Introductory Economics Lecture Notes Lecture 1 PDF

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Introductory Economics - Lecture notes - lecture + 1
Introductory Economics (Yale University)
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Fall 2012
Economics 115:
Introductory Microeconomics
Professor Christopher Udry
27 Hillhouse Ave
27 Hillhouse
christopher.udry@yale.edu

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Outline for Today

Outline for Today
• What is Economics?
What is Economics?
– Scarcity and Opportunity Cost
• Introduction to Supply and Demand
Introduction to Supply and Demand
• The Course Ahead

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From the syllabus:

From the syllabus:
This course is an introduction to microeconomic
This course is an introduction to microeconomic
analysis: the study of how our economy works
to allocate scarce resources among consumers
and firms. The course will develop a
theoretical framework for this analysis and
show how this framework can be applied to
h h hi f k b li d
real‐world issues such as global poverty,
climate change health care reform income
climate change, health care reform, income
distribution, and the role of markets in the
economy.
economy
3

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What is Economics?
What is Economics?
The study of the allocation of scarce resources

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What is scarce?
– Time
– Food
– Talent
– Oil
– Ideas
– Money
–…
What isn’t?

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Scarcity implies Opportunity Cost
The value of a good in its “next

The value of a good in its next best use
best use”
Monetary and non‐monetary

Monetary and non monetary value
value

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Opportunity Cost leads us to :
The Necessity of Trade‐offs
The Necessity of Trade‐offs
… you can’t always get what you want

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Trade‐offs lead us to :
• Marginal Decision‐Making – comparing any
add t o a be e ts o a c o ce to t e e t a
additional benefits of a choice to the extra
costs it would bring.
• Sunk Costs
Sunk Costs – a cost that has already been
a cost that has already been
incurred and cannot be refunded or
recovered.
recovered

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Example 1: Corn
Example 1: Corn

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Example 2: Singer’ss lake
Example 2: Singer lake
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Example 3: marginal vs sunk cost

Example 3: marginal vs sunk cost
• Weekend plane ticket vs
Weekend plane ticket vs fun party
fun party
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Example 4: Data for my phone

Example 4: Data for my phone
• I pay $10/month for data, with no limit
I pay $10/month for data with no limit
– What is the opportunity cost to me of
downloading a 100MB file?
• In Ghana, I use scratch cards which cost $0.10
per MB
per MB.
– What is the opportunity cost to me of
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Method and Intro to Micro

Method and Intro to Micro
• Models
Models – intentionally simplified via
intentionally simplified via
“ASSUMPTIONS”
– Ideally, cut away extraneous to reveal a truth
Ideally cut away extraneous to reveal a truth
– but, can openers
• M
Math –
th language of logic to connect
l fl i t t
assumptions with results (‘proof’)
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MATH LEVEL
• 9TH Grade Algebra
• Simple graphs (but sometimes used in an
Simple graphs (but sometimes used in an
abstract way)
• Logic of calculus (but no formulas, no prior
Logic of calculus (but no formulas no prior
experience required)
If you have had calculus, it will help you intuition
about optimization
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The Process of Economic Thinking

The Process of Economic Thinking
Model
Compare to
Data
P di i
Predictions
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Simple models can produce powerful and useful
results
But be careful
Try to move to greater realism, richer models
Mix theory, data, and experimentation
y, , p
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Types of Questions
• Normative
– How things should work
• Positive
P iti
– How things do work
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What is MICRO economics?
It is the study of choices by
It is the study of choices by
• Individuals
• Firms
And how they interact, mostly in markets
Questions often involve government policies to
regulate, tax, subsidize individual markets
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Macroeconomics: the “Circular Flow”
Between households, output markets, firms,
put a ets
input markets
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Macroeconomics
Concerned with economy‐wide issues, inflation,
Concerned with economy‐wide issues inflation
unemployment, growth
Better to understand the individual components
Better to understand the individual components
before you aggregate to macroeconomics
…. so, Micro is a pre‐Req for Macro
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Real vs. Nominal

Real vs. Nominal
Nominal quantities measured in $, Yen, Euros,
Nominal quantities measured in $ Yen Euros
cedis, etc….
Real quantities measured in units of goods:
Real quantities measured in units of goods:
hours, numbers of cars, tons of steel, calories
consumed
Micro cares about real (macro also cares about
i fl i )
inflation).
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The Course Ahead

The Course Ahead
Textbook
Principles of Microeconomics by N. Gregory
M ki 6th diti
Mankiw, 6th edition, Cengage
C L
Learning, 2012
i 2012
• This book is too easy for you. It provides a
foundation on which we will build Use it as a
foundation on which we will build. Use it as a
backup.
• You are responsible for what we do in class,
You are responsible for what we do in class
which will be harder. Also see supplementary
notes under resources on classesv2.yale.edu.
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Format
The course format is two lectures per week, plus
The course format is two lectures per week plus
small class sections with the teaching fellows.
The times of the sections will be arranged
The times of the sections will be arranged
during the second week of classes. There will
be weekly problem sets (20% of the grade)
be weekly problem sets (20% of the grade),
one midterm exam (30% of the grade) and
one final exam (50% of the grade)
one final exam (50% of the grade).
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Grades
Traditionally, the Econ Intro Curve is about
Traditionally the Econ Intro Curve is about
• 40% A/A‐ (more A‐ than A, though)
• 50% B+/B/B‐,
0% / /
• 10% C‐D‐F.
• Course Drops put at bottom of the curve
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SECTIONS!!
Meet weekly, possible section times are Wed
Meet weekly possible section times are Wed
pm ‐‐ Fri afternoon.
OCS section preference selection opens
OCS section preference selection opens
Saturday at 9 am and closes Tuesday 9 pm. Be
sure to indicate your preferred times! Section
sure to indicate your preferred times! Section
assigned by Wed. AM.
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Question: Do I have to attend Section?
Answer: You would be foolish not to.
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Themes
• First half: models of
First half: models of ‘perfect’
perfect competition.
competition
– Emphasis on conditions necessary for achieving
efficiency in production and distribution
efficiency in production and distribution
• Second half
– Departures from perfect competition/efficiency
Departures from perfect competition/efficiency
– Role of government in a mixed economy
– Poverty, inequality
P t i lit
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Schedule
• Exact dates and readings subject to revision
Exact dates and readings subject to revision
• Introduction
– What is (micro)economics? Read Chapters 1 and
Wh t i ( i ) i ? R d Ch t 1 d
2 plus online “introductory” notes (in “Resources”
on classesv2 yale edu)
on classesv2.yale.edu)
• Supply and Demand
– Supply and Demand, Chapters 4 & 5
S l dD d Ch t 4 & 5
– Benefit and Cost, Chapter 11
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• Consumer Behavior
– Consumer Preferences, Chapters 6 & 21
– Individual Demand, Chapter 7
, p
• Production and Firm Behavior
– Production, Chapter
Production Chapter 13
– Cost, Chapter 14
– Profit Maximization
Profit Maximization
– Economic Efficiency, Chapters 8 & 3
– Equity and Efficiency, Handout
E it d Effi i H d t
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• Monopoly, Chapter 15
• Review for Midterm
; p
• October 17: Midterm in class; no make‐ups without
Dean’s excuse
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Post‐Midterm: turn to more realism, market
failures, government policy
• More Monopoly
o e o opo y aand Imperfect Competition
d pe ect Co pet t o
• Economic Policy
– Public Goods
Public Goods
– Externalities and Pollution
– Savings and Investment
S i dI t t
– Risk, Finance and Insurance
– International Trade
I i lT d
– Poverty and Income Distribution
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• Review for Final
• Final Exam 9:00 AM Monday 12/17: no make‐ups
without Dean’s excuse
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The First Model

The First Model
Supply and Demand
Supply and Demand
One good, many buyers, many sellers in a
O d b ll i
market
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Markets
• What is a market?
– Market – a group of buyers and sellers who trade a
particular good or service.
– Market boundaries can include:
Market boundaries can include:
• Buyers and sellers in the world
• Buyers and sellers locally
– Buyers and sellers not just of “things”
• Market for higher education
• Marriage market: India
Marriage market: India
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The Demand Curve

The Demand Curve
How much would be purchased at each different
price?
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Demand for mobile phones 36

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Demand Schedule
Demand Schedule
• “Willingness
Willingness to pay
to pay”
for the “marginal”
unit
• “marginal” = “extra”,
last , “next”
“last” next , “one
one
more” … it’s the unit
on the margin
“on the margin” of
of
being purchased.
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The Demand Curve holds
The Demand Curve holds “all
all else equal
else equal” (other
(other
than the price)
“ceteris paribus”
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The “Law
The Law of Demand
of Demand”
As price increases, the Quantity demanded
As price increases the Quantity demanded
decreases.
‐‐ more an observation and a prediction than a
more an observation and a prediction than a
law….
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Why does the Demand Curve slope
down?
• Finite income and wealth: opportunity cost
Finite income and wealth: opportunity cost
– Income effect: Can’t afford all previous
consumption as the price rises
consumption as the price rises
– Substitution effect: Other goods become relatively
more attractive (the opportunity cost has
more attractive (the opportunity cost has
increased)
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Movements along vs. Shifts of the
Demand Curve
d
• A
A movement along a fixed demand curve
movement along a fixed demand curve
occurs when the price changes, holding all
else constant
else constant
• A shift of the demand curve (or “a change in
demand”)) occurs when a factor other than
demand occurs when a factor other than
price changes. Example: population increase
shifts demand for mobile phones out
shifts demand for mobile phones out.
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The demand curve for mobile phones shifts out
when population increases
when population increases
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Fall 2012
Economics 115
Economics 115
Lecture 2: Intro to Supply and
Demand

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Outline for Today

Outline for Today
• Course Details
Course Details
• Review
– Scarcity
S it
– Opportunity Cost
• Demand
• Supply (maybe)
• Equilibrium (Wednesday)

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Announcements
• Section Preference opens Saturday at 9:00 AM
Section Preference opens Saturday at 9:00 AM
– Go to https://students.yale.edu/ocs‐
p
preference/select/select?id=6250
– Closes Tuesday at 9PM
– If you fail to sign up, you will need to go to OCS after
9:00 AM on Wednesday to try to find an open section
• Sections Meet Next Week
• Problem Set posted this afternoon. Due a week
from Monday

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Announcements
• No
No Class Monday
Class Monday
• Wednesday Class: Sterling Law School
Auditorium

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• Problem Set Rules:
– Discuss, consult, work in groups. This is helpful
and encouraged
– Write up your own results. It is not OK to copy
someone else’s answer
– Due Mondays at the start of lecture

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Main Ideas from Last Time

• Economics
Economics is all about the allocation of scarce
is all about the allocation of scarce
resources
• Scarcity gives rise to
Scarcity gives rise to “opportunity
opportunity cost
cost”
• Opportunity cost forces us to explicitly
examine trade‐offs
i d ff

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• Relevant Trade‐offs occur
– within an individual or household (e.g. study or
talk))
– within a firm (hire more workers, or buy a better
machine)
– in markets, connecting firms and households (sell
more product at a lower price)
– between gov’t, households and firms (increase a
tax on fuel)
– w/in and between countries, regions, etc…
(impose a tariff)

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THE DEMAND CURVE

THE DEMAND CURVE
p
price?

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The Demand for Gasoline

The Demand for Gasoline

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The Demand Curve is
• A “Demand Schedule” … listing how much is
demanded at each different price
demanded at each different price
• The “willingness‐to‐pay” for the “marginal”
unit
“marginal”=“extra”, “last”, “next”. It is the unit
“
“on the margin” of being purchased.
h i ” fb i h d
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The “LAW
The LAW OF DEMAND
OF DEMAND”
As Price increases,
As Price increases
… Quantity demanded decreases
Not really a law … actually an observation and a
prediction
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Why does demand slope down?
Why does demand slope down?
Finite income/wealth imply Opportunity Costs
• Income effect: can’t afford all previous consumption
p p
• Substitution effect: other goods are relatively more
attractive
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D can be a graph, or a Table:
D
D as an Equation:
E ti
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D might be a line:
A curve:
Or an abstract function:
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Global Warming and the Demand for Gasoline
To reduce consumption, increase price?
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What’s with this “Law of Demand”, anyway?
Look at 1999 – 2005….
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The D curve holds “all else equal”
(other than price)
“ t i
ib ”
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A “shift
A shift of the demand curve
of the demand curve” (a
(a “change
change in
in
demand”) occurs when a factor other than
price changes Example: population increase
price changes. Example: population increase
shifts the demand curve out.
A “movement
A movement along the demand curve
along the demand curve”:: price
price
changes, holding everything else constant.
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A h
A change in the demand curve:
i th d d
What might cause this?
h h h ?
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• Population
• Income
– “normal good” vs
“ l d”
– “inferior good”
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• Prices of other goods
g
– Substitutes
– Complements
l
• Expectations of future prices….
• Change in “tastes”
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A change in P is NOT a “change

A change in P is NOT a change in demand
in demand”
but
a “change in quantity demanded”
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An increase in the Price of Gasoline

An increase in the Price of Gasoline
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D for Gas and an Increase in Incomes in China

D for Gas and an Increase in Incomes in China
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An old question (diamonds vs. water):

An old question (diamonds vs. water):
Does the Price of a Good Reflect

Does the Price of a Good Reflect
Benefit (“utililty”)
or
Cost?
Demand curve reflects Benefit (willingness to pay)
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Demand curve alone can NOT determine both P
Demand curve alone can NOT determine both P
and Q. It is a curve, not a point:
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SUPPLY
• Firms
Firms want to earn a profit
want to earn a profit
• Output of the firm has an Opportunity Cost –
the cost of inputs
the cost of inputs
“Marginal Willingness to Supply”
• Perfectly competitive firm takes price as given
• How much to produce/sell at a fixed and given
p / g
price?
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The Supply Curve

The Supply Curve
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Why does Supply slope up?

Why does Supply slope up?
Increasing Marginal Opportunity Cost
i i lO i C
…but what about Economies of Scale?
Deal with this later
Deal with this later
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• The Supply of Maize: diminishing marginal
returns, increasing marginal opportunity cost
• Think about how he can increase S: more
labor, more fertilizer, more land ....
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• When
When some input is fixed (e.g., land) and the
some input is fixed (e g land) and the
firm adds more and more other inputs (e.g.,
labor fertilizer) diminishing returns
labor, fertilizer), diminishing returns
eventually sets in
• For now, a simple example of a farmer using
For now a simple example of a farmer using
labor on a fixed amount of land
– Later, economies of scale?
L t i f l ?
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• What
What is the opportunity cost to the farmer of
is the opportunity cost to the farmer of
selling one more unit of output?
Q Produced
P d d L b U d
Labor Used C
Cost of Labor
fL b Opportunity Cost of
O i C f
additional Unit
1 2 20 20
2 5 50 30
3 9 90 40
4 14 140 50
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If the price is 20, how much is he willing to
sell? How about if the price is 40?
ll? H b if h i i 40?
Q Labor Cost Opportunity
P d d
Produced U d
Used of
f C t f
Cost of
Labor additional Unit
1 2 20 20
2 5 50 30
3 9 90 40
4 14 140 50
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S as a Graph:
S as a Table:
S as an Equation:
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S might be a line:
A curve:
Or an abstract function:
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The S curve holds “all else equal”
(other than price)
“ t i
ib ”
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A “shift
A shift of the supply curve
of the supply curve” (a
(a “change
change in
in
supply”) occurs when a factor other than price
changes.
changes
Examples:
• Prices of inputs
Pi fi
• Technology
• Number of firms
A “movement
A movement along the supply curve
along the supply curve”:: price
price
changes, holding everything else constant.
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To determine both P & Q need BOTH S & D

To determine both P & Q, need BOTH S & D
““equilibrium”
ilib i ”
no force is working to change P and Q
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Equilibrium P & Q
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Fall 2012
Economics 115
Economics 115
Lecture 3: Equilibrium Supply and
Demand and Introduction to
Elasticity

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Outline for Today

Outline for Today
• Course Details
Course Details
• Review
– Demand and Supply
D d dS l
• Equilibrium
• Elasticity

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Announcements
• Section
Section assignments are complete for those
assignments are complete for those
who used our section preference tool. You
should have received an email, and your
section is listed in OCI and on the classes
server.
• Sections will be held this week. If there is no
classroom or TF listed for your section, go to
another section at the same time for this
h i h i f hi
week only

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Announcements
• If
If you did not use the section preference tool,
you did not use the section preference tool
choose an open section in OCI
• Problem Set 1: Due at the start of class on
Problem Set 1: Due at the start of class on
Monday. Physical problem sets are required…
– PS rules: working together is encouraged. But
PS l ki t th i d B t
write up your own answers. TFs will not answer
questions specific to the PS
questions specific to the PS.

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• What
What causes shifts of the demand curve
causes shifts of the demand curve
(changes in demand)?

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• Movements
Movements along
along the Curve
the Curve – from Δp, ceteris
from Δp ceteris
paribus
• Movements of
Movements of the Curve –
the Curve shifts of the curve
shifts of the curve
from other factors

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• Supply
– Comes from decisions of the firm
– A perfectly competitive firm takes the market
A perfectly competitive firm takes the market
price as given
– How much to produce?
How much to produce?

