.7
5 22.4 2.4
10 31.6 1.6
15 38.7 1.3
20 44.7 1.1
25 50.0 1.0
30 54.8 0.9
35 59.2 0.9
40 63.2 0.8
Table $2$: Production Function for Coffee with a Diminishing Marginal Product of Labor
The marginal product of labor is shown in the third column. For the first few entries, you can calculate it directly from the table because you can easily determine how much output changes from one row to the next. For example, the marginal product of the third hour of labor is 17.3 – 14.1 = 3.2. Finding the marginal product of, say, the 40th unit of labor from the table is trickier because the table doesn’t tell us how much we can produce with 39 hours of labor. Looking back at the formula for the marginal product of labor, however, we can calculate it:
We illustrate this production function in Figure 9.2.4 "A Production Function with a Diminishing Marginal Product of Labor". Notice that while the slope of the production function is always positive, the slope decreases as the labor input increases.
This production function exhibits diminishing marginal product of labor: as more labor is added to a firm, output increases at a decreasing rate.
Toolkit: Section 31.17 "Production Function"
The production function is a description of how much output a firm can produce as it varies its inputs. Typically, we suppose that the production function exhibits the following:
• Positive marginal product of labor
• Diminishing marginal product of labor
The first property means that adding more labor into production means more output—that is, the slope of the production function is positive. The second property explains how the marginal product of labor varies as labor input increases. Though the marginal product of labor is always positive, it will generally decrease as more labor is added to a production process. That is why the second property is called diminishing marginal product of labor. (It is technically possible that the marginal product of labor could even become negative. But because a firm would never pay for workers when they decrease output, we never expect to see a firm operating with a negative marginal product of labor.)
The Cost Function
Now that we have a way of describing a firm’s ability to produce goods, we are well on our way to understanding how a firm produces output. This then allows us to understand how much it will cost a firm to produce different levels of output. Our next goal is to describe these costs. The total cost of producing some specified level of output represents the cost of acquiring all the inputs needed.
To see how this works, let us determine the costs for our earlier housecleaning example. Recall that the production function is
$output\ =\ 0.2 ×\ number\ of\ hours\ of\ labor\ input.$
Suppose that housecleaners can be hired at $10 per hour: $cost\ of\ one\ clean\ house\ = 5\ hours\ × 10\ per\ hour\ = 50.$ The cost of two clean houses is$100, the cost of three clean houses is \$150, and so on.
More generally, suppose we take the linear production function and divide both sides by the level of productivity. We get
The cost of a single hour of labor is given by the wage. Thus we can write
This is the cost function of a firm, which is illustrated in Figure 9.2.5 "The Cost Function". Pay careful attention to the axes in Figure 9.2.3 "A Linear Production Function" and Figure 9.2.5 "The Cost Function". Figure 9.2.5 "A Linear Production Function" has hours of labor on the horizontal axis and output on the vertical axis. Figure 9.2.5 "The Cost Function" has output on the horizontal axis and costs ($= labor\ hours\ ×\ wage$) on the vertical axis.
The cost function shows the cost of producing different levels of output.
Marginal Cost
The cost function in Figure 9.2.5 "The Cost Function" is linear. Because the production function has a constant marginal product of labor, the cost function displays constant marginal cost. What about the case in which the production function has a diminishing marginal product? Then additional labor provides less and less output. Turning this around, it follows that producing each additional unit of output requires more and more labor. We show this in Figure 9.2.6 "The Cost Function with a Decreasing Marginal Productivity of Labor". In this figure, the marginal cost is increasing, so the cost function gets steeper as we produce more output.
Toolkit: Section 31.14 "Costs of Production"
You can review the definition of marginal cost in the toolkit.
If a firm’s technology exhibits a diminishing marginal product of labor, the cost function will increase at an increasing rate.
We show the marginal cost curve in Figure 9.2.7 "The Marginal Cost Function". In this example, marginal cost is a straight line, but this need not be the case in general.
Figure $8$: The Marginal Cost Function
If a firm’s technology exhibits a diminishing marginal product of labor, then the marginal cost will increase as output increases.
Marginal cost depends on the following:
• The cost of inputs into the production process
• The productivity of the inputs into the production process
If the costs of inputs increase, then the marginal cost is higher is well. If the productivity of the inputs into the production function is higher, then the marginal cost is lower. In fact, marginal cost can be written as
We can see from this equation that when the marginal product of labor decreases, the marginal cost of production increases. We see also that an increase in the cost of inputs—in this case an increase in wages—leads to an increase in the marginal cost of production.
The Choice of Inputs
There is one issue that we are ignoring here. Firms typically have many different ways in which they can produce the same quantity of output. A firm might have a choice between two production processes: (1) a process that is simple and cheap to operate but wasteful of raw materials and (2) a process with recycling that uses fewer materials but is more complicated and costly to run. As another example, if a construction company needs to dig a ditch, it could employ 20 people and equip each with a shovel, or it could hire a single individual and a backhoe. Economists say that the first process is labor intensive because it requires a lot of labor relative to capital; they call the second process capital intensive because it requires a relatively large amount of capital.
In medium-sized or large firms, there is usually a specific functional area, called operations, that decides how to produce output. Operational decisions are governed in large part by technical or engineering considerations: what are the ways in which it is physically possible to transform inputs into the desired output? Operational decisions also have an economic component. Given that there may be many different ways to get the same final amount of output, which is the most cost effective? In economics, not surprisingly, we focus on the second of these questions and leave the first to engineers and other technical experts.
The basic principle is intuitive: operations managers tend to choose methods of production that economize on relatively expensive inputs. For example, much garment manufacture takes place in countries like China or Vietnam, where wages are low (that is, labor is relatively cheap). As a result, the production processes tend to be highly labor intensive, using a lot of workers relative to the amount of machinery. By contrast, garment manufacture in richer countries (where labor is much more expensive) tends to use methods of production that require fewer people and more machines.
We simply presume that the operations function of a firm is doing a good job and has succeeded in finding the cheapest way of producing the firm’s output, taking into account both the technical aspects of production and the costs of different inputs. When we talk about the cost function of a firm, therefore, we are assuming that it gives us the lowest cost for producing each given level of output.
The Price/Output Decision
We have now completed our discussion of the first decision that managers must make: how to produce output. The production function tells us what a firm needs in terms of inputs—in this case, labor—to produce a given level of output. The more output a firm wants to produce, the more labor it will hire and the more jobs it will create. The cost function tells us the cost of producing different levels of output, and the marginal cost function tells us the cost of producing additional output.
Marginal cost is the critical ingredient in the next decision made by managers, which is selecting a point on the demand curve. We can think of managers as either choosing the price and then selling the quantity demanded at that price or choosing the level of output and selling it at the price that the market will bear. In either case, they are picking the point on the demand curve whereThis decision of the firm is also covered in detail in Chapter 7 "Where Do Prices Come From?".
$marginal\ revenue\ =\ marginal\ cost.$
We show this decision graphically in Figure 9.2.9 "Output and Price Decisions of a Profit-Maximizing Firm".
A profit-maximizing firm produces a quantity such that marginal revenue equals marginal cost, and the price is determined by the demand curve.
In our discussion of costs to this point, we have not specified whether we were talking about the nominal wage (that is, measured in dollars) or the real wage (that is, adjusted for inflation). The most important thing is being consistent. If we use the nominal wage when calculating our cost functions, then we end up with nominal costs. If we use the real wage, then we end up with real costs. And when we equate marginal revenue and marginal cost, we must be sure that we measure in nominal terms or real terms (not a mixture).
The distinction becomes important only when the general price level changes, so it is not central to our discussion here. When the price level is constant, we can always just suppose that it is equal to 1, in which case the nominal wage and the real wage are equal. Still, when we draw diagrams of the labor market, we typically put the real wage on the axis, so from here on we will explicitly suppose that we are measuring everything in real terms.
We can now explain labor demand by a firm. There are two steps:
1. As in Figure 9.2.9 "Output and Price Decisions of a Profit-Maximizing Firm", a firm produces a level of output such that marginal revenue equals marginal cost.
2. Using Figure 9.2.3 "A Linear Production Function", a firm determines the amount of labor it needs to produce the output chosen in step 1.
We already know that the marginal cost of production depends on the real wage: decreases in the real wage lead to decreases in real marginal costs. Figure 9.2.10 "The Effect of a Change in Marginal Cost on a Firm’s Choice of Output and Employment" shows how a decrease in the real wage affects the output and price decision of a firm. As the real wage decreases, the marginal cost of an additional unit of output decreases, so a firm will choose to produce more output. The price will decrease because the firm must lower the price to sell the additional output.
When the real wage decreases, marginal cost decreases, so the firm reduces price, increases output, and creates jobs.
Because a firm wants to produce more output, it will demand more hours of labor. In other words, a decrease in wages leads to an increase in the quantity of labor demanded. The resulting inverse relationship between the real wage and the amount of labor demanded is shown in Figure 9.2.11 "The Demand for Labor".
Figure $11$: The Demand for Labor
As the real wage increases, the demand for labor input decreases.
The labor demand curve for a single firm is downward sloping. This is true for every firm in the labor market. The market demand curve for labor is obtained by adding together the demand curves of individual firms. So the market demand for labor is downward sloping as well.
Changes in Employment
We can now connect our understanding of the labor market with the data on net job creation that we showed in Figure 9.1.3 "US Net Job Creation from 2000 to 2009". Based on what we have learned, there are three main reasons why jobs might be created or destroyed: (1) changes in the real wage, (2) changes in productivity, and (3) changes in demand.
Changes in the Real Wage
Changes in the cost of labor are one reason firms create or destroy jobs. Decreases in the real wage lead firms to produce more output and hire more workers, thus creating jobs. Increases in the real wage cause firms to produce less output and lay off workers. Going deeper, we can ask why the real wage might change. The answer comes from looking back at Figure 9.2.1 "Labor Market Equilibrium". The real wage changes, causing a change in the quantity of labor demanded, if the labor supply curve shifts.
Population growth is one source of a shift in labor supply. As the number of workers in the economy grows, then total labor supply will shift. At a given wage, there will be more workers and hence the labor supply curve will shift to the right. Other things equal, this causes a decrease in the real wage.
Changes in labor market participation also shift the labor supply curve. A leading example of this is the increased participation of women in the labor market. In the United States, the fraction of women in the labor force rose from about 20 percent in 1950 to about 70 percent in 2000. Participation might also change because of workers’ expectations about the future state of the labor market. If you are worried you won’t have a job next year, you might want to work this year.
Changes in Productivity
Changes in productivity—more precisely, in the marginal product of labor—work exactly like changes in the real wage. Remember that marginal cost depends on both real wages and productivity. If productivity increases, perhaps because a firm has upgraded its capital equipment, then marginal cost decreases. Firms will produce more output and hire more labor. The opposite is true if productivity decreases: in this case, firms will produce less and destroy jobs.
Over long periods of time, productivity in an economy increases. This increase in productivity is driven largely by technological advances: firms get better at producing goods and services and so are able to produce them more cheaply. As workers’ productivity increases, firms demand more labor at any given wage.
Changes in Demand
When a firm’s product becomes more desirable in the market, the demand curve that it faces shifts outward. This shift in demand typically leads to an outward shift in marginal revenue, inducing a firm to produce more output and demand more labor. We show this in Figure 9.2.12 "The Effect of a Change in Demand on a Firm’s Choice of Output and Employment": an outward shift of a firm’s demand curve typically leads to an outward shift in labor demand.
An increase in demand typically leads to an increase in marginal revenue, which in turn induces firms to produce more output and create jobs.
Key Takeaways
• A firm produces a quantity such that the marginal cost of producing an extra unit of output equals the marginal revenue from selling that extra unit of output.
• The demand for labor depends on the level of productivity, the demand for a firm’s product, and the cost of labor compared to the cost of other inputs in the production process.
Exercises
1. uppose the production function exhibits increasing marginal product of labor. What would it look like? What would the cost function look like in this case?
2. Marginal cost is defined as
We also know that
and
$change\ in\ cost = wage \times change\ in\ labor\ input.$
Show how you can use these three equations to derive the condition in the text that
3. Using Figure 9.2.12 "The Effect of a Change in Demand on a Firm’s Choice of Output and Employment", what would happen to a firm’s decision on prices, the quantity of output, and labor demand if the demand curve and marginal revenue curves shifted inward? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/09%3A_Growing_Jobs/9.02%3A_How_Do_Firms_Decide_How_Many_Hours_of_Labor_to_Hire.txt |
Learning Objectives
1. What is the difference between a fixed cost and a variable cost?
2. What factors determine if a firm should remain in business?
3. What is a sunk cost?
So far we have been thinking about a firm simply changing the number of labor hours that it wants to plug into its technology. Such job creation and destruction takes place at individual firms all the time. Some firms see an increase in productivity and hire more workers. Other firms see reduced demand for their output and destroy existing jobs. The joint creation and destruction of jobs underlies the net job creation we displayed earlier in Figure 9.1.3 "US Net Job Creation from 2000 to 2009".
Yet the expansion and contraction of employment in existing plants is only one source of job creation and destruction. During an economic downturn, such as the severe recession that began in 2008, some firms closed factories, and other firms went completely out of business. For example, US automobile manufacturers, such as General Motors, responded to the decreased demand for cars by closing some of their existing manufacturing plants. This led to job destruction at these plants. At other times, when an economy is expanding, new firms enter into business and existing ones open new plants. Thus a complete picture of the job creation and destruction process requires us to understand the economics of entry and exit.
Only when the firm’s managers know how much the firm is going to produce, the price at which it will sell it, and the cost of producing that output can they figure out profits and decide whether it is sensible to be in business at all. This logic applies to both managers of firms that are already in business and entrepreneurs who are considering starting a business. Firms also apply this logic to parts of their operations—for example, a firm may want to decide whether to shut down an existing plant or open a new one.
If a firm that is already in business discovers that its profits are too small to justify its other costs, then it should exit the market, shutting down its operations completely. If an entrepreneur is contemplating starting a new firm and calculates that the profits it will earn justify the costs of setting up operations, then we say that a firm enters the market.
In the previous section, we explained how job creation and destruction take place as firms expand and contract. When Walmart comes to town, however, much more is going on. The opening of a new Walmart means that some new jobs are created. Against that, existing stores may be forced to close down completely. Now that we have looked at a firm’s price and output decisions, we are able to analyze entry and exit decisions.
Exit
Businesses do not stay around forever. At some point, they exit the market, destroying jobs in the process. Restaurants that were a big hit only a few years ago can quickly lose their luster and disappear from the scene. The same is true for many retail outlets. Manufacturing plants also close, taking jobs with them. Imagine, for example, that you own a small clothes retailing store. Then Walmart comes to your town. Now your customers have another place to buy their clothes, and you must decide whether to stay in business. You need to decide which is more profitable: staying in business or closing your business down and selling off any assets you possess.
To understand the factors influencing firm exit, we begin with a key distinction between different kinds of costs.
Toolkit: Section 31.14 "Costs of Production"
Costs that are the same at all levels of production are called fixed costs. Costs that vary with the level of production are called variable costs. As an accounting identity, the total costs of a firm are divided up as follows:
\[total\ costs\ =\ fixed\ costs\ +\ variable\ costs.\]
Table 9.3.1 "Monthly Costs of Production" shows an example of fixed costs, variable costs, and total costs for your store. (To keep life simple, we treat all the different kinds of clothing you sell as if they were the same. Let us call them blue jeans.) The numbers in Table 9.3.1 "Monthly Costs of Production" are based on the following equation for costs:
\[total\ costs\ =\ 14,000 + 10 × quantity.\]
Suppose your firm has fixed costs every month of \$14,000. By definition, these fixed costs do not change as your level of output changes. Think of these as your overhead costs—for example, the cost of renting your retail space, utility bills, the wage of your sales clerk, and so on.
Quantity Fixed Costs (\$) Variable Costs (\$) Total Costs (\$)
0 14,000 0 14,000
1 14,000 10 14,010
2 14,000 20 14,020
200 14,000 2,000 16,000
400 14,000 4,000 18,000
600 14,000 6,000 20,000
800 14,000 8,000 22,000
1,000 14,000 10,000 24,000
1,200 14,000 12,000 26,000
1,400 14,000 14,000 28,000
1,600 14,000 16,000 30,000
1,800 14,000 18,000 32,000
2,000 14,000 20,000 34,000
2,200 14,000 22,000 36,000
2,400 14,000 24,000 38,000
Table \(1\): Monthly Costs of Production
By contrast, variable costs increase as the level of output increases. In this example, if output increases by one, variable costs increase by \$10. You can think of this as the cost of purchasing your blue jeans from the wholesaler. For you, the cost of “producing”—that is, making available for sale—one more unit of output is \$10. Figure 9.3.1 "Total Costs, Fixed Costs, and Variable Costs" graphs the data from this table. Notice that even if your firm produces no output at all, it still incurs fixed costs.
Fixed costs are the same at all levels of output. Variable costs increase as the quantity of output increases. Total costs equal fixed costs plus variable costs.
The Exit Decision
We are now ready to study the decision to continue in business or exit. You need to compare your revenues, defined as price times quantity, with the cost of running your business. Profit is the difference between revenues and costs, so
\[profit\ =\ total\ revenues\ −\ total\ costs\ =\ total\ revenues\ −\ variable\ costs\ −\ fixed\ costs.\]
Quantity Price (\$) Total Revenues (\$) Variable Costs (\$) Fixed Costs (\$) Profits (\$)
0 30 0 0 14,000 –14,000
200 29 5,800 2,000 14,000 –10,200
400 28 11,200 4,000 14,000 –6,800
600 27 16,200 6,000 14,000 –3,800
800 26 20,800 8,000 14,000 –1,200
1,000 25 25,000 10,000 14,000 1,000
1,200 24 28,800 12,000 14,000 2,800
1,400 23 32,200 14,000 14,000 4,200
1,600 22 35,200 16,000 14,000 5,200
1,800 21 37,800 18,000 14,000 5,800
2,000 20 40,000 20,000 14,000 6,000
2,200 19 41,800 22,000 14,000 5,800
2,400 18 42,550 24,000 14,000 5,200
Table \(2\): Demand and Profit before Walmart Comes to Town
The demand for your blue jeans is shown in the first two columns of Table 9.3.2 "Demand and Profit before Walmart Comes to Town". Looking at this table, your profit is at its highest when you set a price at \$20 and sell 2,000 pairs of jeans. In this case, you earn \$6,000 per month. Your revenues are enough to cover your variable costs and your fixed operating costs.
After Walmart comes to town, the demand for your jeans shifts inward because shoppers start going to Walmart instead. Now your demand is as shown in Table 9.3.4 "Demand and Profit after Walmart Comes to Town".
Quantity Price (\$) Revenues (\$) Variable Costs (\$) Fixed Costs (\$) Profit (\$)
0 26 0 0 14,000 –14,000
200 25 5,000 2,000 14,000 –11,000
400 24 9,600 4,000 14,000 –8,400
600 23 13,800 6,000 14,000 –6,200
800 22 17,600 8,000 14,000 –4,400
1,000 21 21,000 10,000 14,000 –3,000
1,200 20 24,000 12,000 14,000 –2,000
1,400 19 26,600 14,000 14,000 –1,400
1,600 18 28,800 16,000 14,000 –1,200
1,800 17 30,600 18,000 14,000 –1,400
2,000 16 32,000 20,000 14,000 –2,000
2,200 15 33,000 22,000 14,000 –3,000
2,400 14 33,600 24,000 14,000 –4,400
Table \(3\): Demand and Profit after Walmart Comes to Town
In response to this decrease in demand, you should drop your price. Your profits are now maximized at \$18. Unfortunately, at this price, you don’t earn enough to cover your fixed costs. Your profits are –\$1,200 a month. Should you remain in business? The answer to this question depends on when you ask.
Suppose you ask this question just after you have paid your monthly fixed operating costs. During the course of a month, you should stay in business because you are earning enough revenues to cover your variable costs. As soon as it is time to pay your monthly fixed cost again, though, you should choose to exit and close down your store. In this case, you would engage in job destruction by firing your sales clerk.
In this simple example, it is easy to see exactly when and why you should exit. A more general rule for when to exit is as follows. You should exit if
\[discounted\ present\ value\ of\ expected\ future\ profits\ <\ value\ of\ recoverable\ assets.\]
To make sense of this rule, we need to look at each part of it in turn.
• Discounted present value. Our previous example considered only a single month. In fact, you must think about the entire future. This means you must use the tool of discounted present value to add up profits earned in different months.For examples of discounted present value in action, look at Chapter 5 "Life Decisions" and Chapter 10 "Making and Losing Money on Wall Street".
• Expected future profits. Even though your price has decreased this month, it might not stay low forever. Perhaps your customers will decide, after they have tried Walmart, that they prefer your store after all. It would then be foolish to close down your store immediately just because you fail to cover fixed costs in one month. This means you must make a decision in the presence of uncertainty: you don’t know for sure if your customers will come back, and if they do, you don’t know for sure that they will not go away again. As a simple example, suppose you think there is a 75 percent chance that the shift in your demand curve is permanent and a 25 percent chance that it will go back to its original position. Looking ahead and using the tool of expected value, you would calculate your expected profit as follows:
In this case, you still expect to make a small profit every month. Provided you were not too risk-averse, you would keep your store in business. Of course, after some months had gone by, you would probably have better information about whether your customers are truly coming back or not.
• Value of recoverable assets. If you are thinking of closing down your store, then you also need to look at your existing assets in the store. You may be able to sell off some of these assets. For example, you could perhaps sell your cash register or computers. We say that such assets are (partially) recoverable assets because you can get back a portion of what you originally paid for these assets.
Toolkit: Section 31.4 "Choices over Time", and Section 31.7 "Expected Value"
You can review the meaning and calculation of discounted present value, expected value, and risk-aversion in the toolkit.
Defining Fixed Costs
Our definition of fixed costs seems very straightforward. Unfortunately, it is not always easy to decide in practice whether a cost is fixed or variable. There are two main reasons for this:
1. Time horizon. Business planning must be carried out over multiple time horizons. You must decide what to do from one week to the next, from one month to the next, and from one quarter to the next. Costs that are fixed over short time horizons may be variable over longer time horizons. For example, suppose your contract with your employee says you must give her six weeks’ notice prior to letting her go. Then her wages are a fixed cost when you are planning for the next six weeks but a variable cost over a longer horizon. Similarly, you may have to lease your store space yearly, in which case that cost is fixed until your lease next comes up for renewal. The bottom line is that whether you think of a cost as fixed or variable depends on your time horizon.
2. “Lumpiness.” Some inputs are easier to vary than others. You can freely decide how many pairs of jeans to buy from your wholesaler, so your purchase of jeans to sell is a variable cost. Other inputs are “lumpy”; they are fixed over some ranges of output but variable over others. This means that some costs are fixed over some ranges of output but variable over others. For example, you might be able to sell up to, say, 10,000 pairs of jeans a month in your current store space. However, if you wanted to expand beyond that, you would no longer have enough room to store your inventory and provide an acceptable shopping space for your customers. Because the size of your store is not something you can vary smoothly, this is a lumpy input.
In fact, if we take a very long time horizon and very large ranges of output, there are few costs that are truly fixed.
Entry
We use very similar reasoning to think about a firm’s decision to enter a market. When Walmart’s senior management team contemplates opening a new store, they compare the costs of entry against the (discounted present value of the) profit they expect to earn once they enter.
What are some of Walmart’s costs when it wants to open a new store?
• Searching for a suitable location
• Going through the necessary legal processes in the particular location
• Purchasing the land
• Dealing with public opposition (through lobbying, advertising, sending representatives to town council meetings, etc.)
• Designing the store
• Building the store
• Adjusting their supply chain logistics so as to be able to supply the store
• Hiring people to work there
You can probably think of many more. We call these Walmart’s entry costs.
Toolkit: Section 31.14 "Costs of Production"
Entry costs are the one-time fixed costs that a firm incurs when establishing a business. The toolkit has more discussion of other kinds of costs.
Such costs of establishing a business can be very substantial. Notice, by the way, that entry costs are for the most part truly fixed costs. Walmart must incur these costs before it can let a single customer inside; these costs are fixed no matter how long the time horizon; these costs are largely independent of Walmart’s scale of operation.
The senior management team must also predict how much profit they expect the store to make. These forecasts are based on the idea that, once the store is opened, the store will set its prices and manage its operations to maximize its profits. Because the team will be uncertain about profits, they will need to use expected value calculations. They will also be counting on a profit flow for years if not decades and will need to use discounted present value calculations. Thus the appropriate decision rule for a firm is to enter ifIn Chapter 15 "Busting Up Monopolies", you will find an example of very similar economic reasoning. There we present a parallel rule for the situation where a firm is deciding whether or not to engage in innovation.
\[discounted\ present\ value\ of\ expected\ future\ profits\ >\ entry\ costs.\]
A firm is more likely to enter if
• the costs of entry are low,
• variable costs are low,
• the revenues from operating are high, and
• demand for its product is very inelastic.
Sunk Costs and Recoverable Costs
Firms that enter markets know that it is possible that they will exit again in the future. Because their profit flow is uncertain, they recognize that there may come a point where they will judge it better to close down their operations. If they close down their operations, they may be able to sell off some of their existing assets. Therefore, when deciding to enter, managers also take into account the extent to which their assets are recoverable. If they are likely to be able to reclaim most of the value of their assets, then entry is more likely to be profitable even if demand turns out to be lower than expected.
Specifically, we can divide entry costs into sunk costs and recoverable costs.
Toolkit: Section 31.14 "Costs of Production"
A sunk cost is a cost that, once incurred, cannot be recovered. A recoverable cost is a cost that, once incurred, can be recovered.
Looking back at our list of Walmart’s entry costs, we can see that many of these costs are sunk costs. All the planning and legal fees are completely tied to this store; if they end up not building the store, they cannot get any of the monies back. The building is a sunk cost as well. Other costs are at least partly recoverable. If they decide not to build the store, they can resell the land. If they have equipped the building with shelving and cash registers and then decide not to open the store, they can resell these assets or move them to another Walmart store instead.
Economic reasoning gives clear instructions about sunk costs: they should be irrelevant for any future decision. Whether it was a good or bad idea to build a store, any decisions made going forward should take into account only the future profitability of the store. For example, suppose that Walmart’s entry costs were \$100 million, of which \$30 million were recoverable. Suppose also that Walmart’s managers estimated the discounted present value of expected profits at \$120 million and therefore decided to build the store. However, once it was built, they discover that they have badly overestimated demand. The managers revise their estimate of future profits by half to \$60 million. They now regret having built the store; it was a bad investment. But they should still keep the store open because it is earning more than they could obtain by closing the store and selling its assets.
Even though the economic principle is clear, people frequently include sunk costs in their calculations instead of ignoring them. This is such a pervasive problem that it is given the name the sunk cost fallacy.
Toolkit: Section 31.14 "Costs of Production"
The sunk cost fallacy is the mistake of including sunk costs in future-looking decisions, even though they should properly be ignored.
Key Takeaways
• A fixed cost is paid regardless of the level of output produced; a variable cost depends on the level of output produced.
• A firm should exit when the discounted present value of its future profits decreases below the value it can receive from selling its assets.
• A sunk cost is a cost that cannot be recovered, such as the cost of entry. This cost should have no effect on the decision to exit.
Exercises
1. Go back to our discussion of the data in Table 9.3.3 "Demand and Profit after Walmart Comes to Town". Explain why you should reduce your price after Walmart arrives in town.
2. Give an example of a fixed cost associated with taking this economics class. Is that cost sunk? How much of it can you recover if you stop taking the class?
3. Suppose the interest rate increases. Explain how that will lead more firms to exit the market. (Hint: think about discounted present value.) | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/09%3A_Growing_Jobs/9.03%3A_Entry_and_Exit.txt |
Learning Objectives
1. What is the process of matching workers and vacancies?
2. What is the optimal strategy to follow when looking for a job?
3. How are wages determined in labor markets?
As we have seen, job creation and destruction occur because of the entry and exit of firms. Jobs are created when firms enter into an industry and destroyed when firms exit. Job creation and destruction also arise as a result of the hiring and firing decisions of existing firms. We have used the labor market as a device to help us understand these hiring and firing decisions.
If you have ever looked for a job, though, then you know there is more to the labor market than supply and demand. Several aspects of the way labor is traded do not fit neatly into this framework. Workers and firms devote time and money to finding one another: search is an important element of the job market. And wages are often determined by some type of bargaining process, perhaps between a single worker and a firm or between a firm and a union that represents many workers.
Internet Job Search
Internet job searches are now an established part of the way labor markets operate. If you are a worker looking for a job, you can go to a site like Monster.com ( http://www.monster.com) or CareerBuilder.com ( http://www.CareerBuilder.com) to search for vacancies posted by firms.The Department of Labor sponsors a website ( www.careeronestop.org) filled with information, including compensation levels, for different occupations. Help with job search is available here as well. When you search on one of these sites, you are asked to provide information about the type of job you are looking for by providing the following:
• Keywords (the type of work you want to do)
• Categories (a description of the occupation)
• Location of the job
• Career level
In addition, you provide information about yourself, such as your work experience and education level. The search engine then provides a list of vacancies posted by firms matching these characteristics.
If there are potential matches for you, you are provided with a list of potential employers. Each will typically provide some information about the job. Sometimes this will include a salary range. These postings often include a description of the type of worker the firm is searching for, using phrases such as “team player,” “responsible,” “leadership skills,” or “people skills.” The next step is then up to you. Along with the job postings comes information about how to contact the firm. You can indicate your interest to the firm, and you may be called in for an interview. If that goes well, a job offer will follow. At this point, negotiation over compensation comes into play.
Eventually, you must decide whether or not to accept the job. What should you do? If you knew for sure that this was your dream job of a lifetime, the decision would be obvious: accept the job. But life is never that easy. In reality, you face considerable uncertainty over any job you are offered:
• What will the job really be like?
• What other options are there?
The first type of uncertainty has multiple dimensions. No matter how many brochures you read about a job, how many other workers you talk to, or how much time you spend watching someone at work, you still will not know everything about a job until you actually go to work. Even then, there are elements of a job that you will not know about until you have worked for many years. An example is promotion. When you consider a job, you will probably hear about opportunities for advancement if you stay with the firm. But whether or not you will be promoted is something that will be resolved in the future and is part of the uncertainty you face when you think about accepting a job.
The second type of uncertainty concerns the alternatives to the job you are considering. If you had a list of all possible jobs available to you, then you could consult that list and pick the best job. But, of course, there is no such list. Instead of being presented with a list, you have to search for a job. If you turn down the job you are offered today, you will not know for sure what job will be available to you tomorrow. Uncertainty over how to respond to a job offer is very important for some workers but less so for others. The difference is determined by how easy it is to change jobs. We can illustrate the point with two extreme examples.
The first case is a job that offers lifetime employment. If you accept this job, it is yours forever. You will never be fired and—let us suppose—you can never quit either. Given this situation and faced with a job offer, what would you do? Presumably the first thought that comes to your mind is “be careful.” You would not accept this job unless you were very sure it was a good match for you. If you are not sure, you should reject the job offer and search more.
The second case is a job that offers very short-term employment, on a week-by-week basis. If you accept this job, you are employed for the week; then you can choose to remain in the job (if it is still available) or leave to search for another one. Also, suppose that during your work time you can still keep an eye out for other jobs. It might be that you can check a computer that displays job ads, look at classified ads in the newspaper, or pass by a few shops advertising job openings during lunch. If you are offered this second type of job, there is no need to be very selective. Your employment is very temporary, and it is easy to change jobs.
The first kind of job is more descriptive of professional positions available to highly skilled workers, where employers are very selective about the type of person they hire. For these types of individuals, searching and changing jobs can be very lengthy and expensive. If they accept a job, it had better be right for them. The second kind of job is one you might be more familiar with as a student—a short-term job such as waiting tables, working as a secretarial temp, or selling in a retail outlet.
Search and Bargaining
The existence of Monster.com and similar search engines makes clear that the trade of labor services is quite different from the trade of, say, US government bonds. The return on a bond is the same regardless of who owns it. But the match between a firm and a worker is special. No two jobs are the same, and no two workers are the same. Also, if you want to buy a US government bond, you can simply call a broker to buy one for you. But if you run a restaurant and want to hire a worker with some very special skills in a particular location, there is no obvious person to call or place to go.
There are three stages of search and bargaining:
1. The meeting of workers looking for jobs with firms looking to fill vacancies
2. The matching of workers with certain characteristics with jobs requiring certain characteristics
3. The determination of wages through a bargaining process
These three elements correspond to the stages you might encounter when you look for a job. First, there is time spent looking for job opportunities. This might involve a recruiting program or search on the Internet. Once you have found a job opening, there is normally a second stage: an interview process. You will typically be interested in the characteristics of the job (such as wages, hours, benefits, promotion possibilities, and job security), and the firm will be interested in your characteristics (such as skills, experience, and trustworthiness). If both you and the firm think that the match is a good one, then the process moves to a third and final stage of bargaining to determine the compensation you will receive.
Searching with a Reservation Wage
We suppose that the bargaining process between a worker and a firm is very simple. The firm makes a take-it-or-leave-it offer. In other words, the firm gives the terms of its offer, including the compensation package and the working conditions, and the worker can then either accept or reject this offer. We also suppose that the offer can be summed up in terms of wages.
To see how this works, imagine that there are two firms each offering jobs at \$10 per hour. One firm provides very flexible working hours, while the other requires you to work from 10 p.m. to 6 a.m. and sometimes on the weekend. The first job is evidently more desirable than the second one. If you would be willing to pay \$4 an hour for the flexibility of the first job, then it is as if the second firm was offering a job at \$6 per hour.
Once a worker has a wage offer in hand, should that person accept or reject it? The answer comes from balancing the benefits of having a job (and therefore a wage) right now versus waiting for another job to come along in the hope that it will pay a higher wage. To see how a worker would make this choice, here is a simple numerical example.
• There are only two possible wage offers: some firms offer \$500 per week, and some offer \$1,000 per week.
• It takes a week to search for a job. If a worker turns down the offer he gets this week, he will not get another offer until next week.
• If a worker accepts a job, he cannot then search for another job.
• The government offers unemployment insurance of \$300 per week.
Suppose a worker gets a job offer of \$1,000 per week. Then the decision is easy: accept that job. The more difficult case is when the worker gets an offer of \$500 per week. By accepting this job, the worker gets \$200 more than with unemployment insurance. But accepting the job also has an opportunity cost. It means that the worker loses out on the chance of getting the higher paying job next week. So what should the worker do?
If you think about this problem, you will probably realize that the answer depends on how likely the worker is to get the better job by waiting. If most of the available jobs are the ones that pay \$1,000 per week, then it is likely to be worth waiting. On the other hand, if most of the jobs pay only \$500 a week, then the worker might have to wait a long time for the better job, so it is likely better to accept the one that pays \$500 a week. More generally, in a world where there are lots of different jobs paying lots of different wages, the best thing for the worker to do is to pick something we call the reservation wage. Workers can follow this rule:
• Accept a job if it offers a wage above the reservation wage.
• Reject a job if it offers a wage below the reservation wage.
Bargaining
If a worker and a firm meet and determine that the match is good, then they proceed to determine wages. There are two ways in which this might happen.If you read Chapter 6 "eBay and craigslist", you will see some close parallels between the mechanisms we discuss here and the ways in which a buyer and a seller may agree on a price. One possibility is the one we just discussed. Firms post vacant jobs and at the same time advertise the wage. If a worker qualifies for the job, then that worker will accept the job if the wage exceeds the reservation wage.
There can also be bargaining between a worker and a firm. A firm will make a profit based on the difference between the marginal product of hiring the extra worker and wages paid to the worker. So a firm will choose to hire the worker as long as the wage is below the marginal product of labor. This is a firm’s valuation of the job. A worker will be willing to take a job as long as the wage exceeds the reservation wage. This is a worker’s valuation of the job. In Figure 9.4.1 "The Valuation of a Job" we show both.
Figure \(1\): The Valuation of a Job
A firm follows the decision rule: “Offer the job if a worker’s marginal product exceeds the wage.” A worker follows the decision rule: “Accept the job if the wage exceeds the reservation wage.”
As long as the marginal product of labor for a worker is higher than a worker’s reservation wage, there is something to gain by employing a worker. The match is potentially a good one. But how will these gains be split? The answer depends on the relative bargaining power of a worker and a firm, which in turn depends on the information that they each possess.
As an example, suppose that a firm knows a worker’s reservation wage and can make a take-it-or-leave-it offer. It would then offer a real wage slightly above the worker’s reservation wage. The worker would accept the job, and all the surplus from the employment relationship would flow to the firm. At the other extreme, suppose that a worker knows his marginal product at the firm, so the worker can make a take-it-or-leave-it offer. Then the worker will offer to work at a real wage slightly below his marginal product. The firm would accept the offer, and all the surplus of the employment relationship would flow to the worker.
Another source of bargaining power for a worker is the other options available to him. If a worker comes into a negotiation with a good job offer from another firm in hand, then this will increase his reservation wage.
Workers can also enhance their bargaining power by negotiating together. Firms typically have many workers. Sometimes these workers group together, form a union, and bargain jointly with a firm. When workers organize in this way, they generally have more bargaining power because they can threaten to strike and shut down the firm. In this way, unionized workers get more of the surplus from their jobs.
In reality, workers don’t know their exact marginal product and firms don’t know the exact reservation wage of their workers. Not surprisingly, bargaining in such situations is more complicated to analyze. Sometimes, gains from trade are not realized. Suppose, for example, that a worker’s reservation wage is below his marginal product. But a firm, thinking that a worker’s reservation wage is really low, makes the worker a very low wage offer. If this wage offer is below the worker’s reservation wage, then the worker will decline the offer and search again—despite the fact that there were gains to trade. Unfortunately, private information prevented the firm and the worker from realizing these gains.
Posting Vacancies
The final element in the search process is the vacancies posted by firms. You can see these vacancies on Monster.com, in the newspaper, and in magazines. Vacancies are costly to post, and it is expensive to evaluate workers. They are the analogy on a firm’s side to the costly search on a worker’s side.
You can think of a firm’s decision of posting vacancies as being very similar to the labor demand for a firm. Firms want to expand output and thus post more vacancies whenever the marginal revenue of selling an extra unit of output increases relative to marginal cost. This could happen, for example, if the demand curve faced by a firm shifts outward. To expand output, the firm needs to hire more workers. It does so by posting vacancies, interviewing workers, and eventually bargaining with the best qualified ones to fill the open positions.
We noted earlier that labor demand also depends on wages: as the real wage decreases, a firm’s real marginal cost decreases, so it will want to hire more workers and expand output. When we think of search and bargaining, say through Monster.com, there is no “market wage” that a firm takes as given. Instead, the wage comes from a bargain between a worker and the firm. But the wage that is eventually agreed on will depend on the outside options of workers and firms. As the prevailing wage in the market decreases, a firm will be able to hire workers at a lower wage and will choose to post more vacancies and expand its workforce.
Key Takeaways
• The search process brings together workers and vacancies of firms. This process lies behind the supply and demand curves for labor.
• For many searches, it is best to follow a reservation wage strategy: accept a job if and only if the wage exceeds the reservation wage.
• Wages are determined through a bargaining process. Sometimes this is through a take-it-or-leave-it offer of the firm. Often there is bargaining between a firm and its workers (or their union) to share the surplus of the employment relationship.
Exercises
1. If a worker becomes very impatient, what will happen to his reservation wage?
2. When Walmart comes to town, what will happen to the vacancies posted by competing stores? What will happen to the reservation wages of salespeople? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/09%3A_Growing_Jobs/9.04%3A_Search.txt |
Learning Objectives
1. What government policies impact job creation and destruction?
2. What are the effects of trade on job creation and destruction?
Governments are very interested in job creation. A political leader whose economy loses a large number of jobs without creating new ones is unlikely to be reelected. On a local level, state and local governments compete fiercely to have firms locate in their region by offering lucrative tax reductions. This is seen as a way to create jobs in the local economy. We now examine some of these policy interventions and trace out their implications, focusing on three policies: restrictions on closing plants, policies that promote small businesses, and trade policies.
Plant-Closing Restrictions
In the United States, if you want to close a factory, you do not have to have approval of the government, but an act of Congress—the Worker Adjustment and Retraining Notification ActUS Department of Labor, “Other Workplace Standards: Notices for Plant Closings and Mass Layoffs,” elaws Employment Law Guide, accessed March 14, 2011, www.dol.gov/compliance/guide/layoffs.htm.—requires you to announce your intentions ahead of time. According to the US Department of Labor, “The Worker Adjustment and Retraining Notification Act (WARN) protects workers, their families, and communities by requiring employers to provide notification 60 calendar days in advance of plant closings and mass layoffs.”US Department of Labor, The Worker Adjustment and Retraining Notification Act (WARN), accessed January 22, 2011, www.dol.gov/compliance/laws/comp-warn.htm.
This law was passed in 1988 during a time of higher than average unemployment in the United States. Similar restrictions apply in some European countries, such as Spain and France. You cannot simply close an unproductive plant; employees must be given advance notice, and government approval may be required. Such restrictions on plant closings are intended to reduce job destruction. After all, if you make something more expensive to do, then less of it will be done. If it becomes more expensive to close plants, then fewer jobs will be destroyed by the exit of plants.
Economists point out, however, that the incentives of such policies are complicated and go beyond the effects on job destruction. To see why, think about our earlier discussion of entry and exit. When a firm decides to enter into an industry, it compares the profit flow from operating to the entry cost. When a firm thinks about the profits it will earn if it enters, it recognizes that if the demand for its product disappears, it can exit and thus avoid periods of negative profits. But if you take this option to exit a market away from a firm, then the value of entering an industry will decrease. Fewer firms will enter, and fewer jobs will be created. Thus laws that make it costly to close plants will also reduce job creation. The effect on net job creation is unclear.
Small Business Promotion
Started in the 1950s, the Small Business Administration (SBA; http://www.sba.gov) is a US government agency whose goal is to protect and promote small businesses. Small firms obtain preferential treatment in terms of taxes, regulation, and other policies. Part of the argument in favor of promoting and protecting small businesses is the view that job creation is centered on these firms. According to the SBA website, small businessesSee http://www.sba.gov/sites/default/files/files/leg_priorities112th.pdf.
• represent 99.7 percent of all employer firms and
• have generated 60–80 percent of net new jobs annually over the last decade.
So it appears that small businesses are critical to an economy.
We must remember that these are indeed small firms, however. Suppose there were 5 firms in an economy. Four of them have 2 workers, and the fifth has 92 workers. The typical firm then has 2 workers: 80 percent of the firms in this economy have 2 or fewer workers. From the perspective of workers, though, things are rather different. Ninety-two percent of the workers are employed by the single large firm. If you ask workers how many employees are in their firm, the typical worker will say 92. Most firms have few workers, but most workers are employed by the large firm.
This is not far from the reality of the US economy, where much economic activity (employment and output) is centered on relatively few firms. A recent study of about 5.4 million businesses found that 182,000 of them operate multiple units. Dividing 182,000 by 5.4 million, we learn that these larger firms are less than 4 percent of the total number of firms. But they account for about 61 percent of the revenue of the business sector of the economy. So most firms are relatively small, but those that are large are huge compared to the rest.Steven J. Davis et al., “Measuring the Dynamics of Young and Small Business: Integrating the Employer and Non-employer Universes” (NBER Working Paper 13226, 2007), accessed January 30, 2011, http://www.nber.org/papers/w13226.
Davis, Haltiwanger, and Schuh point out that “large firms and plants dominate the creation and destruction of jobs in the manufacturing sector.”See Steven J. Davis, John C. Haltiwanger, and Scott Schuh, Job Creation and Destruction (Boston, MA: MIT Press, 1998), chap. 7, sect. 4. Larger firms and plants both destroy and create more jobs. For example, at a job destruction rate of 10 percent a year, a small firm of 50 workers will destroy 5 jobs, while a large plant with 1,000 workers will destroy 100 jobs. So even if the job creation and destruction rates are higher for small firms, this does not necessarily mean that these small entities create and destroy more jobs than large firms do.
This is not to say that small firms are unimportant. Most of the large firms in the economy started small. Likewise, all the older, more successful firms were once young firms. So any impact the SBA has on either small or young firms will influence these firms as they age and grow. However, the rationale for the SBA is not completely clear. Normally, government interventions are based on the idea of either correcting some problem with the operation of free markets or redistributing resources. It is not clear whether the SBA fulfills either of these roles.
Trade Policy
Job creation and destruction are also affected by things that happen outside US borders. The removal of trade barriers allows countries to benefit more fully from the gains from trade. But in the process, some jobs are destroyed, while others are created.
Job destruction frequently takes center stage during debates on trade policy. In the early 1990s, for example, the United States was contemplating a reduction in trade barriers with its neighbors—Canada and Mexico—through negotiation of the North American Free Trade Agreement (NAFTA). Ross Perot, a third-party candidate for the US presidency in 1992 and 1996, was extremely critical of NAFTA. His focus was on job destruction, and he was famous for forecasting “a giant sucking sound” as employment opportunities moved from the United States to Mexico in response to NAFTA.
The loss of some jobs from a reduction in trade barriers is part of the adjustment one would expect. For countries to reap the gains from trade brought about by the removal of trade barriers, production patterns across countries must change. That process leads to job destruction and creation. Firms that used to produce certain goods in one country exit, as firms in other countries start to produce those goods instead. Workers at the exiting firms will certainly lose their jobs, but other jobs are created in the economy at the same time.
NAFTA was implemented in January 1994. More than 15 years later, it is still difficult to say exactly what the effects were and will be of NAFTA. Economics is not a laboratory science. It is not possible to subject the economies of Canada, Mexico, and the United States to this reduction in trade barriers, holding everything else the same. Instead, we have to look at data from before and after 1994 to try to infer the effects of NAFTA. But of course many other economic factors have also changed over this period. In parts of the United States where manufacturing jobs have been lost over the last 15 years, there is a tendency to hold NAFTA responsible. In fact, there is little evidence that NAFTA led to net job destruction.
What has happened over the last decade is that the US manufacturing sector has been exposed to increased competition from other countries, most notably China. It is this trade that has had a bigger impact on US manufacturing. At the same time, this has meant that NAFTA has been less of a success story for the Mexican economy than was predicted and hoped, as US consumers have purchased very cheap goods from China rather than Mexico.
Key Takeaways
• In the United States, firms are able to close plants if they choose to do so. This is not the case in all countries.
• The government promotes small businesses, viewing them as a source of job creation.
• The reduction of trade barriers creates new jobs and destroys others.
Exercises
1. If plants, once opened, were never allowed to be closed, what would this do to the incentives of a firm to open a plant?
2. In your college classes, what is the analogue of the statement that most firms have few workers, but most workers are employed by the large firm? Is it that most classes are small, but most students are in large classes? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/09%3A_Growing_Jobs/9.05%3A_Government_Policies.txt |
In Conclusion
During election season in the United States, the adverse effects of trade on jobs are often talked about extensively. In the 2008 Michigan presidential primary election, for example, candidates offered different ways in which they claimed they would help the automobile industry and bring more jobs to the Michigan economy. In the South Carolina primary in the same year, job losses in the textile industry received lots of attention. One large textile manufacturer in the region, Swift, had been cutting jobs steadily and was closing up, apparently planning to move production to South America. Individuals who lost their jobs due to this closing reported that they experienced a period of unemployment as they searched for a new job. Some found new jobs, either in an automobile assembly plant or working on optic fibers. Others moved from working in manufacturing to services. This is job creation and destruction in action. It happens all the time, all across the world.
Viewed abstractly, job creation and destruction are healthy processes for an economy. Through the process of job creation and destruction, workers are induced to move from less productive to more productive jobs. Such movement enhances the overall productivity of an economy. From the perspective of individual workers, however, the process looks very different. Job destruction means that people lose their jobs, which are a source of income and perhaps also of pride and dignity. They may have to spend some period of time unemployed, and they may lose important benefits, such as health insurance. They may have to relocate in search of jobs that are being created elsewhere; such relocation can be difficult and costly.
In sum, although the productivity of an economy as a whole may increase, this need not translate into improvements for workers who lose their jobs. Some find higher-paying jobs, but others, particularly those with few skills, see their wages decrease. One of the big challenges faced by governments and policymakers is to encourage the efficient reallocations of workers while minimizing the individual hardships that workers confront.
Key Links
exercises
1. A statistic called “unit labor cost,” which is the cost per unit of output of the labor input, is often calculated. How is this different from marginal cost?
2. Would you think that a firm’s managers would have a different viewpoint than its workers on whether or not a plant should be shut down?
3. All else being the same, which firms would you expect to be more capital intensive—those with labor contracts that pay high wages or those with easy access to funds on capital markets?
4. How is the labor demand curve of a firm influenced by the cost of other inputs, such as energy?
5. If a firm operates with high fixed costs, should it set a higher price for its output to be able to cover those fixed costs?
6. Would a firm ever remain in business even though it is earning negative profits in the current year? How does this decision depend on the interest rate?
7. Besides labor, what other markets can you think of where search is important?
8. All else being the same, who will have a higher reservation wage—someone who can receive unemployment insurance for 13 weeks or someone who can receive unemployment insurance for 26 weeks?
9. What do you think is the role of “friends” in helping you find your first job? What about subsequent jobs?
10. In economic downturns, what happens to the ratio of unemployed workers to vacancies?
11. Why do people quit jobs? Do you think that the number of job quitters is higher or lower during economic downturns??
12. In many European countries, it is very difficult for a firm to close one of its plants. What might be the effects of an increase in the cost of closing a plant on job creation, destruction, and reallocation?
13. Suppose that the establishment of a Walmart in a nearby town led to the creation of 100 jobs in that store and the destruction of 150 retail jobs in the town. Is the net loss of 50 jobs enough reason to oppose the opening of the Walmart? What other benefits might a Walmart bring? What other costs might it impose?
14. What might be the effects of a reduction in child-care costs on an unemployed worker’s reservation wage?
Spreadsheet Exercise
1. Revisit Table 9.3.1 "Monthly Costs of Production" through Table 9.3.3 "Demand and Profit after Walmart Comes to Town". Suppose your fixed operating costs were \$12,000 instead of \$14,000. Redo the tables with this change. Should you stay in business after Walmart arrives? Explain.
Economics Detective
1. The Bureau of Labor Statistics produces data on labor turnover called JOLTS ( http://www.bls.gov/jlt). Using that information, create a table and a plot of data to illustrate what has happened to job openings and the quit rate since January 2007. How would you explain these findings? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/09%3A_Growing_Jobs/9.06%3A_End-of-Chapter_Material.txt |
In 2006 and 2007, the financial district in Shanghai, China, was in a frenzy. Figure 10.1.1 "Shanghai Stock Exchange Index" shows the value of stocks in that market since its inception in 2000. Starting in early 2006, the value of stocks traded on this market exploded. The market rose by 130 percent in 2006; by May 2007, it was up over 50 percent for that year.See finance.yahoo.com/q/hp?s=000001.SS&=00&=1&=2006&=11&=31&=2007&=d&=66&=330. The market peaked in late 2007 and is currently at about 50 percent of that value. A lot of money was made by those who invested in the Shanghai market. And unfortunately a lot of money was lost.
This figure shows the closing prices on the Shanghai stock exchange between January 2000 and April 2010. Stock prices rose rapidly from 2006, peaking in October 2007, but decreased substantially over the next year. In late 2009, stocks rebounded again.
These gains attracted many investors. Funds from abroad poured into Shanghai. The savings accounts of Chinese households were another source of investment funds. From a People’s Daily Internet article posted on May 13, 2007, we learn the following: “More than 70 billion yuan (9.1 billion U.S. dollars) was transferred from savings accounts in Shanghai to stock trading accounts in the first four months of this year, the Shanghai branch of the People’s Bank of China estimated on Saturday. In April alone, [savings deposits denominated in Chinese currency] with Chinese banking institutions decreased by 8.5 billion yuan (1.1 billion U.S. dollars).”“Chinese Pour Savings Deposits into Stock Market,” People’s Daily, May 13, 2007, accessed March 14, 2011, http://english.peopledaily.com.cn/200705/13/eng20070513_374113.html.
During May 2007, stories circulated about households spending many hours carefully evaluating individual stocks and market returns. At the same time, it appeared that many relatively uninformed individuals were simply betting on the market, gambling on a quick return.
We said that some investors made money in the Shanghai market. Does that mean there is a lot of money to be made by investing in that market? These phrases sound similar but mean very different things. It is one thing to look back at a market and say you could have made money investing in that market. It is quite another to forecast that you will be able to make a high return in a market in the future. Investors who were attracted to the market in late 2007 had a very different experience: they lost a lot of money. Those who came into market in late 2008 were again able to profit as the market value rose over the following year.
In this chapter, we study the markets for different kinds of assets. Assets include stocks—such as are traded in Shanghai, on Wall Street, and in other financial centers around the globe—but, as we will see, there are many other kinds of assets as well. Information on assets is easy to obtain. If you open almost any newspaper, the business section contains an enormous amount of detailed information on stocks sold in a variety of markets. That same section will contain information on bonds, which are another type of frequently traded asset. Part of our interest in this chapter is defining these assets more precisely. The terms stocks and bonds are used commonly, but we want to understand exactly what these assets are and how they are traded.
As we wrote this chapter, we had no idea whether we, too, should be putting our personal savings in the Shanghai stock exchange or in some other market around the globe. In the middle of 2007, it looked as if the surge in the Shanghai market was over. Market participants were concerned that the time of high gains had ended. Yet by November 2007, market values had again started to escalate. And then, as we said, the market peaked in late 2007 and decreased rapidly for the next year. This is part of the story of asset markets. They are extremely volatile and unpredictable. When you see these high returns in Shanghai and other markets, you might wonder:
“Can I get rich by trading stocks and bonds?”