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• The supply curve
The supply curve

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• Can
Can read the graph both ways:
read the graph both ways: “supply
supply at a
at a
given price”, or “marginal willingness to
supply
supply”

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• When
When some input is fixed (e.g., land) and the
some input is fixed (e g land) and the
firm adds more and more other inputs (e.g.,
labor fertilizer) diminishing returns
labor, fertilizer), diminishing returns
eventually sets in. More on this later…
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• With
With diminishing returns, the supply curve
diminishing returns the supply curve
slopes up.
• For now, we
For now we’llll assume diminishing returns
assume diminishing returns
always, so supply slopes up
– Later, economies of scale?
L t i f l ?
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• What shifts S?
What shifts S?
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• Changes in input prices
Changes in input prices
• Changes in technology
• Changes in number of firms in the market
Ch i b f fi i h k
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• Shifts in the supply curve:
pp y
– Supply increases (goes up) means curve shifts out (to
the right)
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• Equilibrium
– No force is acting to change P or Q
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• Perfectly Competitive Equilibrium
– Many “price‐taking firms” (e.g. Harounan Iddrisu,
maize farmer; not Apple or GM)
– Homogeneous goods (e.g., maize; not medical
care)
– Perfect information in the market (on price,
quality, etc…)
– Well‐defined property rights (rule of law,
government)
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• Equilibrium P & Q for oil:
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Equilibrium price p* is the price at which
D(p*)=S(p*)
WHY?
If D(p)>S(p) then “Excess Demand” (shortage)
If D(p)>S(p) then “Excess Demand” (shortage)
and p rises
If D(p)<S(p) then “Excess Supply” (surplus) and p
falls
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• Equilibrium P & Q: An increase in D
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• Equilibrium P & Q: Improved technology of
production, the Green Revolution
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Example: Markets come to the U.S.S.R.
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The algebra of equilibrium
Demand: Q  Y  P
D
Y is something we might change to shift around

Y is something we might change to shift around
demand, like income.
Supply Q S  W  P
Supply:
W is something we might change to shift supply,
like wages.
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In equilibrium, Q D  Q S
So
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Algebra for last slide
So
Y  P W  P * *
Y  W  2 P*
Y W
P *
2
How does equilibrium P change if we increase Y
or W?
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Substitute the equilibrium P* into D (or S, it DOES
NOT MATTER)
NOT MATTER).
How does equilibrium Q change if we increase Y or
W?
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Algebra for last slide
Y W
P *
2
Q Y P
D
 Y W 
Q Y 
*

 2 
Y W
Q 
*
2
How does equilibrium Q change if we increase Y or W?
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Analysis of Taxation: A “Carbon Tax” on Gasoline
• A tax places a ‘wedge’ between the price paid
by t e co su e a d t e p ce ece ed by t e
by the consumer and the price received by the
firm: For the firm to get , the consumer has
P f
p y Pc  P f  t
to pay
27

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The change in equilibrium P and Q from the
gasoline tax
28

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Burden (“Incidence”) of the tax
Who pays the tax relative to the pre‐tax
equilibrium?
Hint: It does not matter who actually sends the
cash to the government!
29

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Graph: The Burden of Taxation
30

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The Burden of Taxation:
Graph: For a given tax, P goes up more when D
s steep
is steep
31

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Analysis of taxation: 2 Equivalent Graphs
32

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Graph: For a given increase in demand, P goes
up more when S is steep
33

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BUT: slope depends on the units we choose
Needed: a unit‐free measure of “steepness”
34

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Elasticity
Is the % change in Quantity associated with a
g e % c a ge
given % change in Price
ce
%Q
%P
35

lOMoARcPSD|1876427
Elasticity
%Q
This is a unit‐free measure:
%P
36

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Elasticity
Q
100 *
% Q Q Q P
 
% P 100 * P P Q
P
37

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Elastic vs. Inelastic Demand:
38

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• Definitions
|Elasticity| < 1 ….. “inelastic”
|Elasticity| > 1
|Elasticity| > 1 ….. “elastic”
elastic
|Elasticity| = 1 …… “unit elastic”
39

lOMoARcPSD|1876427
Elasticity is defined at a point on a curve:
At a point, the flatter D curve is more elastic
40

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Next time: Use elasticity to describe the burden
of a tax, or the impact of other changes in S or
D
Then: Go “behind the demand curve”. Study
household behavior
household behavior
41

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Fall 2012
Economics 115
Economics 115
Lecture 4: Elasticity and Taxation;
General Marginal Analysis

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Outline for Today

Outline for Today
• Course Details
Course Details
• Review
– Equilibrium and taxes
E ilib i dt
• Elasticity
• Marginal Analysis

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Announcements
• Problem
Problem set 1 due now
set 1 due now
• Second problem set posted today
• Contact/see head TA kota.mori@yale.edu if
C / h d k i@ l d if
you need help with your section assignment

lOMoARcPSD|1876427

• Equilibrium Supply and Demand
Equilibrium Supply and Demand
– What shifts S and D, how do these shifts influence
P and Q?
P and Q?
– Taxation (in problems/exams/life think of post tax
c
equilibrium p p
equilibrium p as )
as )

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Equilibrium in the labor market
Here, firms demand labor, workers supply labor

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• Change in equilibrium w&L from a payroll tax
paid by employee

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• Change in equilibrium w&L from a payroll tax
paid by employer

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Irrelevance of Payer Identity

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• Tax Burden (“incidence”): calculate from change
in equilibrium price not from who hands the
in equilibrium price, not from who hands the
money over
• Who actually pays doesn
Who actually pays doesn’tt matter….
matter
WSJ, Sept. 9 2011
“Mr
Mr. Cantor (R., Va.), speaking at a Christian
Cantor (R Va ) speaking at a Christian
Science Monitor lunch with reporters, said that
p y p y
while a current payroll‐tax break for employees
might not be boosting employment much, giving
a break to employers is ‘much more of an
i
incentive for employers to begin to weigh the risk
i f l b i i h h ik
of hiring.’”

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For a given shift back in S, P goes up more when
D is steep
10

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For a given increase in D, P goes up more when S
is steep
11

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So, “steepness” matters. But slope
Q
P
Changes if you change units (e.g., it becomes
much steeper if you switch from measuring in
pennies to measuring in dollars).
Needed: unit free measure of steepness
12

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Elasticityy
Is the % change in Quantity associated with a
%Q
%P
13

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Elasticity
%Q
%P
14

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Elasticity
Q
100 *
% Q Q Q P
 
% P 100 * P P Q
P
15

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Elastic vs. Inelastic Demand:
16

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• Definitions
|Elasticity| < 1 ….. “inelastic”
|Elasticity| > 1
|Elasticity| > 1 ….. “elastic”
elastic
|Elasticity| = 1 …… “unit elastic”
17

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Elasticity is defined at a point on a curve:
At a point, the flatter D curve is more elastic
18

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Taxation and Elasticity

Taxation and Elasticity
• Why would government put a tax on a good?
Why would government put a tax on a good?
– To raise revenue, G (so a decline in Q is bad)
– To discourage consumption (so a decline in Q is
To discourage consumption (so a decline in Q is
the point)
• How
How much ΔR and how much ΔQ result from a
much ΔR and how much ΔQ result from a
given tax both depend on elasticities
19

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Elasticity and the Gas Tax
Because D is inelastic in the short run, we need a
big tax to get a big reduction in Q
20

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Elasticity and Total Revenue
R = P * Q
R = P Q
If demand is elastic (E<‐1), Q will fall more than
P rises (in proportions), so revenue will fall.
If demand is inelastic (E>‐1), Q will fall
proportionately less than P rises, so revenue
will increase
21

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Elasticity of Supply
Elasticity of Supply
What is the % change in quantity supplied for a
given % change in price.
(we can make elasticities of anything with
respect to anything just about)
respect to anything, just about)
22

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Example: Land Use Elasticity and
Ethanol
Demand for ethanol leads to increased price of food
crops
Clearing land from forest to plant crops releases a
LOT of carbon; hence increases global warming
LOT of carbon; hence increases global warming
Question: what is the elasticity of crop land use
Question: what is the elasticity of crop land use
with respect to the price of crops?
If this is a big number, ethanol promotion is a very
bad idea for combating global warming….
23

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Elasticity of a Straight‐line Demand Curve
y g
Q  A  BP
Q
 Q
 B
P
P
P
Elasticity   B
Q
24

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Linear Demand
A 1
P  Q
B B 25

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The burden of a tax with perfectly elastic demand
26

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The burden of a tax with perfectly elastic supply
27

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Marginal Analysis
Marginal Analysis
• What
What is the optimal level of any activity (x) in
is the optimal level of any activity (x) in
the abstract?
• Core idea:
Core idea:
– Simplest version: should you do a little more? A
little less? Find out if yes move in that direction
little less? Find out … if yes, move in that direction
until the answer is no.
– Best version: If you have chosen the optimal x
Best version: If you have chosen the optimal x
(however you managed to get there) the answer
to both questions is no.
q
28

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In the abstract think of the benefit of x:
B(x)
and the cost of x:
and the cost of x:
C(x)
th
the net benefit (or “total return”) to x is
tb fit ( “t t l t ”) t i
B(x) – C(x)
What x gives the highest net benefit?

29

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Marginal Benefit:
B
MB( x ) 
x
…the change in benefit of a small increase in x
Marginal Cost:
C
C ( x) 
MC
x
30

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Marginal Analysis:
Start at x0. Would you do better by increasing x?
If MB(x0)>MC(x0) then yes, increase x
But
if MB(x
( 0))<MC(x
( 0)) then decrease x
Keep doing this until you find the optimum x*
at which
at which
MB(x*)=MC(x*)
Marginal benefit equals marginal cost at the
optimum
31

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We will use marginal analysis to understand
problems of
• Consumers
• Firms
• Government
• Society at large
32

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We’ll start small…
The Consumer’ss Problem
The Consumer Problem
How best to divide a fixed budget across a set of
goods?
There are general principles here: The answer
depends on preferences prices and resources
depends on preferences, prices, and resources
(income)
33

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There are two main parts of our analysis of the
consumer problem
bl
1. Preferences :
A. do you prefer choice 1 to choice 2? Or choice 2
to choice 1? Or maybe you don’t care (you are
indifferent)
B. throughout, we’ll assume that people have clear,
stable preferences (with which they can
consistently rank a set of choices)
2. The budget constraint
A. This shows us the opportunity cost of
consumption. We’ll start here…
34

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A toy budget constraint

A toy budget constraint
35

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The budget constraint:
With two goods:
p1 x1  p2 x2  y
p1 is the price of good 1; x
i th i f d 1 1 is the quantity
i th tit
consumed of good 1; y is income
This has the advantage of being easy to graph.
But in reality, people consume many goods:
px i
i i y
36

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Fall 2012
Economics 115
Economics 115
Lecture 5: Introduction to Demand

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Announcements
• Second
Second problem set due on Monday
problem set due on Monday
• All sections will be held as scheduled this
week
• See head TA kota.mori@yale.edu if you need
h l ih
help with your section assignment
i i

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Outline for Today

Outline for Today
• Review
– Elasticity
Marginal Analysis
• Introduction to Demand

lOMoARcPSD|1876427

• Price elasticity of demand or supply:
Price elasticity of demand or supply:
%Q

%P

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Elasticity of a Straight‐line Demand Curve
y g
Q  A  BP
Q
 Q
 B
P
P
P
Elasticity   B
Q
5

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Linear Demand
A 1
P  Q
B B 6

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Marginal Analysis
Marginal Analysis
• What
What is the optimal level of any activity (x) in
is the optimal level of any activity (x) in
the abstract?
• Core idea:
Core idea:
– Simplest version: should you do a little more? A
little less? Find out if yes move in that direction
little less? Find out … if yes, move in that direction
until the answer is no.
– Best version: If you have chosen the optimal x
Best version: If you have chosen the optimal x
(however you managed to get there) the answer
to both questions is no.
q

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In the abstract think of the benefit of x:
B(x)
and the cost of x:
C(x)
the net benefit (or “total return”) to x is
( )
B(x) – C(x)
e g : think of x as a program to provide clean
e.g.: think of x as a program to provide clean
water in villages

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Marginal Benefit:
B
MB( x ) 
x
…the change in benefit of a small increase in x
Marginal Cost:
C
C ( x) 
MC
x

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Marginal Analysis:
But
if MB(x
( 0))<MC(x
( 0)) then decrease x
at which
at which
MB(x*)=MC(x*)
optimum
10

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We will use marginal analysis to understand
problems of
• Consumers
• Firms
• Government
• Society at large
11

lOMoARcPSD|1876427
We’ll start small…
The Consumer’ss Problem
The Consumer Problem
goods?
There are general principles here: The answer
depends on preferences prices and resources
depends on preferences, prices, and resources
(income)
12

lOMoARcPSD|1876427
There are two main parts of our analysis of the
consumer problem
bl
1. Preferences :
A. do you prefer choice 1 to choice 2? Or choice 2
to choice 1? Or maybe you don’t care (you are
indifferent)
B. throughout, we’ll assume that people have clear,
stable preferences (with which they can
consistently rank a set of choices)
2. The budget constraint
A. This shows us the opportunity cost of
consumption. We’ll start here…
13

lOMoARcPSD|1876427
An Extra‐Simple Budget Constraint:
Cake for Al + Cake for Bo = Full Cake
14

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The budget constraint:
With two goods:
p1 x1  p2 x2  y
p1 is the price of good 1; x
i th i f d 1 1 is the quantity
i th tit
consumed of good 1; y is income
This has the advantage of being easy to graph.
But in reality, people consume many goods:
px i
i i y
15

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Consider a worker, who likes leisure (H) and
consumption (C). Wage is w. All income is
from work.
C = w(24
C w(24‐H)
H)
What is the opportunity cost of 1 hour of
leisure?
$w of consumption
C+wH = 24w
16

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Budget constraints for different kinds of analysis:
• Lifetime budget: opportunity cost of
consuming now is less consumption when
retired
• Government budgets: purchase more guns
Government budgets: purchase more guns
(defense) or butter (say, education).
17

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Consider any two goods
p1 x1  p2 x2  y
Consume 1 more unit of x1, spending goes up by p1, so
spending on x
p g 2 must go down. By how much?
g y
p2 x2   p1x1   p1
p1
x2  
p2
p1
The opp cost of x1 in terms of x2 is the ratio of prices
p2
18

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Graphing the budget constraint:
p1 x1  p2 x2  y 19

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The slope of the budget constraint:
p1 x1  p2 x2  y
We have x2 on the vert axis, so solve for it:
p2 x2  y  p1 x1
y p1
x2   x1
p2 p2
So the slope is the (negative of) the ratio of
prices; the opportunity cost of good 1 in terms
of good 2
of good 2
20

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Graph: increase income
p1 x1  p2 x2  y 21

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Graph: increase p2
p1 x1  p2 x2  y 22

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The budget constraint gives us our “opportunity
set”: what we can choose to consume.
BUT, which point on the budget constraint do
we want most to choose?
“Utility” from choosing a specific combination of
“Utilit ”f h i ifi bi ti f
good 1 and 2:
U(x1,x2)
23

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U(x
( 1,x2)
Assigns a number that ranks the “utility” that the
consumer gets from a given bundle of
t f i b dl f
consumption goods.
• U(.) is an ordinal
U( ) is an ordinal function –
function changing units
changing units
changes nothing
• Contrast with cardinal
Contrast with cardinal function in which
function in which
magnitudes matter.
– Cardinality is required for interpersonal comparisons
y q p p
of utility, which economists typically avoid
– Contrast with “happiness research”
24

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Time for marginal analysis…
Marginal Utility
Extra utility from an additional (marginal)
increase in the consumption of one good (x1),
increase in the consumption of one good (x )
holding the consumption of other goods (x2)
fixed.
fixed
U
MU1 
x1
25

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Graphing marginal utility
Diminishing Marginal Utility
26

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Case 1: Declining MU in one good

Joe Party…
Joe Party…
U=ln(S)+P
S+P=24
That is,
P=24‐S
P 24 S
What is the benefit of increasing S by 1?
MUS=Δln(S). MC of S is that P goes down by 1,
which costs 1 “util”

lOMoARcPSD|1876427
Graphing MU(S) for Joe Party
28

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U=ln(S)+P
Marginal gain to JP of ΔS=1 is MUS
Marginal cost of ΔS=1 is 1
So, increase S if MUS S >1
So, increase S if MU 1
Decrease S if MUS <1
Optimal studying: MUS (S)=1
29

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Optimal study level for Joe Party
30

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 6: Utility
9/17/2012

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Announcements
• Second
Second problem set due now. Use either box
problem set due now Use either box
at the front of the room.
• Third problem set is posted on the classes
server today
d

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Outline for Today

Outline for Today
• Review
– Marginal analysis
– Budget Constraints
Budget Constraints
• Utility
• Deriving Demand

lOMoARcPSD|1876427

g y
But
if MB(x0)<MC(x0) then decrease x
at which
MB( *)=MC(x
MB(x ) MC( *)
optimum
4

lOMoARcPSD|1876427
Consumer Demand
Consumer Demand
• Simplest model
Simplest model
– “rational choice” – consistent, stable preferences
• Contrast with behavioral economics which focuses on
systematic errors
• This provides “preferences” which guide choice
– Fixed budget constraint
Fixed budget constraint
• Defines the opportunity cost of goods
– Combine preferences and opportunity costs to
Combine preferences and opportunity costs to
derive the demand function of an individual
– Add these up to get market demand

lOMoARcPSD|1876427
Budget constraints for different kinds of analysis:
• Government budgets: purchase more guns
(defense) or butter (say, education).
• Lifetime budget: opportunity cost of
retired

lOMoARcPSD|1876427
The budget constraint with two goods:
p1 x1  p2 x2  y

lOMoARcPSD|1876427
Saving for retirement: Income today is Y1
Income tomorrow is 0. Consumption today is C1,
consumption tomorrow is C2. Interest rate is r
Budget constraint is
Budget constraint is
C2  (Y  C1 )(1  r )

lOMoARcPSD|1876427
Graphing the budget constraint:
p1 x1  p2 x2  y 9

lOMoARcPSD|1876427
The slope of the budget constraint:
p1 x1  p2 x2  y
We have x2 on the vert axis, so solve for it:
p2 x2  y  p1 x1
y p1
x2   x1
p2 p2
prices; the opportunity cost of good 1 in terms
of good 2
of good 2
10

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Graph: increase p2
p1 x1  p2 x2  y 11