Road Map
This chapter begins with a walk down a fictionalized Wall Street, where we describe various kinds of assets. We focus mainly on financial markets, although we will look at other assets as well. Financial markets are familiar to many of us from the financial pages of newspapers or reports on the evening news. Such markets provide a link between borrowers and lenders ( Figure 10.1.2). Many of us are borrowers from banks, perhaps because we have a student loan, a car loan, or a mortgage for a house. Much of what we borrow from banks comes from deposits placed in banks by other households. Firms also borrow in the financial markets. They issue stock and sell bonds in financial markets to finance their investment in new factories and machines.
Financial markets link borrowers and lenders.
We then turn to a discussion of the pricing of assets. We begin by thinking about an unusual asset: a fruit tree. A fruit tree gives us a certain amount of fruit each year, and the value of the tree depends on the value of the fruit it produces. We explain how to calculate the value of a fruit tree that lives for several years and yields an uncertain crop, and we show how exactly the same principles apply to the valuation of stocks, bonds, houses, and other assets. Finally, we explain why—if financial markets are functioning well—the price of an asset will equal its value.
Finally, we ask whether it is easy to make money by trading assets. We explain that the gains and losses from trading assets are based on two factors: (1) luck and (2) the skill of investors who quickly recognize profit opportunities before others notice these opportunities. If financial markets are functioning well, then it is very difficult for the casual investor to make money consistently by trading financial assets. And even if—as many believe—financial markets do not function perfectly, this still does not mean that there is easy money to be made. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/10%3A_Making_and_Losing_Money_on_Wall_Street/10.01%3A_Financial_Roller_Coasters.txt |
Learning Objectives
1. What are the different types of assets traded in financial markets?
2. What can you earn by owning an asset?
3. What risks do you face?
Wall Street in New York City is the financial capital of the United States. There are other key financial centers around the globe: Shanghai, London, Paris, Hong Kong, and many other cities. These financial centers are places where traders come together to buy and sell assets. Beyond these physical locations, opportunities for trading assets abound on the Internet as well.
We begin the chapter by describing and explaining some of the most commonly traded assets. Ownership of an asset gives you the right to some future benefit or a stream of benefits. Very often, these benefits come in the form of monetary payments; for example, ownership of a stock gives you the right to a share of a firm’s profits. Sometimes, these benefits come in the form of a flow of services: ownership of a house gives you the right to enjoy the benefits of living in it.
Stocks
One of the first doors you find on Wall Street is called the stock exchange. The stock exchange is a place where—as the name suggests—stocks are bought and sold. A stock (or share) is an asset that comes in the form of (partial) ownership of a firm. The owners of a firm’s stock are called the shareholders of that firm because the stock gives them the right to a share of the firm’s profits. More precisely, shareholders receive payments whenever the board of directors of the firm decides to pay out some of the firm’s profits in the form of dividends.
Some firms—for example, a small family firm like a corner grocery store—are privately owned. This means that the shares of the firm are not available for others to purchase. Other firms are publicly traded, which means that anyone is free to buy or sell their stocks. In many cases, particularly for large firms such as Microsoft Corporation or Nike, stocks are bought and sold on a minute-by-minute basis. You can find information on the prices of publicly traded stocks in newspapers or on the Internet.
Stock Market Indices
Most often, however, we hear not about individual stock prices but about baskets of stocks. The most famous basket of stocks is called the Dow Jones Industrial Average (DJIA). Each night of the week, news reports on the radio and television and newspaper stories tell whether the value of the DJIA increased or decreased that day. The DJIA is more than a century old—it started in 1896—and is a bundle of 30 stocks representing some of the most significant firms in the US economy. Its value reflects the prices of these stocks. Very occasionally, one firm will be dropped from the index and replaced with another, reflecting changes in the economy.You can learn more about the DJIA if you go to NYSE Euronext, “Dow Jones Industrial Average,” accessed March 14, 2011, www.nyse.com/marketinfo/indexes/dji.shtml.
Figure \(1\): The DJIA: October 1928 to July 2007
This figure shows the closing prices for the DJIA between 1928 and 2010.
Source: The chart is generated from finance.yahoo.com/q?s=^DJI.
Figure 10.2.1 "The DJIA: October 1928 to July 2007" shows the Dow Jones Industrial Average from 1928 to 2011. Over that period, the index rose from about 300 to about 12,500, which is an average growth rate of about 4.5 percent per year. You can see that this growth was not smooth, however. There was a big decrease at the very beginning, known as the stock market crash of 1929. There was another very significant drop in October 1987. Even though the 1929 crash looks smaller than the 1987 decrease, the 1929 crash was much more severe. In 1929, the stock market lost about half its value and took many years to recover. In 1987, the market lost only about 25 percent of its value and recovered quite quickly.
One striking feature of Figure 10.2.1 "The DJIA: October 1928 to July 2007" is the very rapid growth in the DJIA in the 1990s and the subsequent decrease around the turn of the millennium. The 1990s saw the so-called Internet boom, when there was a lot of excitement about new companies taking advantage of new technologies. Some of these companies, such as Amazon, went on to be successful, but most others failed. As investors came to recognize that most of these new companies would not make money, the market fell in value. There was another rise in the market during the 2000s, followed by a substantial fall during the global financial crisis that began around 2008. Very recently, the market has recovered again.
If these ups and downs in the DJIA were predictable, it would be easy to make money on Wall Street. Suppose you knew the DJIA would increase 10 percent next month. You would buy the stocks in the average now, hold them for a month, and sell them for an easy 10 percent profit. If you knew the DJIA would decrease next month, you could still make money. If you currently owned DJIA stocks, you could sell them and then buy them back after the price decreased. Even if you don’t own these stocks right now, there is still a way of selling first and buying later. You can sell (at today’s high price) a promise to deliver the stocks in a month’s time. Then you buy the stocks after the price has decreased. This is called a forward sale. If this sounds as if it is too easy a way to make money, that’s because it is. The ups and downs in the DJIA are not perfectly predictable, so there are no easy profit opportunities of the kind we just described. We have more to say about this later in the chapter.
Although the DJIA is the most closely watched stock market index, many others are also commonly reported. The Standard and Poor’s 500 (S&P 500) is another important index. As the name suggests, it includes 500 firms, so it is more representative than the DJIA. If you want to understand what is happening to stock prices in general, you are better off looking at the S&P 500 than at the DJIA. The Nasdaq is another index, consisting of the stocks traded in an exchange that specializes in technology-based firms.
We mentioned earlier that the DJIA has increased by almost 5 percent per year on average since 1928. On the face of it, this seems like a fairly respectable level of growth. Yet we must be careful. The DJIA and other indices are averages of stock prices, which are measured in dollar terms. To understand what has happened to the stock market in real terms, we need to adjust for inflation. Between 1928 and 2007, the price level rose by 2.7 percent per year on average. The average growth in the DJIA, adjusted for inflation, was thus 4.8 percent − 2.7 percent = 2.1 percent.
The Price of a Stock
As a shareholder, there are two ways in which you can earn income from your stock. First, as we have explained, firms sometimes choose to pay out some of their income in the form of dividends. If you own some shares and the company declares it will pay a dividend, either you will receive a check in the mail or the company will automatically reinvest your dividend and give you extra shares. But there is no guarantee that a company will pay a dividend in any given year.
The second way you can earn income is through capital gains. Suppose you own a stock whose price has gone up. If that happens, you can—if you want—sell your stock and make a profit on the difference between the price you paid for the stock and the higher price you sold it for. Capital gains are the income you obtain from the increase in the price of an asset. (If the asset decreases in value, you instead incur a capital loss.)
To see how this works, suppose you buy, for \$100, a single share of a company whose stock is trading on an exchange. In exchange for \$100, you now have a piece of paper indicating that you own a share of a firm. After a year has gone by, imagine that the firm declares it will pay out dividends of \$6.00 per share. Also, at the end of the year, suppose the price of the stock has increased to \$105.00. You decide to sell at that price. So with your \$100.00, you received \$111.00 at the end of the year for an annual return of 11 percent:
(We have used the term return a few times. We will give a more precise definition of this term later. At present, you just need to know that it is the amount you obtain, in percentage terms, from holding an asset for a year.)
Suppose that a firm makes some profits but chooses not to pay out a dividend. What does it do with those funds? They are called retained earnings and are normally used to finance business operations. For example, a firm may take some of its profits to build a new factory or buy new machines. If a firm is being managed well, then those expenditures should allow a firm to make higher profits in the future and thus be able to pay out more dividends at a later date. Presuming once again that the firm is well managed, retained earnings should translate into extra dividends that will be paid in the future.
Furthermore, if people expect that a firm will pay higher dividends in the future, then they should be willing to pay more for shares in that firm today. This increase in demand for a firm’s shares will cause the share price to increase. So if a firm earns profits but does not pay a dividend, you should expect to get some capital gain instead. We come back to this idea later in the chapter and explain more carefully the connection between a firm’s dividend payments and the price of its stock.
The Riskiness of Stocks
Figure 10.2.1 "The DJIA: October 1928 to July 2007" reminds us that stock prices decrease as well as increase. If you choose to buy a stock, it is always possible its price will fall, in which case you suffer a capital loss rather than obtain a capital gain. The riskiness of stocks comes from the fact that the underlying fortunes of a firm are uncertain. Some firms are successful and earn high profits, which means that they are able to pay out large dividends—either now or in the future. Other firms are unsuccessful through either bad luck or bad management, and do not pay dividends. Particularly unsuccessful firms go bankrupt; shares in such a firm become close to worthless. When you buy a share in a firm, you have the chance to make money, but you might lose money as well.
Bonds
Wall Street is also home to many famous financial institutions, such as Morgan Stanley, Merrill Lynch, and many others. These firms act as the financial intermediaries that link borrowers and lenders. If desired, you could use one of these firms to help you buy and sell shares on the stock exchange. You can also go to one of these firms to buy and sell bonds. A bond is a promise to make cash payments (the coupon) to a bondholder at predetermined dates (such as every year) until the maturity date. At the maturity date, a final payment is made to a bondholder. Firms and governments that are raising funds issue bonds. A firm may wish to buy some new machinery or build a new plant, so it needs to borrow to finance this investment. Or a government might issue bonds to finance the construction of a road or a school.
The easiest way to think of a bond is that it is the asset associated with a loan. Here is a simple example. Suppose you loan a friend \$100 for a year at a 6 percent interest rate. This means that the friend has agreed to pay you \$106 a year from now. Another way to think of this agreement is that you have bought, for a price of \$100, an asset that entitles you to \$106 in a year’s time. More generally (as the definition makes clear), a bond may entitle you to an entire schedule of repayments.
The Riskiness of Bonds
Bonds, like stocks, are risky.
• The coupon payments of a bond are almost always specified in dollar terms. This means that the real value of these payments depends on the inflation rate in an economy. Higher inflation means that the value of a bond has less worth in real terms.
• Bonds, like stocks, are also risky because of the possibility of bankruptcy. If a firm borrows money but then goes bankrupt, bondholders may end up not being repaid. The extent of this risk depends on who issues the bond. Government bonds usually carry a low risk of bankruptcy. It is unlikely that a government will default on its debt obligations, although it is not impossible: Iceland, Ireland, Greece, and Portugal, for example, have recently been at risk of default. In the case of bonds issued by firms, the riskiness obviously depends on the firm. An Internet start-up firm operated from your neighbor’s garage is more likely to default on its loans than a company like the Microsoft Corporation. There are companies that evaluate the riskiness of firms; the ratings provided by these companies have a tremendous impact on the cost that firms incur when they borrow.
Inflation does not have the same effect on stocks as it does on bonds. If prices increase, then the fixed nominal payments of a bond unambiguously become less valuable. But if prices increase, firms will typically set higher nominal prices for their products, earn higher nominal profits, and pay higher nominal dividends. So inflation does not, in and of itself, make stocks less valuable.
Toolkit: Section 31.8 "Correcting for Inflation"
You can review the meaning and calculation of the inflation rate in the toolkit.
One way to see the differences in the riskiness of bonds is to look at the cost of issuing bonds for different groups of borrowers. Generally, the rate at which the US federal government can borrow is much lower than the rate at which corporations borrow. As the riskiness of corporations increases, so does the return they must offer to compensate investors for this risk.
Real Estate and Cars
As you continue to walk down the street, you are somewhat surprised to see a real estate office and a car dealership on Wall Street. (But this is a fictionalized Wall Street, so why not?) Real estate is another kind of asset. Suppose, for example, that you purchase a home and then rent it out. The rental payments you receive are analogous to the dividends from a stock or the coupon payments on a bond: they are a flow of money you receive from ownership of the asset.
Real estate, like other assets, is risky. The rent you can obtain may increase or decrease, and the price of the home can also change over time. The fact that housing is a significant—and risky—financial asset became apparent in the global financial crisis that began in 2007. There were many aspects of that crisis, but an early trigger of the crisis was the fact that housing prices decreased in the United States and around the world.
If you buy a home and live in it yourself, then you still receive a flow of services from your asset. You don’t receive money directly, but you receive money indirectly because you don’t have to pay rent to live elsewhere. You can think about measuring the value of the flow of services as rent you are paying to yourself.
Our fictional Wall Street also has a car dealership—not only because all the financial traders need somewhere convenient to buy their BMWs but also because cars, like houses, are an asset. They yield a flow of services, and their value is linked to that service flow.
The Foreign Exchange Market
Further down the street, you see a small store listing a large number of different three-letter symbols: BOB, JPY, CND, EUR, NZD, SEK, RUB, SOS, ADF, and many others. Stepping inside to inquire, you learn that that, in this store, they buy and sell foreign currencies. (These three-letter symbols are the currency codes established by the International Organization for Standardization ( http://www.iso.org/iso/home.htm). Most of the time, the first two letters refer to the country, and the third letter is the initial letter of the currency unit. Thus, in international dealings, the US dollar is referenced by the symbol USD.)
Foreign currencies are another asset—a simple one to understand. The return on foreign currency depends on how the exchange rate changes over the course of a year. The (nominal) exchange rate is the price of one currency in terms of another. For example, if it costs US\$2 to purchase €1, then the exchange rate for these two currencies is 2. An exchange rate can be looked at in two directions. If the dollar-price of a euro is 2, then the euro price of a dollar is 0.5: with €0.5, you can buy US\$1.
Suppose that the exchange rate this year is US\$2 to the euro, and suppose you have US\$100. You buy €50 and wait a year. Now suppose that next year the exchange rate is US\$2.15 to the euro. With your €50, you can purchase US\$107.50 (because US\$(50 × 2.15) = US\$107.50). Your return on this asset is 7.5 percent. Holding euros was a good investment because the dollar became less valuable relative to the euro. Of course, the dollar might increase in value instead. Holding foreign currency is risky, just like holding all the other assets we have considered.The currency market is also discussed in Chapter 8 "Why Do Prices Change?".
The foreign exchange market brings together suppliers and demanders of different currencies in the world. In these markets, one currency is bought using another. The law of demand holds: as the price of a foreign currency increases, the quantity demanded of that currency decreases. Likewise, as the price of a foreign currency increases, the quantity supplied of that currency increases. Exchange rates are determined just like other prices, by the interaction of supply and demand. At the equilibrium exchange rate, the quantity of the currency supplied equals the quantity demanded. Shifts in the supply or demand for a currency lead to changes in the exchange rate.
Toolkit: Section 31.20 "Foreign Exchange Market"
You can review the foreign exchange market and the exchange rate in the toolkit.
Foreign Assets
Having recently read about the large returns on the Shanghai stock exchange and having seen that you can buy Chinese currency (the yuan, which has the international code CNY), you might wonder whether you can buy shares on the Shanghai stock exchange. In general, you are not restricted to buying assets in your home country. After all, there are companies and governments around the world who need to finance projects of various forms. Financial markets span the globe, so the bonds issued by these companies and governments can be purchased almost anywhere. You can buy shares in Australian firms, Japanese government bonds, or real estate in Italy.Some countries have restrictions on asset purchases by noncitizens—for example, it is not always possible for foreigners to buy real estate. But such restrictions notwithstanding, the menu of assets from which you can choose is immense. Indeed, television, newspapers, and the Internet report on the behavior of both US stock markets and those worldwide, such as the FTSE 100 on the London stock exchange, the Hang Seng index on the Hong Kong stock exchange, the Nikkei 225 index on the Tokyo stock exchange, and many others.
You could buy foreign assets from one of the big financial firms that you visited earlier. It will be happy to buy foreign stocks or bonds on your behalf. Of course, if you choose to buy stocks or bonds associated with foreign companies or governments, you face all the risks associated with buying domestic stocks and bonds. The dividends are uncertain, there might be inflation in the foreign country, the price of the asset might change, and so on. In addition, you face exchange rate risk. If you purchase a bond issued in Mexico, you don’t know what exchange rate you will face in the future for converting pesos to your home currency.
You may feel hesitant about investing in other countries. You are not alone in this. Economists have detected something they call home bias. All else being equal, investors are more likely to buy assets issued by corporations and governments in their own country rather than abroad.
A Casino
Toward the end of your walk, you are particularly surprised to see a casino. Stepping inside, you see a casino floor, such as you might find in Las Vegas, Monaco, or Macau near Hong Kong. You are confronted with a vast array of betting opportunities.
The first one you come across is a roulette wheel. The rules are simple enough. You place your chip on a number. After the wheel is spun, you win if—and only if—you guessed the number that is called. There is no skill—only luck. Nearby are the blackjack tables where a version of 21 is played. In contrast to roulette, blackjack requires some skill. As a gambler in blackjack, you have to make choices about taking cards or not. The objective is to get cards whose sum is as high as possible without going over 21. If you do go over 21, you lose. If the dealer goes over 21 and you don’t, you win. If neither of you goes over 21, then the winner is the one with the highest total. There is skill involved in deciding whether or not to take a card. There is also a lot of luck involved through the draw of the cards.
You always thought of stocks and bonds as serious business. Yet, as you watch the players on the casino floor, you come to realize that it might not be so peculiar to see a casino on Wall Street. Perhaps there are some similarities between risking money at a gambling table and investing in stocks, bonds, or other assets. As this chapter progresses, you will see that there are some similarities between trading in financial assets and gambling in a casino. But you will learn that there are important differences as well.
Key Takeaways
• Many different types of assets, such as stocks, bonds, real estate, and foreign currency, are traded in financial markets.
• Your earnings from owning an asset depend on the type of asset. If you own a stock, then you are paid dividends and also receive a capital gain or incur a capital loss from selling the asset. If you own real estate, then you have a flow of rental payments from the property and also receive a capital gain or incur a capital loss from selling the asset.
• Risks also depend on the type of asset. If you own a bond issued by a company, then you bear the risk of that company going bankrupt and being unable to pay off its debt.
exercises
1. If you live in a house rather than rent it, do you still get some benefits from ownership? How would these benefits compare with the income you could receive if you rented out the house?
2. What assets are subject to the risk of bankruptcy? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/10%3A_Making_and_Losing_Money_on_Wall_Street/10.02%3A_A_Walk_Down_Wall_Street.txt |
Learning Objectives
1. What factors determine the value of an asset?
2. How do you use discounted present value to calculate the value of an asset?
3. How is risk taken into account when valuing an asset?
Our basic explanation of assets reveals that there are two ways in which you can earn money from holding an asset: (1) You may receive some kind of payment that we call a flow benefit—a dividend payment from a stock, a coupon payment from a bond, a rental check from an apartment, and so on. (2) The price of the asset may increase, in which case you get a capital gain. You might guess that the price of an asset should be linked in some way to the payments you get from the asset, and you would be right. In this section, we explain how to determine the price of an asset. To do so, we use two tools: discounted present value and expected value.These tools are discussed at length in Chapter 5 "Life Decisions".
Toolkit: Section 31.4 "Choices over Time" and Section 31.7 "Expected Value"
You can review the meaning and calculation of discounted present value and expected value in the toolkit.
The Value of an Orange Tree
Imagine that you own a very simple asset: an orange tree. The orange tree pays a “dividend” in the form of fruit that you can sell. What is the value to you of owning such a tree? You can think of this value as representing the most you would be willing to pay for the orange tree—that is, your valuation of the tree. As we proceed, we will link this value to the price of the orange tree.
We begin by supposing your orange tree is very simple indeed. Next year, it will yield a crop of precisely one orange. That orange can be sold next year for \$1. Then the tree will die. We suppose that you know all these things with certainty.
The value to you of the orange tree today depends on the value of having \$1 next year. A dollar next year is not worth the same as a dollar this year. If you have a dollar this year, you can put it in the bank and earn interest on it. The technique of discounted present value tells us that you must divide next year’s dollar by the nominal interest factor to find its value today:
Here and for the rest of this chapter we use the nominal interest factor rather than the nominal interest rate to make the equations easier to read. The interest factor is 1 plus the interest rate, so whenever the interest rate is positive, the interest factor is greater than 1. We use the nominal interest factor because the flow benefit we are discounting has not been corrected for inflation. If this flow were already corrected for inflation, then we would instead discount by the real interest factor.
Toolkit: Section 31.6 "The Credit Market"
You can review nominal and real interest rates and nominal and real interest factors in the toolkit.
To see why this formula makes sense, begin with the special case of a nominal interest rate that is zero. Then using this formula, the discounted present value of a dollar next year is exactly \$1. You would be willing to pay at most \$1 today for the right to receive \$1 next year. Similarly, if you put \$1 in a bank paying zero interest today, you would have exactly \$1 in the bank tomorrow. When the nominal interest rate is zero, \$1 today and \$1 next year are equally valuable. As another example, suppose the nominal interest rate is 10 percent. Using the formula, the discounted present value is = \$0.909. If you put \$0.909 in a bank account paying a 10 percent annual rate of interest (an interest factor of 1.1), then you would have \$1 in the bank at the end of the year.
A Tree That Lives for Many Years
Our orange tree was a very special tree in many ways. Now we make our tree more closely resemble real assets in the economy. Suppose first that the tree lives for several years, yielding its flow benefit of fruit for many years to come. Finding the value of the tree now seems much harder, but there are some tricks that help us determine the answer. Orange trees—like stocks, bonds, and other assets—can be bought and sold. So suppose that next year, you harvest the crop of one orange, sell it, and then also sell the tree. Using this strategy, the value of the tree is as follows:
The first term is the same as before: it is the discounted present value to you of the crop next year (\$1.00 in our example). The second term is the price that you can sell the tree for next year. After all, if the tree lives for 10 years, then next year it will still have 9 crops remaining and will still be a valuable asset.
This expression tells us something very important. The value of an asset depends on
• the value of the flow benefit (here, the crop of oranges) that you obtain while owning the asset,
• the price of the asset in the market when you sell it.
The insight that the value of the tree equals the value of the crop plus next year’s price greatly simplifies the analysis. If you know the price next year, then you know the value of the tree to you this year. Of course, we do not yet know how the price next year is determined; we come back to that question later.
We can now give a more precise definition of the return on an asset: it is the amount you obtain, in percentage terms, from holding the asset for a year. The return has two components: a flow of money (such as a dividend in the case of a stock) and the price of the asset. In the case of the orange tree, the return is calculated as
Because we know that
it follows that
In this simple case, the return on the asset is equal to the nominal interest rate. If we wanted the real return, we would use the real interest factor (1 + the real interest rate) instead.
A Tree with a Random Crop
So far we have assumed that you know the orange crop with certainty. This is a good starting point but is not realistic if we want to use our story to understand the value of actual assets. We do not know for sure the future dividends that will be paid by a company whose stock we might own. Nor do we know the future price of a stock or a bond.
Looking back at the tree that lives for one year only, imagine you do not know how many oranges it will yield. Start by assuming that you can buy a tree that lasts for one period and whose crop is not known with certainty. The value of the tree depends on the following.
• The expected value of the crop. You must list all the possible outcomes and the probability of each outcome. For example, Table 10.3.1 "Expected Crop from an Orange Tree" shows the case of a tree where there are three possible outcomes: 0, 1, or 2 oranges. The probability of 0 oranges is 10 percent—that is, 1 in 10 times on average, the tree yields no fruit. The probability of 1 orange is 50 percent: half the time, on average, the tree yields 1 fruit. And the probability of 2 oranges is 40 percent. The expected crop is obtained by adding together the numbers in the final column: 1.3 oranges.
• A risk premium is an addition to the return on an asset that is demanded by investors to compensate for the riskiness of the asset. This adjustment reflects the riskiness of the crop and how risk-averse the owner of the tree is. If the owner is risk-neutral, there is no need for a risk premium. Obviously enough, if the crop is known with certainty, there is also no need for a risk premium.
Toolkit: Section 31.7 "Expected Value"
You can review the concepts of risk aversion and risk-neutrality in the toolkit.
Outcome (Number of Oranges) Probability Probability × Outcome
0 0.1 0
1 0.5 0.5
2 0.4 0.8
Table \(1\): Expected Crop from an Orange Tree
The easiest way to see how the risk premium works is to recognize that someone who is risk-averse will demand a higher return to hold a risky asset. Earlier, we said that the return on an asset without risk equals the nominal interest rate. In the case of a risky asset, however,
From this we can see that there is a relationship between risk and return. If the crop is not risky, then the risk premium is zero, so the return equals the nominal interest rate. As the crop becomes riskier, the risk premium increases, causing an increase in the return per dollar invested.
We can see how the risk premium affects the value of the tree by rearranging the equation:
For a given expected crop, the higher is the risk premium, the lower is the value of the tree.
The Value of an Asset in General
We have been talking about orange trees because they nicely illustrate the key features of more complex assets. We can combine the insights from our analysis of the orange tree to obtain a fundamental equation that we can use to value all kinds of assets:
We apply this equation throughout the remainder of the chapter. To keep things simple, however, we will suppose most of the time that there is no risk premium—that is, we will discount using the nominal interest factor alone, except when we explicitly want to talk about the riskiness of different assets. We can now use this formula to value assets that are more familiar, such as bonds, stocks, cars, and houses.
The Value of a Bond
Suppose that you want to value a bond that lasts only one year. You will receive a payment from the borrower next year and then—because the bond has reached its maturity date—there will be no further payments. Naturally enough, the bond is worthless once it matures, so its price next year will be zero. This bond is like the first orange tree we considered: it delivers a crop next year and then dies. Hence we can value the bond using the formula
For example, if the coupon on the bond called for a payment of \$100 next year and the nominal interest rate was zero, then the value of the bond today would be \$100. But if the nominal interest rate was 10 percent, then the value of the bond today would be = \$90.91.
If the bond has several years until maturity,
This expression for the value of a bond is very powerful. It shows that a bond is more valuable this year if
• the coupon payment next year is higher,
• the bond will sell for a higher price next year, or
• interest rates are lower.
We explained earlier that bonds are subject to inflation risk. There are two ways of seeing this in our example. Imagine that inflation increases by 10 percentage points.
This inflation means that the coupon payment next year will be worth less in real terms—that is, in terms of the amount of goods and services that it will buy. Also, from the Fisher equation, we know that increases in the inflation rate translate into changes in the nominal interest rate. If inflation increases by 10 percentage points and the real rate of interest is unchanged, then the nominal rate increases by 10 percentage points. So the discounted present value of the bond decreases. Inflation risk might cause a bondholder to include a risk premium when valuing the bond.
Toolkit: Section 31.8 "Correcting for Inflation"
You can review the Fisher equation in the toolkit.