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The budget constraint gives us our “opportunity
set”: what we can choose to consume.
BUT, which point on the budget constraint do
“Utility” from choosing a specific combination of
“Utilit ”f h i ifi bi ti f
good 1 and 2:
U(x1,x2)
12

lOMoARcPSD|1876427
U(x
( 1,x2)
Assigns a number that ranks the “utility” that the
consumer gets from a given bundle of
t f i b dl f
consumption goods.
• U(.) is an ordinal
U( ) is an ordinal function –
function changing units
changing units
changes nothing
• Contrast with cardinal
Contrast with cardinal function in which
function in which
magnitudes matter.
– Cardinality is required for interpersonal comparisons
y q p p
of utility, which economists typically avoid
– Contrast with “happiness research”
13

lOMoARcPSD|1876427
Time for marginal analysis…
Marginal Utility
fixed.
fixed
U
MU1 
x1
14

lOMoARcPSD|1876427
Graphing marginal utility
15

lOMoARcPSD|1876427
Gran Achatz: founder and head chef of Alinea
restaurant, on Fresh Air with Terry Gross
restaurant, on Fresh Air with Terry Gross
3/3/2011
“So there's something that we call the law of
di i i hi
diminishing returns in our cooking. That's why
i ki Th ' h
the steak is only two ounces, because by your
y y, y
fifth bite you're really, you're done. You're done
with that steak. You know what it's going to taste
like. The actual flavor starts to deaden on the
palate If we were to make you take 10 more
palate. If we were to make you take 10 more
bites, by the time you got to bite 15, the steak's
just not that compelling anymore.”
16

lOMoARcPSD|1876427

Joe Party
Joe Party…
U=ln(S)+P
S
S+P=24
2
That is,
P=24‐S
What are the benefits and costs of increasing S
What are the benefits and costs of increasing S
by 1?

lOMoARcPSD|1876427
U=ln(S)+P
Marginal gain to JP of ΔS=1 is MUS
Marginal cost of ΔS=1 is 1
Good for Joe to increase S if marginal gain > MC
Good for Joe to increase S if marginal gain MC
So, increase S if MUS >1
D
Decrease S if MU
S if MUS <1
Optimal studying: MUS (S*)=1
18

lOMoARcPSD|1876427
Graphing MU(S) for Joe Party
Optimal MUS(S*)=1
19

lOMoARcPSD|1876427
An increase in the taste for studying…
20

lOMoARcPSD|1876427
So far, no prices or incomes. So let’s push on:
Case 2: “Money Metric” Utility
U=g(X)+M
g(X) is a function of x with declining slope… that
is diminishing MUX
is, diminishing MU
Budget constraint:
pX+M=Y
or
M=Y‐pX
21

lOMoARcPSD|1876427
What are the marginal costs and benefits of a
small increase in X?
g ( X )
Utility increases by MU X ( X ) 
X
This is the marginal benefit.
And M goes down by p, which costs you p ‘utils’,
which is the marginal cost.
g ( X *)
At the optimal X*,,
At the optimal X p
X
22

lOMoARcPSD|1876427
Graphing money metric utility
MUX(X*)=p
23

lOMoARcPSD|1876427
Effect of a change in price
MUX(X*)=p
What happens with change in Y?
24

lOMoARcPSD|1876427
The General 2 Good Case
U ( x1 , x2 )
Marginal utilities
U ( x1 , x2 )
MU1 ( x1 , x2 ) 
x1
U ( x1 , x2 )
MU 2 ( x1 , x2 ) 
x2
25

lOMoARcPSD|1876427
26

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Deriving demand in the 2 good case

Start at some x1 on the budget constraint:
Start at some x on the budget constraint:
Y p1
x2   x1
p2 p2
Should you increase x1? The marginal benefit is MU1.
p1
What’s the marginal cost? x2 has to go down by
p2
p1
and the cost of that is MU 2
p2

lOMoARcPSD|1876427
Did increasing x1 help us out? Only if
p1 MU1 p1
MU1  MU 2 , or
or 
p2 MU 2 p2
MU1 p1
We should decrease x1 if 
MU 2 p2
and of course, x1 is just right if
MU1 p1

MU 2 p2

lOMoARcPSD|1876427
Optimal Consumption Rule

MU1 p1

MU 2 p2
MU1
is the Marginal Rate of Substitution.
MU 2
In words, optimal consumption satisfies the
requirement that the marginal rate of
substitution equals the ratio of prices

lOMoARcPSD|1876427
MU1 p1
We can rewrite  as
MU 2 p2
MU1 MU 2

p1 p2
So optimal consumption also equalizes marginal
utility per dollar of any two goods.

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The algebra of consumption

The algebra of consumption
We’ve
We ve been shortening the equations… O.C. is
been shortening the equations… O.C. is
MU1 ( x1 , x2 ) p1

MU 2 ( x1 , x2 ) p2
We also have the budget constraint:
p1 x1  p2 x2  Y
How many equations is this? How many
unknowns?

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We can solve these 2 equations for the 2
We can solve these 2 equations for the 2
* *
unknowns: x1 , x2
The optimal consumption is a function of
p1 , p2 , Y and preferences (MU).

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Graphing Consumer Choice

• Basic concept: the Indifference Curve
Basic concept: the Indifference Curve
– Do you prefer A to B, B to A or are you indifferent
between the 2?
between the 2?

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The Indifference Curve
all points on a given indifference curve give equal utility
p g g q y
(these are “level sets” of the Utility function U(x,y)).
Think of contour lines on a topographical map

lOMoARcPSD|1876427
Slope of the Indifference Curve
Given Δx1 how much can you decrease x2 to
eep U co sta t So e
keep U constant. Solve
MU1x1  MU 2 x2  0
to find x2 MU1


x1 MU 2
So the slope of the curve is the (negative of) the
ratio of the MUs
ratio of the MUs.

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The slope of the Indifference Curve
Curved like this because of diminishing MU

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Which indifference curve represents a higher
utility?

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Add the budget constraint; graph optimal
consumption
at optimum, ratio of MUs = ratio of prices

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Increase Y

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Decrease p2

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 7: The Consumer’s Problem and
the Demand Curve
9/19/12

lOMoARcPSD|1876427
Announcements
• Third
Third problem set due on Monday.
problem set due on Monday
• Reminder on problem sets: please feel free to
work in groups indeed this is encouraged
work in groups, indeed, this is encouraged.
But write up your own answers.

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Outline for Today

Outline for Today
• Review
– Marginal Utility
• Deriving Demand
Deriving Demand

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Review: Utility
U(x1,x2)
fixed.
fixed
U
MU1 
x1

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Special Case Review “Money Metric” Utility
U=g(X)+M
g(X) is a function of x with declining slope that
g(X) is a function of x with declining slope… that
is, diminishing MUX
Budget constraint:
Budget constraint:
pX+M=Y
or
M=Y‐pX
p

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What are the marginal costs and benefits of a
small increase in X?
g ( X )
Utility increases by MU X ( X ) 
X
This is the marginal benefit.
And M goes down by p, which costs you p ‘utils’,
which is the marginal cost.
g ( X *)
At the optimal X*,,
At the optimal X p
X
6

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U=g(X)+M
For this special utility function, the MUx does
NOT depend on M – it only depends on X
g ( X )
MU X ( X ) 
X

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Graphing money metric utility
MUX(X*)=p

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The General 2 Good Case
U ( x1 , x2 )
Marginal utilities
U ( x1 , x2 )
MU1 ( x1 , x2 ) 
x1
U ( x1 , x2 )
MU 2 ( x1 , x2 ) 
x2

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Start at some x1 on the budget constraint:
Start at some x on the budget constraint:
Y p1
x2   x1
p2 p2
Should you increase x1? The marginal benefit is MU1.
p1
What’s the marginal cost? x2 has to go down by
p2
p1
and the cost of that is MU 2
p2
10

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MU1 p1

MU 2 p2
MU1
is the Marginal Rate of Substitution.
MU 2
In words, optimal consumption satisfies the
substitution equals the ratio of prices
11

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• Basic concept: the Indifference Curve
Basic concept: the Indifference Curve
– Do you prefer A to B, B to A or are you indifferent
between the 2?
between the 2?
12

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The Indifference Curve
p g g q y
(these are “level sets” of the Utility function U(x1,x2)).
13

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eep U co sta t So e
MU1x1  MU 2 x2  0
to find x2 MU1


x1 MU 2
ratio of the MUs
ratio of the MUs.
14

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Why is it downward sloping?
Why is it curved in like this?
y
15

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Which indifference curve represents a higher
utility?
16

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Can indifference curves intersect?
Transitivity as essential to the idea of rational choice
17

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Suppose you don’t like one of the goods…
18

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Add the budget constraint; graph optimal
consumption
19

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Increase Y
20

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Decrease p2
21

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Look at that again: demand slopes down, usually
22

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An inferior good
23

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Increase p2, with substitutes
24

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Increase p2, with perfect complements
25

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Increase p2, with perfect substitutes
26

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Demand with perfect substitutes
p1
If  MRS consume only x1
p2
27

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Example: Wages and Taxes
C  w(24  H ) C  wH  24 w
1
C  H  24
w
28

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Increase w. How does this change the BC?
29

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Two things going on here:
• Substitution effect: increased wage raises the
oppo tu ty cost o e su e e at e to C, te d
opportunity cost of leisure relative to C, tend
to work more
• Income effect: increased wage raises your
Income effect: increased wage raises your
real income, if leisure is normal you consume
more (so you are working less)
30

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In General: Substitution Effect
Effect of a change in relative prices, holding
utility constant
ut ty co sta t (a
(along a fixed indiff
o g a ed d cu curve)
e)
31

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Strong substitution effect: close substitutes
32

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Fall 2012
Economics 115
Economics 115
Lecture 8: Indifference Curves and
Demand
9/24/2012

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Announcements
• Third
Third problem set due now; use either box at
problem set due now; use either box at
the front of the room.
• 4th problem set posted later today.
problem set posted later today
• Two past midterms and their answers are now
posted on the classes server.
d h l

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Outline for Today

Outline for Today
• Review
– Indifference Curves
• Continue
Continue: Consumer Choice in the 2 Good
Consumer Choice in the 2 Good
Case
• Deriving Demand
– Income and substitution effects

lOMoARcPSD|1876427
Review: The Indifference Curve
p g g q y
(these are “level sets” of the Utility function U(x1,x2)).

lOMoARcPSD|1876427
Review: Shape of the Indifference Curve
Downward sloping, curved, no intersections

lOMoARcPSD|1876427
eep U co sta t So e
MU1x1  MU 2 x2  0
to find x2 MU1


x1 MU 2
ratio of the MUs
ratio of the MUs.
6

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Review: optimal consumption

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Review: Increase Y

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Increase Y with 2 normal goods

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An inferior good
10

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Decrease p2
11

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Look at that again: demand slopes down, usually
12

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Increase p2, with substitutes
13

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Increase p2, with perfect complements
14

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Increase p2, with perfect substitutes
Constant MRS
15

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Demand with perfect substitutes
p1
If  MRS consume only x1
p2
16

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Example: Wages and Taxes
C  w(24  H ) C  wH  24 w
1
C  H  24
w
17

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Increase w. How does this change the BC?
18

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to work more
19

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utility constant
ut ty co sta t (a
e)
20

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21

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Little substitution effect from strong
complements
22

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Income Effect
A decrease in p, for example, permits you to
o e to a g e d cu
move to a higher indiff curvee
• For a normal good, this increases
consumption
• For an inferior good, this reduces
consumption
23

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Graphing substitution and income effects
24

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Does D slope down?
P1 goes up
• Substitution effect: x
Substitution effect: x1 goes down
goes down
• Income effect:
– If 1 is normal, then x
f i l h 1 goes down
d
– If 1 is inferior, then x1 goes up
Add the two together to get the overall effect.
For normal goods, definitely slopes down
For inferior goods, still probably slopes down
25

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Giffen Goods
So inferior that demand curve slopes up!
P1 goes up
goes up
• Substitution effect: x1 goes down
• Income effect:
– If 1 is normal, then x1 goes down
g g
26

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A real world Giffen good
Demand for rice among urban poor in Hunan
g p
Price elasticity of demand = +.22
Jensen and Miller, AER Sept 2008
27

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Individual demand curve
28

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From consumer demand to market demand
Horizontal sum of individual D curves
29

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The Supply Function

The Supply Function
• Supply of goods generated by firms
Supply of goods generated by firms
• Perfect competition
– Each firm is too small to influence the price of its
E h fi i t ll t i fl th i f it
output, or of its inputs
– Homogeneous goods
Homogeneous goods
– Perfect information
– Just one product
J t d t
30

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What do firms do?
• Firms make money … that is, they maximize
p o ts
profits
– But is this true?
• Firms may want to maximize size, or do good (social
y , g (
entrepreneurs), or maximize power
• Conflict between managers and shareholders?
31

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Fine. Profit maximization is the objective…
But what do firms do?
Firms produce outputs from inputs:
Q=F(L,K)
A firm chooses L and K to produce Q in such a way
as to maximize profits.
Short‐run: think of K as fixed (sunk). Choose
optimal L.
32

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How does the firm choose an optimal L?
• What is the benefit of increasing L?
– Output goes up by
Output goes up by F ( L, K )
L
– This is the
This is the “marginal
marginal productivity of labor
productivity of labor” MP
MPL
– The price at which the firm can sell it’s output is p.
The total revenue of the firm is pQ So if the firm
The total revenue of the firm is pQ. So if the firm
increases L by 1 unit is
p MPL  L  p MPL
– pMPL is the
is the “marginal
marginal revenue product of labor
revenue product of labor”
33

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• What is the marginal cost of increasing L?
– The cost of each extra unit of labor is w
– So the marginal cost is wΔL=w
g
• Is it worth increasing L?
– Yes if MB>MC, that is, pMP
Yes if MB>MC that is pMPL > w.
>w
• Optimal L* is when pMPL = w
34

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 9: Demand, Cost
9/26/2012

lOMoARcPSD|1876427
Announcements
• Two
Two past midterms and their solutions are
past midterms and their solutions are
now available on the classes server
• Problem Set 4 due on Monday
Problem Set 4 due on Monday

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Review
– Consumer choice with 2 goods
• Continue: Deriving Demand
Continue Deriving Demand
• Firms and Supply
– Perfect competition
– Short run production

lOMoARcPSD|1876427
Review: Wages and Leisure
C  w(24  H ) C  wH  24 w
1
C  H  24
w

lOMoARcPSD|1876427
Increase w…

lOMoARcPSD|1876427
to work more

lOMoARcPSD|1876427
utility constant
ut ty co sta t (a
e)

lOMoARcPSD|1876427

lOMoARcPSD|1876427
Little substitution effect from strong
complements

lOMoARcPSD|1876427
Income Effect
A decrease in p, for example, permits you to
o e to a g e d cu
move to a higher indiff curvee
• For a normal good, this increases
consumption
• For an inferior good, this reduces
consumption
10

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Graphing substitution and income effects
11

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Does D slope down?
P1 goes up
• Substitution effect: x
Substitution effect: x1 goes down
goes down
• Income effect:
– If 1 is normal, then x
f i l h 1 goes down
d
12

lOMoARcPSD|1876427
Giffen Goods
So inferior that demand curve slopes up!
P1 goes up
goes up
• Substitution effect: x1 goes down
• Income effect:
– If 1 is normal, then x1 goes down
g g
13

lOMoARcPSD|1876427
A real world Giffen good
Demand for rice among urban poor in Hunan
g p
Price elasticity of demand = +.22
Jensen and Miller, AER Sept 2008
14

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Individual demand curve
15

lOMoARcPSD|1876427
From consumer demand to market demand –
horizontal sum of individual D curves
16

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The Supply Function

The Supply Function
• Supply of goods generated by firms
Supply of goods generated by firms
• Perfect competition
– Each firm is too small to influence the price of its
E h fi i t ll t i fl th i f it
output, or of its inputs
Homogeneous goods
– Perfect information
– Just one product
J t d t
17

lOMoARcPSD|1876427
What do firms do?
• Firms make money … that is, they maximize
p o ts
profits
– But is this true?
• Firms may want to maximize size, or do good (social
y , g (
entrepreneurs), or maximize power
• Conflict between managers and shareholders?
18

lOMoARcPSD|1876427
Fine. Profit maximization is the objective…
But what do firms do?
Firms produce outputs from inputs:
Q=F(L,K)
A firm chooses L and K to produce Q in such a way
as to maximize profits.
Short‐run: think of K as fixed (and sunk). Choose
optimal L.
19

lOMoARcPSD|1876427
How does the firm choose an optimal L?
L
– This is the
MPL
– pMPL is the
is the “marginal
20

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Diminishing Marginal Product
21

lOMoARcPSD|1876427
g
>w
• Definition: the marginal value product of labor
fi i i h i l l d fl b
is pMPL
22

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Short‐run Optimal Choice of L
23

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Output of the Perfectly Competitive Firm
• Should the firm produce more?
– What
What’ss the benefit? Revenue is pQ
the benefit? Revenue is pQ
• So the marginal benefit is pΔQ
• The marginal benefit of increasing Q by 1 is p
g g y p
24

lOMoARcPSD|1876427
– What’s the cost? Let TC(Q) be the cost to the firm
of producing output Q
TC (Q )
– So the marginal cost of increasing Q is Q Q
– The marginal cost of increasing Q by 1 is MC
– … which we will assume for now is upward sloping
25

lOMoARcPSD|1876427
Optimal Output Choice of the Firm
p=MC
26

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MC is the firm’s supply curve
27

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Additional Cost Concepts
• Fixed Costs: costs necessary to have any Q at
y y y p
all. They don’t vary as you expand Q
• Variable Costs: Costs that vary as you expand
Q. TC(Q)=FC+VC(Q)
Q. TC(Q) FC+VC(Q)
• Profits: TR‐FC‐VC
• (recall TR=p*Q)
( ll TR *Q)
28

lOMoARcPSD|1876427
Graphing Costs
29

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 10: Short run production and
Cost
10/1/2012

lOMoARcPSD|1876427
Announcements
• Material
Material in the text that we do not cover in
in the text that we do not cover in
class, TF sessions or home works will not be
included in either the midterm or final
• Midterm is in 2.5 weeks: Wednesday, 10/17 in
class
• Problem set 4 is due now
• Problem set 5 will be posted this evening
Problem set 5 will be posted this evening
• Tentative date: Makeup final SUNDAY Dec 16,
9:00 AM
9:00 AM
2

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Firms and Supply
Firms and Supply
– Short run production
– Deriving the cost function
Deriving the cost function

lOMoARcPSD|1876427
Review: Profit Maximizing Firms
Profit is revenue minus cost
Π=pQ‐C(Q)
p ( )
Two equivalent ways of looking at the way firms
Two equivalent ways of looking at the way firms
squeeze out as much profit as possible
1. Chose Q to max Π, while summarizing the
Chose Q to max Π, while summarizing the
cost of producing that Q via C(Q) (the cost
function))
2. Choose inputs directly … easiest when there
y p
is only one input
4

lOMoARcPSD|1876427
Review: How does the firm choose an optimal L?
L
– This is the
MPL
– pMPL is the
is the “marginal
5

lOMoARcPSD|1876427
g
>w

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Short‐run Optimal Choice of L

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Diminishing Marginal Product

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Alternative approach: Choose Q, given a cost
function
• Should the firm produce more?
S ou d t e p oduce o e
– What’s the benefit? Revenue is pQ
• So the marginal benefit is pΔQ
g p Q
• The marginal benefit of increasing Q by 1 is p

lOMoARcPSD|1876427
– What’s the cost? Let TC(Q) be the cost to the firm
of producing output Q
TC (Q )
– So the marginal cost of increasing Q is Q Q
– The marginal cost of increasing Q by 1 is MC
– … which we will assume for now is upward sloping
because of diminishing marginal returns
10

lOMoARcPSD|1876427
Optimal Output Choice of the Firm
p=MC(Q)
11

lOMoARcPSD|1876427
MC is the firm’s supply curve
Where does this come from?