The Value of a Stock
Now let us use our general equation to evaluate the dividend flow from stock ownership. Imagine you are holding a share of a stock this year. You can hold it for a year, receive the dividend payment if there is one, and then sell the stock. For now we treat both the dividend and the price next year as if they are known for sure. What is the value of a share under that plan?
This equation is similar to the one we used for the fruit tree and the bond. The flow benefit in this case is the dividend paid on the stock. Because the dividend is received next year, we have to discount it back to the current year using the nominal interest factor. The other part of the value of the share comes from the fact that it can be sold next year. Again, that share price must be discounted to put it in today’s terms. If the share does not pay a dividend next year, then its value is even simpler: the value of the share this year equals its price next year discounted by the nominal interest factor.
The return to owning the share comes in two forms: the dividend and the gain from selling the share next year. To calculate the return per dollar invested, we divide the dividend and future price by the value of a share this year:
Table 10.3.2 "Discounted Present Value of Dividends in Dollars" shows an example where we calculate the value of a stock using two different interest rates: 5 percent and 10 percent.
Dividend Price Next Year Discounted Present Value (5%) Discounted Present Value (10%)
1 2 2.86 2.73
1 4 4.76 4.55
2 4 5.71 5.45
Table \(2\): Discounted Present Value of Dividends in Dollars
The Value of a House
There are other familiar assets that can also be valued in the same way. A house is an asset that delivers a benefit each year in the form of providing shelter. The value of a house is the flow of services that it provides over the coming year plus the price it could be sold for next year. Of course, instead of living in your house and enjoying the service flow, you could rent it out instead. Then
For a house and similar assets, the value today reflects
• the flow of services of the asset over a year,
• the resale value next year, and
• the interest rate that is used to discount the future flows.
This completely parallels what we have already found for both bonds and stocks.
Key Takeaways
• The value of an asset is the most you would pay to own that asset. The value today is the discounted value of the sum of the dividend (or service flow) plus the future price of the asset.
• Because the return of owning an asset comes in the future, you use discounted present value to calculate the current value of the asset. If the dividend and future price are not corrected for inflation, then you discount using the nominal interest rate. If the dividend and future price have already been corrected for inflation, then you discount using the real interest rate.
• The value of an asset is reduced by a risk premium that takes into account the riskiness of the asset and your risk aversion.
Checking your understanding
1. plain why an increase in the price of an asset in the future will increase its value today. Is this a violation of the law of demand?
2. In the section "The Value of a House", we talked about houses. Can you think of other assets that could be valued using a similar formula?
3. Revise Table 10.3.1 "Expected Crop from an Orange Tree" so that the probability of getting 0 oranges is 0 and the probability of getting 3 oranges is 0.1. What is the expected crop from this tree? Is it more or less valuable to you? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/10%3A_Making_and_Losing_Money_on_Wall_Street/10.03%3A_The_Value_of_an_Asset.txt |
Learning Objectives
1. What is arbitrage?
2. How are asset prices determined?
So far we have focused on the value of an asset to an individual: “What is the value to you of the asset (fruit tree, bond, stock, car, house, etc.) you are holding?” Now we want to go a step further and see what the market price is for the asset. We already know that the two are connected. For example, when we valued a bond, we wrote
Part of the value of a bond to you is the price you can sell it for on the market next year. Now we explain that the current price of a bond is closely connected to its current value.
Arbitrage
Assets are traded in markets around the world. Typically, there are a large number of (potential) buyers and sellers for any given asset: thousands of people might be willing to buy Microsoft Corporation stock or sell government bonds if they felt the price was right. Also, assets are homogeneous: one US government 10-year bond is the same as another. This means that asset markets are a good example of competitive markets, which means that we can look at asset markets using supply and demand.
Toolkit: Section 31.9 "Supply and Demand"
You can review supply and demand and competitive markets in the toolkit.
To derive the supply and demand curves for assets, we use the idea of arbitrage. This is the act of buying and then reselling an asset to take advantage of profit opportunities. The idea of arbitrage is to “buy low” and “sell high.” Arbitrage is usually carried out across two markets to profit from any difference in prices. The strict definition of arbitrage refers to buying and selling where there is no risk, meaning that profits can be made with certainty. A weaker meaning of arbitrage allows risk to be associated with the process.
Imagine you passed a coffee shop and saw the sign shown in Figure 10.4.1 "Arbitrage at a Coffee Shop". This would make an economist salivate, not because of the prospect of good coffee but because it presents an opportunity for arbitrage. Facing an offer like this, you could immediately go and buy a pound of coffee beans for \$10. Then you could turn around and sell the coffee at \$12 per pound. You would have made \$2 easy profit. Forget about drinking the coffee: just buy and sell, buy and sell, pound after pound—and become a billionaire. This is an example of arbitrage.
Sadly, you will never see a coffee shop making you an offer like this. We are confident of this because any coffee shop that made such an offer would very quickly go out of business. After all, if you can make a profit by buying at a low price and selling at a high price, then whoever is on the other side of these transactions is making a loss.
Arbitrage in the Supply-and-Demand Framework
We can think about arbitrage using the supply-and-demand framework. There are two markets: in one the coffee shop sells coffee, while in the other the coffee shop buys coffee. The demand of potential buyers would be extremely large, and the supply of coffee (from people selling it back) would likewise be very large. With the prices for buying and selling coffee as stated in the sign, demand could never equal supply in these two markets. An arbitrage possibility like this is not consistent with market equilibrium.
Using similar logic, we can argue that the price of an asset will equal its value. To see why, we begin again with an orange tree that will yield an orange worth \$1 next year. Owners of this asset value it at
They will be willing to sell the asset at this price but not if the price is any lower. They would definitely want to sell if the price were higher. But buyers can perform exactly the same calculation. They would be willing to buy the asset at this price but not if the price were any higher. They would definitely want to buy if the price were lower. Figure 10.4.2 "Asset Demand and Supply" shows the supply of and demand for trees in this case.
(a) Owners of trees are willing to sell at a price equal to the discounted present value of the tree, and the supply curve is flat (perfectly elastic) up to the total available stock of trees. (b) Potential buyers of trees are willing to buy at a price equal to the discounted present value of the tree, and the demand curve is flat (perfectly elastic).
The supply side is shown in part (a) of Figure 10.4.2 "Asset Demand and Supply". There is a given stock of trees available. For prices below the asset value, no one wants to sell the asset. At prices above the value, everyone wants to sell the asset. So the supply curve is horizontal at a price equal to the asset value, all the way up to the point where every tree is on the market. At that point, the supply curve becomes vertical. The demand function is in part (b) of Figure 10.4.2 "Asset Demand and Supply". At a price above the discounted present value of the tree, the quantity demanded is zero: no one will pay more than the discounted present value for the asset. If the price equals the value, the demand is flat (horizontal). At a price below the value, the asset looks like a great deal because there are arbitrage opportunities. So demand is very large.
Figure \(3\): Asset Market Equilibrium
Because buyers and sellers place the same value on the tree, the demand and supply curves lie on top of each other at this value, so the price will equal the discounted present value of the tree.
We put these curves together in Figure 10.4.3 "Asset Market Equilibrium". Both supply and demand are horizontal at a price equal to the discounted present value of the asset. Thus at this price, and at this price only, supply equals demand. We obtain a powerful prediction: assets will be priced at their discounted present value. If we see the prices of assets (such as stocks or bonds) increase or decrease, this model of the asset market tells us to attribute these variations to changes in the discounted present value of dividends.
The supply and demand curves in these figures look rather untraditional. We are used to seeing upward sloping supply curves and downward sloping demand curves. But in the market for the tree, everyone values the asset in exactly the same way. That valuation is given by the discounted present value of the dividend stream. As a result, Figure 10.4.3 "Asset Market Equilibrium" does not tell us how much people will trade or if they will trade at all. When the price equals the discounted present value, buyers are indifferent about buying, and sellers are indifferent about selling. Everyone is happy to trade, but no one particularly wants to trade. In reality, though, the market for an asset may look much more like a “normal” supply-and-demand diagram, as in Figure 10.4.4 "Asset Market Equilibrium: A More Familiar View", with an upward-sloping supply curve and downward-sloping demand curve. The reason is that different individuals may have differing views about the discounted present values of the asset, because Chapter 6 "eBay and craigslist" discusses in some detail the reasons why people trade. We explain that important motives for trade are that people have different tastes and skills. To these we can add the two motives just mentioned here.
• different buyers and sellers have different information that causes them to make different forecasts of future dividends, or
• different buyers and sellers differ in their attitudes toward risk.
Figure \(4\): Asset Market Equilibrium: A More Familiar View
If potential buyers and sellers of an asset differ in their beliefs about the dividend from that asset or differ in terms of their degree of risk aversion, then we obtain demand and supply curves of the familiar form.
For example, suppose some buyers are optimistic about future dividends from a stock, while others are pessimistic. Optimistic buyers will calculate a high discounted present value and have a high willingness to pay. Pessimistic buyers will calculate a lower discounted present value and be willing to pay less for the asset. Such differences in views can hold for sellers as well. Alternatively, suppose some buyers and sellers are more risk-averse than others. The less risk-averse the buyer, the higher the price he is willing to pay because he uses a lower risk premium when calculating his discounted present value. The less risk-averse the seller, the higher the price she is willing to accept.
There is one last, more subtle point. We have been imprecise—intentionally—about what exactly it means for an asset to be risky. Buyers and sellers care not only about assets in isolation but also about how those assets fit into their entire portfolio—that is, the entire collection of assets that they own. An asset that seems very risky to one person may appear less risky to another because he holds other assets that balance out the risks. The riskiness of an individual asset depends on the diversification of the portfolio as a whole.
In Figure 10.4.3 "Asset Market Equilibrium", all traders in the market valued the asset in exactly the same way, so arbitrage guaranteed that the price equals the discounted value of the flow benefit. In Figure 10.4.4 "Asset Market Equilibrium: A More Familiar View", there is no immediate guarantee that this will still be true. Even with differences in valuation, however, we expect that the price of an asset is still likely to be (at least approximately) equal to its true discounted present value. In particular, if some traders in the market do not care about risk and are accurately informed about the flow benefit, arbitrage will still keep the market price close to the discounted present value of the stock.
We have not yet explained how supply and demand actually come together in financial markets—that is, who actually makes the market? If you study the workings of a market such as the New York Stock Exchange, you will learn that it works through specialized traders. If you want to buy a stock, you typically contact a stockbroker who communicates your demand to his firm on Wall Street. Another broker then takes that order onto the floor of the stock exchange and looks for a seller. If a seller is found, then a deal can be made. Otherwise, the broker can place your order with another specialist who essentially “makes the market” by buying and selling securities at posted prices. So in the end, the market has some elements of posted prices (take-it-or-leave-it offers) and some elements of a double-oral auction.Both of these are discussed in more detail in Chapter 6 "eBay and craigslist".
The Price and Value of a Long-Lived Asset
Previously, we explained how to value an asset assuming you hold it for one year, receive the flow benefit (the fruit, the dividend, or the coupon payment), and then sell it at the current market price. We said that (assuming no risk premium)
We have also discovered that, in general,
\[value\ of\ asset\ =\ price\ of\ asset.\]
We combine those two pieces of information to complete our study of the valuation of assets. Imagine an orange tree that lives for two years and yields a crop valued at \$1 each year. We already know that we can value the tree as follows:
But now we know that the price of the tree next year will equal the value of the tree next year:
Next year, we can apply exactly the same formula:
Why is this true? The year after next, this particular tree will be worthless because it will be dead. So the value of the tree today is
This is a more complicated formula. It tells us that the value of the tree today is the discounted present value of the flow benefit tomorrow plus the discounted present value of the value of the tree tomorrow—which is itself the discounted present value of the flow benefit the year after. In other words, the value of the tree today is the discounted present value of the flow benefits over the entire lifetime of the tree. What is more, we could use exactly the same logic if the tree were to yield a crop for 3 years, 10 years, or 100 years.
There is one last step. If we again use the idea that the price of the tree should equal its value, then we can conclude the following:
\[price\ of\ tree\ this\ year\ =\ discounted\ present\ value\ of\ the\ flow\ of\ benefits\ from\ the\ tree.\]
This logic applies to all assets, not only trees, so we can now apply it to bonds and stocks:
\[price\ of\ bond\ today\ =\ discounted\ present\ value\ of\ the\ flow\ of\ payments\ from\ the\ bond\]
and
\[price\ of\ share\ today\ =\ discounted\ present\ value\ of\ the\ flow\ of\ dividend\ payments.\]
A final note on uncertainty. We have been assuming that dividends are known with certainty. If they are not, then we need to modify the valuation of the stock by (1) replacing “dividend” with “expected dividend” and (2) adding a risk premium to the interest rate. As discussed previously, the adjustment for risk will reflect both the riskiness of the stock and the aversion to risk of investors. Riskier stocks generally have a lower value and a higher expected return.
Key Takeaways
• Arbitrage entails the buying and selling of assets to make a profit. In equilibrium, there are no profits to be made through arbitrage.
• The price of an asset is (approximately) equal to the discounted present value of the flow of benefits (dividends, service flow, etc.) from the asset.
Exercises
1. Suppose an orange tree lives for two years, with a crop of five oranges in the first year and three in the second year. The price is \$2 in the first year and \$5 in the second year. If the interest rate is 20 percent, what is the price of the orange tree?
2. Explain why an increase in interest rates will reduce the price of a bond. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/10%3A_Making_and_Losing_Money_on_Wall_Street/10.04%3A_Asset_Markets_and_Asset_Prices.txt |
Learning Objectives
1. Is it possible to make large profits in asset markets?
2. Is it easy to make large profits in asset markets?
3. What are some factors that cause asset prices to increase and decrease?
4. Why do asset prices respond to new events but not forecasted ones?
5. Are markets efficient?
The title of this chapter speaks of making and losing money on Wall Street. We have gone into considerable detail about what determines the price of assets, but we have not yet discussed how easy or hard it is to make money by buying and selling these assets.
Can Easy Profits Be Made on Wall Street?
Our fictional Wall Street contained places where you could buy many different kinds of assets, such as real estate and automobiles as well as stocks and bonds. But it also contained a building that wasn’t selling assets at all: the casino.
Is Wall Street Like a Roulette Wheel?
Is buying and selling shares like gambling on a roulette wheel, where gains and losses are purely a matter of luck? To answer this question, think more about the uncertainty associated with buying stocks and bonds. Suppose we are buying a stock that will pay dividends over four years, as in Table 10.5.1 "Discounted Present Value of Dividends in Dollars", and suppose that the interest rate is 5 percent. From Table 10.5.1 "Discounted Present Value of Dividends in Dollars", we know that the discounted present value of the stock is \$609.61. We then expect this will also be the price of the stock.
Year Dividend (\$) Discounted Present Value (\$, Interest Rate = 5%)
1 100 95.2381
2 90 81.63265
3 120 103.6605
4 400 329.081
Discounted present value (all years) 609.61
Table \(1\): Discounted Present Value of Dividends in Dollars
Can you make money buying and selling this stock? It seems unlikely. If the price of a stock is equal to the present discounted value of the flow of dividends, then you get what you pay for. If you sell the stock, then instead of an asset that would have paid you the equivalent of \$609.61, you receive \$609.61 in cash. If you buy the stock, the reverse is true. Either way, you are no richer or poorer after the transaction; you are just holding your wealth in a different form.
Economists often use the metaphor of \$100 bills lying on the ground to describe a situation where easy money can be made. Our example of the arbitrage opportunity in the coffee shop, where you could buy beans at \$10 a pound and resell them at \$12 a pound, is an example: getting rich in that coffee shop is as easy as picking up money on the floor. But if the value of a stock is the discounted present value of the dividends that it will pay, then there is no easy money to be made. There are no \$100 bills lying around. You should not anticipate spectacular earnings from owning assets. You can earn a reasonable rate of return, equal to the nominal interest rate, but no more. A market with the characteristic that you cannot expect to earn abnormal profits is called an efficient market. In such a market, the price of an asset accurately reflects the best forecast of the value of that asset. The value of an asset is the discounted present value of the flow benefits.
Yet this may strike you as odd. There are many people who certainly make it rich by buying and selling stocks, bonds, and other assets. Some of these individuals—like Warren Buffett or George Soros—are household names. Does the fact that some people get very rich on Wall Street mean that markets are not efficient?
There are a couple of possible answers to this question. The first is that even when markets are efficient, some people may get rich. Go back to the stock we were considering earlier but with one small change. Imagine that the numbers in Table 10.5.1 "Discounted Present Value of Dividends in Dollars" are now expected dividends. They tell you what this stock can be expected to pay out on average, but they are not guaranteed. For example, it might be the case that in year four, the firm will pay a dividend of \$800 with 50 percent probability but will also pay \$0 with 50 percent probability. The expected dividend is \$400. If people care only about the expected value of the dividends (if they are risk-neutral), the price of the stock still equals the (expected) discounted present value.
Now, there are still no \$100 bills on the ground. You cannot expect to make unusual profits by buying this stock or others like it. However, some people will get lucky and thus get rich. If you bought this stock, and it ended up paying the high dividend, you would end up with a return nicely above the market interest rate. If it failed to pay the dividend, however, you would get a lower return than the market interest rate. As we looked around the economy, we would see some lucky investors earning high returns and other unlucky investors earning low returns. In this world, buying and selling assets in the stock market is really not that different from betting on a roulette wheel. Buying an asset is like placing your chip on a certain number. If the number comes up, you get rich. If it does not, you lose.
When you go to a casino, you should not expect to win at roulette. But this does not mean that you can never earn spectacular amounts of money. It happens frequently: casinos thrive on advertising these success stories. The same goes for buying an asset, such as a stock. Suppose you buy a share in a pharmaceutical company. The price of the share when you purchase it might indeed equal the expected discounted present value of dividends. Yet the following week the company could have a major discovery that will allow it to be much more profitable in the future. Expected dividends will increase, and so will the stock price. This is certainly good news for you. But it is also no different from getting lucky on the roulette wheel.
Spectacular successes tend to be more visible than losses. In the 1990s, some people earned large amounts (sometimes spectacularly large amounts) from certain successful Internet companies. But many other people lost money on Internet companies that were ultimately unsuccessful, and you are less likely to hear about them.
Is Wall Street Like a Blackjack Table?
More than luck is required when investing on Wall Street, however. Just as there are skilled players of blackjack in the casino, there are people who are skilled in assessing the prospects of different firms in an economy.
If the price of a share equals the discounted present value of the dividends that a company will pay, then the total value of all the shares in a company should equal the discounted present value of the total profits the firm will pay out—both now and in the future. The total value of all the outstanding shares in a firm is called its market capitalization.
The price of a share increases whenever a firm’s market capitalization increases, and a firm’s market capitalization should increase whenever there is reason to think that the firm has become more profitable—either now or in the future. If markets are efficient, therefore, we expect share prices to respond to new information about a firm. Traders in large financial firms make their money in part by gathering new information about firms and then acting very quickly on that new information. News about a firm—good or bad—is likely to be incorporated quickly into a firm’s market price, but a trader who can move fast can make money from these movements.
When economists use the metaphor of \$100 bills lying on the ground, they are pointing out that if opportunities for easy profits arise, they will disappear very quickly. It is not impossible that someone will drop a \$100 bill. But it is highly unlikely that that bill will lie unretrieved for more than a few minutes. If there is easy money to make in the market by buying a stock, professional traders will jump on the opportunity quickly. This has an important implication for the rest of us. If you read in the newspaper today that Merck Pharmaceuticals has just announced a new pharmaceutical compound that is highly effective in treating lung cancer, there is no point in calling your broker and instructing him to buy Merck stock on the basis of this news. Somebody—a very smart trader with her ear to the ground and lots of knowledge about the pharmaceutical industry—might well have made money buying Merck stock at the first hint of this news. But by the time there is an announcement in the paper, the increase in Merck’s expected profits has long been factored into the price.
Are Markets Efficient?
The theory of efficient financial markets is very powerful because it gives us a key to understanding the prices of assets. Go back to our equation for the value of an asset:
In the case of a share, the flow benefit is the value of the dividend. If the price next year is the discounted present value of further dividends from that point in time onward, then this equation is another way of saying that the value of the share today equals the discounted present value of dividends.
But what if the price that everyone expects an asset to sell for next year is—for some reason—much higher than the discounted present value of the flow benefit from the asset starting next year? As an example, consider a house. You buy a house in part to enjoy living in it—to enjoy “housing services.” You also buy a house as a possible source of capital gains if the price of the house increases. Imagine you live somewhere where everyone seems to think housing prices will increase a lot over the next few years. Then you should be willing to pay more for a house. After all, if you anticipate a large capital gain in five years from selling the house, you can pay more for it now and still expect a good return. So if everyone expects the price of houses to increase in the future, then the current demand for houses increases, so the current price increases. The price increase today reflects the expectation of higher prices in the future.
Now fast forward to next year. We can say the same thing applied to next year: “If everyone expects the price of houses to increase in the future, then the current demand for houses increases, so the current price increases.” This can go on from year to year: housing prices are high because everyone expects higher prices in the future. Higher prices have an element of self-fulfilling prophecy: prices increase because everyone thinks prices will continually increase.
This is sometimes called a housing bubble. In a bubble, the increase in the price of housing does not reflect an increase in the value people place in housing services. In the language of economics, the price is not changing because of any change in the fundamentals. Furthermore, it is possible that prices will not actually keep increasing. If everyone suddenly becomes more pessimistic about the future of housing prices, then the capital gains that everyone anticipated are gone, and housing prices collapse. In this case, the bubble bursts, and prices fall—sometimes very rapidly.
Many economists think that something like this happened in the early stages of the global financial crisis that started in around 2007. The price of housing in many markets had been increasing substantially, and people expected this to continue. At some point, people stopped being so confident that house prices would keep increasing—and, sure enough, the price of houses then decreased rapidly.
The same idea applies to stocks. If everyone believes the value of a particular stock will be higher in the future, then the price will be bid up today. If these beliefs persist, they can sustain a bubble in the stock. If everyone believes that stocks will generally increase in price, then this can lead to a bubble in the entire stock market.
Data on the prices of stocks can perhaps help us see if the efficient market view is accurate, or if we instead see lots of bubbles. This sounds like an easy exercise but is actually very hard. It is difficult to calculate the discounted present value of expected dividends because it requires forecasts of the future. The usual interpretation of this evidence is that the efficient market hypothesis is not capable of explaining all the variations in asset prices, particularly over short periods of time.
An extreme example illustrates this point well. Here is a quotation from an article that appeared in the Wall Street Journal after the collapse in the US stock market in 1987: “Calmly appraised, the intrinsic value of American industry didn’t fall 23 percent in a day.”Roger Lowenstein, “After the Fall: Some Lessons Are Not So Obvious,” Wall Street Journal, August 25, 1997. “The intrinsic value of American industry” refers to the total market capitalization of all the firms quoted on the stock exchange. It is hard to explain such short-run variations in asset prices from the perspective of discounted present value of dividends.
Economist Robert Shiller claims that stock markets can exhibit “irrational exuberance.” He argues that asset prices move around too much to be explained by theories that rely on the discounted present value of dividends to the price of assets. Instead, the fluctuation of prices, at least over short periods of time, might also be influenced by expectations and bubbles. More generally, Shiller is one of many financial economists who believe that economic theory needs to be supplemented with some ideas from social psychology to do a better job of explaining the performance of financial assets. Such behavioral finance has identified several anomalies—that is, occasions on which asset prices apparently diverge from the values predicted by efficient market theory.
Despite the insights of behavioral finance, most economists take the view that, at the very least, efficient market theory is the best starting point for thinking about asset prices. Efficient market theory provides us with two key insights: (1) the price of a stock should reflect expectations about future profits, which means that (2) the price of a stock should change when—and only when—there is new information that changes those expectations. Many economists nonetheless think this approach is incomplete and that behavioral finance can also help us understand financial markets. A word of caution: even if markets are not always efficient, this still does not mean that there are easy ways to make money on Wall Street.
Changes in Asset Quantities and Asset Prices
Each weekday in the United States, around 5 p.m. Eastern Standard Time, there are reports on the performance of the markets that day. At other times of the day, you can learn about other markets around the world. Newscasters report on the volume of trade (the number of shares exchanged) and some index of the price of stocks, such as the DJIA. In economic terms, these are reports about the price and quantity in a market. Therefore we can use the supply-and-demand framework, and more specifically the tool of comparative statics, to consider what makes asset prices increase and decrease.
Toolkit: Section 31.16 "Comparative Statics"
You can review how to carry out a comparative statics exercise in the toolkit.
If we take the efficient-market view that the price of an asset equals its discounted present value, then any change in the price of an asset must be due to some change in its expected discounted present value. If, for example, the price of General Motors stock increases, this should reflect some information about the prospects and hence future dividends of this company. Moreover, any information that makes the price increase or decrease must be new. If it were old information that everyone in the market already knew, then it would have already been factored into the stock price. Hundred-dollar bills do not stay on the ground for long. So what are some of the big events that can change asset prices?
Product Development News
Part of the profitability of a firm comes from its innovative activities in developing and marketing new products. Open a computer magazine, for example, and you will see hundreds of advertisements for a wide range of new products. How does news about a new product affect the price of a firm’s stock?
Consider the following story:
Pfizer stock tumbled Monday after the world’s biggest drugmaker abruptly pulled the plug on its most important experimental medicine—a drug meant to treat heart disease that instead caused an increase in deaths and heart problems in people taking it in a clinical trial.
Shares of Pfizer sank about 11 percent in afternoon trading as investors worried what the New York-based company would do to replace the product, torcetrapib, in its pipeline.
Pfizer CEO Jeffrey Kindler unveiled his company’s pipeline at an analyst meeting last week, before the bad news on torcetrapib.
Trading was heavy with more than 235 million shares changing hands by mid-afternoon—nearly seven times the stock’s average daily volume.
On Saturday, Pfizer and the Food and Drug Administration announced that the drug company would halt a clinical trial of torcetrapib due to an increased rate of death and heart problems in patients who took it.
Just two days earlier, Pfizer’s new CEO Jeffrey Kindler had told hundreds of investors and analysts at a research meeting that the drugmaker could seek approval for the medicine as early as next year if clinical data supported it.Aaron Smith, “Heart Drug Pulled, Pfizer Tumbles,” CNNMoney.com, December 4, 2006, accessed January 29, 2011, http://money.cnn.com/2006/12/04/news/companies/pfizer_stock/index.htm.
Pfizer’s announcement is the exogenous variable in this comparative statics exercise. The story tells us that the announcement led to a decrease in price and a large amount of trading. Let us try to make sense of this. First the announcement clearly contained new information that the markets had not anticipated. Indeed, the article tells us that, a few days previously, there had been positive information about this product.
Because market participants did not previously know the results of the clinical trials, and because the announcement is bad news, analysts and market professionals immediately revise downward their estimates of the future profitability of Pfizer. They now expect that dividends in future years will be lower than they had previously thought. This reduction in the discounted present value of dividends causes the stock price to decrease.