Where does this come from?
12

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Firm’s production problem
Produce a given output Q at least cost
There are 2 different dimensions of efficiency that
y
come into play here
1. Technological efficiency: Don’t waste any inputs!
2. Economic efficiency: appropriately choose inputs
to balance the relative cost of inputs with their
relative productivity
13

lOMoARcPSD|1876427
Thanks to Peter Fuleky at Univ of Hawaii

14

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Iso‐quants
Equal output varying inputs; level sets of F(K L)

Equal output, varying inputs; level sets of F(K,L)
15

lOMoARcPSD|1876427
Planting rice in California
Planting rice in Java
16

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Iso‐quants further from the origin are higher Q
17

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Iso‐quants don’t intersect
18

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Slope of the iso‐quant
You know the drill: if I increase L by a little, how
much can I reduce K and keep Q constant?
MPL L  MPK K  0
MPK K   MPL L
K MPL

L MPK
The slope of the isoquant is the negative of the ratio
of the marginal products…
19

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How much does a given set of inputs cost?
Cost = wL+rK
“Cost Minimization” for any given Q, find the
yg
combination of L,K that minimizes the cost of
producing that Q.
20

lOMoARcPSD|1876427
Iso‐Cost Line
C=wL+rK
21

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Slope of the iso‐cost line
wL  rK  C
K  C  wL
rK L
C w
K  L
r r
22

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Costs are lower closer to the origin
23

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Minimal Cost Production: economic efficiency
24

lOMoARcPSD|1876427
Rule for Cost Minimization
MPL w

MPK r
Ratio of the marginal products = ratio of input prices
g p p p
MPL MPK

w r
Marginal product per $ spent is equated across
factors
25

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 11: Cost and Supply
10/3/2012

lOMoARcPSD|1876427
Announcements
• Midterm
Midterm is Wednesday, 10/17 in class
is Wednesday 10/17 in class
• Efficiency.pdf, some notes on economic
efficiency will be posted on the classes server
efficiency will be posted on the classes server.
These will be useful for next week’s classes.
• PS 5 is due on Monday
PS 5 i d M d
• Timing: We’re 1 class behind the syllabus.

lOMoARcPSD|1876427
Outline for Today

Outline for Today
– Review: Short run production
Review: Short run production
– Deriving the cost function
– Supply

lOMoARcPSD|1876427
Review: Firm’s production problem
Produce a given output Q at least cost
1. Technological efficiency: Don’t waste any inputs!
g y y p
2. Economic efficiency: appropriately choose inputs
to balance the relative cost of inputs with their
relative productivity

lOMoARcPSD|1876427
Thanks to Peter Fuleky at Univ of Hawaii

5

lOMoARcPSD|1876427
Iso‐quants
Equal output varying inputs; level sets of F(K L)

Equal output, varying inputs; level sets of F(K,L)
6

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How much does a given set of inputs cost?
Cost = wL+rK
“Cost Minimization” for any given Q, find the
yg
combination of L,K that minimizes the cost of
producing that Q.

lOMoARcPSD|1876427
Costs are lower closer to the origin

lOMoARcPSD|1876427
Minimal Cost Production: economic efficiency

lOMoARcPSD|1876427
Rule for Cost Minimization
MPL w

MPK r
Ratio of the marginal products = ratio of input prices
g p p p
MPL MPK

w r
factors
10

lOMoARcPSD|1876427
Change in input prices – make K cheaper
11

lOMoARcPSD|1876427
The Cost Function
Our input choice graph gives us the cost minimizing
inputs of L and K for a given w, r and Q. Write
these as
L*(w,r,Q) and K*(w,r,Q)
So the COST FUNCTION is defined as
C(w,r,Q)=wL*(w,r,Q)+rK*(w,r,Q)
12

lOMoARcPSD|1876427
Cost as a Function of Q
Curves up because of diminishing returns – the
isoquants are getting further apart from each other
are getting further apart from each other
13

lOMoARcPSD|1876427
Recall P=MC, so MC is firm S
14

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Industry Supply
Horizontal sum of firm supply curves

Horizontal sum of firm supply curves
15

lOMoARcPSD|1876427
Algebra of industry supply
Start with supply curve for 1 firm:
p  a  bq
bq  p  a
1 a
q  p
b b
Sum of N identical firms
N Na
Q  Nq  p
b b
Put p on LHS
Put p on LHS
N Na
p Q
b b
b
pa Q
N 16

lOMoARcPSD|1876427
Industry Supply and Demand
17

lOMoARcPSD|1876427
Now we understand what generates the S and D
with which we started.
This permits us to understand the first argument of
“welfare economics”… This is the argument that
markets work (…as if by an invisible hand…) to
k t k( if b i i ibl h d ) t
lead to an efficient allocation of resources.
We’ve already seen a little of this. Where?
18

lOMoARcPSD|1876427
To make the welfare argument, we need a definition
of efficiency.
First idea: Consumer, Producer and Social Surplus
19

lOMoARcPSD|1876427
Consumer Surplus
“Good” measured by consumer’s “willingness to
pay” for a product
Area under D, above P is “consumer surplus”=wtp‐
cost
20

lOMoARcPSD|1876427
Calculate CS on a market demand curve
CS weights preferences by income: for many goods,
rich consumers are willing to pay more.
Market: one dollar, one vote
21

lOMoARcPSD|1876427
Producer Surplus
Area over S below P is “producer

Area over S, below P is producer surplus
surplus”
22

lOMoARcPSD|1876427
Consumer and Producer Surplus in Market
Equilibrium
23

lOMoARcPSD|1876427
The Deadweight Loss of Taxation
24

lOMoARcPSD|1876427
The Deadweight Loss of a Rent Ceiling
25

lOMoARcPSD|1876427
To better understand Producer Surplus, consider
costs and profits a bit more
• Cost Concepts
– (total) Costs defined as C(w,r,Q), simplify to C(Q)
– Marginal costs
– Fixed Cost
– Variable Cost VC=Cost – Fixed Cost
C (Q )
– Average Cost
Average Cost =
Q
– Profits Π=R
Profits Π=R‐VC‐FC
VC FC
26

lOMoARcPSD|1876427
Producer Surplus = R‐VC
R‐VC=Π+FC (so Π=PS‐FC)

27

lOMoARcPSD|1876427
Cost Curves
28

lOMoARcPSD|1876427
What are the profits of a firm?
• π=R – VC –FC
• Or, compare price to average cost
Or, compare price to average cost
29

lOMoARcPSD|1876427
Average cost concepts
C (Q)
• Average Cost:
Average Cost: AC 
Q
VC (Q)
• Average Variable Cost:
A V i bl C t AVC 
Q
FC (Q)
• Average Fixed Cost: AFC 
Q
Note: C=VC+VC and AC = AVC+AFC
30

lOMoARcPSD|1876427
Example 1
For Q>0
C(Q) a+bQ
C(Q)=a+bQ
• Fixed Cost = a
• MC b
MC = b
a
• AC = Q  b
• AVC = b
a
• AFC = Q
AFC
31

lOMoARcPSD|1876427
Graph of Example 1
32

lOMoARcPSD|1876427
Example 2
C (Q)  a  bQ 2
• FC=a
• MC=2bQ (trust me…)
• AVC = bQ
a
• AFC =
Q
a
• AC = Q  bQ
AC =
33

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Graph of Example 2
34

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The “typical” AC curve is u‐shaped
35

lOMoARcPSD|1876427
MC=AC when the AC curve is flat
If MC>AC, AC must be increasingg
If MC<AC, AC must be decreasing
When MC=AC, AC remains flat
,
36

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 12: Social Surplus, and
Perfect Competition in the Long Run
10/8/2012

lOMoARcPSD|1876427
Announcements
• Economics and the Election
Economics and the Election
– Wednesday, 10/10 7:30pm Law School Auditorium
Taxes, Spending, and Health Care
– “Taxes Spending and Health Care” with
with
– Alan Auerbach
– Michael Graetz
Mi h l G t
– Amanda Kowalski
– http://new.livestream.com/yale
h // li / l

lOMoARcPSD|1876427
Announcements
• Midterm is Wednesday, 10/17 in class
dte s ed esday, 0/ c ass
– Last names A‐L: SLB auditorium (usual classroom)
– Last names M‐R: Dunham Lab 220
– Last names S‐Z: Davies auditorium (Becton Center
courtyard entrance, 15 Prospect St)
– One bonus point on the exam for being in the right
One bonus point on the exam for being in the right
classroom
• Efficiency.pdf
Efficiency.pdf online, not needed until
online, not needed until
Wednesday
; p g
• PS 5 is due now; PS 6 will be posted tonight
3

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Review:
Review: Consumer and Producer Surplus
Consumer and Producer Surplus
• Deadweight Loss
• We have not talked about what determines N,
We have not talked about what determines N
the number of firms in a market
• Perfect competition in the long‐run
Perfect competition in the long‐run
– Average costs
– Entry and Exit
Entry and Exit
– The LR supply curve
– Efficiency of LR supply
Efficiency of LR supply
4

lOMoARcPSD|1876427
Consumer Surplus
“Good” measured by consumer’s “willingness to
pay” for a product
Area under D, above P is “consumer surplus”=wtp‐
cost

lOMoARcPSD|1876427
Producer Surplus
Area over S below P is “producer

Area over S, below P is producer surplus
surplus”
6

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Consumer and Producer Surplus in Market
Equilibrium

lOMoARcPSD|1876427
The Deadweight Loss of Taxation

lOMoARcPSD|1876427
The Deadweight Loss of a Rent Ceiling

lOMoARcPSD|1876427
To better understand Producer Surplus, consider
costs and profits a bit more
• Cost Concepts
– (total) Costs defined as C(w,r,Q), simplify to C(Q)
– Marginal costs
– Fixed Cost
– Variable Cost VC=Cost – Fixed Cost
C (Q )
– Average Cost
Average Cost =
Q
– Profits Π=R
Profits Π=R‐VC‐FC
VC FC
10

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Producer Surplus = R‐VC

11

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Cost Curves
12

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What are the profits of a firm?
• π=R – VC –FC
• Or, compare price to average cost
Or, compare price to average cost
13

lOMoARcPSD|1876427
Average cost concepts
C (Q)
• Average Cost:
Average Cost: AC 
Q
VC (Q)
• Average Variable Cost:
A V i bl C t AVC 
Q
FC (Q)
• Average Fixed Cost: AFC 
Q
Note: C=VC+VC and AC = AVC+AFC
14

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Example 1
For Q>0
C(Q) a+bQ
C(Q)=a+bQ
• Fixed Cost = a
• MC b
MC = b
a
• AC = Q  b
• AVC = b
a
• AFC = Q
AFC
15

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Graph of Example 1
16

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Example 2
C (Q)  a  bQ 2
• FC=a
• MC=2bQ (trust me…)
• AVC = bQ
a
• AFC =
Q
a
• AC = Q  bQ
AC =
17

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Graph of Example 2
18

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The “typical” AC curve is u‐shaped
19

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MC=AC when the AC curve is flat
If MC>AC, AC must be increasingg
If MC<AC, AC must be decreasing
When MC=AC, AC remains flat
,
20

lOMoARcPSD|1876427
Profits and AC
  R(Q)  C (Q)
 pQ  C (Q)
 p  Q  AC (Q)  Q
 ( p  AC (Q))  Q
21

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Graphing profits and AC
22

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P too low relative to AC: π<0, so exit
23

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P high relative to AC: π>0, so entry
24

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Long‐run equilibrium N: p=min(AC)
LR Supply curve: p=min(AC)
25

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Efficiency of LR equilibrium
In the LR perfectly‐competitive equilibrium,
In the LR perfectly‐competitive equilibrium
AC is at its lowest point
26

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Free versus paid ticket

Free versus paid ticket
• Write down the name of an event (e.g., sports event, music show) that
is of moderate interest to you
is of moderate interest to you. _________________
• VARIANT #1
– Suppose you won a free ticket to the above event. The event is 60 miles
Suppose you won a free ticket to the above event The event is 60 miles
away from campus. The day of the game there is a major snowstorm, and
the only way to get there is to drive. Assume you have access to a car. The
roads are very bad. Do you still go to the event?
• VARIANT #2
VARIANT #2
– Suppose you paid $50 for a ticket to the above event. The event is 60 miles
away from campus. The day of the game there is a major snowstorm, and
the only way to get there is to drive. Assume you have access to a car. The
roads are very bad. Do you still go to the event?
y y g

lOMoARcPSD|1876427
Lost ticket versus lost bill

Lost ticket versus lost bill
• VARIANT #1
– Imagine that you have decided to see a play where admission is $20.
As you enter the theatre you discover that you have lost a $20 bill
that was in your pocket. You still have enough money in your
pocket. Would you still pay $20 for a ticket to the play?
k t W ld till $20 f ti k t t th l ?
• VARIANT #2
– Imagine that you have decided to see a play and paid the admission
price of $20 per ticket. As you enter the theatre you discover that
i f $20 i k h h di h
you have lost your ticket. The seat was not marked and the ticket
cannot be recovered. Would you pay another $20 for another
ticket?

lOMoARcPSD|1876427
2011 RESULT OF SUNK COST SURVEY % of people who

said "Yes"
(%)
90
80
70
60
50
40
1.Paid ticket 1.Free ticket 2.Lost ticket 2.Lost money

lOMoARcPSD|1876427
Sunk Costs
What about the timing of costs?

What about the timing of costs?
Sunk costs are paid in the past and can’t be
recovered.
30

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Sunk Costs
• Do not influence pricing
Do not influence pricing
• Do not affect exit
• Sunk costs of entry DO affect entry
Firms may stay in the market even if the current
p y
level of profits that they earn are too low to
justify the entry of new firms who would
p y , y
have to pay a fixed, sunk cost of entry.
31

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Sunk Cost Fallacy
is acting as though sunk costs matter when they
is acting as though sunk costs matter when they
ought to be ignored
32

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Sunk Costs vs Fixed Costs
Not necessarily the same thing:
• Fixed costs do not vary with Q, but they
Fixed costs do not vary with Q but they
might be recoverable if you don’t produce Q
and so are not necessarily sunk (rental cost
and so are not necessarily sunk (rental cost
of the factory)
• The degree of sunk cost could vary with Q
The degree of sunk cost could vary with Q
and hence not be fixed
33

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“Social Surplus”
• Notice what we did with CS: we added up p
the (WTP‐P) of different consumers. But
g p
‘adding up’ utilities doesn’t make sense –
recall our discussion weeks ago
• Move to a more general principle:
Move to a more general principle:
“Pareto Efficiency”
34

lOMoARcPSD|1876427
Pareto Efficiency
An allocation of resources is Pareto Inefficient if
t e sa e esou ces cou d be e a ocated to
the same resources could be re‐allocated to
make everyone better off (or, at least some
g y
better off without hurting anyone.) )
Pareto Efficient not Pareto Inefficient

Pareto Efficient = not Pareto Inefficient
35

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A Pareto Frontier
For every Pareto inefficient allocation, there is an
alternative Pareto efficient allocation preferred
by everyone
36

lOMoARcPSD|1876427
Not every Pareto efficient allocation is Pareto
y
preferred to every Pareto inefficient allocation
37

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 13: Efficiency
10/10/2012

lOMoARcPSD|1876427
Announcements
• Economics and the Election
– Tonight 7:30pm Law School Auditorium
Taxes, Spending, and Health Care
– “Taxes Spending and Health Care” with
with
– Alan Auerbach
– Michael Graetz
Mi h l G t
– Amanda Kowalski
– http://new.livestream.com/yale
h // li / l

lOMoARcPSD|1876427
Announcements
dte s ed esday, 0/ c ass
– Last names M‐R: Dunham Lab 220
One bonus point on the exam for being in the right
classroom
• Extra Review Sessions for the Midterm!
Extra Review Sessions for the Midterm!
– Sunday, October 14 8pm‐9pm in WLH119
– Monday, October 15 8pm‐9pm in WLH119

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Review:
Review: Consumer and Producer Surplus
Consumer and Producer Surplus
• Deadweight Loss
• We have not talked about what determines N,
We have not talked about what determines N
the number of firms in a market
• Perfect competition in the long‐run
Perfect competition in the long‐run
– Average costs
– Entry and Exit
Entry and Exit
– The LR supply curve
– Efficiency of LR supply
Efficiency of LR supply
4