The way this works in the supply-and-demand framework is shown in Figure 10.5.1 "Bad News about a Firm’s Product Reduces the Value of Its Stock.". The bad news influences both the demand and supply curves. Prospective buyers of the stock are not willing to pay as much for it, given the bad news. So at a given stock price, the quantity demanded decreases. In Figure 10.5.1 "Bad News about a Firm’s Product Reduces the Value of Its Stock.", the demand curve shifts to the left. Owners of the stock are now less interested in holding their shares. So at a given price, the quantity supplied increases. This means that the supply curve shifts to the right.
Bad news about a clinical trial causes many current holders of Pfizer stock to want to sell their shares and makes people less likely to want to buy Pfizer stock.
The bad news has an unambiguous effect on the price of the stock: it decreases. The effect of the announcement on the quantity traded is not clear. It depends on the steepness of the curves and the relative shifts in supply and demand. In this particular example, we know that there was an unusually large amount of trading, so the equilibrium quantity increased.
Had the results of the clinical trials already been leaked to the market, there would have been no new information from the announcement. The test results would already have been incorporated in the asset price. The supply and demand curves would not have moved at all.
Monetary Policy
In most modern economies, interest rates are set (or more precisely heavily influenced) by a central bank through its conduct of monetary policy. This process and its effects on an economy are studied in detail in macroeconomics courses. Here, we look at the effect of monetary policy on asset prices.
Because monetary policy influences interest rates, the link to asset prices is immediate. We know that the price of an asset equals its discounted present value, and that interest rates are used for the discounting process. A change in interest rates therefore directly affects asset prices. Using the example in Table 10.5.1 "Discounted Present Value of Dividends in Dollars", if a monetary authority were to increase the interest rate from 5 percent to 10 percent, then the asset price would decrease by about \$81.
Figure \(2\): Equilibrium Asset Prices Respond to a Decrease in Interest Rates
A reduction in interest rates shifts the demand curve for assets (stocks, bonds, and other assets) to the right and shifts the supply curve to the left.
Figure 10.5.2 "Equilibrium Asset Prices Respond to a Decrease in Interest Rates" shows the impact of monetary policy on the supply-and-demand framework. As the interest rate decreases, the discounted present value of an asset increases. So at a given price, the demand for an asset increases. This is shown as an outward shift in demand. Also, at a given price, the supply of the asset decreases. As the interest rate decreases, more holders of the asset want to hold onto it, so the quantity supplied to the market is lower at each price. A rightward shift of the demand curve, combined with a leftward shift in the supply curve, tell us that the price of an asset increases when the interest rate decreases. The effect of the interest rate change on the quantity traded is ambiguous: it depends on the relative slopes of the curves and how much the curves shift.
Multiple Asset Markets
On the walk down Wall Street, we noticed that there were many markets, all trading simultaneously. Yet we have looked at the market for each particular asset in isolation. This is a fine tactic for understanding how to do comparative statics. But the real world is more complex: a single event can impact multiple markets.
Take, for example, the bad news on the test results for Pfizer. We saw that this news forced the firm’s stock price to decrease. But Pfizer may have also borrowed in years past by issuing bonds. What will happen to them when the bad news hits the bond market? The price of a bond is the discounted present value of the interest payments on a bond over its lifetime, taking into account the possibility of bankruptcy. So the bad news from the pharmaceutical company ought to depress the price of its bonds. This happens largely because the chance of bankruptcy—while surely small—increases with the bad news.
We observed earlier that the global financial crisis had its origins, at least in part, in the real estate market. The effects quickly spread beyond the housing market. Many people had borrowed to buy houses, and these loans—known as mortgages—were financial assets held by banks. When housing prices decreased, the value of these mortgages decreased as well. Moreover, these mortgages were often combined in various ways to make new assets. When housing prices decreased, the price of these related assets decreased as well. And because financial institutions sometimes had difficulty working out the value of their assets, there was a risk that they would go bankrupt. This in turn meant that anyone who had lent to such an institution now had an asset that was less valuable. Thus a collapse in the price of one asset—houses—led to a decrease in the price of all sorts of other assets in the economy as well.
Key Takeaways
• If markets are efficient, then, on average, there are no excessive profits to be made in asset markets. Some people will be lucky and do better than average, while others will be unlucky and do worse than average.
• Efficient markets provide a benchmark for asset valuation, though asset prices may sometimes deviate from these values.
• We use comparative statics to study the effects of changes in asset supply and demand on prices. Shifts in asset demand may come from new information about a new product or a new technique established by a firm. Monetary policy may also influence the demand for an asset.
• Asset markets respond to events, like the surprise announcement of a new product. Asset markets do not respond to changes today that were announced in the past, such as a change in interest rates by a central bank that was announced (or forecasted) weeks earlier.
check your understanding
1. Explain how the expected return from playing slot machines is negative even though lots of people have great stories about winning money playing slot machines. Can you tell a similar story about stock markets?
2. If you see housing prices in a city decrease by 50 percent over six months, how would you explain this using the efficient markets viewpoint?
3. Suppose there is good news about a company’s future product. What happens to the value of its stock?
4. Using the supply-and-demand framework, show how an increase in interest rates can increase the quantity of an asset sold. Now show how a decrease in interest rates can increase the quantity of an asset sold. What are the key differences between the two figures you just created? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/10%3A_Making_and_Losing_Money_on_Wall_Street/10.05%3A_Efficient_Markets.txt |
In Conclusion
The performance of the stock market is one of the most closely watched of all economic statistics. This chapter provided some clues as to why people care so much about the value of stocks and other assets.
One reason is that people save by purchasing stocks and other assets. Thus savers want to know what determines the value of assets in the economy. Having read this chapter, you should now understand that the value of any asset is closely linked to the flow of benefits that the asset provides. Indeed, if markets are efficient, then the value of any asset should equal the discounted present value of the flow of benefits.
There are two other reasons why we pay so much attention to the stock market. (1) If the value of a stock reflects the discounted present value of expected dividends, then the market capitalization of a firm represents the best guess as to the value of that firm—which depends ultimately on the profits that it will generate in the future. In that case, a stock market index represents our best guess of the overall value of all firms. It truly is a measure of an economy as a whole. (2) The stock market plays a key role in allocating an economy’s saving to those firms that can make the most profitable use of those funds.
Key Links
exercises
1. List the factors you think would make stock prices increase and decrease in the Shanghai stock exchange.
2. An October 2007 article in the Economist magazine discusses land prices and office rents. According to the article, rents have recently increased, and land prices have been increasing in the past few years as well. Why would land prices and rents move together?
3. Following from Question 2, what do you think has happened to the price of office buildings as rental rates have increased?
4. Suppose an orange tree yields a crop of one orange after the first year and then two oranges in the second year. As before, let the price of an orange be \$1 in both years. What is the value to you of buying the tree today and then selling it next year, after you have harvested the first orange? (Hint: first find the value of the tree tomorrow and then use that as the price for selling the tree.)
5. Suppose an orange tree lives for two years, with a crop of five oranges in the first year and three in the second year. The price is \$2 in the first year and \$5 in the second year. If the interest rate is 20 percent, what is the price of the orange tree?
6. (Advanced) The table titled Discounted Present Value Exercise provides information about the crop from an orange tree as well as the interest rate for a tree that lives four years. Assume that the price of oranges is \$1 in the first year and then increases at 10 percent per year. What is the discounted present value of this tree?
7. Suppose prospective buyers of houses become very optimistic about the future prices of houses. Existing owners, on the other hand, become very pessimistic about the future value of houses. What happens to the price of houses today?
8. Suppose housing markets are efficient. If you see rapidly increasing prices in a market, do you think that rental rates are increasing as well?
9. Explain how contractionary monetary policy can reduce housing prices.
10. (Advanced) In the first row of Table 10.3.2 "Discounted Present Value of Dividends in Dollars", we considered a stock that pays a dividend of \$1 this year and that will have a price of \$2 next year. Suppose the inflation rate from this year to next year is 5 percent. There are two ways that you can correct for this inflation.
1. You can leave next year’s price in nominal terms and deflate by the nominal interest rate, as we did in the table.
2. You can adjust next year’s price and put it in terms of today’s dollars, so next year’s price is a “real price.” Then you can discount using the real interest rate, which you can get from the Fisher equation.
Show that you get the same answer for the discounted present value using the second method as using the first method. (Note: when the interest rate is 10 percent, you should get exactly the same answer; when the interest rate is 5 percent, there will be a very small difference because the Fisher equation is an approximation.)
11. Can you think of an exogenous event that would cause the demand curve but not the supply curve for an asset to shift?
12. (Advanced) Explain why the DJIA and other stock market indices are more useful after they have been adjusted for inflation.
Economics Detective
1. Find data from a stock exchange in another country. Create a version of Figure 10.2.1 "The DJIA: October 1928 to July 2007" for that stock exchange.
2. What is the current annual return on US government bonds? What is the current annual return on government bonds issued by Argentina? How would you explain the differences in returns?
3. Find recent data on the yields on the debt of Ireland, Spain, and Portugal. What happened to these yields, relative to the yield on German debt, in both October 2010 and November 2010? How might you explain the patterns you find? (Hint: think about our discussion of the riskiness of bonds.)
4. The chapter opened with a discussion of the stock market in Shanghai. Suppose you wanted to buy shares of a company trading on that exchange. How would you go about doing that?
5. Look at data on housing prices in your area. Do they fluctuate as much as stock prices?
Spreadsheet Exercise
1. Suppose an orange tree lives for three years, with a crop of 5 oranges in the first year, 3 in the second year, and 10 in the third year. The price is \$2 in the first year and \$5 in the second and third years. If the interest rate is 20 percent the first year and then 10 percent the next two years, what is the price of the orange tree?
Year Number of Oranges Price of Orange Revenue Interest Rate
1 5 1.00 0.05
2 6 0.10
3 4 0.075
4 10 0.20
TABLE \(1\): DISCOUNTED PRESENT VALUE EXERCISE
10.07: Appendix- A General Formulation of Discounted Present Value
This section presents a more general way of thinking about discounted present value. The economic idea is the same as the one we encountered when discussing the pricing of orange trees. Here the idea is to isolate the central ideas of discounted present value. We then use this more general formulation to talk about the pricing of stocks in an asset market.
We begin by defining the t-period real interest factor between the present date and some future date t years from now. The t-period real interest factor is simply the amount by which you must discount when calculating a discounted present value of a flow benefit (already adjusted for inflation) that will be received t years from now.
Suppose we have an asset that will provide real dividend payments every year for t years. Suppose that Dt is the real dividend in period t, and Rt is the real interest factor from the current period to period t. Then the price of the asset is given by
or
All we did was to divide the dividends (D) due in period t by the interest factor Rt and then add them together.
If interest rates are constant over time, then the interest factors are easy to determine. Suppose that the annual real interest rate for one year is r. Then $R_{1}=(1+r)$ because this is the factor we would use to discount from next year to the present. What about discounting dividends two periods from now? To discount D2 to period 1, we would divide by (1 + r). To discount that back again to the current period we would again divide by (1 + r). So to discount D2 to the present we divide D2 by $(1+r) \times(1+r)=(1+r)^{2}$. That is, $R_{2}=(1+r)^{2}$. In general, $R_{t}=(1+r)^{t}$ when interest rates are constant.
If real interest rates are not constant over time, the calculation of Rt is more tedious. If $R_{1}=\left(1+r_{1}\right)$, then $R_{2}=\left(1+r_{1}\right) \times\left(1+r_{2}\right)$, where r2 is the real interest rate between period 1 and period 2. In the calculation of R2, you can think of (1 + r2) as discounting the flow from period 2 to period 1 and then (1 + r1) as discounting the flow from period 1 to period 0. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/10%3A_Making_and_Losing_Money_on_Wall_Street/10.06%3A_End-of-Chapter_Material.txt |
Even in rich economies like those of the United States or Western Europe, there are numerous jobs where the level of pay is very low. Perhaps you have experienced this yourself—for example, waiting tables, bagging groceries, or working at a fast-food restaurant. Strikingly, many of these jobs pay exactly the same hourly wage. In 2010 in the United States, for example, the wage for jobs in fast-food restaurants was often \$7.25. If you worked for Burger King in Georgia or Arby’s in Iowa, you were likely to receive exactly the same wage. In Washington State, you would have earned more—\$8.67 an hour—but you would have again found that many different employers were offering exactly the same wage. Had you looked for a job in a fast-food restaurant in 1995 in the United States, you would probably have been offered \$4.25. The story is similar in many other countries. In New Zealand, the wage at fast-food restaurants in 2010 was typically NZ\$12.75 (about \$9.50); in France it was €9.00 (about \$12.50).
The fact that different US employers from Wisconsin to Pennsylvania offer the same hourly wage is not a coincidence. It is the result of legislation by the federal government that sets a lower limit on the wage that firms can pay. Such regulations are called minimum wage laws, and they are found in many different countries. Figure 11.1.1 "US Department of Labor Poster" is a poster you might have seen where you have worked. This is from the US Department of Labor and outlines your rights as an employee. This chapter is about the origins and consequences of the government intervention summarized in this poster.
Governments enact such laws because they want to ensure that those who work earn a “living wage.” Were you to work in the United States at the current federal minimum wage for 40 hours a week, 50 weeks a year (a total of 2,000 hours), you would earn \$14,500. This is slightly above the current poverty level for an individual (which is \$11,369) but is well below the average income in the United States. Without minimum wage legislation, the wage earner in a family could have a full-time job, work hard every day, and still not be able to keep the family out of poverty.
Minimum wage laws have been in existence in some parts of the world for a long time. The Industrial Conciliation and Arbitration Act of New Zealand set a minimum wage more than a century ago, in 1894. The first minimum wage in the United States was established in Massachusetts in 1912. Working conditions at that time were terrible in comparison to those in modern developed economies. Women, men, and children worked long hours in very dangerous working conditions for extremely low pay. It was quite natural, confronted with these sweatshops, to feel that the government could do more to actively protect the rights of workers and secure a fair standard of living for them. Those of us fortunate to live in rich economies are now largely spared from such working conditions, but in much of the world, people continue to work in unsafe and unhealthy conditions for very low pay.
The US federal government first established a minimum wage in 1938, as part of the Fair Labor Standards Act. Not all workers were covered by this act, however. The US Constitution charges the federal government with the duty of regulating interstate trade, so the act originally covered only those workers who were involved with trade that crossed state lines. Over time, however, amendments to the legislation have increased its coverage, and it now applies to all workers.See the following discussion for more details: US Department of Labor, Wage and Hour Division (WHD), “Fact Sheet #14: Coverage Under the Fair Labor Standards Act (FLSA),” revised July 2009, accessed March 14, 2011, http://www.dol.gov/whd/regs/compliance/whdfs14.htm.
Prior to the Fair Labor Standards Act, many states instituted their own minimum wage laws, and minimum wages still differ from state to state. For example, Oregon’s current minimum wage is \$8.50, about 17 percent higher than the federal minimum. These state-by-state differences complicate the life of economic historians who wish to study minimum wages. But for the economic analyst, these differences are extremely valuable because they are like an experiment: we can compare the experiences of different states with different laws.
In the United States, the minimum wage was raised in 2007, 2008, and 2009. Prior to that, the minimum wage had been constant for a decade; it had last been raised in 1997 following an act of Congress passed in 1995. President Clinton’s 1995 message to the Congress, accompanying his minimum wage proposal, laid out arguments for the minimum wage increase. The following quote is from the Congressional Record:
To the Congress of the United States:
I am pleased to transmit for your immediate consideration and enactment the ‘Working Wage Increase Act of 1995.’ This draft bill would amend the Fair Labor Standards Act to increase the minimum wage in two 45 cents steps—from the current rate of \$4.25 an hour to \$4.70 an hour on July 4, 1995, and to \$5.15 an hour after July 3, 1996.
To reform the Nation’s welfare system, we should make work pay, and this legislation would help achieve that result. It would offer a raise to families that are working hard, but struggling to make ends meet. Most individuals earning the minimum wage are adults, and the average worker affected by this proposal brings home half of the family’s earnings. Numerous empirical studies indicate that an increase in the minimum wage of the magnitude proposed would not have a significant impact on employment. The legislation would ensure that those who work hard and play by the rules can live with the dignity they have earned.
I urge the Congress to take prompt and favorable action on this legislation.Congressional Record, February 13, 1995 (House), page H1677-H1678, accessed March 3, 2011, frwebgate2.access.gpo.gov/cgi-bin/TEXTgate.cgi?WAISdocID=C6M4yE/0/1/0&WAISaction=retrieve.
President Clinton’s words were forceful, and legislators in many different countries have been convinced by arguments such as these. Yet despite their widespread existence, minimum wage laws are highly contentious. Some commentators and analysts think that minimum wage laws are badly misguided and do much more harm than good.
The superficial appeal of minimum wage legislation is clear: it allows us to know that people who hold down jobs will at least earn a basic living wage—hard work will be rewarded by a minimum standard of living. Sometimes this is expressed differently: those who work hard should receive a “fair” wage for their efforts. (Fair is in quotation marks because not everyone agrees on what is fair and what is unfair, so it is hard to define exactly what the word means here.) Chapter 13 "Superstars" contains more discussion. In other words, minimum wage legislation has a redistributive goal: the aim is to put more of society’s resources in the hands of the working poor.
Economics, however, teaches us that many policy actions can have unintended consequences. To assess whether it is a good idea for the government to intervene in this manner, we need to develop a framework for understanding the effects of minimum wage laws. In particular, we want to answer the following questions:
1. What are the consequences of a statutory minimum wage?
2. Why is there so much disagreement about whether the minimum wage is a good idea?
We will not tell you whether or not the minimum wage is a good thing. By the end of this chapter, you should be in a position to make your own informed opinion about this controversial public policy question.
Road Map
Because the minimum wage says that firms are not allowed to pay below a certain price for the labor they hire, it is natural that our analysis focuses on the labor market. Of course, there is no single labor market—rather, we might think about there being many different markets for different types of skilled individuals. Lawyers, plumbers, engineers, web designers, and airline pilots earn much more than the minimum wage. In this chapter, though, we are focusing on people who earn relatively low wages, which means that we should look at the unskilled labor market. Sellers of labor in this market are not bringing any specialized skills; buyers of labor are not looking for any particular qualifications. The unskilled labor market is largely a market for time.
The minimum wage is set in terms of money—dollars in the United States, euros in France, and so on. Over time, increases in prices can erode the value of the minimum wage. We therefore begin this chapter by explaining how to adjust for the effects of higher prices. We then turn to the unskilled labor market. We look at what happens when we impose a minimum wage in that market, and then we look at what happens when the minimum wage changes.
Who is affected by minimum wage changes? Recognizing that people move in and out of jobs, we go beyond a supply-and-demand framework and consider these dynamic changes in the labor market. When we take into account these movements, we obtain a more sophisticated answer to this question. Then, once we are done with theory, we turn to evidence. We look at what different studies have found about the effects of changes in the real wage, and we assess how well these studies match up with our theory. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/11%3A_Raising_the_Wage_Floor/11.01%3A_Working_at_Minimum_Wage.txt |
Learning Objectives
1. What is the difference between the real minimum wage and the nominal minimum wage?
2. What determines the equilibrium real wage and the level of employment?
When the federal minimum wage was first introduced in the United States in 1938, it was set at \$0.25 per hour. Since then, Congress has raised the minimum wage several times. Figure 11.2.1 "Nominal Federal Minimum Wage in the United States" shows the minimum wage since 1938. You can see that the wage increases in steps whenever Congress enacts an increase in the wage.
The figure shows the federal minimum wage in the United States. When introduced in 1938 the minimum wage was set at \$0.25 per hour. The minimum wage, since 2009, is \$7.25 per hour.
Source: US Department of Labor.
The repeated increases in the minimum wage are not primarily due to the increased generosity of the US Congress. As you probably know, prices and wages have also tended to increase over time—a process we call inflation. The price level in 2007 was, on average, 14.8 times higher than in 1938, so \$0.25 per hour is equivalent in modern terms to \$3.70 (\$0.25 × 14.8 = \$3.70). Most of the increase in the minimum wage has simply been about keeping up with inflation. That said, the current minimum wage is \$7.25, so the federal minimum wage has increased faster than the rate of inflation since its inception.
We call the wage in dollars the nominal wage. It is not the most useful measure of the amount that workers are receiving. Inflation means that a given nominal wage becomes worth less and less over time in terms of the goods and services that it buys. Between 1938 and 1957, for example, the general price level in the United States doubled. Had there been no change in the minimum wage, the \$0.25 per hour minimum wage would have been worth only half as much in 1957 as it was when it was established.
From Nominal to Real Wages
The nominal wage is the wage measured in money (dollars in the United States). The real wage is the nominal wage in an economy adjusted for changes in purchasing power. It is defined as the nominal wage divided by the general price level:
Workers care about the real wage, not the nominal wage, because the real wage captures the trade-off between leisure time and goods and services. Firms care about the real wage, not the nominal wage, because it measures the true cost of hiring labor. Figure 11.2.2 "Real Minimum Wage in the United States" shows the real minimum wage—that is, the minimum wage adjusted for inflation. The real minimum wage is defined as
Toolkit: Section 31.8 "Correcting for Inflation"
The conversion from nominal wages to real wages is an example of the more general idea of correcting for inflation. If you have data expressed in nominal terms (for example, in dollars) and want to covert them to real terms, you should follow the following four steps:
1. Select your deflator. In most cases, the Consumer Price Index (CPI) is the best deflator to use. You can find data on the CPI (for the United States) at the Bureau of Labor Statistics website ( www.bls.gov).
2. Select your base year. Find the value of the index in that base year.
3. For all years (including the base year), divide the value of the index in that year by the value in the base year. Notice that the value for the base year is 1.
4. For each year, divide the value in the nominal data series by the number you calculated in step 3. This gives you the value in “base year dollars.”
The minimum wage was at its highest in real terms in the 1960s, and the current minimum wage it is still well below that level.
Source: US Department of Labor and Bureau of Labor Statistics. Estimates for 2008 and 2009 are based on 2.5 percent annual inflation (equivalent to the average of the previous two years).
The real minimum wage increases in jumps whenever the nominal wage is increased, but it declines over time as it is eroded by inflation. The erosion of the minimum wage by inflation was recognized by President Clinton in the address that we quoted in our introduction. In that request to Congress he also said:
The first increment of the proposal simply restores the minimum wage to its real value following the change enacted in 1989.
If the Congress does not act now, the minimum wage will fall to its lowest real level in 40 years. That would dishonor one of the great promises of American life—that everyone who works hard can earn a living wage. More than 11 million workers would benefit under this proposal, and a full-time, year-round worker at the minimum wage would get a \$1,800 raise—the equivalent of 7 months of groceries for the average family.
When President Clinton referred to “7 months of groceries,” he was converting the increase in the minimum wage into real terms, just as our technique for converting to inflation does. Instead of using the bundle of goods that goes into the CPI, however, he was using a bundle of goods representing groceries for the average family.
Nominal and Real Wages in the Labor Market
The challenge when analyzing the minimum wage is that it is set in nominal terms, but workers and firms care about the real minimum wage. To help us understand the difference, we begin with a specific numerical example of the labor market. Suppose we have the following labor supply-and-demand equations, where labor supply and labor demand are measured in hours:
\[labor\ supply\ =\ 10,000\ ×\ real\ wage\]
and
\[labor\ demand\ =\ 72,000\ –\ 8,000\ ×\ real\ wage.\]
Think of this example as referring to the weekly demand for and supply of unskilled labor in a small city. It is reasonable to think of this as a competitive market, in which market participants will typically agree on a price at or close to the point where supply equals demand. In the supply-and-demand framework, the intersection of the supply and demand curves tells us the equilibrium price in the market and the equilibrium quantity traded. In the labor market, the place where supply and demand meet tells us the equilibrium wage and the equilibrium number of hours worked.
Toolkit: Section 31.3 "The Labor Market", and Section 31.9 "Supply and Demand"
You can find more detail about the underpinnings of labor market supply and demand and the workings of the competitive market in the toolkit.
First we solve for the equilibrium in this market. In equilibrium, the quantity of labor supplied equals the quantity of labor demanded, so
\[10,000\ ×\ real\ wage\ =\ 72,000 – 8,000 ×\ real\ wage.\]
Add (\(8,000\ ×\ real\ wage\)) to each side:
\[18,000 ×\ real\ wage\ = 72,000.\]
Then divide both sides by 18,000 to obtain
\[real\ wage\ = 4.\]
If we plug this value of the real wage back into either the supply or the demand equation, we find that the equilibrium quantity of hours worked is 40,000 hours. For example, we might have 1,000 workers, each of whom works a 40-hour week. The equilibrium is illustrated in Figure 11.2.3 "Labor Market Equilibrium".
Figure \(3\): Labor Market Equilibrium
The market for unskilled labor is in equilibrium at an hourly wage of \$4 and a total of 40,000 hours. In this diagram, we assume that the price level is 1, so the real wage equals the nominal wage.
Suppose that this example pertains to the base year. From our discussion of correcting for inflation, we know that in the base year we set the price level equal to 1. When the price level is 1, the real wage equals the nominal wage. In the initial year, therefore,
and
In the base year, the nominal wage is \$4 per hour.
Now imagine we have 10 percent inflation, which means that the price of all goods and services in the economy increases by 10 percent over the course of a year. If a household paid \$100 a week for groceries last year, it must pay \$110 this year; if a household used to pay \$500 a month in rent, it must now pay \$550; and so on. Turning this around, a dollar is worth less than it used to be; you need \$1.10 to purchase what you could have bought for \$1 this year. The price level has increased from 1 to 1.1.
To see what this means in terms of the labor market diagram, think about the situation at a given nominal wage, such as \$2.20 per hour. Last year, when the price level was 1, households were willing to supply 22,000 hours (= 10,000 × 2.2). But \$2.20 now is worth the equivalent of only \$2, so households are willing to supply only 20,000 (10,000 × = 10,000 × 2) hours of labor instead. The same idea applies at every wage; households will supply only the amount of labor that they would previously have supplied when the wage was 10 percent higher.
A similar logic applies to the demand for labor. The increase in the price level means that firms get 10 percent more dollars for the goods that they sell. As a consequence, the labor performed by workers generates more dollars than it used to. If it was worth paying \$7 for an hour of work before, it is now worth paying \$7.70 for that same hour of work.
In terms of real wages, however, nothing has changed. The equilibrium real wage is still \$4, as it was before. But because
the nominal wage must increase by 10 percent to match the increase in the price level. The equilibrium in the labor market is shown in Figure 11.2.4 "Labor Market Equilibrium after 10 Percent Inflation". It is no coincidence that this diagram looks exactly the same as Figure 11.2.3 "Labor Market Equilibrium"; that is the point. An increase in the price level is matched by an increase in the nominal wage, and nothing changes in terms of the real wage or the real equilibrium quantity of labor.
Figure \(4\): Labor Market Equilibrium after 10 Percent Inflation
If there is 10 percent inflation, the price level increases from 1 to 1.1, the real wage is unchanged, and the nominal wage increases by 10 percent.
Key Takeaways
• The nominal minimum wage is set by governments. The real minimum wage is the real value of the nominal minimum wage. It is determined by dividing the nominal minimum wage by the price level.
• The levels of the real wage and employment are determined by labor market equilibrium.