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Graphing profits and AC

lOMoARcPSD|1876427
P too low relative to AC: π<0, so exit

lOMoARcPSD|1876427
P high relative to AC: π>0, so entry

lOMoARcPSD|1876427
Long‐run equilibrium N: p=min(AC)
LR Supply curve: p=min(AC)

lOMoARcPSD|1876427
“Social Surplus”
• Notice what we did with CS: we added up p
the (WTP‐P) of different consumers. But
g p
‘adding up’ utilities doesn’t make sense –
recall our discussion weeks ago
• Move to a more general principle:
Move to a more general principle:
“Pareto Efficiency”

lOMoARcPSD|1876427
Pareto Efficiency
t e sa e esou ces cou d be e a ocated to
g y
better off without hurting anyone.) )
Pareto Efficient not Pareto Inefficient

10

lOMoARcPSD|1876427
A Pareto Frontier
by everyone
11

lOMoARcPSD|1876427
Not every Pareto efficient allocation is Pareto
y
preferred to every Pareto inefficient allocation
12

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A Crucial Claim
Definition: an allocation of resources = what
firms produce what, how they produce these
things, who consumes what
Claim: The allocation of resources in a perfectly
competitive equilibrium is Pareto Efficient
Important: “perfectly competitive”, no
p p y p
imperfect competition, no externalities (e.g.,
no pollution)
13

lOMoARcPSD|1876427
Efficiency in Consumption
• Each consumer allocates her Y efficiently
ac oss goods S e ca t be ade bette o
across goods. She can’t be made better off
unless she gets more Y
• What about reallocating goods across
What about reallocating goods across
people? Suppose we take x1 from Bob and
give it to Alice and take x2 from Alice and
give it to Alice, and take x from Alice and
give it to Bob. Could we make both of them
better off?
better off?
14

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1. Take Δx1=1 from person a, give this to b
2. Take Δx2 from person b, give this to a
3 Try to keep a
3. Try to keep a indifferent and make b
indifferent and make b better
better
off.
Is this possible? To keep a indifferent
Is this possible? To keep a indifferent:
 MU1a x1  MU 2a x2  0
MU 2a x2  MU1a
a
MU
x2  1
a
MU 2
So the amount of x2 b must give a
So the amount of x must give a to keep a
to keep a
indifferent is a’s MRS (MRSa). 15

lOMoARcPSD|1876427
Can b be made better off by getting one unit of
x1 and giving up MRSa units of x2?
16

lOMoARcPSD|1876427
U  MU
U x1  MU
b
U x2 b
1
b
2
 MU  MU MRS b
1
b
2
a
This is positive if
MU  MU MRS  0b
1
b
2
a
MU  MU MRS b
1
b
2
a
b
MU
 MRS a 1
b
MU 2
17

lOMoARcPSD|1876427
But we know from studying consumer choice
that for every consumer:
p1
MRS 
p2
p1
So MRS 
a
 MRS b
p2
Therefore: in market equilibrium, there can be
no Pareto improving exchanges of goods
between consumers.
So the allocation of goods across consumers is
fg
Pareto efficient.
18

lOMoARcPSD|1876427
That’s the consumption side … what about
production?
19

lOMoARcPSD|1876427
Here, there are two conditions to check:
1. Is the allocation of production across firms
e ce t
efficient? That is, could we reduce total
at s, cou d e educe tota
costs by shifting production from one firm to
another?
2. Is the use of factors efficient? That is, could
we take L from firm A and give it to firm B
and K from firm B and give it to firm A and
increase total production?
20

lOMoARcPSD|1876427
Efficient Allocation of Production Across Firms
Industry cost with two firms is
C1 (q1 )  C2 (q2 )
Could we lower total cost by reallocating
output, holding q1  q2 fixed?
Try Δq1=1, Δq1=‐1
21

lOMoARcPSD|1876427
But the market equilibrium equates MC across
firms
fi
MC1(q1)=MC2(q2) implies efficient allocation of
production across firms
22

lOMoARcPSD|1876427
Economic policy can move the allocation away
from efficiency.
Suppose firm 1 is subsidized at $s per unit, but
firm 2 is not. Profit maximization by 1
implies:
MC1 (q1 )  p  s
For firm 2
MC2 (q2 )  p
So
MC1 (q1 )  MC2 (q2 )
And total cost would be reduced by moving q
from 1 to 2
23

lOMoARcPSD|1876427
Efficient Use of Inputs
Could we reallocate inputs across firms?
Try: take 1 of L from firm A and give it to firm B
Take some K from B and give it to firm A.
Could we keep A’s output constant and increase
B’s output?
24

lOMoARcPSD|1876427
Keep A’s output fixed:
 MP L  MP K  0
L
A
K
A
MPKA K  MPLA
MPLA
K  A
MPK
(which is the slope of the isoquant…)
MPLA
So we take K  MP A from B to give to A, and B
K
gets 1 unit of L from A. Can B’s output go up?
25

lOMoARcPSD|1876427
Change in B’s output:
Q B  MPLB L  MPKB K
A
MP
 MPLB  MPKB L
MPKA
This is positive if
A
MP
MPLB  MPKB L
A
0
MPK
A
MP
MPLB  MPKB L
MPKA
MPLB MPLA

MPK MPKA
B
26

lOMoARcPSD|1876427
So we can increase output of firm B while
B A
keeping output of A constant if MP
MP

MP
MP
L
B
L
A
K K
But, of course, you remember that EVERY firm
MP
in the market chooses inputs so that wr  MP L
So…
B A
MP w MP
  L
B
L
A
MP r MP
K K
And the allocation of inputs in a perfectly
27

lOMoARcPSD|1876427
We have shown:
In a perfectly competitive equilibrium:
• The fact that consumers set their MRS equal to
relative prices ensures that the allocation of
goods across consumers is Pareto Efficient
• The fact that firms set MC=p ensures that the
Th f t th t fi t MC th t th
allocation of production across firms is Pareto
Efficient
• The fact that firms set the ratio of MPs of
p
factors to the factor price ratio ensures that the
allocation of factors across firms is Pareto
Efficient
28

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 14: Pareto Efficiency and
Perfect Competition
10/15/2012

lOMoARcPSD|1876427
Announcements
• Remaining review session:
Remaining review session:
– Tonight 8pm‐9pm in WLH119
Midterm is Wednesday 10/17 in class
– Last names M
Last names M‐R:
R: Dunham Lab 220
Dunham Lab 220
classroom

lOMoARcPSD|1876427
• Efficiency.pdf online
• No problem set this week
• No review sections this week

lOMoARcPSD|1876427
Outline for Today

Outline for Today
– Review: Efficiency in consumption
Review: Efficiency in consumption
– Efficiency in Production
• Outputs
• Inputs

lOMoARcPSD|1876427
Review: Problems with Social Surplus
• Ignores other markets
• Willingness to Pay depends on Income, as well
Willingness to Pay depends on Income, as well
as preferences
• Adding up WTP is implicitly comparing U
Adding up WTP is implicitly comparing U
across people

lOMoARcPSD|1876427
Review: Pareto Efficiency
More modest: don’t waste
make everyone better off (or at least some
better off without hurting anyone.)

lOMoARcPSD|1876427
Review: A Pareto Frontier
by everyone
7

lOMoARcPSD|1876427
Review: Not every Pareto efficient allocation is
Pareto preferred to every Pareto inefficient
allocation
ll ti
8

lOMoARcPSD|1876427
Review: The Perfectly Competitive Market
Equilibrium is Pareto Efficient
We need to check:
e eed to c ec
• Efficient in Consumption
• Efficient in Production
Efficient in Production

lOMoARcPSD|1876427
Review: Efficiency in Consumption
• What about reallocating goods across
people? Suppose we take x
peop e Suppose e ta e 1 from Bob and
o ob a d
give it to Alice, and take x2 from Alice and
g
give it to Bob. Could we make both of them
better off?
10

lOMoARcPSD|1876427
1. Take Δx1=1 from person a, give this to b
2. Take Δx2 from person b, give this to a
3 Try to keep a
3. Try to keep a indifferent and make b
indifferent and make b better
better
off.
Is this possible? To keep a indifferent
Is this possible? To keep a indifferent:
 MU1a x1  MU 2a x2  0
MU 2a x2  MU1a
a
MU
x2  1
a
MU 2
So the amount of x2 b must give a
So the amount of x must give a to keep a
to keep a
indifferent is a’s MRS (MRSa). 11

lOMoARcPSD|1876427
Can b be made better off by getting one unit of
x1 and giving up MRSa units of x2?
12

lOMoARcPSD|1876427
U  MU
U x1  MU
b
U x2 b
1
b
2
 MU  MU MRS b
1
b
2
a
This is positive if
MU  MU MRS  0b
1
b
2
a
MU  MU MRS b
1
b
2
a
b
MU
 MRS a 1
b
MU 2
13

lOMoARcPSD|1876427
But we know from studying consumer choice
that for every consumer:
p1
MRS 
p2
p1
So MRS 
a
 MRS b
p2
Therefore: in market equilibrium, there can be
no Pareto improving exchanges of goods
between consumers.
So the allocation of goods across consumers is
fg
Pareto efficient.
14

lOMoARcPSD|1876427
That’s the consumption side … what about
production?
15

lOMoARcPSD|1876427
Here, there are two conditions to check:
1. Is the allocation of production across firms
e ce t
efficient? That is, could we reduce total
at s, cou d e educe tota
costs by shifting production from one firm to
another?
2. Is the use of factors efficient? That is, could
and K from firm B and give it to firm A and
16

lOMoARcPSD|1876427
Efficient Allocation of Production Across Firms
Industry cost with two firms is
C1 (q1 )  C2 (q2 )
Could we lower total cost by reallocating
output, holding q1  q2 fixed?
Try Δq1=1, Δq2=‐1
17

lOMoARcPSD|1876427
But the market equilibrium equates MC across
firms
fi
MC1(q1)=MC2(q2) implies efficient allocation of
production across firms
18

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Economic policy can move the allocation away
from efficiency.
Suppose firm 1 is subsidized at $s per unit, but
firm 2 is not. Profit maximization by 1
implies:
MC1 (q1 )  p  s
For firm 2
MC2 (q2 )  p
So
MC1 (q1 )  MC2 (q2 )
from 1 to 2
19

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Efficient Use of Inputs
Could we reallocate inputs across firms?
Take some K from B and give it to firm A.
Could we keep A’s output constant and increase
B’s output?
20

lOMoARcPSD|1876427
Keep A’s output fixed:
 MP L  MP K  0
L
A
K
A
MPKA K  MPLA
MPLA
K  A
MPK
(which is the slope of the isoquant…)
MPLA
So we take K  MP A from B to give to A, and B
K
gets 1 unit of L from A. Can B’s output go up?
21

lOMoARcPSD|1876427
Change in B’s output:
Q B  MPLB L  MPKB K
A
MP
 MPLB  MPKB L
MPKA
This is positive if
A
MP
MPLB  MPKB L
A
0
MPK
A
MP
MPLB  MPKB L
MPKA
MPLB MPLA

MPK MPKA
B
22

lOMoARcPSD|1876427
So we can increase output of firm B while
B A
keeping output of A constant if MP
MP

MP
MP
L
B
L
A
K K
But, of course, you remember that EVERY firm
MP
in the market chooses inputs so that wr  MP L
So…
B A
MP w MP
  L
B
L
A
MP r MP
K K
And the allocation of inputs in a perfectly
23

lOMoARcPSD|1876427
We have shown:
In a perfectly competitive equilibrium:
• The fact that consumers set their MRS equal to
relative prices ensures that the allocation of
goods across consumers is Pareto Efficient
• The fact that firms set MC=p ensures that the
Th f t th t fi t MC th t th
allocation of production across firms is Pareto
Efficient
• The fact that firms set the ratio of MPs of
p
factors to the factor price ratio ensures that the
allocation of factors across firms is Pareto
Efficient
24

lOMoARcPSD|1876427
Equity and Efficiency

Equity and Efficiency
25

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The largest distortion

The largest distortion
26

lOMoARcPSD|1876427
Nobel Memorial Prize in Economics

Nobel Memorial Prize in Economics
• Lloyd Shapley
Lloyd Shapley
– Foundations of Cooperative Game Theory
– Stable matching; marriage market example
Stable matching; marriage market example
• Al Roth
– Stability and efficiency of real world matching
markets; with added constraints like no payments
permitted
– Residency match; Kidney donations
27

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Fall 2012
Economics 115
Economics 115
Lecture 15: Monopoly
10/22/2012

lOMoARcPSD|1876427
Announcements
• New
New problem set posted this afternoon, cue in
problem set posted this afternoon cue in
2 weeks
• TF sections do not meet this week
TF sections do not meet this week
• Midterm scores have been posted; exams will
b
be returned next week
d k
• Make‐up exams: anyone with a Dean’s excuse
should see me immediately after class

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Monopoly
– MR of a monopolist
MR f li t
– Monopolist profit maximization
– DWL of monopoly
– Returns to scale, natural monopoly
• Monopolistic competition

lOMoARcPSD|1876427
MONOPOLY
One seller in the market

One seller in the market
So what?
A monopolist knows that if she increases Q, P
will decline

lOMoARcPSD|1876427
Why do monopolies exist?
• Firms merge to create a monopoly (or
co ude to act as o e)
collude to act as one). This is now illegal via
s s o ega a
anti‐trust law
• Regulation by Government (why?)
Regulation by Government (why?)
• Emerge as a consequence of “natural
monopoly” {you saw this in example 1 of
monopoly” {you saw this in example 1 of
average cost curves… more coming later}

lOMoARcPSD|1876427
The monopolist chooses the best place (for it!)
on the demand curve

lOMoARcPSD|1876427
Marginal Revenue
p
MR (Q )  p  Q
Q 7

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Marginal Revenue
If the monopolist increases Q by 1 unit
• It sells one more unit, and gets p (great!)
It sells one more unit and gets p (great!)
• Drives down the price of all units it can sell
by Qp (not so great )
by (not so great….)
The second factor applies to all of the goods it
sells (what we call the infra‐marginal goods)

lOMoARcPSD|1876427
Marginal Revenue with a linear demand curve
p  a  bQ
p
MR(Q )  p  Q
Q
 p  bQ
 a  bQ  bQ
 a  2bQ
Compare the slopes of MR(Q) and the dd curve.

lOMoARcPSD|1876427
Profit Maximization
Think about the costs and benefits of increasing
Q by
Q by 1 if you are a monopoly:
you a e a o opo y
p
Benefit: Increase Revenue by MR(Q )  p  Q Q
Cost Increase costs by MC(Q)
Cost: Increase costs by MC(Q)
The usual argument tells us to set Q such that
MR(Q)=MC(Q)
Same rule as perfect comp but different MR

Same rule as perfect comp, but different MR
10

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Graph monopoly profit maximization
11

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Algebra of monopoly profit
p  a  bQ
mc  c (a constant)
MR  a  2bQ
Set MR=MC and…
a  2bQ  c
2bQ  a  c
ac
Q
2b
12

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DWL of monopoly
13

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When is the monopoly p particularly high?
“inverse elasticity pricing rule”
14

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Algebra of monopoly pricing, part II
MR (Q )  MC (Q )
p
p(Q )  Q  MC (Q )
Q
p
p  MC   Q
Q
Q
p  MC p Q

p Q p
p  MC 1

p Elasticity of demand
15

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MR and Elasticity
Note: MR>0 implies |η|>1
Monopolists never set Q in the inelastic part of D
16

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Algebra of MR>0 implies |η|>1
p
MR  p  Q0
Q
p
p Q0
Q
Q
p Q  0
p
Q p
1 0
p Q
Q p
  1
p Q 17

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Natural Monopoly
For some technologies, lowest cost production
For some technologies lowest cost production
involves only one firm
So there is a trade‐off between cost of
production and competition
18

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Returns to Scale
• Increasing returns to scale: decreasing AC. A
0% c ease a puts s assoc ated t a
10% increase in all inputs is associated with a
greater than 10% increase in output
• Decreasing RTS: increasing AC. A 10%
Decreasing RTS: increasing AC A 10%
increase in all inputs is associated with a less
than 10% increase in outputs
than 10% increase in outputs
• Constant RTS
19

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Returns to Scale
U‐shaped AC
20

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Example of Natural Monopoly: IRTS at all Q
C (Q)  F  mQ
F
AC (Q)   m
Q
21

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Can we have Perfect Comp w/IRTS?
P=m implies negative profits
22

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Monopoly pricing with IRTS
23

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So, regulated pricing
1. “Best” option: p=marginal cost; firm makes
oss, so s subs d ed (a d t e ta es to
loss, so firm is subsidized (and the taxes to
finance that might cause a different DWL)
2. “Second best”: p = average cost, lowest price
consistent with no loss
consistent with no loss
24

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Regulated average cost pricing
Does the govt have the info and incentives to do
this?
25

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Example: Electric Utility Regulation
• Why is this a natural monopoly? (not in
p oduct o ; aybe d st but o )
production; maybe in distribution)
• State commission sets rates after holding
hearings Economic? Political? Competent?
hearings. Economic? Political? Competent?
• Lack of regulation may lead to monopoly
pricing.
pricing
26

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Market Structure Outline

27

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Differentiated Products and
Monopolistic Competition
l
28

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Short vs. Long Run Monopolistic
Competition
29

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Monopolistic competition and excess capacity

30

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Fall 2012
Economics 115
Economics 115
Lecture 16: Imperfect Competition
and Introduction to Game Theory
10/31/2012

lOMoARcPSD|1876427
Announcements
• Problem
Problem set 7 due next Wednesday, 11/7
set 7 due next Wednesday 11/7
• TF sections do meet this week
• Exams will be returned next Monday after
ill b d d f
class
• Make‐up exams: anyone with a Dean’s excuse
should see me immediately after class

lOMoARcPSD|1876427

• Rick Levin
Rick Levin
– Michael Woodford, Columbia
– John Geanakoplos, Yale
John Geanakoplos Yale
– William Nordhaus, Yale
– Robert Shiller, Yale
R b t Shill Y l
– Aleh Tsyvinski, Yale
• Thursday, Nov 1. 7:30PM, Law School
h h l
Auditorium

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Reviewing Monopoly
– Monopolist profit maximization
M li t fit i i ti
– Returns to scale, natural monopoly
• Monopolistic competition

lOMoARcPSD|1876427
Marginal Revenue
p
MR (Q )  p  Q
Q 5

lOMoARcPSD|1876427
Graph monopoly profit maximization

lOMoARcPSD|1876427
Algebra of monopoly pricing, part II
MR (Q )  MC (Q )
p
p(Q )  Q  MC (Q )
Q
p
p  MC   Q
Q
Q
p  MC p Q

p Q p
p  MC 1

p Elasticity of demand
7

lOMoARcPSD|1876427
Large fixed costs, U‐shaped average cost with large
Q at min

lOMoARcPSD|1876427
Can we have Perfect Comp w/IRTS?
P=m implies negative profits

lOMoARcPSD|1876427
Monopoly pricing with IRTS
10

lOMoARcPSD|1876427
Regulated average cost pricing
Does the govt have the info and incentives to do
this?
11

lOMoARcPSD|1876427
Example: Electric Utility Regulation
• Why is this a natural monopoly? (not in
p oduct o ; aybe d st but o )
production; maybe in distribution)
• State commission sets rates after holding
hearings Economic? Political? Competent?
hearings. Economic? Political? Competent?
• Lack of regulation may lead to monopoly
pricing.
pricing
12

lOMoARcPSD|1876427

13

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Product differentiation
Product differentiation
14

lOMoARcPSD|1876427
Differentiated Products and
Monopolistic Competition
l
15

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Competition
16

lOMoARcPSD|1876427

17

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Game Theory and Oligopoly

Game Theory and Oligopoly
• In
In oligopoly, you (as the firm) have to predict
oligopoly you (as the firm) have to predict
the actions of rival firms. But they are
predicting what you will do
predicting what you will do.
• “Wh
“What do I think that you think that I think
d I hi k h hi k h I hi k
that you think that….”
18

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Local oligopoly
Local oligopoly
19

lOMoARcPSD|1876427
2/3 average game

2/3 average game
• Take out a piece of paper. Put your name on
p p p y
it.
• Everyone write a whole number between 0
and 100
and 100.
• If the number you write is closest to 2/3 of the
average of all the numbers written by
everyone in the class, you win.
i th l i
• The winner will get $5, or $25 to a charity of
your choice (subject to my consent). Tie
broken randomly.
• Everyone has the same instructions.
20

lOMoARcPSD|1876427
“Cornout”
Cornout Model
Model
• Our first game theory model. Each firm
g y
chooses own quantity of output.
• Nash equilibrium:
– Each firm does the best it can, given the actions of
all other firms
all other firms
21

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Cournot Duopoly
Total Output is Q  q1  q2
Profit of firm 1 is
 1 (q1 , q2 )  p (Q)  q1  C1 (q1 )

 p (q1  q2 )  q1  C1 (q1 )
22

lOMoARcPSD|1876427
Let’s compare MR in different kinds of market
structures:
Perfect comp MR>Cournot MR>monopoly MR:
p p
p  p q1  p  Q
Q Q
Which will lead to
Perfect comp Q>Cournot Q>monopoly Q
23

lOMoARcPSD|1876427
Cournot MR:
R1 ( q1 , q2 )  p( q1  q2 ) q1
p
MR1  p  q1
Q
24

lOMoARcPSD|1876427
Let’s compare MR in different kinds of market
structures:
Perfect comp MR>Cournot MR>monopoly MR:
p p
p  p q1  p  Q
Q Q
Which will lead to
Perfect comp Q>Cournot Q>monopoly Q
25

lOMoARcPSD|1876427
Linear Cournot Duopoly:
• Linear Demand
Li D d
p  a  bQ
Q  a  b( q1  q2 )
• Fi
Fixed MC, fixed at mc
d MC fi d t i for each firm i. Not
f h fi i N t
necessarily the same
• MR:
26

lOMoARcPSD|1876427
Recall p  a  b( q1  q2 )
So p
MR1  p  q1
Q
 a  b( q1  q2 )  bq
b 1
 a  bq2  2bq1
And of course
MR2  a  bq1  2bq2
27

lOMoARcPSD|1876427
The idea of a “best reply”
28

lOMoARcPSD|1876427
So, what is the “best reply” in this situation?
The Nash equilibrium is to choose the best q
given the other firm’ss q:
given the other firm q:
MR2  mc2
a  bq1  2bq2  mc2
a  mc2  bq1  2bq2
a  mc2 1
 q1  q2
2b 2
29

lOMoARcPSD|1876427
Graph both “best replies”
a  mc2 1
q2  R2 ( q1 )   q1
2b 2
a  mc1 1
q1  R1 ( q2 )   q2
2b 2 30

lOMoARcPSD|1876427
Nash equilibrium (mutual best reply)
31

lOMoARcPSD|1876427
Increase in demand
32

lOMoARcPSD|1876427
Calculating equilibrium
• To make it easy, mc same for both firms
T k it f b th fi
• 2 eq, 2 unknowns
a  mc2 1
q2   q1
2b 2
a  mc1 1
q1   q2
2b 2
33

lOMoARcPSD|1876427
a  mc 1 a  mc 1
q2   q1 ; q1   q2
2b 2 2b 2
a  mc 1 a  mc 1 
q1     q1 
2b 2  2b 2 
1 a  mc 1
q1   q1
2 2b 4
3 1 a  mc
q1 
4 4 b
1 a  mc
q1 
3 b
2 a  mc
Q  q1  q 2 
3 b
34

lOMoARcPSD|1876427
Compare quantities
p  a  bQ
• Competition: p=mc implies
C titi i li
a  mc
Q
b
• Cournot
2 a  mc
Q
3 b
• Monopoly
M l
1 a  mc
Q
2 b
35

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 17: Oligopoly
11/5/2012

lOMoARcPSD|1876427
Announcements
• Problem
Problem set 7 due Wednesday, 11/7
set 7 due Wednesday 11/7
• (short) Problem set 8 online on Wednesday,
due Monday 11/12
due Monday 11/12
• Exams will be returned today after class

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Reviewing Monopolistic Competition
• Results of 2/3 Game
l f 2/3 G
• Oligopoly

lOMoARcPSD|1876427
Competition

lOMoARcPSD|1876427

5

lOMoARcPSD|1876427
2/3 average game

2/3 average game
• Take out a piece of paper. Put your name on
p p p y
it.
• Everyone write a whole number between 0
and 100
and 100.
• If the number you write is closest to 2/3 of the
average of all the numbers written by
everyone in the class, you win.
i th l i
• The winner will get $5, or $25 to a charity of
broken randomly.
• Everyone has the same instructions.

lOMoARcPSD|1876427
2/3 average game

2/3 average game
• Levels of reasoning:
– Answers void of reasoning:
• Above 67: Mathematically impossible to win (100 * 2/3 = 67). Not paying
attention (lets hope).
• 50: Did not notice the 2/3 part of the game.
50: Did not notice the 2/3 part of the game.
– First level of reasoning:
• 33 (=2/3*1/2)
– Second level of reasoning:
• 22
– Third level of reasoning:
• 15
– …and so on
and so on

lOMoARcPSD|1876427
2/3 average game

2/3 average game
• Infinite…
– … this is a solvable problem. Lets see, everyone will just
thi i l bl bl L t ill j t
keep iterating because everyone knows that everyone
knows that everyone knows, etc., so the answer is clearly 0
or 1. Those are the only two answers from which no‐one
has an incentive to deviate So assuming that people
has an incentive to deviate. So assuming that people
choose randomly between zero and one (or at least no
more than 75% choose 1 over 0), I will choose zero. The
answer must be zero. I don’t like this! Everyone will win,
so really there is not much to win. Oh well…
y
• The right answer…
• Hmm… some people are clueless. they will choose randomly.
• Some people will take one iterative step.
• Some people will take two.
• Some people will take three.
• Some people will take infinite.
• What is the distribution of iterative thinking in this classroom?

lOMoARcPSD|1876427
The mean guess was 30.4; 2/3 of that is 20.3. Five
students guessed 20.

lOMoARcPSD|1876427
“Cornout”
Cornout Model
Model
• Our first game theory model. Each firm
g y
chooses own quantity of output.
• Nash equilibrium:
– Each firm does the best it can, given the actions of
all other firms
all other firms
10

lOMoARcPSD|1876427
• Linear Demand
Li D d
p  a  bQ
Q  a  b( q1  q2 )
• Fi
Fixed MC, fixed at mc
d MC fi d t i for each firm i. Not
f h fi i N t
necessarily the same
• MR:
11

lOMoARcPSD|1876427
Recall p  a  b( q1  q2 )
So p
MR1  p  q1
Q
 a  b( q1  q2 )  bq
b 1
 a  bq2  2bq1
And of course
MR2  a  bq1  2bq2
12

lOMoARcPSD|1876427
13

lOMoARcPSD|1876427
So, what is the “best reply” in this situation?
The best reply is to choose the best q given the
other firm’ss q:
other firm q:
MR2  mc2
a  bq1  2bq2  mc2
a  mc2  bq1  2bq2
a  mc2 1
 q1  q2
2b 2
14

lOMoARcPSD|1876427
Graph both “best replies”
a  mc2 1
q2  R2 ( q1 )   q1
2b 2
a  mc1 1
q1  R1 ( q2 )   q2
2b 2 15

lOMoARcPSD|1876427
16

lOMoARcPSD|1876427
Increase in demand
17

lOMoARcPSD|1876427
Calculating equilibrium
• To make it easy, mc same for both firms
T k it f b th fi
• 2 eq, 2 unknowns
a  mc 1
q2   q1
2b 2
a  mc 1
q1   q2
2b 2
18

lOMoARcPSD|1876427
a  mc 1 a  mc 1
q2   q1 ; q1   q2
2b 2 2b 2
a  mc 1 a  mc 1 
q1     q1 
2b 2  2b 2 
1 a  mc 1
q1   q1
2 2b 4
3 1 a  mc
q1 
4 4 b
1 a  mc
q1 
3 b
2 a  mc
Q  q1  q 2 
3 b
19

lOMoARcPSD|1876427
Compare quantities
p  a  bQ
• Competition: p=mc implies
C titi i li
a  mc
Q
b
• Cournot
2 a  mc
Q
3 b
• Monopoly
M l
1 a  mc
Q
2 b
20

lOMoARcPSD|1876427
Bertrand’s Critique
• Almost precisely the Cournot
Al t i l th C t model
d l
– Constant marginal cost, equal for the two firms
Homogeneous goods
– BUT… firms choose the P they set, rather than the
Q.
• This fundamentally changes the Nash
equilibrium
• Suppose firm 1 sets p
f 1>mc
– What is the Best Response of firm 2 to this?
21

lOMoARcPSD|1876427
• If firm 1 sets p
If fi 1 t 1>mc
– Best Response of firm 2 to this is to set p2 just a
bit below p1 and therefore capture the whole
bit below p and therefore capture the whole
market
– Each firm responds in kind, until p1 = p2 =mc – just
as in competitive equilibrium
as in competitive equilibrium.
22

lOMoARcPSD|1876427
Monopoly, and Bertrand Duopoloy
23

lOMoARcPSD|1876427
Which makes sense? Cournot or Bertrand?
• Quantity setting (Cournot) more plausible if
Quantity setting (Cournot) more plausible if
firms are ‘committed’ to quantity and find it
easy to change P. For example, perhaps they
have to build a new factory to capture the
have to build a new factory to capture the
whole market… can’t do that right away.
• Price setting (Bertrand) more plausible if firms
g( ) p
are more ‘committed’ to P (maybe through
contracts?) and quantity produced can
respond rapidly
respond rapidly
Real world? Firms actually choose capacity,
y p y
price, quantity, advertising, quality, etc… The
d l h
games they play are multi‐dimensional.
24

lOMoARcPSD|1876427
Collusion
H ’ b tt id !! L t’ j t ll d and both
Here’s a better idea!! Let’s just collude d b th
charge high prices.
BUT. Can I trust you? Or will you cheat on the
deal?
25

lOMoARcPSD|1876427
The Prisoners’ Dilemma with Goats
26

lOMoARcPSD|1876427
The Prisoners’ Dilemma
Two farmers face a choice: they each have goats.
If they tie up their goat the goat doesn’tt eat
If they tie up their goat, the goat doesn eat
the other’s growing crop. But then they have
to feed the goat.
Cooperating leads to the best joint outcome.
But each farmer has a private incentive to cheat.
27

lOMoARcPSD|1876427
28

lOMoARcPSD|1876427
Back to collusion
Two firms Best we can do is to each charge the
Two firms. Best we can do is to each charge the
monopoly price, and each sell ½ the monopoly
quantity
What is the best response after the meeting is
over?
• Bertrand: charge slightly less than monopoly
price, capture whole market for myself!
• Cournot: best response is q  BR ( 1 Q M )
1 1
2
JUST like the P.D.: best response is “don’t
JUST lik th P D b t i “d ’t
cooperate”
29

lOMoARcPSD|1876427
“Solutions” to the Prisoners’ Dilemma
If you are going to play the game many times,
threaten not to cooperate in the future if you
are cheated upon today
If the value of cooperation is high enough, then
you may cooperate today to avoid the
punishment of future non‐cooperation
30

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 18: Repeated Games; Begin
Externalities
11/7/2012

lOMoARcPSD|1876427
Announcements
• Problem
set 7 due now
• (short) Problem set 8 online this afternoon,
due Monday 11/12
due Monday 11/12

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Reviewing Oligopoly
• Repeated Games
dG
• Externalities

lOMoARcPSD|1876427

lOMoARcPSD|1876427

lOMoARcPSD|1876427
Increase in MC of firm 1

lOMoARcPSD|1876427
• Almost precisely the Cournot
Al t i l th C t model
d l
– Constant marginal cost, equal for the two firms
Homogeneous goods
– BUT… firms choose the P they set, rather than the
Q.
• This fundamentally changes the Nash
equilibrium
• Suppose firm 1 sets p
f 1>mc
– What is the Best Response of firm 2 to this?

lOMoARcPSD|1876427
• If firm 1 sets p
If fi 1 t 1>mc
– Best Response of firm 2 to this is to set p2 just a
bit below p1 and therefore capture the whole
bit below p and therefore capture the whole
market
– Each firm responds in kind, until p1 = p2 =mc – just
as in competitive equilibrium
as in competitive equilibrium.

lOMoARcPSD|1876427
Collusion
H ’ b tt id !! L t’ j t ll d and both
Here’s a better idea!! Let’s just collude d b th
charge high prices.
BUT. Can I trust you? Or will you cheat on the
deal?

lOMoARcPSD|1876427
The Prisoners’ Dilemma with Goats
10

lOMoARcPSD|1876427
Two farmers face a choice: they each have goats.
If they tie up their goat the goat doesn’tt eat
If they tie up their goat, the goat doesn eat
the other’s growing crop. But then they have
to feed the goat.
Cooperating leads to the best joint outcome.
But each farmer has a private incentive to cheat.
11

lOMoARcPSD|1876427
12

lOMoARcPSD|1876427
Back to collusion
Two firms Best we can do is to each charge the
Two firms. Best we can do is to each charge the
monopoly price, and each sell ½ the monopoly
quantity
What is the best response after the meeting is
over?
• Bertrand: charge slightly less than monopoly
price, capture whole market for myself!
• Cournot: best response is q  BR ( 1 Q M )
1 1
2
JUST like the P.D.: best response is “don’t
JUST lik th P D b t i “d ’t
cooperate”
13

lOMoARcPSD|1876427
“Solutions” to the Prisoners’ Dilemma
If you are going to play the game many times,
are cheated upon today
If the value of cooperation is high enough, then
you may cooperate today to avoid the
punishment of future non‐cooperation
14

lOMoARcPSD|1876427
New Topic: Public Goods and
Externalities
l
• Externalities
– When an action by someone causes a cost or
benefit to another party with whom the decision
maker has not engaged in a direct market
transaction, this effect is an externality
– Externalities can be positive or negative
15

lOMoARcPSD|1876427
Effluent from tanneries, Kano Nigeria

Effluent from tanneries, Kano Nigeria
16

lOMoARcPSD|1876427
Pollution
Marginal social cost ≠ marginal (private) cost
17

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Deadweight Loss of Pollution
18

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“Pigouvian” tax
Correct the externality via a tax equal to the
marginal external cost at the socially optimal Q
19

lOMoARcPSD|1876427
Example: Optimal Tax on Gasoline
20

lOMoARcPSD|1876427
Pigouvian taxes vs Efficiency Standards

Current policy: “Corporate Average Fuel
Efficiency” (CAFE) standard: each
manufacturer has to meet the same standard,
f t h t t th t d d
separately for trucks and cars.
Thi
This prevents Pareto improving trades (say firm
t P t i i t d ( fi
T has lower mc for small cars, and firm G has
lower mc for large Get same fuel efficiency
lower mc for large. Get same fuel efficiency
for lower cost if T produces more small and G
more large cars.
more large cars.
Pigouvian tax achieves social optimum, CAFE
does not
does not
21

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Efficient environmentalism
Given an amount of pollution reduction, we
want to minimize cost of achieving this.
Equivalently, given an amount we are willing to
spend to reduce pollution, we want to
dt d ll ti tt
maximize the amount of pollution reduction.
22

lOMoARcPSD|1876427
Suppose producing Q involves creating pollution
Should we tax Q? Or tax pollution itself?
23

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Demand for Pollution
Isocost/isoquant graph gives D for pollution
conditional on output. Tax on pollution changes
production technique, and lowers Q as well
24

lOMoARcPSD|1876427
Global Warming
Three policies
• Regulation: require plants to install pollution
Regulation: require plants to install pollution‐
reducing equipment, require better lightbulbs,
etc… Socially inefficient
• Pigouvian Tax on carbon emissions (this is an
efficient tax revenue producing as well)
efficient tax, revenue producing as well)
• “Cap and Trade”
25