Exercises
1. Looking at Figure 11.2.2 "Real Minimum Wage in the United States", explain why the real minimum wage increases very quickly but never decreases very quickly.
2. Why do labor demand and supply depend on the real and not the nominal wage? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/11%3A_Raising_the_Wage_Floor/11.02%3A_Nominal_Wages_and_Real_Wages.txt |
Learning Objectives
1. What happens when a government imposes a minimum wage?
2. If there is inflation under a minimum wage system, what happens to the level of employment?
3. What are the efficiency costs of a minimum wage?
Adam Smith, the 18th-century economist who founded modern economics, had a vivid metaphor for the idea that supply would equal demand in a competitive market: he referred to an “invisible hand” guiding markets to equilibrium. Joan Robinson, a famous economist at Cambridge University in the first half of the 20th century, wrote that “the hidden hand will always do its work but it may work by strangulation.”Joan Robinson, “The Pure Theory of International Trade,” in Collected Economic Papers (Oxford: Basil Blackwell, 1966), 189. What she meant by this was there is no guarantee that the equilibrium wage in the market would in fact be a living wage.
The Imposition of a Minimum Wage
When the government imposes a minimum wage, firms are not permitted to pay less than the amount that the government mandates. Suppose we are again in the base year, so the price level is 1. Imagine that the market equilibrium wage is \$4 per hour, but the government now passes legislation stating that all firms must pay at least \$5 per hour. At this wage, supply does not equal demand. Figure 11.3.1 "Labor Market with a Minimum Wage" illustrates what happens.
With a minimum wage of \$5, the supply of labor is 50,000 hours, but firms demand only 32,000 hours of labor, so the labor market is not in equilibrium.
Markets are based on voluntary trades. In Figure 11.3.1 "Labor Market with a Minimum Wage", we see that sellers (the workers who supply labor) would like to sell 50,000 hours of labor to the market at the set minimum wage—that is, 250 more people would like to have a 40-hour-a-week job when the wage increases from \$4 to \$5. But firms wish to purchase only 32,000 hours of labor—firms want to hire 200 fewer workers (8,000 fewer hours). In a market with voluntary trade, no one can force firms to hire workers. As a result, the equilibrium quantity of labor traded in the market will be determined by how much the firms wish to buy, not how much workers want to sell.
We can now answer our first motivating question of the chapter: what is the consequence of imposing a minimum wage? Two things happen when the government imposes a minimum wage:
1. The amount of labor hired in the market decreases. In our example, the number of unskilled workers employed decreases from 1,000 to 800. Thus while those who have jobs earn a higher wage, there are now some individuals who no longer have jobs. Employment has decreased.
2. At the government-imposed wage, there are more people who want to work than are able to find jobs. Thus the minimum wage has created unemployment. Because 1,250 people would like jobs at a wage of \$5 but only 800 jobs are available, 450 people are unemployed; they would like a job at the prevailing wage, but they are unable to find one.
The number of unemployed workers is 450, even though employment decreased by only 200 workers. The difference comes from the fact that the higher wage also means that more people want to work than before. In this case, the higher wage means 250 more people would like a job.
We have assumed in this discussion that everyone works for 40 hours, in which case the number of people employed must decrease by 200. Another possibility is that everyone who wants a job is able to get one, but the number of hours worked by each individual decreases. Because there are 32,000 hours of work demanded and 1,250 people who want jobs, each worker would work 25.6 hours a week. In this situation, we say that there is underemployment rather than unemployment. Yet another possibility is that, after the introduction of the minimum wage, the number of people employed stays the same as before (1,000), but those individuals are allowed to work only 32 hours per week. In this case, we have both underemployment (of the previously employed) and unemployment (of the extra workers who want a job at the higher wage). In real-life situations, there may be both unemployment and underemployment.
Inflation and the Minimum Wage
Although inflation made no difference to our basic analysis of the labor market, it does change our analysis of the minimum wage. Minimum wages are fixed in nominal terms and do not automatically change when there is inflation. So if the minimum wage is set at \$5 and the price level increases from 1 to 1.1, the real minimum wage declines. Looking back at the definition of the real minimum wage, we find that
The effect of a reduction in the real minimum wage is shown in Figure 11.3.2 "A Reduction in the Real Minimum Wage". At the lower real wage, firms are willing to hire more workers. Employment increases from 32,000 hours to 35,600 hours: 90 more people can find jobs.
Figure \(2\): A Reduction in the Real Minimum Wage
A 10-percent increase in the price level leads to a reduction in the real minimum wage to \$4.55 and an increase in employment from 32,000 to 35,600.
In Figure 11.3.2 "A Reduction in the Real Minimum Wage", the real minimum wage of \$4.55 is still higher than the equilibrium wage of \$4.00. To put the same point another way, the equilibrium nominal wage has increased to \$4.40, but this is still below the nominal minimum wage of \$5.00. However, if the price level were to increase by 25 percent or more from the base year, the minimum wage would become completely irrelevant. The minimum wage would be below the market wage. Economists say that the minimum wage would no longer be “binding” in this case.
It is exactly this process of increasing prices that lies behind Figure 11.2.2 "Real Minimum Wage in the United States". As the price level increases, the minimum wage becomes worth less in real terms (and has less of an effect on employment). Eventually, Congress acts to increase the minimum wage to bring it back in line with inflation—although, as Figure 11.2.2 "Real Minimum Wage in the United States" shows, Congress has allowed the real minimum wage to decline substantially from its high point in the late 1950s. The reduction in the real minimum wage also leads to a reduction in unemployment, as shown in Figure 11.3.3 "Effects on Unemployment of a Reduction in the Real Minimum Wage".
The reduction in the real minimum wage to \$4.55 leads to a decrease in unemployment.
Efficiency Implications of a Minimum Wage
Markets are a mechanism that allow individuals to take advantage of gains from trade. Whenever a buyer has a higher valuation than a seller for a good or service, they can both benefit from carrying out a trade. This is how economies create value—by finding opportunities for mutually beneficial trades.
The minimum wage interferes with this process in the unskilled labor market. It reduces employment, which is the same as saying that fewer transactions take place. Because each voluntary transaction by definition generates a surplus, anything that reduces the number of transactions causes a loss of surplus. In economists’ terminology, the minimum wage leads to a departure from efficiency. We can represent that inefficiency graphically. Figure 11.3.4 "Deadweight Loss from Minimum Wage" shows the effect of the minimum wage, using the ideas of buyer surplus and seller surplus.
Toolkit: Section 31.10 "Buyer Surplus and Seller Surplus" and Section 31.11 "Efficiency and Deadweight Loss"
You can review the different kinds of surplus, as well as the concepts of efficiency and deadweight loss, in the toolkit.
Figure \(4\): Deadweight Loss from Minimum Wage
With no minimum wage (a), all the possible gains from trade in the market are realized, but with a minimum wage (b), some gains from trade are lost because there are fewer transactions.
In part (a) of Figure 11.3.4 "Deadweight Loss from Minimum Wage", we see the market without the minimum wage. In the labor market, it is the firm who is the buyer. The total buyer surplus is the profit that firms obtain by hiring these workers; it is the difference between the cost of hiring these workers and the revenues that they generate. Graphically, it is the area below the labor demand curve and above the market wage. The total sellersellers’ surplus#8217;s surplus is the benefit that accrues to workers from selling labor time. Sellers of labor (workers) receive surplus equal to the area below the market wage and above the supply curve.
In part (b) of Figure 11.3.4 "Deadweight Loss from Minimum Wage", we show the effect of the minimum wage. As we already know, the higher wage leads to a reduction in employment. Fewer transactions occur, so the total surplus in the market is reduced. Economists call the lost surplus the deadweight loss from the minimum wage policy.
The most obvious cost of the minimum wage is this loss of surplus. But there may be other hidden costs as well. Whenever people are prevented from carrying out mutually beneficial trades, they have an incentive to try to get around these restrictions. Firms and workers may try to “cheat,” conducting hidden transactions below the minimum wage. For example, a firm might pay a worker for fewer hours than he or she actually worked. Alternatively, a firm might reduce other benefits of the job. Such cheating not only subverts the minimum wage law but also uses up resources because the firm and the worker must devote effort to devising ways around the law and ensuring that they do not get caught.
The loss in surplus could also be greater than is shown in Figure 11.3.4 "Deadweight Loss from Minimum Wage". The figure is drawn under the presumption that the trades taking place in the labor market are the ones that generate the most surplus. But suppose that the minimum wage is \$5.00. It is possible that someone who would be willing to work for, say, \$2.00 an hour loses her job, whereas someone willing to work for, say, \$4.50 is employed.
Remember that if there were no restrictions in the labor market, the wage would adjust so that anyone wanting to work could find a job. This means that both the person willing to work for \$2.00 and the person willing to work for \$4.50 could both find a job as long as the wage is above \$4.50. If the equilibrium wage were \$4.00, then the person willing to work for only \$4.50 would not be employed. In either case, this is the efficient outcome, consistent with obtaining all the gains from trade.
Key Takeaways
• When the government imposes a minimum wage, the real wage is determined by the minimum wage divided by the price level, not by the interaction between labor supply and demand.
• If there is inflation and a fixed nominal minimum wage, then the level of employment will increase and the real minimum wage will decrease.
• The minimum wage creates deadweight loss because some trades of labor services do not take place.
check your understanding
1. Draw a diagram for a labor market where the minimum wage is not binding.
2. What happens to the real minimum wage and the level of employment if there is deflation—that is, if the price level decreases? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/11%3A_Raising_the_Wage_Floor/11.03%3A_The_Effects_of_a_Minimum_Wage.txt |
Learning Objectives
1. What happens to the levels of employment and unemployment if the real minimum wage increases?
2. What determines the size of the change in employment when the real minimum wage increases?
3. What determines the size of the change in unemployment when the real minimum wage increases?
Suppose that the government is considering an increase in the minimum wage. What should we expect to happen? How will firms and workers respond? One might be tempted simply to ask firms what they would do in the face of an increase in the minimum wage. Unfortunately, this is likely to be both infeasible (or at least prohibitively expensive) and inaccurate. It would be an immense amount of work to interview all the firms in an economy. What is more, there is no guarantee that managers of firms would give accurate answers if they were asked hypothetical questions about a change in the minimum wage. Instead, government statisticians use statistical sampling techniques to interview a random sample of firms in an economy, and they ask them about their actual behavior—they ask questions such as the following: “How many workers do you employ at present?” and “How much do you pay them?” The data from such surveys are useful but do not directly help us determine the effects of a change in the minimum wage. For this we need more theory.
The Effect of a Minimum Wage Increase on Employment and Unemployment
Figure 11.4.1 "Effects of Increasing the Real Minimum Wage" amends our view of the labor market to show an increase in the minimum wage from \$5 to \$6. (We suppose that the price level is constant, so an increase in the nominal minimum wage implies an increase in the real minimum wage.) The increase in the minimum wage leads to a reduction in the level of employment: employment decreases from 32,000 to 24,000. Labor is now more expensive to firms, so they will want to use fewer hours. At the same time, the higher minimum wage means that more people would like jobs. The increase in the amount of labor that people would like to supply, and the decrease in the amount of labor that firms demand, both serve to increase unemployment.
Figure \(1\): Effects of Increasing the Real Minimum Wage
An increase in the value of the hourly real minimum wage from \$5 to \$6 leads to a decrease in employment from 32,000 hours to 24,000 hours (a) and an increase in unemployment (b).
Our model generates a qualitative prediction: an increase in the minimum wage will decrease employment and increase unemployment. At the same time, the wage increase will ensure that those with jobs will earn a higher wage. So we can see that there may be both advantages and disadvantages of increasing the minimum wage. To go further, we have to know how big an effect such a change would have on employment and unemployment—that is, we need the quantitative effects of a higher minimum wage.
To understand the quantitative effects, we want to know when to expect big or small changes in employment or unemployment—which depends on the wage elasticity of labor demand and the labor supply. Remembering that the wage is simply the price in the labor market, the wage elasticity of demand is an example of the price elasticity of demand in a market:
From Figure 11.4.1 "Effects of Increasing the Real Minimum Wage", we can see that the wage elasticity of labor demand tells us everything we need to know about the effects of a change in the wage on employment. If the demand curve is relatively elastic, then a change in the minimum wage will lead to a relatively large change in employment. If the demand curve is relatively inelastic, then a change in the minimum wage will lead to a relatively small change in employment. This is intuitive because the elasticity of labor demand tells us how sensitive firms’ hiring decisions are to changes in the wage. An elastic demand for labor means that firms will respond to a small change in the wage by laying off a large number of workers, so the employment effect will be large. The elasticity of labor supply is not relevant if we are concerned only with employment effects. This is illustrated in Figure 11.4.2 "The Employment Effect of a Change in the Minimum Wage" and summarized in Table 11.4.1 "Employment Effects of a Change in the Real Minimum Wage".
Figure \(2\): The Employment Effect of a Change in the Minimum Wage
If labor demand is relatively elastic (a), a change in the minimum wage has a big effect on employment, while if labor demand is relatively inelastic (b), the same change in the minimum wage has a much smaller effect on employment.
Effect on Employment
Elastic demand Large change
Inelastic demand Small change
Table \(1\): Employment Effects of a Change in the Real Minimum Wage
If we are interested in the effect on unemployment, however, we must look at both demand and supply. A worker is counted as unemployed if he or she is looking for a job but does not currently have a job. The labor supply curve tells us how many workers are willing to work at a given wage; those who are not employed are looking for a job. To understand the effects of the minimum wage on unemployment, we need to look at the mismatch between supply and demand at the minimum wage, so we must look at the supply of labor as well as the demand for labor. The price elasticity of supply measures the responsiveness of the quantity supplied to a change in the price: in the case of the labor market, we obtain the wage elasticity of labor supply:
Toolkit: Section 31.2 "Elasticity"
You can review the general definition and calculation of elasticities in the toolkit.
The more elastic the labor supply curve, the bigger the change in labor supply for a given change in the real wage ( Figure 11.4.3 "The Unemployment Effect of a Change in the Minimum Wage"). A bigger change in labor supply means a bigger change in unemployment. Combining this with Table 11.4.1 "Employment Effects of a Change in the Real Minimum Wage", we get the results summarized in Table 11.4.2 "Unemployment Effects of a Change in the Real Minimum Wage". If demand and supply are both inelastic, the change in the minimum wage has little effect on unemployment. The higher wage does not make much difference to firms’ hiring decisions (inelastic demand), and it does not induce many additional workers to look for a job (inelastic supply). The overall effect on unemployment is small. By contrast, if both curves are elastic, then an increase in the wage will lead to a big decrease in the number of jobs available and a big increase in the number of job seekers. If we can find good estimates of the elasticities of labor demand and supply, we will be able to make good predictions about the likely effect of an increase in the minimum wage.
If the labor supply is relatively elastic (a), a change in the minimum wage has a big effect on unemployment, while if the labor supply is relatively inelastic (b), the same change in the minimum wage has a much smaller effect on unemployment.
Effects on Unemployment
Elastic Supply Inelastic Supply
Elastic demand Very large change Large change
Inelastic demand Large change Small change
Table \(2\): Unemployment Effects of a Change in the Real Minimum Wage
Key Takeaways
• All else being the same, an increase in the real minimum wage will reduce employment and increase unemployment.
• The size of the change in employment when the minimum wage increases is determined by the elasticity of the labor demand curve.
• The size of the change in unemployment when the minimum wage increases is determined by the elasticities of the labor demand and supply curves.
check your understanding
1. Why doesn’t the elasticity of labor supply matter for the effects of changes in the real minimum wage on employment?
2. If prices increase, what will happen to the level of unemployment when there is a binding minimum wage? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/11%3A_Raising_the_Wage_Floor/11.04%3A_Minimum_Wage_Changes.txt |
Learning Objectives
1. Which parts of the economy are affected by the minimum wage?
2. When the minimum wage increases, who gains and who loses?
3. What is an equity-efficiency trade-off?
We said earlier that governments impose minimum wages because they care about ensuring that the working poor earn a fair wage. Another way of saying this is that the minimum wage is an intervention by the government that is meant to change the distribution of society’s resources. If unskilled workers are going to earn more, then this means they are obtaining more of the total resources available in an economy. And if they are getting more, then somebody else must be getting less. We would like to have some way of thinking about the effects of the minimum wage on the distribution of income.
To talk about distribution, we need to divide society into groups and then examine how much each group gets. One group is obviously those who receive the minimum wage—the working poor. Another group we need to consider is the unemployed. And then there is everybody else: all of those individuals who are sufficiently skilled to have jobs that pay more than the minimum wage. This is a large group, encompassing electricians and CEOs, but—for our present purposes—it makes sense to group them all together. Let’s call them the “relatively rich,” by which we mean that they are richer than unemployed or employed unskilled workers. So we have three groups: the unemployed, the working poor, and the relatively rich. How are these groups affected by an increase in the minimum wage?
Winners and Losers from the Minimum Wage
We know that the working poor are made better off by an increase in the minimum wage—after all, the whole point of the increase is to ensure that these individuals earn more. We can see this gain in Figure 11.3.4 "Deadweight Loss from Minimum Wage": it is the extra surplus that sellers obtain at the expense of buyers. Remember, though, that some of the working poor will lose their jobs as a result of the higher minimum wage. So our first conclusion is that those members of the working poor who keep their jobs are unambiguously made better off.
The increase in the minimum wage means that there are more people who are unemployed. Those who are already unemployed are not directly affected by the increase in the minimum wage. These unemployed individuals may be indirectly affected, however, because it becomes harder for them to find jobs.
Are there any effects on the relatively rich? The answer is yes. The increase in the minimum wage means that firms will earn lower profits. We can see this because buyer surplus is reduced in Figure 11.3.4 "Deadweight Loss from Minimum Wage". Although firms are just legal entities, they are owned by individuals. When a firm earns lower profits, the shareholders of that firm receive lower income. The working poor and the unemployed are not, for the most part, individuals with portfolios of stocks; the shareholders of firms are the relatively rich. Thus the relatively rich are made worse off by the increase in the minimum wage. Our broad conclusion is therefore that the working poor benefit from an increase in the minimum wage, but everybody else in society is made worse off.
There is another concern when we think about the distribution of income. One consequence of the minimum wage is that jobs become a scarce resource: more people want jobs than there are jobs available. We must consider how this scarce resource is allocated. Do workers line up outside factory gates? In this case, the time that they spend waiting in line is an additional cost of the minimum wage. Does some individual control who gets hired? Then there is the potential for corruption, whereby jobs are sold, meaning that the gains from the minimum wage flow not to workers but to this individual instead.
Does the Minimum Wage Benefit Unskilled Labor as a Whole?
We have concluded so far that the minimum wage benefits the working poor but at the cost of creating unemployment: some people who used to have jobs will lose them as a result of the minimum wage. Because of the flows between unemployment and employment in a dynamic labor market, it does not really make sense to think of the unemployed and the employed as different people. If we instead think about unskilled labor as a whole—a group that includes both those with jobs and those unable to find jobs—what can we conclude about the effects of an increase in the minimum wage? There are a few different ways of looking at this question.
The Wage Bill
First, we can look at total wages paid in the labor market, sometime called the wage bill. By looking at the wage bill, we can find out if the additional wages earned by the working poor exceed the wages lost by those who find themselves unemployed.
Total wages are equal to the total hours worked multiplied by the hourly wage:
\[total\ wages\ =\ real\ minimum\ wage\ ×\ hours\ worked.\]
Because we are measuring the wage in real terms, total wages are likewise measured in real terms. Figure 11.5.1 "The Wage Bill" provides a graphical interpretation of the wage bill: total wages paid are given by the shaded rectangle.
Figure \(1\): The Wage Bill
The wage bill is equal to the rectangle under the demand curve. For example, if the real wage is \$4 per hour and employment is 40,000 hours, then the wage bill is 160,000.
From this equation it can be shown that To derive this equation, we first apply the rules of growth rates to obtain
\[percentage\ change\ in\ total\ wages\ =\ percentage\ change\ in\ real\ minimum\ wage\ +\ percentage\ change\ in\ hours\ worked.\]
Then divide both terms by the percentage change in the minimum wage and use the definition of the elasticity of demand:
\[percentage\ change\ in\ total\ wages\ =\ percent\ change\ in\ real\ minimum\ wage\ ×\ (1 – [–(elasticity\ of\ demand)]).\]
The elasticity of demand is a negative number: if wages increase (that is, the change in the wage is positive), then hours worked decreases (that is, the change in hours worked is negative). It is therefore easier if we use –(elasticity of demand) because this is a positive number. The equation tells us that the change in the total wage is positive if the percentage increase in wages is greater than the percentage decrease in hours worked—in other words, if –(elasticity of demand) is less than 1.
If the demand for labor is relatively sensitive to changes in the wage, employment will decrease significantly following an increase in the minimum wage. Total wages paid will decrease. This is shown in part (a) of Figure 11.5.2 "Effects of an Increase in the Minimum Wage on the Wage Bill". Before the increase, total wages are given by the sum of areas A and B. After the increase, total wages are given by the sum of areas A and C. We get the opposite conclusion if labor demand is inelastic. In this case, an increase in the wage increases the total wages paid. The conclusion is intuitive: if employers do not change their hiring very much when wages increase, then total wages will increase. But if an increase in the minimum wage leads to a big decrease in the demand for labor, total wages paid will decrease.
If labor demand is relatively elastic (a), a change in the minimum wage leads to a reduction in the wage bill: the original wage bill is A + B, and the new wage bill is A + C. If labor demand is relatively inelastic (b), the same change in the minimum wage leads to an increase in the wage bill.
Seller Surplus
The wage bill tells us how much workers are paid in total. A better measure of the benefits obtained by workers is the total sellersellers’ surplus#8217;s surplus in the market. We cannot measure this exactly unless we know exactly what the labor supply curve looks like, but we can conclude that just looking at the wage bill understates the benefits to workers of the increased wage. The reason is simple and does not even need any diagrams. Following an increase in the minimum wage, workers work fewer hours in total. Everything else being the same, people prefer leisure time to working. For example, suppose that total wages increase following an increase in the minimum wage. Then workers gain twice: they are being paid more, and they are working less.
Even if total wages decrease, workers might still be better off. They might be more than compensated for the lower wages by the fact that they don’t have to work as many hours. We are not saying that having a job is a bad thing; those who are working prefer having a job to being unemployed. But those who are working also prefer working fewer hours.
Expected Wage
So far, we have looked at the minimum wage through the lens of a competitive labor market. This is not a bad approach: as we have argued, the unskilled labor market is probably a reasonably good example of a competitive market. It is, however, a static way of thinking about the labor market, when the labor market is in fact highly dynamic. Chapter 9 "Growing Jobs" contains more discussion. People move in and out of jobs: they quit or are laid off from old jobs, and they search for new jobs. A worker who is employed this month may find herself unemployed next month; a worker with no job this month may be hired next month.
Earlier we claimed that an increase in the minimum wage has no direct effect on the unemployed. This is true in the static labor market picture, but once we take a more dynamic view of the labor market, it no longer makes very much sense to draw a hard-and-fast distinction between the employed and the unemployed. Over time, they will include many of the same people. So when we look at the distributional effects of the minimum wage, it is better to draw the distinction between unskilled workers (that is, the employed and unemployed together) and the relatively rich. With this in mind, let us now consider whether the unskilled as a group are likely to benefit from the minimum wage.
We might expect that unskilled workers will spend some of their time employed and some unemployed. When employed, they earn the minimum wage, but when unemployed, they receive much less. To keep things simple, suppose these workers earn nothing when unemployed. On average, the fraction of time that workers spend employed rather than unemployed is given by
We can think of this as the probability that a typical unskilled worker will be employed at any given time. Combining this with the idea of expected value, we can calculate the expected wage of such a worker. If a worker earns nothing when unemployed, then the expected wage is as follows:
Toolkit: Section 31.7 "Expected Value"
You can review probability and expected values in the toolkit.
How does this expected wage change when there is an increase in the minimum wage? The answer, as you might expect by now, depends on the elasticities of demand and supply. Specifically, it turns out that the expected wage will increase if
\[–(elasticity\ of\ labor\ demand)\ +\ elasticity\ of\ labor\ supply\ < 1.\]
If both demand and supply are sufficiently inelastic, the average wage will increase. Conversely, if they are both relatively elastic, then expected wages will decrease.
There are some things missing from this story. In a more careful analysis, we would take into account the fact that workers are probably risk-averse and dislike the randomness of their earnings. We would likewise take into account that unemployed workers obtain some income—perhaps from unemployment insurance. This actually makes it more likely that an increase in the minimum wage will increase the expected wage. These are details, however. We can draw two big conclusions from our discussion so far:
1. Under some circumstances at least, an increase in the minimum wage will have the effect of redistributing income from the relatively rich to unskilled workers. Policymakers may wish to reduce inequality in society, and the minimum wage is one possible tool that they can use. At the same time, the minimum wage comes at a cost to society: it distorts decisions in the labor market and leads to deadweight loss. This is an equity-efficiency trade-off.
2. The distributional impact of a change in the minimum wage cannot be deduced from economic theory. It depends on the elasticities of labor demand and supply in the market for unskilled labor and is an empirical question. In the next section, therefore, we turn to the evidence on minimum wages.
Key Takeaways
• The minimum wage affects buyers and sellers of labor services in the markets where the minimum wage is binding. It also affects the owners of these firms.
• Buyers and sellers of labor services in low wage (unskilled) labor markets are directly affected by changes in the real wage. Workers in this market who keep their jobs are better off. Those that lose their jobs are made worse off, at least in the short run. Owners of the firms are hurt because of reduced profits from the minimum wage. The magnitude of these effects depends on the elasticities of labor demand and supply.
• The equity-efficiency trade-off means that policies that increase equity can create inefficiencies. The minimum wage provides an example of that trade-off.
check your understanding
1. Why does an increase in the minimum wage reduce the profits of a firm?
2. If the real minimum wage is reduced by inflation, can the real wage bill paid to workers increase? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/11%3A_Raising_the_Wage_Floor/11.05%3A_The_Minimum_Wage_and_the_Distribution_of_Income.txt |
Learning Objectives
1. How do economists determine the elasticities of labor supply and labor demand?
2. What are the estimates of these elasticities?
3. What are the estimated effects of an increase in the minimum wage?
For the most part, economists cannot carry out experiments to test their theories and must use much more indirect methods. They must rely on observations that are generated by the everyday experience of individuals in an economy. In a textbook like this, we constantly draw demand and supply curves, and we get so used to seeing these diagrams that we might be fooled into thinking that we can just go out and observe them in the real world. In fact, all we observe are the market outcomes—the equilibrium price and quantity that are traded. Our conception of the labor market might look like part (a) of Figure 11.6.1 "Models and Data", but the data that we actually gather look like part (b) of Figure 11.6.1 "Models and Data".
We construct an entire framework based on the supply and demand curves for labor (a), but at any time we observe only a single data point: the wage and the level of employment (b).
If we want to estimate a demand curve, we need much more than part (b) of Figure 11.6.1 "Models and Data". We need more data points. We need different observations. In the case of the labor market, we might be able to use the fact that the minimum wage changes over time. Figure 11.6.2 "Inferring Labor Demand from Data" shows an example. Minimum wage changes allow us to observe different points on the labor demand curve. Given enough observations, we might be able to get a good idea of what the demand curve looks like and come up with an estimate of labor elasticity.
Figure \(2\): Inferring Labor Demand from Data
We may be able to infer a demand curve for labor by looking at what happens to the quantity of hours worked as the minimum wage changes.
Reality is messier. In actual labor markets, many things are going on at once. At the same time that the wage is changing, firms might be facing changes in the demand for their products, changes in the costs of other inputs, changes in their technology, or changes in their competitive environment. All of these changes would cause the labor demand curve to shift. As an example, look at Figure 11.6.3 "Difficulties Inferring Labor Demand from Data". The story here is as follows: The minimum wage is increasing over time, but—perhaps because of increased product demand—the demand for labor is also increasing over time. What we observe is shown in Figure 11.6.3 "Difficulties Inferring Labor Demand from Data". The unwary analyst, looking at these data, might conclude that minimum wages have little or no effect on the demand for labor.
When the demand curve for labor is shifting at the same time as the minimum wage is changing, it is more difficult to see the effects of the minimum wage.
Economists who analyze data are forever trying to distinguish effects of interest (for example, minimum wage changes) from those caused by changes in other variables (for example, product demand). The key to successful empirical work is obtaining informative sources of variation and excluding irrelevant sources of variation. In the case of the minimum wage, we might look at differences in the minimum wage at different times, or we might look at differences in the minimum wage in different places (such as specific states in the United States).
Estimates of Labor Demand Elasticity
Labor economist Daniel Hamermesh summarizes the findings from numerous studies in his book, Labor Demand.Daniel S. Hamermesh, Labor Demand (Princeton, NJ: Princeton University Press, 1996). Based on his review of all these studies, Hamermesh argues that a good estimate of −(elasticity of labor demand) is about 0.3. This means that if we increase the minimum wage by 10 percent, employment will decrease by about 3 percent. With these, we would conclude that labor demand is relatively inelastic, and the employment and welfare implications of the minimum wage are not that large. Labor supply also tends to be relatively inelastic, partly because the income effects and substitution effects of changes in the wage tend to be offsetting. It certainly seems possible, then, that an increase in the minimum wage will raise expected wages.
We must be careful, though. Hamermesh notes that labor demand becomes more elastic as the skill level of workers decreases. It is difficult to find substitutes for workers with specialized skills. If you need an electrician, then you must hire an electrician, even if plumbers are much cheaper. If you need an airline pilot, you can’t hire a computer programmer. If you are running a store, however, and you find that labor is becoming more expensive, you might be able to upgrade your cash registers and inventory control systems and get by with fewer employees. We might expect the elasticity of demand at the minimum wage to be significantly higher.
It is therefore useful to look at studies that focus directly on minimum wage changes. One approach is to look at the relationship over time between the minimum wage and the employment experience of groups that are most directly affected by the minimum wage. Alternatively, one can look across groups that are differentially affected by the minimum wage to gauge its effect.
A reminder before we proceed. The point of going through this material is not only to help you understand the effects of a change in the minimum wage but also to provide you with a glimpse of how economic research proceeds so that you can do a better job of evaluating evidence that economists compile in all sorts of areas.
Economists have focused particular attention on teenage workers because that group is typically unskilled and is likely to be subject to the minimum wage. (This is not to say that the effects of the minimum wage are primarily on teenagers. Indeed, about two-thirds of minimum wage earners are adults.) Figure 11.6.4 "Teenage Unemployment in the United States" graphs the teenage unemployment rate over the period from 1956 to 2007 along with the real minimum wage for this period. We would like to know if the minimum wage has an impact on the teenage unemployment rate. This figure is suggestive of a relationship, particularly in the last couple of decades. For example, the real minimum wage fell during the 1980s, and the teenage unemployment rate also fell during that time. The teenage unemployment rate also often seems to increase around the time that the minimum wage increases. On the other hand, teenage unemployment also fell substantially during the 1960s at a time when there were several increases in the minimum wage.
The figure shows the federal minimum wage in the United States, adjusted for inflation, together with the teenage unemployment rate.
Source: US Department of Labor and Bureau of Labor Statistics.
If the only cause of changes in teenage employment were minimum wage changes, Figure 11.6.4 "Teenage Unemployment in the United States" might give us lots of answers. But this is a very big “if.” In terms of our analysis of supply and demand, it would amount to saying that the supply and demand for labor didn’t change over the entire period. In fact, you can make an enormously long list of things that might have shifted the supply curve, the demand curve, or both. Examples include whether the economy was in a boom or a recession, changes in tax rates, technological advances, and population growth. As we saw in Figure 11.6.3 "Difficulties Inferring Labor Demand from Data", it is difficult to disentangle the effects of a changing minimum wage from the effects of other changes. Thus we cannot isolate the effects of the minimum wage just by looking at diagrams like Figure 11.6.4 "Teenage Unemployment in the United States".
We need some way to take into account these other factors so that we can focus on the effects of the minimum wage. This is a complicated statistical problem that arises time and again in economics, and the ways of dealing with it go far beyond this textbook. Indeed, this problem is one of the hardest things about studying economic data. But even though the statistical details are complex, there are three simple ideas that are important to understand:
1. The basic idea of these statistical techniques is that economists attempt to include in their analysis—as best they can—all the factors that shift the demand and supply curves. Then they can predict what would have happened if there had been no change in the minimum wage. Once they have done this, they can then determine the effect of minimum wage changes.
2. When different economists study the same problem, they do not always reach the same conclusion. The reason that they disagree is usually not because they have different ideas about economic theory. Almost all economists have the same general framework for understanding labor markets, for example. Economists disagree because they use different approaches to take into account all the other factors.
3. If economists could conduct direct experiments, such as those performed in the physical sciences, they would not have this problem. They would be able to completely control the stimulus (minimum wage changes), and thus get an accurate estimate of the response (changes in employment). Instead, the best we can do is to look at past minimum wage changes and try to determine what happened.
Studies from the 1970s and early 1980s found some evidence that increases in the minimum wage reduced the employment of 16- to 19-year-olds. According to economists David Card and Alan Krueger, the average estimate is that a 10 percent increase in the minimum wage would reduce employment by about 1.5 percent.David Card and Alan Krueger, Myth and Measurement: The New Economics of the Minimum Wage (Princeton, NJ: Princeton University Press, 1995). So the implied value of −(elasticity of labor demand) is about 0.15. With an average employment rate of about 50 percent, this means that a 10 percent increase in the minimum wage would reduce the rate of teenage employment by about 0.75 percentage points.
It is striking that this estimate is lower than the estimate from looking at labor demand as a whole. What is more, Card and Krueger note that more recent studies produce even smaller estimates of these effects.David Card and Alan Krueger, Myth and Measurement: The New Economics of the Minimum Wage (Princeton, NJ: Princeton University Press, 1995), Table 7.3.2 "Calculating Revenues". In their own work, they find that the apparent negative effects of the minimum wage on employment are statistically insignificant. This result holds not only for all 16- to 19-year-olds but also when the sample is split by race and sex.
The evidence from teenage employment studies suggests that, as an empirical matter, the effects of the minimum wage on employment may be very small. This result has surprised many economists. Although economic theory did not suggest actual magnitudes for the labor demand elasticity, the existence of substitutes for unskilled labor did suggest that labor demand would be at least somewhat elastic.
Not surprisingly, there have been many other studies of the minimum wage. Some researchers have found larger employment elasticities for teenage employment than those reported by Card and Krueger. Sometimes we are simply unable to give a definitive answer to empirical questions in economics. This can be frustrating for both students of economics and practitioners—but we are not going to pretend that the world is simpler than it actually is.
Cross-Section Studies
The studies we have just discussed analyzed the minimum wage by looking at minimum wage changes over time. Another approach to analyzing the effects of the minimum wage is to take advantage of differences over individuals rather than variations over time. Economists call these cross-section studies because they look at a cross section of different individuals or firms at a point in time. Many of these studies look at the effects of minimum wage changes at the level of an individual worker. Others exploit differences in minimum wage laws across states. Such differences across states give rise to a natural experiment because they can substitute, at least in part, for economists’ inability to conduct experiments in which only one thing changes at a time.
Here is an example. Recall that in 1938 a minimum wage of \$0.25 per hour was put into effect under the Fair Labor Standards Act. In the United States, this minimum wage was about 40 percent of the average manufacturing wage. However, the law also applied to Puerto Rico, which was much poorer, where this minimum wage was about twice the average factory rates. In a book published more than 25 years ago, researchers John Petersen and Charles Stewart noted that the increase in the minimum wage led to numerous factory closings, and there was a dramatic decrease in output and employment.John M. Peterson, and Charles T. Stewart Jr., Employment Effects of Minimum Wage Rates (Washington: American Enterprise Institute, 1969). In the case of Puerto Rico, the introduction of the minimum wage apparently had a large adverse effect on employment.
Peterson and Stewart also provide an extensive account of early studies of minimum wages that looked at employment and wages at individual production sites. These studies compared employment before and after a change in the minimum wage in an attempt to infer the effects of the policy. A study of the seamless hosiery industry from 1938 to 1941 is of particular interest. This period saw the introduction of the \$0.25 per hour minimum wage, followed by an increase to \$0.325 per hour in September 1939. A researcher named A. F. Hinrichs looked at 76 different plants and divided them into two groups: those that paid high wages and those that paid low wages. We would expect the minimum wage to have a much bigger effect at the low-wage plants. Between September 1938 and September 1939, the low-wage plants had employment losses of 12 percent. Employment at high-wage plants actually expanded by 23 percent, perhaps in part because workers who lost jobs in the low-wage plants became part of the labor supply for the previously higher-wage plants. A similar pattern was noted for the period from 1938 to 1940.
A much more recent study by Card and Krueger is another example of this approach. They studied employment patterns in fast-food restaurants in New Jersey and Pennsylvania. The key to their research was that, during the period of study, the minimum wage was increased in New Jersey but not in Pennsylvania. (Remember that individual states sometimes set minimum wages above the federal minimum.) From this natural experiment, Card and Krueger found that the increased minimum wage in New Jersey actually seemed to have increased employment.
The evidence from other countries (both cross-section studies and studies over time) is likewise mixed. A recent Organisation for Economic Co-operation and Development report has a summary of minimum wage studies from different countries: “Making the Most of the Minimum: Statutory Minimum Wages, Employment and Poverty,” accessed March 14, 2011, http://www.oecd.org/dataoecd/8/57/2080222.pdf. One study of Greek labor markets, for example, found a negative effect for men but a positive effect for women. Another study found negative effects for Mexico but not for Colombia. Different researchers in France have come to different conclusions about the effects of the minimum wage there; researchers in New Zealand likewise disagree; and so on.
Beyond Employment Effects
We started with what seemed to be some simple questions about the minimum wage. The answers turned out to be quite complex. Empirical research does not deliver a definitive answer about whether minimum wages have a big effect on employment. This leads to some disagreement among economists, particularly because the minimum wage is a politically charged issue. From the perspective of policymaking, the lack of a consensus creates difficulty in formulating good policy. On the other hand, the lack of a consensus provides a stimulus for continued work on these important issues.
Though we have emphasized the employment effects of minimum wage changes, there are other effects of minimum wages as well. First, remember that the main argument in favor of minimum wages is that they are a vehicle for redistributing income toward the working poor. Card and Krueger present a detailed analysis of the types of individuals most likely to be directly affected by minimum wage changes. Although empirical work often focuses on the employment of teenage workers, young workers are not the only group in the labor market that is paid close to the minimum wage. About 50 percent of the workers affected by the April 1990 increase in the minimum wage were older than 24 years old, for example.
How much income then flows to these workers as a consequence of an increase in the minimum wage? Card and Krueger conclude that the increase in the minimum wage during 1990 and 1991 had only a tiny effect on the distribution of income. They calculate that the minimum wage increase from \$3.35 to \$4.25 transferred about \$5.5 billion of income to low-wage earners. This amounts to about 0.2 percent of family earnings. The host of transfer programs in place in the United States swamps the effects of the minimum wage on the redistribution of income. The evidence from other studies and countries is broadly in line with this conclusion: several studies find some effects of minimum wages on income distribution, but these effects are typically small.
Second, we can think about the effect of the minimum wage on firms. An increase in the minimum wage increases firms’ marginal cost of production. As a consequence, firms will increase their prices and sell less output. Because of this, increases in the minimum wage reduce profits, so we might expect to see this reflected in the share prices of firms that employ minimum wage workers. Relative to the large empirical literature on employment effects, the implications for employers have been largely neglected. Card and Krueger survey the evidence and find relatively small effects on the stock market value of firms.
Key Takeaways
• Economists use data from labor market outcomes (wages and employment) to infer the shapes of labor supply and demand curves. A key part of this inference is to isolate economic variation to trace out one of the curves.
• Based on many studies, −(elasticity of labor demand) is about 0.3. So if we increase the minimum wage by 10 percent, employment will decrease by 3 percent.
• Studies that look directly at the effects of minimum wage changes find minimal effects of minimum wage changes on employment and unemployment.
check your understanding
1. Why is it so difficult to determine the effects of minimum wage changes on unemployment?
2. What is a natural experiment?
3. Why do changes in the real minimum wage allow researchers to trace out the labor demand curve? | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/11%3A_Raising_the_Wage_Floor/11.06%3A_Empirical_Evidence_on_Minimum_Wages.txt |
In Conclusion
The minimum wage is a public policy that is debated the world over. It has widespread public support because there is something very appealing about the notion that those who work hard will be rewarded with a reasonable standard of living. Economists, living up to their reputation as dismal scientists, point out that this is all very well, but there may be unintended consequences of such a policy:
• A minimum wage leads to a reduction in employment and to unemployment.
• A minimum wage leads to fewer trades than in a competitive market and therefore to inefficiency.
The theory of the minimum wage is straightforward and convinces most economists that, even if the minimum wage has some benefits in terms of the distribution of income, it carries costs with it as well. There is less consensus among economists about whether the redistribution brought about by the minimum wage is desirable. Although the working poor benefit, others are made worse off—including those who are unemployed, who are perhaps even more in need of help than the working poor. Individuals differ in their beliefs about how society’s resources should be distributed, and there is no right answer to the question “what is fair?”
When we looked at the evidence on minimum wages, however, we found that the picture is much less clear. Although some studies are in line with the predictions of theory, many studies suggest that, in practice, the effect of the minimum wage on employment is minimal. At the same time, the effect of the minimum wage on the distribution of income is small as well. In the end, it is difficult to resist concluding that the minimum wage is much less important—in terms of both benefits and costs—than one would think from the rhetoric of the debate.
When you read the newspapers or watch television, you will frequently hear economists offer different viewpoints on economic policies. These disagreements are typically not because economists differ on the theory. The disagreements often come down to different opinions about how to analyze and interpret economic data. Remember as well that television and print journalists go out of their way to find differing points of view because that makes a better story, so the disagreement you see in the media is usually not representative of economists as a whole. That said, economists also have different political viewpoints, and they are sometimes guilty of letting their political preferences cloud their economic analysis.
Having gone through the arguments in this chapter, you should be better able to assess debates and discussion on the minimum wage the next time it comes to the forefront of public debate. This chapter has a much broader purpose, however. We have been studying the effect of government intervention in a market, and we have shown how we can use our tools of supply and demand to understand the likely effects of that intervention. There are many other examples of government interventions that can be investigated using very similar reasoning.
Finally, we have learned something about how empirical work is conducted in economics. Because economists cannot conduct experiments, they are forced to trawl through messy data in an attempt to test their theories. It is difficult to be sure that the variables in which we are interested are indeed changing enough to be useful, and it is even more difficult to disentangle those changes from all the other irrelevant changes that affect the data that we observe.
Key Links
• Bureau of Labor Statistics: www.bls.gov
• Department of Labor: http://www.dol.gov
• US minimum wage laws: www.dol.gov/esa/minwage/america.htm
exercises
1. List three jobs you think probably pay minimum wage and three jobs that you think do not.
2. Illustrate an increase in the minimum wage when both demand and supply are (a) relatively inelastic and (b) relatively elastic. Explain why the change in unemployment is smaller when the curves are inelastic.
3. Explain why the deadweight loss from the minimum wage is larger if labor demand is relatively elastic.
4. How does the elasticity of labor supply affect the deadweight loss from the minimum wage? Specifically, if labor supply is more elastic, is the deadweight loss smaller or larger? What is the economic intuition behind your answer?
5. (Advanced) Draw a version of Figure 11.3.4 "Deadweight Loss from Minimum Wage" for the case where a single individual controls access to scarce jobs. Suppose that she is able to charge job searchers a fee (the same fee for all searchers) equal to the difference between the minimum wage and the wage that workers would be willing to accept. What area of the figure does she obtain?
6. In our discussion of the evidence of the effects of minimum wage changes, we said, “If economists could conduct direct experiments, such as those performed in the physical sciences, they would not have this problem.” Exactly what problem were we referring to?
7. What is the difference between cross-sectional and time-series studies? Does one hold “more things fixed” than the other?
8. Suppose the government imposed a maximum wage in the market for some high-paying job. Draw a diagram to illustrate this market. What would be the consequences of this maximum wage?
9. Explain why, when we analyze the minimum wage, the elasticity of labor supply affects the unemployment rate but not the employment rate.
10. Why does the government not set a minimum wage for corporate lawyers and airline pilots?
11. If the rate of inflation is 10 percent higher than expected, and –(elasticity of labor demand) is 5, what will happen to the employment level in jobs that pay the minimum wage?
12. What happens to the rate of unemployment of minimum wage workers if the rate of inflation is lower than expected?
13. Does the elasticity of labor supply have an effect on the change in the wage bill when there is an increase in the minimum wage? Does this elasticity have an effect on the unemployment rate when the minimum wage changes?
14. (Advanced) Using the discussion of estimation of labor demand, if you could conduct an experiment to see the effects of a minimum wage increase, what exactly would you do?
15. (Advanced) Using supply and demand curves in the market for fast food, what are the effects of an increase in the minimum wage in this market? Think about shifts in both the supply curve and the demand curve. Explain your predictions.
16. Why isn’t an increase in the minimum wage just a redistribution from firms to workers?
17. A politician is in favor of getting rid of the minimum wage entirely. How would you argue against that proposal?
Economics Detective
1. Pick three countries and find the minimum wage in each country.
2. Find a country that does not have a minimum wage. Do you think the lack of a minimum wage means that workers are badly treated in that country?
3. Find some recent discussion of minimum wage legislation in either the United States or some other country. What arguments were made to support the minimum wage? What arguments were made against the minimum wage?
Spreadsheet Exercise
1. (Advanced) Find data on the minimum wage and the price level for another country. Construct a real minimum wage series for that country. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/11%3A_Raising_the_Wage_Floor/11.07%3A_End-of-Chapter_Material.txt |
You come downstairs one morning and find a note on the table.
Please go to the store today and buy the following:
• A bag of sugar
• Two pints of milk
So far there is nothing unusual about this. You plan to go to the grocery store on your way home that evening. Then you read on.
• One carton of cigarettes
• One bottle of whiskey
These are a bit trickier. If you are like many readers of this book, you may not be allowed to purchase alcohol or possibly even cigarettes. In the United States, you must be 21 or over to buy alcohol and over 18 (or 19 in some states) to purchase cigarettes. Depending on where you live, it may also be quite inconvenient to purchase alcohol. In some places, by law, alcohol is sold only at certain times of day. In some places—certain states in the United States and certain countries in Europe, for example—it is sold only in government-run stores.
Many goods, like alcohol, are restricted in terms of who can buy them, when they can be purchased, and where they can be purchased. Alcohol laws differ from country to country. In most European countries, for example, you can buy alcohol at the age of 18. The laws also change over time. Thirty years ago, 18-year-olds could buy alcohol in the United States as well. Ninety years ago, it was illegal for anyone to buy alcohol in the United States.
Next on the list is the following.
• Two tickets for the sold-out rock concert in town tomorrow night
This may also be difficult. You know that you can probably find someone who has tickets and is willing to sell them, but you know that local laws say that this, too, is illegal. So-called scalping of tickets is forbidden. Still, if you go to eBay, you’ll probably be able to find some tickets for sale.
Then the list gets stranger:
• Six Cohiba cigars
• One French raw milk camembert
• Four ounces of marijuana
At this point (at least if you are living in the United States), you begin to seriously worry. You search the Internet for “Cohiba” and discover that these cigars are manufactured in Cuba, but you vaguely remember that it is illegal to import goods from Cuba to the United States. You know that camembert is a French cheese, but “raw milk” sounds strange. More online investigation informs you that it is also illegal to import cheeses into the United States unless they are made from pasteurized milk. Apparently, raw milk cheeses may carry dangerous bacteria. As for marijuana, you already know that it is illegal in the United States.
You read on.
• Also, please hire a cleaning person (an undocumented migrant worker would probably be the cheapest)
This is another transaction that you know is illegal. That said, you know that there are many illegal immigrants working in your town. It would be easy to find someone to hire if you were willing to break the law. With some foreboding, you turn the list over and read the other side.
• Finally, please buy one human kidney (suitable for transplant).
Most of the things that were on the list up to this point were goods or services that you would probably be able to find if you had to. Even though some of them could not be purchased legally, it would not be too hard to find out where to purchase most of them. (Oddly, it would probably be easier to get the marijuana than the cheese.) A human kidney is a different proposition, however. You’re pretty sure, even without research, that buying and selling human organs is illegal, and you would have no idea where to go to buy a kidney even if you were willing to break the law.
We know that the market interaction of buyers and sellers creates value in an economy.We discuss this in detail in Chapter 6 "eBay and craigslist", and Chapter 8 "Why Do Prices Change?". In a market, sellers supply a good or a service, and buyers demand that good or service. Because each transaction is voluntary, the value that the buyer places on the good is always greater than its value to the seller. This means that each trade creates some value. In addition, if the market is competitive, all value-creating trades occur in the market; there are no disappointed buyers or sellers.
This logic suggests that governments should be doing everything in their power to encourage and facilitate trade. Yet, in practice, there are several ways in which governments do the opposite: they actively intervene to restrict trade. We have just listed a large number of examples, and you can surely think of many more. We would like to understand all the restrictions that are deliberately put in place to impede trade.
Our main aim here is not to analyze the rationales behind these restrictions, although we do briefly explain some of them. In other chapters, we provide more insight into precisely why governments impose these and other limitations on our ability to transact with one another.See in particular Chapter 13 "Superstars", and Chapter 15 "Busting Up Monopolies". Our goal in this chapter is to explore what happens when governments interfere with trade in different ways.
One message of this chapter is a reiteration of the gains from trade, together with the recognition that they provide a powerful incentive for people to get together and transact with one another. It seems that whenever the government steps in to try to prevent them from trading, people still try to find a way around these restrictions. The gains from trade are a powerful motivator. Indeed, people continue to trade even when this is an illegal act that carries a significant risk of fines or imprisonment. We use the term underground economy to describe where these trades occur. The question we want to answer in this chapter is as follows:
What are the consequences of government restrictions on trade?
Road Map
In this chapter, we will see many different ways in which governments intervene. For most of our analysis, we use the supply-and-demand framework. We analyze different kinds of government policy and examine the following questions:
• What happens to prices and quantities?
• What happens to welfare and the distribution of income?
• What happens to incentives? Are there any resulting unintended consequences?
We organize our discussion by looking at different categories of restrictions on trade. First, we look at the sale of goods and services in domestic markets. Then we turn to restrictions in international markets for goods and services. Finally, we turn to restrictions not on goods and services but on labor, both within and across countries. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/12%3A_Barriers_to_Trade_and_the_Underground_Economy/12.01%3A_An_Unusual_Shopping_List.txt |
Learning Objectives
1. What tools does the government use to control market transactions?
2. Why might the government restrict trades?
3. What are the effects of these restrictions on market outcomes and welfare?
Looking at your shopping list, there are some items that you simply cannot buy. For example, marijuana and the raw milk cheese from France are not available for purchase in stores in the United States. And depending on your age as well as the time and day of the week, you may not be able to buy the cigarettes and whiskey. We begin by discussing these types of market interventions.
Closing Down the Market
The most fundamental intervention in a market occurs when the government closes down trading completely—that is, the government simply says that it is illegal to trade certain goods or services. Examples are numerous and stem from many different motivations.
Health and safety. Most governments ban addictive drugs, such as heroin, cocaine, and marijuana. The primary reason is that these and similar drugs are deemed to be harmful to those who use them. A secondary reason is that governments may think—rightly or wrongly—that the trade of such drugs also has other harmful implications, such as increased crime.
Governments also ban trade in other products for similar reasons of health and safety. One of the functions of government in most countries is to oversee the safety of products, both generally and more specifically in terms of health risks. In the United States, the Food and Drug Administration certifies factories and food processing and also oversees the approval of pharmaceuticals. Meanwhile, the Bureau of Consumer Protection ( http://www.ftc.gov/bcp) is charged with ensuring that goods meet certain legislated safety standards. Goods that do not meet these standards cannot be legally traded. For example, it is illegal to sell a new car without seatbelts and airbags in the United States.
Ethics, morality, and religion. The exchange of some goods and services is banned for ethical or moral reasons. Examples include the trading of human organisms, the sale of alcohol, and various forms of prostitution.
The ban on the trading of human organs is rooted primarily in an ethical belief that buying and selling body parts is wrong. Many people argue that the moral case for banning organ selling is very shaky, and the world would be a better place if such trades were allowed. It is true that many find the idea of trading body parts for dollars to be repulsive. We have a sense that people would sell a kidney only if they were truly in desperate financial straits, and there is something terrible about the image of, say, a mother selling a kidney to feed her children. Yet there are people who die every day because doctors are unable to find a suitable organ donor in time; that, too, is a sad image.
In many places, the consumption and sale of alcoholic beverages is forbidden, often for religious reasons. The sale of alcohol is prohibited in some Muslim countries, such as Saudi Arabia and Kuwait. Religious pressure also led to a 13-year ban on alcohol in the United States under the 18th Amendment to the Constitution; this state of affairs was known as Prohibition. Indeed, in many counties in the United States, the sale of alcohol is still prohibited. Likewise, many other countries in the world have regions that are “dry.”
Not surprisingly, there is often disagreement about which trades should be ruled immoral or unethical. Different laws in different countries regarding the sale of alcohol are one illustration of this. Another example is prostitution, which is illegal in many places yet legal in others. For example, prostitution is legal (although heavily regulated by the government) in the Netherlands and in parts of Nevada.
Fairness. Sometimes, the government simply takes the view that certain trades are unfair. For example, scalping—the reselling of tickets to concerts and exhibitions—is frequently prohibited for this reason. The following story illustrates that people often see the reselling of tickets as unfair.
Perry Loesberg wanted to surprise his 10-year-old daughter Amy with tickets to “Hannah Montana,” the sizzling-hot concert tour featuring 14-year-old TV star Miley Cyrus.