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Cap and Trade vs. Tax
Question: who gets the initial allocation of pollution
credits? Does NOT matter for efficiency Certainly
credits? Does NOT matter for efficiency. Certainly
does for distribution of benefits.
26

lOMoARcPSD|1876427
Positive externalities
Marginal social benefit ≠marginal (private) benefit
27

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Pigouvian Subsidy
28

lOMoARcPSD|1876427
Public Goods
Remember Singer’s Lake? 29

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Pure Public Good
A good which features
• Non
Non‐rivalry
rivalry in consumption (my benefit does
in consumption (my benefit does
not diminish yours)
• Non‐excludability (cannot prevent anyone
Non‐excludability (cannot prevent anyone
from consuming it)
30

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 19: Externalities and Public
Goods
11/12/2012

lOMoARcPSD|1876427
Announcements
• Problem set 8 due now
ob e set 8 due o
• Problem set 9 online this afternoon, due Monday
11/26
• No public goods handout; we’re cutting a bit to
save time
• Final dates:
– Sunday 12/16/2012 at 9:00
– Tuesday 12/18/2012 at 9:00
– Designate your choice upon return from Thanksgiving

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Externalities
• Public Goods
bli G d

lOMoARcPSD|1876427
New Topic: Public Goods and
Externalities
l
• Externalities
– When an action by someone causes a cost or
maker has not engaged in a direct market
transaction, this effect is an externality
– Externalities can be positive or negative

lOMoARcPSD|1876427
Pollution
Marginal social cost ≠ marginal (private) cost

lOMoARcPSD|1876427
Deadweight Loss of Pollution

lOMoARcPSD|1876427
“Pigouvian” tax
Correct the externality via a tax equal to the
marginal external cost at the socially optimal Q

lOMoARcPSD|1876427
Pigouvian taxes vs Efficiency Standards

Current policy: “Corporate Average Fuel
Efficiency” (CAFE) standard: each
manufacturer has to meet the same standard,
f t h t t th t d d
separately for trucks and cars.
Thi
This prevents Pareto improving trades (say firm
t P t i i t d ( fi
T has lower mc for small cars, and firm G has
lower mc for large Get same fuel efficiency
lower mc for large. Get same fuel efficiency
for lower cost if T produces more small and G
more large cars.
more large cars.
Pigouvian tax achieves social optimum, CAFE
does not
does not
8

lOMoARcPSD|1876427
Example: Optimal Tax on Gasoline

lOMoARcPSD|1876427
Efficient environmentalism
dt d ll ti tt
10

lOMoARcPSD|1876427
Suppose producing Q involves creating pollution
Should we tax Q? Or tax pollution itself?
11

lOMoARcPSD|1876427
Demand for Pollution
12

lOMoARcPSD|1876427
Global Warming
Three policies
• Regulation: require plants to install pollution
Regulation: require plants to install pollution‐
reducing equipment, require better lightbulbs,
• Pigouvian Tax on carbon emissions (this is an
efficient tax revenue producing as well)
efficient tax, revenue producing as well)
• “Cap and Trade”
13

lOMoARcPSD|1876427
Cap and Trade vs. Tax
14

lOMoARcPSD|1876427
Positive externalities
Marginal social benefit ≠marginal (private) benefit
15

lOMoARcPSD|1876427
Pigouvian Subsidy
16

lOMoARcPSD|1876427
Pure Public Good
• Non
Non‐rivalry
not diminish yours)
from consuming it)
17

lOMoARcPSD|1876427
Public Goods
Remember Singer’s Lake? 18

lOMoARcPSD|1876427
Examples of Pure Public Goods
• National
National Defense
Defense
• Existence of national parks (not going to
national parks)
national parks)
• Charity (if you care about poverty reduction,
not “going to heaven”)
t“ i t h ”)
19

lOMoARcPSD|1876427
Modeling Public Goods
Each consumer gets benefits from the existence
of Q units of the public good:
Utilityi  U i (Q )  M
Q is total market output, not consumption by
individual i. M is consumption of other goods
(money spent on all other goods).
20

lOMoARcPSD|1876427
Person i is willing to pay for another unit of Q as
long as
MU i (Q )  MC
if no one else provides the good, i will choose
MU i (Q )  MC *
i
But suppose someone else is already providing
Q  Qi* then i will not provide any and will FREE
RIDE.
21

lOMoARcPSD|1876427
Private Provision of Public Goods
Suppose person j has the highest preferred
amount of Q. This consumer chooses to buy
Q such that
MU j (Q )  MC *
j
A d
And everyone else buys none and free rides.
l b df id
22

lOMoARcPSD|1876427
Behavioral Economics
Classic economic reasoning is that people are
perfectly selfish and happy to free‐ride.
Experiments show that many people are only
partial free‐riders, happy to provide at least
ti l f id h t id t l t
some of the good.
Thank goodness: voting, unions, charity
23

lOMoARcPSD|1876427
Social benefit of Public Goods
Each additional unit provides a non‐rivalrous
benefit to everyone. The marginal social
benefit (MSB) is:
MSB (Q )   MU i (Q)
i
24

lOMoARcPSD|1876427
Marginal Social Benefit
Vertical sum of MUs
25

lOMoARcPSD|1876427
Socially Optimal Provision of Public Goods
MSB(Q)   MU i (Q)  MC (Q)

i 26

lOMoARcPSD|1876427
Optimal vs. Private Provision of Public Goods
Private:
MC (Q )  MU j (Q )
Pr Pr
“maximum marginal private benefit = MC”
Optimal:
p
MC (Q )   MU i (Q )
* *
Or i
1 1
N
MC (Q ) 
*
N
 MU (Q )
i
i
*
“average marginal benefit = per‐capital marginal
cost”
cost
27

lOMoARcPSD|1876427
Public Choice
Choice of appropriate level of Q is
fundamentally a political decision – it matters
for everyone
Suppose voters choose Q, but each voter
disagrees about the best Q. Who decides?
Median Voter theory
28

lOMoARcPSD|1876427
Assume:
• Constant marginal cost = mc
• Each voter pays a share 1/N of the cost of the
Each voter pays a share 1/N of the cost of the
project. So the per person marginal cost of
increasing Q is mc/N
• Label voters 1,2,3…N so that MU1  MU 2  ...  MU N
(thi
(this rank, we assume, does not depend on Q)
k d td d Q)
Then each voter’s preferred Q is Qi:
mc
MU i (Q )  i
N
29

lOMoARcPSD|1876427
The Median Voter Argument
• Let voter m be the median of the N voters in
this ranking
mc
• This voter prefers Q : MU m (Q ) 
m m
Given majority rule between Qm and any other
alternative
lt Q Qm will get more than 50% of
ti Q, Q ill t th 50% f
the vote.
30

lOMoARcPSD|1876427
Preferred Levels of Q for different voters
31

lOMoARcPSD|1876427
Does Majority Rule lead to Optimal Provision of
Public Goods?
32

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 20: Public Goods and
Decision‐Making Through Time
11/14/2012

lOMoARcPSD|1876427
Announcements
• Problem
Problem set 9 due Monday 11/26
set 9 due Monday 11/26
• No public goods handout; we’re cutting a bit
to save time
to save time
• Final dates:
– Sunday 12/16/2012 at 9:00
– Tuesday 12/18/2012 at 9:00
– Designate your choice upon return from
Thanksgiving

lOMoARcPSD|1876427
Outline for Today

Outline for Today
• Public Goods
• Decision Making Over Time
ii ki O i

lOMoARcPSD|1876427
Review: Efficient environmentalism
dt d ll ti tt

lOMoARcPSD|1876427
Review: Taxing Pollution as an ‘input’

lOMoARcPSD|1876427
Review: Demand for Pollution

lOMoARcPSD|1876427
Review: Cap and Trade vs. Tax
7

lOMoARcPSD|1876427
Pure Public Good
• Non
Non‐rivalry
not diminish yours)
from consuming it)

lOMoARcPSD|1876427
Modeling Public Goods
of Q units of the public good:
Utilityi  U i (Q )  M
Q is total market output, not consumption by
individual i. M is consumption of other goods
(money spent on all other goods).

lOMoARcPSD|1876427
Person i is willing to pay for another unit of Q as
long as
MU i (Q )  MC
if no one else provides the good, i will choose
MU i (Q )  MC *
i
But suppose someone else is already providing
Q  Qi* then i will not provide any and will FREE
RIDE.
10

lOMoARcPSD|1876427
Private Provision of Public Goods
Suppose person j has the highest preferred
amount of Q. This consumer chooses to buy
Q such that
MU j (Q )  MC *
j
A d
And everyone else buys none and free rides.
l b df id
11

lOMoARcPSD|1876427
Behavioral Economics
perfectly selfish and happy to free‐ride.
Experiments show that many people are only
partial free‐riders, happy to provide at least
ti l f id h t id t l t
some of the good.
Thank goodness: voting, unions, charity
12

lOMoARcPSD|1876427
Social benefit of Public Goods
Each additional unit provides a non‐rivalrous
benefit to everyone. The marginal social
benefit (MSB) is:
MSB (Q )   MU i (Q)
i
13

lOMoARcPSD|1876427
Marginal Social Benefit
Vertical sum of MUs
14

lOMoARcPSD|1876427
Socially Optimal Provision of Public Goods
MSB(Q)   MU i (Q)  MC (Q)

i 15

lOMoARcPSD|1876427
Private:
MC (Q )  MU j (Q )
Pr Pr
Optimal:
p
MC (Q )   MU i (Q )
* *
Or i
1 1
N
MC (Q ) 
*
N
 MU (Q )
i
i
*
cost”
cost
16

lOMoARcPSD|1876427
Public Choice
Choice of appropriate level of Q is
fundamentally a political decision – it matters
for everyone
disagrees about the best Q. Who decides?
Median Voter theory
17

lOMoARcPSD|1876427
Assume:
• Constant marginal cost = mc
• Each voter pays a share 1/N of the cost of the
Each voter pays a share 1/N of the cost of the
project. So the per person marginal cost of
• Label voters 1,2,3…N so that MU1  MU 2  ...  MU N
(thi
(this rank, we assume, does not depend on Q)
k d td d Q)
Then each voter’s preferred Q is Qi:
mc
MU i (Q )  i
N
18

lOMoARcPSD|1876427
The Median Voter Argument
• Let voter m be the median of the N voters in
this ranking
mc
• This voter prefers Q : MU m (Q ) 
m m
Given majority rule between Qm and any other
alternative
lt Q Qm will get more than 50% of
ti Q, Q ill t th 50% f
the vote.
19

lOMoARcPSD|1876427
Preferred Levels of Q for different voters
20

lOMoARcPSD|1876427
Public Goods?
21

lOMoARcPSD|1876427
New Topic!
Decision Making Over Time
How to think about Benefits and Costs that are
How to think about Benefits and Costs that are
spread over time?
Basic Idea: dollars in the future are not worth as
Basic Idea: dollars in the future are not worth as
much as dollars right now
• Impatience
I ti
• Investment value of dollars today
We are not concerned with inflation here….
22

lOMoARcPSD|1876427
What is $1 today worth “tomorrow” or “next
year”?
Interest rate is r. (e.g., 3% interest r=0.03)
Put $x in the bank today, get
$(x+rx)=$(1+r)x
next period (principle plus interest).
23

lOMoARcPSD|1876427
So, what is the present value of $1 next year?
How much would you need in the bank today
How much would you need in the bank today
(v0) to get $1 tomorrow?
(  r )v0  1
(1
1
v0 
1 r
1
So is the one period discount rate on future
1 r
money.
24

lOMoARcPSD|1876427
The present value of $x next period is
(1  r )v0  x
1
v0  x
1 r
25

lOMoARcPSD|1876427
The present value of $x two periods in the
future:
26

lOMoARcPSD|1876427
Math for the last slide:
$x in period 2. What’s that worth next period
(period 1)?
1
v1  x
1 r
Today (period 0), what is that v1 worth?
1
v0  v1
1 r
1  1 
v0   x
1 r 1 r 
2
 1 
v0    x
1 r 
27

lOMoARcPSD|1876427
What is the present value of a stream of
payments into the future? (like your future
flow of income)
28

lOMoARcPSD|1876427
Get income in the future: Y0 , Y1 , Y2 , Y3...
2 3
1  1   1 
v0  Y0  Y1    Y2    Y3  ...
1 r 1 r  1 r 
 t
 1 
v0     Yt
t 0  1  r 
29

lOMoARcPSD|1876427
PV of Y forever:
First, remember a bit of math:
for 0  x  11,

1  x  x  x  x  ...   x t
2 3 4
t 0
t
is the sum of a geometric series and is equal to

1
1 x
For example for x=1/2 this is

For example, for x=1/2, this is

1 1 1
  1
x t
t 1
   ...  2
2 4 8
30

lOMoARcPSD|1876427
PV of Y forever:
(get the first Y this period, which is period 0)
 t
 1 
v0    Y
t 0  1  r 
 t
 1 
 Y  
t 0  1  r 
1
Y
1
1
1 r
1 r 1 r 1
Y Y  Y (  1)
1 r 1 r r
1
 Y Y
r 31

lOMoARcPSD|1876427
Often, the situation is you get your first Y
starting in period 1. So you get Y less in PV.
Instead of Y+Y(1/r), you get
1
v0  Y
r
You can always double check: suppose you put
Y
v 
r in the bank today. Every year, you get rv0
0
in interest, and rv0=Y every period…
32

lOMoARcPSD|1876427
Examples with numbers:
What is the PV of $100 per year forever, if the
interest rate is 5%?
100
 2000
0.05
What is the PV of a $1000 bond that pays out
$60 per year for 10 years, and then $1000 in
the 10th year?
the 10
t 10
10
 1   1 
 
t1  1.05

1 05 
60  
 11.05
 1000  1077.22
05 
33

lOMoARcPSD|1876427
An application
An application
Consider two ways to use a valuable asset, like a
Consider two ways to use a valuable asset like a
truck.
In poor countries the following is a standard
In poor countries, the following is a standard
picture
34

lOMoARcPSD|1876427
C ll hi “
Call this “method 1”
h d 1”
35

lOMoARcPSD|1876427
C ll hi “
h d 2”
36

lOMoARcPSD|1876427
Is method 1 irrational?
Think about the time path of income…
When does method 1 make sense?
37

lOMoARcPSD|1876427
Example
• Income today: Y
• Income tomorrow: 0
• Can save today and get back (1+r)S tomorrow
• Utility is U(C
y ( 1))+βU(C
β ( 2)
Budget constraint:
C2  (1  r )(Y  C1 )
1
C1  C2  Y
1 r
PDV of consumption equals the PDV of income
38

lOMoARcPSD|1876427
Optimal Savings for Retirement
Upward sloping supply of savings (as r increases)?
39

lOMoARcPSD|1876427
Demand for investment
Consider a project that costs I. It generates a
stream of additional profits, Y1 , Y2 , Y3...
Should you invest? Compare I to PV of future
profits:
profits:
 t
 1 
   Yt
t 1  1  r 
What happens to this PV as r increases? So as r
increases, are more or fewer investment
projects undertaken?
40

lOMoARcPSD|1876427
Supply and demand for savings…
41

lOMoARcPSD|1876427
Fall 2012
Economics 115
Economics 115
Lecture 21: Decision‐Making Through
Time and in Risky Environments
11/26/2012

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Announcements
• Problem set 9 due now
• Problem set 10 online this afternoon
• Choose your Final date:
Ch i ld
– Sunday 12/16/2012 at 9:00
– Tuesday 12/18/2012 at 9:00
• Sign up using the Sign‐up tool on the Classes
Server
• Makeup class: Friday Dec 7 1
Makeup class: Friday Dec 7 1‐2:15
2:15 at SSS 114.
at SSS 114.
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Outline for Today

Outline for Today
• Decision Making Over Time
• Risk and Insurance
ik d

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Review: Socially Optimal Provision of Public
Goods
MSB(Q)   MU i (Q)  MC (Q)

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Private:
MC (Q )  MU j (Q )
Pr Pr
Optimal:
p
MC (Q )   MU i (Q )
* *
Or i
1 1
N
MC (Q ) 
*
N
 MU (Q )
i
i
*
cost”
cost
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Public Goods?