Instead, he was the one surprised. Though he bought a \$30 fan club membership to get access to tickets ahead of the general public, and then logged on to the Ticketmaster Web site before the general public sale began, Loesberg still came up empty-handed.…
Tickets to each of the 54 shows on the “The Best of Both Worlds: Hannah Montana and Miley Cyrus” tour…sold out within minutes of going on sale. Almost immediately, online marketplaces such as StubHub and craigslist were offering dozens of seats, many selling for more than \$2,000 each. Tickets were originally priced at \$22–\$66.
What kind of ignited parents is I think they thought it should be more fair,” said Debra Rathwell, senior vice president for AEG Live, the tour’s promoter…“We would like fans to sit in these seats. But everything you do, [scalpers] find a way to skirt around it.”
Many of the purchasers are parents unfamiliar with the post-Internet ticket market. They were amazed at the availability of tickets—not to mention the high prices—on the re-sale market.…
Many have pointed to computer software programs that allow users to, in essence, cut in line on the Ticketmaster Web site.…The outcry over Hannah Montana is unusual for other reasons. Ray Waddell, senior editor at Billboard magazine, said parents and children are being disappointed, and their complaints have found sympathetic ears, including the attorneys general of Missouri, Arkansas, Connecticut and Pennsylvania…
It has been like the Wild West out there,” said Waddell. “Things are going to tighten up, (there will be) more regulation about who’s selling, who’s buying and how they are getting their tickets.”Peggy McClone, “Parents Are Angry about ‘Hannah Montana’ Ticket Sales,” The Star Ledger, October 29, 2007, accessed January 29, 2011, http://www.nj.com/news/index.ssf/2007/10/parents_are_upset_about_hannah.html.
Restrictions on Who Can Trade
There are many products that can be legally traded, but the government places substantial conditions on the terms of those trades. For example, several legal goods and services cannot be purchased by minors and can be sold only by licensed sellers. Obvious examples are alcohol and cigarettes, but there are many others. Casino gambling is restricted to adults. Many pharmaceuticals can be sold only by licensed pharmacists and bought only with a doctor’s prescription.
These restrictions vary a lot by time and place, which again tells us that there is no simple right or wrong where these laws are concerned. Different states have different laws. Not all stores can sell liquor. In Sweden, for example, alcohol is sold only in state-run stores. The legal drinking age in Europe is different from the legal drinking age in the United States. Some drugs require a prescription in some countries yet are available over-the-counter in others.
Implications
Figure 12.2.1 "Supply, Demand, and the Gains from Trade" shows the buyer surplus and seller surplus in a competitive market and reminds us that the gains from trade in a competitive market are at a maximum. All mutually beneficial trades have been carried out. Government interventions in markets typically have the effect of eliminating some or all these gains from trade.
Toolkit: Section 31.10 "Buyer Surplus and Seller Surplus"
You can review the different kinds of surplus and the gains from trade in the toolkit.
Figure \(1\): Supply, Demand, and the Gains from Trade
The area below the demand curve and above the price is the buyer surplus; the area above the supply curve and below the price is the seller surplus.
The economic analysis of the closing of a market is very simple. If the government successfully prevents trade, then the quantity traded is zero. All producer and consumer surpluses in Figure 12.2.1 "Supply, Demand, and the Gains from Trade" are lost. An economist’s first response to the closing of a market—any market—is that it brings a loss because some potential gains from trade go unrealized. The question then becomes whether any benefits from closing down a market justify the lost gains from trade.
As our examples reveal, there are many reasons for closing a market, so there is no simple answer to the question, “Is it good to shut down a market?” Each argument must be looked at on a case-by-case basis, and the particulars of specific examples are beyond the scope of this book. Entire books have been written, for example, on the market for human organs or the legalization of prostitution.
When you read the shopping list at the beginning of the chapter, you might also have been struck by the fact that the government’s success in blocking trade is often limited. You probably would find it difficult to buy a heart for transplant on the open market. But if you know where to go, you could almost certainly buy marijuana. Even if you are underage, you may be able to get a fake identification card and buy alcohol. And buying scalped tickets to a concert or a sports event is usually easy, if you have the money. The economic message is simple and fundamental. When there are gains from trade, people will try to realize those gains. When trades are illegal, economic activity moves into the so-called underground economy but is unlikely to disappear completely.
Rationing
Another way in which governments intervene in markets is not by banning trade outright but by placing a restriction on the quantity traded. In most modern economies, such restrictions are little used in a domestic context but are much more prevalent in international trade. If we look back in history, though, we can find instances of rationing in the domestic economy. Rationing means that the quantity available on the market is less than the equilibrium quantity. Some surplus goes unrealized because willing buyers and sellers are prevented from trading. During and after World War II, many basic goods were rationed in the United States, Britain, and elsewhere.
The following excerpt by journalist Joelle Kirch Preksta comes from oral histories of World War II collected by the Carnegie Library.
Ruth showed me several of the ration books she was issued during World War II.…She explained that staples such as sugar, butter, and eggs were rationed in order to help supply our troops overseas and therefore were difficult to obtain in stores.…The following excerpt [is] taken from the “Instructions” section of the books…
1. This book is valuable. Do not lose it.
2. Each stamp authorizes you to purchase rationed goods in the quantities and at the times designated by the Office of Price Administration. Without the stamps, you will be unable to purchase those goods.
Rationing is a vital part of your country’s war effort.…Any attempt to violate the rules is an effort to deny someone his share and will create hardship and discontent. Such action, like treason, helps the enemy. Give your whole support to rationing and thereby conserve our vital goods. Be guided by the rule: “If you don’t need it, DON’T BUY IT.”
The books also contained a warning which indicated that someone who violated the rules for the ration books could be imprisoned for as long as 10 years or fined as much as \$10,000.Ruth L. Baxter, interview by Joelle Kirch Preksta, May 21, 2001, Carnegie Library of Pittsburgh, www.carnegielibrary.org/research/pittsburgh/history/ww2/ww27.html.
Despite these strong moral and legal sanctions—comparing black market trading with treason, no less—there was a substantial underground market for all sorts of rationed goods. For example, the Carnegie oral histories describe a young woman in her twenties named Mary: “She somewhat embarrassingly recalled that she was able to dishonestly procure an extra carton of cigarettes every month for herself because her aunt worked at the drug store where they could be purchased. To this day she says she feels somewhat guilty over this unpatriotic indiscretion.”Mary Hresko and Mary Vincher Shiner, interview by Mark Kernion, May 21, 2001, Carnegie Library of Pittsburgh, www.carnegielibrary.org/research/pittsburgh/history/ww2/ww29.html.
Figure 12.2.2 "The Implications of Quantity Rationing" shows the implications of quantity rationing. Part (a) of Figure 12.2.2 "The Implications of Quantity Rationing" shows that there is a deadweight loss. We see that a quantity ration does not tell us what the price will be. It could be anywhere between the minimum price that the marginal seller will accept (the price found on the supply curve) and the maximum price that the marginal buyer will pay (the price found on the demand curve). In the absence of any other mechanism, the price is determined by bargaining among buyers and sellers. In the case of World War II rationing, sellers were often in stronger bargaining positions, which pushed the price toward the higher end of the range. For this reason, quantity rations were often supplemented by a maximum price, called a price ceiling (part (b) of Figure 12.2.2 "The Implications of Quantity Rationing"). Figure 12.2.3 "A World War II Poster" shows a poster from this period.
Toolkit: Section 31.11 "Efficiency and Deadweight Loss"
You can review the concepts of efficiency and deadweight loss in the toolkit.
Figure \(2\): The Implications of Quantity Rationing
A quantity ration leads to deadweight loss but by itself does not tell us what the price will be.
Price ceilings during World War II led to illegal trading above the fixed price, so the government campaigned to prevent people from trading in these markets.
Hulton Archive/Getty Images
Price Ceiling
It is more common for governments to intervene in an economy by using price tools rather than quantity tools. In particular, governments sometimes intervene using restrictions on how high the price in a market can go. This is called a price ceiling. A classic example of a price ceiling is rent control. In New York City and some other places, there are restrictions on how much landlords can increase the rent on apartments.
Figure 12.2.4 "The Effects of a Price Ceiling" illustrates a price ceiling. Notice that (unless there is also a quantity ration in place) the price ceiling must be below the equilibrium price; otherwise the policy is irrelevant. The main economic implications of a price ceiling can be readily seen from this figure.
• Because no one can force you to sell if you don’t want to, the quantity traded is determined by the supply curve.
• Because the quantity traded is below the equilibrium quantity, there is an inefficiency (deadweight loss).
• Because the quantity demanders wish to buy exceeds the quantity suppliers wish to sell, there must be some kind of rationing in the market to determine who actually buys the good or the service in question.
With no price ceiling (a), all the possible gains from trade in the market are realized. With a price ceiling (b), some gains from trade are lost because there are fewer transactions.
Rent controls keep the price of an apartment rental below its equilibrium level. Not surprisingly, lots of people would like to live in rent-controlled apartments. The quantity demanded is greater than the quantity supplied. Because the price is, by law, not allowed to undergo the adjustment that would restore equilibrium in the market, some other kind of rationing must take place instead.
Rent controls are enacted with distributional goals in mind. The aim is to ensure that people with lower incomes are not priced out of the rental market. Put differently, the goal is to redistribute income from sellers to buyers—that is, from landlords to those who are renting apartments. A difficulty with price ceilings is that people have an incentive to try to get around the restrictions in creative ways. There is often more to a transaction than a simple exchange of money for a good or a service. There may be nonmonetary aspects of the transaction that governments find harder to regulate. When apartments are covered by rent controls, landlords often ask for “key money.” This is an off-the-books, up-front payment that renters must agree to pay before renting the apartment. In other words, it is a polite term for a bribe. In addition, some landlords may not put much money or effort into the upkeep of rent-controlled apartments, thus compensating for the low rent by reducing the quality of the apartment.
In emergency circumstances, temporary price ceilings may be put into effect. These take the form of laws that prevent so-called price gouging. For example, in the aftermath of a hurricane, some goods and services are typically very hard to come by. Basic necessities like food and water may be in limited supply. In the weeks and months after such a disaster, building supplies and similar products may be almost completely unavailable.
After Hurricane Katrina, price-gouging laws applied to states affected by the storm.
While there is no federal price gouging law, many states have enacted some type of prohibition or limitation on price increases during declared emergencies. All of the affected states—Louisiana, Mississippi, Alabama, and Florida—have price gouging laws that are triggered by the declaration of an emergency in the state. Generally, the laws prohibit the sale of goods and services in the designated emergency area at prices that exceed the prices ordinarily charged…
However, there exists a general exemption for increased prices that are the result of additional costs incurred for procuring the goods or services in question.
In Alabama,…evidence of unconscionable pricing exists “if any person, during a state of emergency declared pursuant to the powers granted to the Governor, charges a price that exceeds, by an amount equal to or in excess of 25% the average price at which the same or similar commodity or rental facility was obtainable in the affected area during the last 30 days immediately prior to the declared state of emergency.”Angie A. Welborn and Aaron M. Flynn, “Price Increases in the Aftermath of Hurricane Katrina: Authority to Limit Price Gouging,” Congressional Research Service Report for Congress, September 2, 2005, accessed January 29, 2011, www.fas.org/sgp/crs/misc/RS22236.pdf.
Think about the market for lumber (wood for building purposes) in the first few weeks following a hurricane. Were we to apply supply and demand reasoning to this situation, we would get a diagram like Figure 12.2.5 "The Market for Lumber after a Hurricane". Because there is a great deal of new construction going on, there is a rightward shift in the demand for lumber. The supply of lumber is likely to be fairly inelastic, at least until it is possible to start bringing supplies in from other states. Thus the shift in the demand will lead to a large increase in the existing price. If the price is allowed to increase to its new equilibrium, existing suppliers will obtain a big gain. Price-gouging laws, however, prevent suppliers from raising their prices in this way.
Figure \(5\): The Market for Lumber after a Hurricane
If the market were allowed to work, the price of lumber would increase substantially, but there would not be much more wood supplied. If suppliers are not allowed to increase prices, then demand exceeds supply.
This presents two problems. First, suppliers no longer receive the price signal that tells them to bring more wood to market. In the short run, this may not matter so much. After all, Figure 12.2.5 "The Market for Lumber after a Hurricane" shows that, with inelastic supply, the shift in the demand curve would not in fact lead to a big increase in the quantity supplied, even if the price were allowed to adjust. In the longer run, though, this is more of a problem because there is less incentive for suppliers from further away to bring in additional lumber.
The second problem with forcing sellers to keep their price fixed is that the increase in demand will lead to a shortage. This is also shown in Figure 12.2.5 "The Market for Lumber after a Hurricane". Because demand now outstrips supply, the limited supply will have to be rationed in some way. Most likely, what will happen is that demanders will have to queue to get the lumber that they need. The time that they must spend standing in line has an opportunity cost; they would rather spend that time doing something else. We can think of the time spent in line as increasing the effective price that they have to pay.
These arguments do not necessarily mean that price-gouging laws have no merit. In the aftermath of a hurricane, many things may be happening. Lumber firms may see a temporary increase in their market power. Such an increase in market power gives them an incentive to increase prices, so price-gouging laws may serve as a way to limit the abuse of monopoly power.
Price Floor
A price floor is closely analogous to a price ceiling. The difference, as the name suggests, is that it is a government-imposed minimum price rather than a government-imposed maximum price. The government says that all transactions must be at or above this minimum price. The minimum wage is the most important example of a price floor.We devote a whole chapter to the analysis in Chapter 11 "Raising the Wage Floor". With the minimum wage, the aim is to redistribute income from buyers to sellers—that is, from firms to suppliers of unskilled labor.
Figure 12.2.6 "The Implications of a Price Floor" illustrates a price floor. The main economic implications of a price floor can be seen from this figure.
• Because no one can force you to sell if you don’t want to, the quantity traded is determined by the demand curve.
• Because the quantity traded is below the equilibrium quantity, there is inefficiency (deadweight loss).
• Because the quantity suppliers wish to sell exceeds the quantity demanders wish to buy, there must be some kind of rationing in the market to determine who actually sells the good or the service in question.
With no price floor (a), all the possible gains from trade in the market are realized. With a price floor (b), some gains from trade are lost because there are fewer transactions.
Just as renters use key money and other devices to get around rent control, firms (and workers) sometimes devise ways to get around minimum wage requirements. Employers who are forced to pay a minimum wage may provide worse working conditions than those who pay a market wage. Or, if you want to work at a company and are willing to work at less than the minimum wage, you can negotiate a deal with your employer so that you are paid the minimum wage for reported hours but then work additional hours for nothing. The minimum wage regulations in the United States stipulate that this is illegal, punishable with fines of \$1,100 per violation.US Department of Labor, “Wages: Minimum Wage,” accessed March 14, 2011, http://www.dol.gov/dol/topic/wages/minimumwage.htm.
Sometimes individuals work their way around such restrictions even more blatantly. In the former Soviet Union, price ceilings were put in place in an attempt to keep the prices of basic goods down for households. Martin Walker, a journalist in Moscow, wrote of his experiences with these price ceilings in the food markets outside Moscow.Martin Walker, Guardian. A butcher offering to sell Walker a side of beef assured him that the price per kilogram was fixed. “However,” said the butcher, “the weight is subject to negotiation.”
In the Soviet Union, the limited supply of goods led to long lines for those who wanted to purchase basic commodities, such as bread. You can think of these lines as an additional component of the price: you pay money plus the value of the time that you spend standing in line.
Although price ceilings and price floors have different implications for the price in the market, they both imply that the quantity traded in the market will be less than the equilibrium quantity. The reason is simple: neither buyers nor sellers can be forced to trade if they do not want to. If the price is above the equilibrium price, the quantity is determined by the amount of the good or the service that people are willing to buy. Some would-be sellers are disappointed because they cannot find someone to buy from them. With a minimum wage, for example, not everyone who wants a job can find one. If the price is below the equilibrium price, the quantity is determined by the amount of the good or the service that people are willing to sell. Some would-be buyers are disappointed because they cannot find someone to sell to them. With rent control, for example, not everyone who wants a cheap apartment can find one.
Taxes and Subsidies
Price floors, price ceilings, and quantity restrictions are important but relatively rare policies. The government intervenes regularly in almost every market in the economy in a different way—by the imposition of taxes. Had you purchased the milk and sugar on our shopping list, for example, you would very likely have paid a sales tax. Sometimes cities levy their own sales taxes as well. On certain goods, such as alcohol or gasoline, you may pay additional taxes.
Taxes
A tax is a payment made to the government that is associated with an economic transaction. Although the details of taxes can differ substantially, most taxes come down to one simple point: the price paid by the buyer is higher than the price received by the seller.
Suppose you want to purchase a book for its list price, say, \$20. In the United States, if you take this book to the cash register, you will typically be charged a sales tax. If the sales tax is 5 percent, you will have to pay \$21 for the book. The store collects the \$1 tax on behalf of the government. So who is paying this tax? On the one hand, the amount of the tax is marked right there on the receipt as an amount you have to pay. Yet it is the store that actually sends the money to the government.
Imagine, by contrast, that you had to give the bookstore only \$20 but then were personally responsible for sending the sales tax to the government. You would have to file a sales tax declaration each year for every item you bought. That would be both inconvenient and difficult for the government to monitor; for this reason, sales taxes are funneled through the seller. But we are interested in a more fundamental question: would this make a difference on who pays the tax? The answer is no. You would still pay \$21, the government would still get \$1, and the bookstore would still get \$20.
In other words, it does not make any difference whether the tax is imposed on buyers or sellers. This is one of the most surprising results that economics teaches us. In our book example, the conclusion may seem obvious. Yet people often to fail to appreciate the far-reaching significance of this insight.
For example, social security taxes in most countries are imposed on both workers and employers. Suppose the government changed its policy and declared that the portion of social security that was previously paid by the employer now had to be paid by the worker instead. Looking at this as employed workers, we might think that we had just been hit with a huge tax increase. Indeed, if nothing else changed, the policy change would make workers worse off. Fortunately, the logic of supply and demand would quickly come to our rescue. At existing wages, firms would no longer be able to hire all the workers they wanted. Wages would be bid up, and before long we would expect to see workers and firms no better and no worse off than they were previously.
Who Pays the Tax?
The key question, then, is not who sends the money to the government. The key question is, What happens to prices when a tax is imposed?
To answer this, imagine that the government increases taxes on gasoline by 50 cents a gallon and consider two extreme cases. First, suppose the price of gas increases by 50 cents a gallon. Households are evidently paying the tax; the amount they must pay per gallon has gone up by the full amount of the tax. Now suppose that the price of gasoline at the pump does not change at all. Then firms are paying the tax: they are receiving 50 cents less per gallon once they pay the tax to the government. Most often, we expect to see the price of gasoline increase but by less than 50 cents. Therefore, the burden of the tax is shared between the gas station and the household. It is the change in the price that tells us who really pays the tax.
Figure 12.2.7 "The Deadweight Loss from a Tax", and Figure 12.2.8 "The Loss in the Buyer Surplus and the Seller Surplus from a Tax" illustrate the effects of a tax.
• The gap between the buyer’s price and the seller’s price means that the quantity sold is less than the market equilibrium quantity ( Figure 12.2.7 "The Deadweight Loss from a Tax").
• There is a deadweight loss: some mutually beneficial trades go unrealized. This is again visible in Figure 12.2.7 "The Deadweight Loss from a Tax". There are potential trades where the buyer’s valuation exceeds the seller’s valuation. However, because the difference in valuations is less than the amount of the tax, these trades are not worthwhile once the tax must be paid.
• There is a reduction in both the buyer surplus and the seller surplus, as can be seen in Figure 12.2.8 "The Loss in the Buyer Surplus and the Seller Surplus from a Tax". The buyer surplus is the area under the demand curve and above the price paid. The seller surplus is the area above the supply curve and below the price received.
• Figure 12.2.8 "The Loss in the Buyer Surplus and the Seller Surplus from a Tax" also shows that some of the surplus generated by these trades now goes to the government in the form of tax revenues. Government tax revenues equal the amount of the tax multiplied by the quantity traded. Graphically, they are equal to the rectangle shown in part (b) of Figure 12.2.8 "The Loss in the Buyer Surplus and the Seller Surplus from a Tax".
A tax means that there is a wedge between the price paid by the buyer and the price received by the seller.
Figure \(8\): The Loss in the Buyer Surplus and the Seller Surplus from a Tax
The total surplus is the sum of the buyer surplus (a), the seller surplus (b), and the tax revenue received by the government (c).
Tax incidence is the way in which the burden of a tax is divided between buyers and sellers. In general, the incidence of a tax depends on the price elasticity of supply and the price elasticity of demand. Figure 12.2.9 "Tax Incidence with Inelastic and Elastic Demand" shows why tax incidence depends on the elasticity of demand. That figure has two parts. In both parts, we start from the same initial competitive equilibrium and impose a tax of the same size. This means that the gap between the price paid by buyers and the price received by sellers is identical.
Figure \(9\): Tax Incidence with Inelastic and Elastic Demand
When demand is inelastic (a), most of the burden of the tax is borne by buyers, while the opposite is true when demand is elastic (b).
In part (a) of Figure 12.2.9 "Tax Incidence with Inelastic and Elastic Demand", demand is inelastic. Buyers are not very price sensitive, so even if the price increases, their quantity demanded does not change a great deal. The result is that the price paid by buyers increases a lot. Most of the burden of the tax is borne by buyers. In part (b) of Figure 12.2.9 "Tax Incidence with Inelastic and Elastic Demand", demand is elastic. As the price increases, the quantity demanded decreases a great deal. In this case, the price paid by buyers increases much less, and the price received by sellers decreases by more. Most of the burden of the tax is borne by sellers.
Keep in mind also that the distortion induced by the tax is smaller when demand is inelastic. The key indicator of the distortion is how much change there is in the quantity traded. When demand is inelastic, the quantity traded changes by less. As a consequence, there is a much smaller deadweight loss in part (a) of Figure 12.2.9 "Tax Incidence with Inelastic and Elastic Demand" than in part (b) of Figure 12.2.9 "Tax Incidence with Inelastic and Elastic Demand".
Why Do Governments Impose Taxes?
Given our analysis so far, you might think that governments should not impose taxes at all. After all, taxes reduce the surplus received by buyers and sellers. However, there are several reasons why governments tax households and firms, despite the adverse consequences for the gains from trade.Many of these arguments for taxation are also discussed in other chapters.
Raising revenue. Governments perform certain essential functions, such as maintaining a legal system and defending the borders. Governments also typically supply various goods and services (such as roads, schools, and streetlights) as well as paying out subsidies to certain industries and transfers to individuals. All of these require government revenues. We are not interested right now in which of these things governments should do nor with the question of whether governments intervene too much or too little in the economy. It is simply a fact that governments incur a lot of expenses, and these expenses must be paid for through taxation. One key reason for taxes is therefore to raise revenue to fund government activities.
In fact, governments sometimes finance their expenses through borrowing rather than current taxation. But borrowing is the same as deferred taxation: the debt obligation must eventually be paid through taxes levied in the future.
Redistributing income. Taxes are a means by which governments can take money from one group of people and give it to another. Governments often use progressive taxation, meaning that the rich are taxed proportionately more than the poor. Taxation then serves to make the distribution of income more equal.In Chapter 13 "Superstars", we look in detail at the arguments for redistribution in society.
Externalities. In some circumstances, an individual’s actions have an influence, either positive or negative, on others in the economy. Economists call such an effect an externality. Chapter 14 "Cleaning Up the Air and Using Up the Oil" is all about such externalities. In the presence of externalities, distortions in the market and some type of government intervention may be warranted. Often, that intervention takes the form of taxes and subsidies that alter individual incentives to encourage behavior that promotes economic efficiency.
Sometimes externalities are adverse; these are known as negative externalities. The effect of second-hand smoke is an example. Other times there are positive externalities associated with an action. An example is education, which has benefits to society as well as to the individual who obtains the education. When there are negative externalities, the government can impose a tax to discourage the activity in question. When there are positive externalities, the corresponding government response is a subsidy.
Uninformed choices. Economists generally presume that informed individuals will make informed choices. Not everyone agrees with economists about this. One often hears the argument that governments ought to intervene so that individuals do not make the “wrong decisions.” Take, for example, the decision to smoke cigarettes. It has been known for a long time that cigarette smoking is harmful to one’s health. One reasonable view is that smoking should be purely a matter of individual choice: people can make their own choices about the enjoyment of smoking versus the adverse health effects. As long as individuals make informed choices, there seems to be little basis for government intervention.
But another view is that people are not always capable of informed choice. Perhaps people are not good at making decisions that involve their health 30 years from now. Perhaps people are not good at making decisions about addictive substances. Perhaps it is not appropriate to think of rational individuals making informed choices when many people start smoking as children. An argument can then be made that governments should step in and alter incentives, through taxes and subsidies, to help people make better choices.
Toolkit: Section 31.2 "Elasticity"
You can review the definition and calculation of elasticities in the toolkit.
Subsidies
A subsidy is the opposite of a tax. It is a payment made to a producer to encourage production. A subsidy means that the price paid by the buyer is lower than the price received by the seller. Figure 12.2.10 "The Deadweight Loss from a Subsidy" shows the deadweight loss from a subsidy. Subsidies distort markets not by leading to too small a quantity being traded but by causing too large a quantity to be traded. The deadweight loss lies to the right-hand side of the competitive equilibrium quantity because some trades occur where the cost exceeds the benefit. Figure 12.2.11 "The Buyer Surplus and the Seller Surplus after the Imposition of a Subsidy" shows the buyer surplus and the seller surplus in the presence of a subsidy. Both are increased by the subsidy. However, subsidies mean that the government spends resources rather than taking them in. The figure shows that the cost of the subsidy is greater than the increased surplus received by the buyers and the sellers. The difference between the cost and the increases in surplus is the deadweight loss
A subsidy means that some transactions are now carried out even though they actually destroy value.
The buyer surplus and the seller surplus are shown in (a) and (b), and the cost of the subsidy is shown in (c). The total surplus is obtained by adding together the buyer surplus and the seller surplus and then subtracting the subsidy paid by the government.
Figure 12.2.12 "The Different Ways in Which Governments Intervene in Markets" summarizes the different kinds of trade restrictions that we have looked at.
Key Takeaways
• Government restrictions take a variety of forms, including bans on trades, controls on prices, and the imposition of taxes and subsidies to change incentives. These are summarized in Figure 12.2.12 "The Different Ways in Which Governments Intervene in Markets".
• Some of the reasons governments restrict trades are to protect individuals and society from unsafe and unhealthy products, for moral reasons, and for fairness.
• Through these restrictions, some gains from trade may be lost. For example, in the presence of taxes, there are deadweight losses due to the lost gains from trade. If a market is shut down entirely, then all the gains from trade are lost. In some cases, individuals find a way to circumvent government restrictions to realize these gains from trade.
Exercises
1. In what sense is the closing down of a market like a tax?
2. If the government sets a tax rate, how is the quantity of revenue collected determined?
3. Explain why the allocation of the tax burden does not depend on who pays a tax to the government. | textbooks/socialsci/Economics/Economics_-_Theory_Through_Applications/12%3A_Barriers_to_Trade_and_the_Underground_Economy/12.02%3A_How_the_Government_Controls_What_You_Buy_and_Sell.txt |
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