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Review: present value of $x next period is
(1  r )v0  x
1
v0  x
1 r

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What is the present value of a stream of
payments into the future? (like your future
flow of income)

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Get income in the future: Y0 , Y1 , Y2 , Y3...
2 3
1  1   1 
v0  Y0  Y1    Y2    Y3  ...
1 r 1 r  1 r 
 t
 1 
v0     Yt
t 0  1  r 

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PV of Y forever:
First, remember a bit of math:
for 0  x  11,

1  x  x  x  x  ...   x t
2 3 4
t 0
t
is the sum of a geometric series and is equal to

1
1 x
For example for x=1/2 this is

For example, for x=1/2, this is

1 1 1
  1
x t
t 1
   ...  2
2 4 8
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PV of Y forever:
(get the first Y this period, which is period 0)
 t
 1 
v0    Y
t 0  1  r 
 t
 1 
 Y  
t 0  1  r 
1
Y
1
1
1 r
1 r 1 r 1
Y Y  Y (  1)
1 r 1 r r
1
 Y Y
r 11

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Often, the situation is you get your first Y
starting in period 1. So you get Y less in PV.
Instead of Y+Y(1/r), you get
1
v0  Y
r
You can always double check: suppose you put
Y
v 
r in the bank today. Every year, you get rv0
0
in interest, and rv0=Y every period…
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Examples with numbers:
What is the PV of $100 per year forever, if the
interest rate is 5%?
100
 2000
0.05
$60 per year for 10 years, and then $1000 in
the 10th year?
the 10
t 10
10
 1   1 
 
t1  1.05

1 05 
60  
 11.05
 1000  1077.22
05 
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An application
An application
Consider two ways to use a valuable asset, like a
Consider two ways to use a valuable asset like a
truck.
In poor countries the following is a standard
In poor countries, the following is a standard
picture
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C ll hi “
h d 1”
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C ll hi “
h d 2”
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Is method 1 irrational?
Think about the time path of income…
When does method 1 make sense?
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Example
• Income today: Y
• Income tomorrow: 0
• Can save today and get back (1+r)S tomorrow
• Utility is U(C
y ( 1))+βU(C
β ( 2)
Budget constraint:
C2  (1  r )(Y  C1 )
1
C1  C2  Y
1 r
PDV of consumption equals the PDV of income
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Optimal Savings for Retirement
Upward sloping supply of savings (as r increases)?
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Demand for investment
Consider a project that costs I. It generates a
stream of additional profits, Y1 , Y2 , Y3...
Should you invest? Compare I to PV of future
profits:
profits:
 t
 1 
   Yt
t 1  1  r 
What happens to this PV as r increases? So as r
increases, are more or fewer investment
projects undertaken?
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Supply and demand for savings…
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New Topic: Risk
When looking into the future, you not only have
When looking into the future, you not only have
to deal with r, you have to deal with risk.
Risk vs. Uncertainty
Here, we will deal with risk. If you have lent
money to somebody, you are paid back with
probability p.
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One solution:
Diversification
“don’t put all your eggs in one basket”
Example 1:
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One solution:
Diversification
“don’t put all your eggs in one basket”
Example 1: Yale Endowment
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Example 2: Intercropped Maize (corn) and Peanut
p pp ( )
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But you can’t “diversify away” all risk…
• Idiosyncratic risk affects only one asset
– One stock, or one crop
, p
• Systemic or aggregate risk affects many or all
assets
– All stocks (a global recession), or a drought that
affects all crops
affects all crops
One problem in our current crisis: we treated
too many risks (from mortgages for example)
too many risks (from mortgages, for example)
as idiosyncratic when they were really
systemic.
systemic
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Modeling Risk: Think of lotteries, or bets.
Bet pays
Y  Y H with probability p
with probability p
Y  Y with probability (1‐p)
L
S
So expected Y is
t dYi
EY  pY  (1  p )Y
H L
is a weighted average of YH and Y

This is a weighted average of Y
This and YL, with the
, with the
weights being the probabilities they occur
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Expected Utility
Weighted average of utility in each
Weighted average of utility in each “state
state of the
of the
world” (which is what we portentously call the
outcome of the bet)
outcome of the bet)
EU  pU (Y H )  (1  p )U (Y L )
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KEY POINT:
With diminishing marginal utility,

U ( EY )  EU
and risk averse consumers will be willing to pay
to reduce their risk, providing a profit
opportunity for insurance companies.
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Think of fire risk
With probability p, no fire, you can spend Y on
consumption
With probability (1‐p) you lose L in resources
from a fire.
from a fire.
Expected income: EY  pY  (1  p )(Y  L)
Expected utility:
EU  pU (Y )  (1  p)U (Y  L)
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Risk Aversion and Expected Utility
p y
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Actuarially Fair Insurance
Zero profit, premium = expected loss
premium = (1
premium (1‐p)L
p)L
With insurance, if there is no fire, your income is
Y‐(1‐p)L
If there is a fire your income is Y‐(1‐p)L, the same
Utility with insurance:
EU  pU (Y  (1  p ) L)  (1  p )U (Y  (1  p ) L)
 U (Y  (1  p ) L)
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Risk Aversion, Expected Utility and Insurance
, p y
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Great! Actuarially fair insurance solves the risk
y
problem.
If the insurance company can sell enough
If the insurance company can sell enough,
idiosyncratic policies, it can diversify its own
risk…
risk
What are the possible problems with insurance?
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Asymmetric Information
y f
1. Moral Hazard – having insurance changes
behavior
2. Adverse Selection – worse risks buy
insurance better risks do not
insurance, better risks do not.
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Health Insurance and Moral Hazard
• Once insurance pays for drugs, consumer does
not care about the price of prescriptions
• Consumers on insurance use more
prescription drugs
This causes a high price for insurance, which
some people can’t afford – they still face risk
This problem would go away if the insurance
company could be sure what drugs you
“need”. This is why there are deductibles and
co‐pays
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Also, patented drugs are produced by (legal)
Also patented drugs are produced by (legal)
monopolies. Insurance lowers elasticity and
thus raises drug prices
thus raises drug prices.
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Health Insurance and Adverse Selection
Consumers know more about their riskiness
than does the insurance company.
At a given premium, riskier consumers prefer to
k f
buy insurance – this drives cost of insurance
pool above population average cost –
l b l i this
hi
increases price of insurance – only most risky
consumers still want to buy –
ill b price goes even
i
higher, more drop out, price rises again, etc…
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Fall 2012
Economics 115
Economics 115
Lecture 22: Risk and Imperfect
Information
11/28/2012

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Announcements
• Problem
Problem set 10 due on Monday
set 10 due on Monday
• Choose your Final date by Friday using the
Sign up tool on the Classes Server
Sign‐up tool on the Classes Server
• Makeup class: Friday Dec 7 1‐2:15 at SSS 114.
Thi ill b
This will be review only.
i l
• We’re going to skip “Introduction to
International Trade”; we’re out of time.

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Outline for Today

Outline for Today
• Risk and Insurance
• Moral Hazard, Adverse Selection
l d d S l i

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Bet pays
with probability p
L
S
So expected Y is
t dYi
EY  pY  (1  p )Y
H L

, with the

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Expected Utility
state of the
of the
outcome of the bet)
outcome of the bet)
EU  pU (Y H )  (1  p )U (Y L )

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KEY POINT:

U ( EY )  EU

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Think of fire risk
With probability p, no fire, you can spend Y on
consumption
With probability (1‐p) you lose L in resources
from a fire.
from a fire.
Expected income: EY  pY  (1  p )(Y  L)
Expected utility:
EU  pU (Y )  (1  p)U (Y  L)

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Risk Aversion and Expected Utility
p y

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Actuarially Fair Insurance
Zero profit, premium = expected loss
premium = (1
premium (1‐p)L
p)L
With insurance, if there is no fire, your income is
Y‐(1‐p)L
If there is a fire your income is Y‐(1‐p)L, the same
Utility with insurance:
EU  pU (Y  (1  p ) L)  (1  p )U (Y  (1  p ) L)
 U (Y  (1  p ) L)

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Risk Aversion, Expected Utility and Insurance
, p y
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Great! Actuarially fair insurance solves the risk
y
problem.
If the insurance company can sell enough
If the insurance company can sell enough,
idiosyncratic policies, it can diversify its own
risk…
risk
What are the possible problems with insurance?
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Asymmetric Information
y f
1. Moral Hazard – having insurance changes
behavior
2. Adverse Selection – worse risks buy
insurance better risks do not
insurance, better risks do not.
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Moral Hazard
1. If insurance pays for the drugs you use, you
don’tt care about the price of prescriptions
don care about the price of prescriptions
2. If unemployment insurance compensated
you (completely) for losing a job no need to
you (completely) for losing a job, no need to
work hard to keep the job
3. If crop insurance compensated a farmer for
f i d f f
the loss of her crop due to insect infestations,
why bother with pesticide
h b h ih i id
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Moral Hazard
In each case, the problem arises because the
consumer takes (or does not take) an action
consumer takes (or does not take) an action
that the insurance company cannot observe
e g if unemployment insurance could be
e.g., if unemployment insurance could be
written along with a requirement that you
work hard (and that this hard work can be
work hard (and that this hard work can be
verified), the problem is solved
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• Deductibles
• Co‐Payments
Co Payments
• Managed Care
These do not provide full insurance, so patients
p f , p
still face risk
Moral hazard prevents insurance market from
Moral hazard prevents insurance market from
fully shielding consumers from risk
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Insurance and Adverse Selection
than does the insurance company.
At a given premium, riskier consumers prefer to
k f
buy insurance – this drives cost of insurance
pool above population average cost –
l b l i this
hi
increases price of insurance – only most risky
consumers still want to buy –
ill b price goes even
i
higher, more drop out, price rises again, etc…
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• Refuse to insure high risk consumers (e.g., “no
pre‐existing
pre existing conditions
conditions”))
• Sell group insurance policies (this reduces
selection; e g YHP)
selection; e.g., YHP)
• Don’t sell insurance at all when there is a big
adverse selection problem, or set very high
d l i bl hi h
prices (individual health insurance)
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1000 farmers, growing corn; 50% chance of
1000 farmers growing corn; 50% chance of
YH=100, 50% chance of YL=0. U(Y)= Y
EY =
EU =
EU =
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Insurance pays 100 if no rain. Actuarially fair
p y y
price is
Do people want to buy?
l b ?
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Now suppose 500 farmers actually have 75%
pp y
chance of YH=100,
While the other 500 farmers actually have a 25%
chance of YH=100
At the actuarially fair price of p=50, will the safe
f
farmers want to buy?
b ?
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If only the risky farmers buy, what is the
y y y,
actuarially fair price?
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“ObamaCare”
• Key feature: to solve the AS problem
mandatory insurance plus “community
mandatory insurance, plus community
rating” (same price to all)
• To solve MH problem: change doctor
To solve MH problem: change doctor’ss
incentives? Has not happened yet.
• To solve lack of competition in insurance
l l k f ii i i
markets (no actuarially fair insurance):
Regulation
l i
22

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New Topic: Global Distribution of Income and
Welfare
Why should we care?
• Utilitarianism
– Classical: Bentham, Mills
– Modern: Singer
• Liberalism
– Rawls: the veil of ignorance
• Capabilities:
C bili i
– Sen, Martha Nussbaum, Thomas Pogge
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Poverty and action
y
• Why do something?
– Efficiency and Market Failures
Efficiency and Market Failures
– Equity in the distribution of welfare
• Why do nothing?
– Often, “doing something” can make matters worse
• Moral hazard
• Neo‐colonialism
N l i li
• Corruption, misguided policies
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First, Measurement
First, Measurement
• Why measure?
Why measure?
– To have a sense of scale
– To know what makes a difference
To know what makes a difference
• Evaluation
– To know where a difference needs to be made
To know where a difference needs to be made
• ‘Targeting’
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Income
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Income vs Welfare
Income vs
• Is average income all we care about?
Is average income all we care about?
• Look at S. Africa in the previous graph
– Distribution vs. Avg
Di t ib ti A Levels
L l
• Poverty
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Gapminder.org 28

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Poverty and Welfare

Poverty and Welfare
• Poverty
Poverty may not be all we care about either
may not be all we care about either
• But it is highly correlated with many other
things we care about
– 40% of children under five in Mali have measurable signs
of malnutrition; 53% in India. 0% in Sweden.
– Life expectancy at birth in Mali is only 49 years; 36 years in
Sierra Leone. 77 in Sweden.
– adult female literacy in Mali is 28%; 60% in Nigeria.
100% is Sweden.
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Outliers: Equatorial Guinea (‐), Eritrea (+) 31

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Broader measures
Broader measures
• United
United Nations Development Program
Nations Development Program –
Human Development Index
• Combination of (a) standard of living
Combination of (a) standard of living
(gni/pop); (b) long and healthy life (life
expectancy); (c) knowledge (mean schooling
expectancy); (c) knowledge (mean schooling
now, current enrolment rates)
• Scaled between 0 and 1
S l db 0 d1
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Fall 2012
Economics 115
Economics 115
Lecture 23: Information Asymmetries;
Introduction to Global Distribution
12/3/2012

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Announcements
• Problem
Problem set 10 due now.
set 10 due now
• Problem set 11 will not be graded; it will be
online this afternoon
online this afternoon.
Thi ill b
This will be review only.
i l

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Outline for Today

Outline for Today
• Moral Hazard, Adverse Selection
• Global distribution of income and welfare
Gl b l di ib i fi d lf

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Bet pays
with probability p
L
S
So expected Y is
t dYi
EY  pY  (1  p )Y
H L

, with the

lOMoARcPSD|1876427
Expected Utility
state of the
of the
outcome of the bet)
outcome of the bet)
EU  pU (Y H )  (1  p )U (Y L )

lOMoARcPSD|1876427
KEY POINT:

U ( EY )  EU

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Expected Utility and Expected Income
p y p
1000 farmers, growing corn; 50% chance of
1000 farmers growing corn; 50% chance of
EY =
EU =
EU =

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Expected Y vs. Expected U

Expected Y vs. Expected U

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p y p
Now change the probabilities; 75% chance of
Now change the probabilities; 75% chance of
EY =
EU =
EU =

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p y p
Change the probabilities again; 25% chance of
Change the probabilities again; 25% chance of
EY =
EU =
EU =
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Go back to the 50%‐50% case. Insurance pays p y
100 if no rain. Actuarially fair price is
Do people want to buy?
l b ?
11

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Now suppose 500 farmers actually have 75%
pp y
chance of YH=100,
chance of YH=100
At the actuarially fair price of p=50, will the safe
f
farmers want to buy?
b ?
12

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If only the risky farmers buy, what is the
y y y,
actuarially fair price?
13

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“ObamaCare”
• Key feature: to solve the AS problem
mandatory insurance plus “community
mandatory insurance, plus community
rating” (same price to all)
• To solve MH problem: change doctor
To solve MH problem: change doctor’ss
incentives? Has not happened yet.
• To solve lack of competition in insurance
l l k f ii i i
markets (no actuarially fair insurance):
Regulation
l i
14

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New Topic: Global Distribution of Income and
Welfare
Why should we care?
• Utilitarianism
– Classical: Bentham, Mills
– Modern: Singer
• Liberalism
– Rawls: the veil of ignorance
• Capabilities:
C bili i
– Sen, Martha Nussbaum, Thomas Pogge
15

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Poverty and action
y
• Why do something?
– Efficiency and Market Failures
Efficiency and Market Failures
– Equity in the distribution of welfare
• Why do nothing?
– Often, “doing something” can make matters worse
• Moral hazard
• Neo‐colonialism
N l i li
• Corruption, misguided policies
16

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First, Measurement
First, Measurement
• Why measure?
Why measure?
– To have a sense of scale
– To know what makes a difference
To know what makes a difference
• Evaluation
– To know where a difference needs to be made
To know where a difference needs to be made
• ‘Targeting’
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Income
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Income vs Welfare
Income vs
• Is average income all we care about?
Is average income all we care about?
• Look at S. Africa in the previous graph
– Distribution vs. Avg
Di t ib ti A Levels
L l
• Poverty
19

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Gapminder.org 20

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Poverty and Welfare

Poverty and Welfare
• Poverty
100% is Sweden.
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Broader measures
Broader measures
• United
• Geometric average of (a) a standard of living
Geometric average of (a) a standard of living
index (based on gni/pop); (b) long and healthy
life (life expectancy); (c) knowledge (mean
schooling now, current enrollment rates)
S l db 0 d1
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Measuring Poverty
Measuring Poverty
• Poverty headcount ratio
• Poverty Gap
G
• Poverty Gap, with weighting of some sort
– Rawlsian extreme case
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How the poor spend:
You know how to think about this:
Income effects
Called “Engel Curves”
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Engel Curve for Food
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Percentage of Household Budget spent on Food
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Rural Rural Rural Rural Urban Urban Urban Urban
$1 $2 $2-$4 $6-$10 $1 $2 $2-$4 $6-$10
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Health and Income: p(death w/in 5
years|alive
| l at age 50))
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Indonesia <$2 Indonesia $2-$4 Indonesia $6-$10 Vietnam<$2 Vietnam $2-$4 Vietnam $6-$10
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But social obligations remain

% HHs with
any Festival
Entertainment Festivals Expenditure
Living on less than $1 a day
Rural
Cote d'Ivoire 0.0% 1.3% 59.9%
Guatemala 0.1% 7.7%
India - Udaipur 0.0% 14.1% 99.4%
I d
Indonesia
i 0 0%
0.0% 2 2%
2.2% 80 3%
80.3%
Mexico 0.7% 0.0% 2.7%
Nicaragua 0.0% 0.0% 1.8%
Pakistan 0.3% 2.4% 64.8%
Panama 0.6% 0.0% 0.0%
Papua New Guinea 0.2% 1.5% 21.7%
Peru 0.0%
South Africa 0.1% 3.2% 90.3%
Timor Leste 0.0% 0.0% 49.0%
31

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How the poor earn

How the poor earn
• Farming, agriculture
Farming agriculture
• Through self‐owned businesses
– Do they fit our image of “entrepreneurs”?
D th fit i f“ t ”?
• Many have multiple occupations, especially in
rural areas
• Most work is unspecialized/unskilled
• On a small scale, with few employees and few
assets
32

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Poverty Traps and Aid Effectiveness

• Jeffrey Sachs, “The End of Poverty”
– Aid works
– Give more
– Poverty traps require “big push”
– Mill
Millennium Villages @ 500k/year as demonstration
i Vill @ 500k/ d t ti
• Bill Easterly, “White Man’s Burden” ; Dambisa Moyo, “Dead Aid”
– Aid fails (mostly due to corruption & misguided policies)
• “Top
Top down
down” bad: difficult to know what is going on on
bad: difficult to know what is going on on the ground, what is needed,
the ground what is needed
etc.
– Let markets work
– Handouts destroy incentives
• Recommended holiday reading:
– Esther Duflo and Abhijit Banerjee: Poor Economics
– Dean Karlan, More Than Good Intentions
33

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An Example: Immunization against
childhood disease
h ldh d d
• Only about 60% of kids get DTP vaccine
Only about 60% of kids get DTP vaccine
• Why not?
– Supply? (lack of clinics)
S l ? (l k f li i )
– Demand? (externalities, knowledge)
34

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• A way to find out
• Experiment in Udaipur, Rajasthan
• Fixingg supply
pp y (60
( villages)
g )
– Regular immunization camps, every month
• Encouraging demand (30 or those 60)
– Small incentives for immunization (one packet of
lentils a month)
• Control group (60 villages)
35

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Impact of Immunization Program Geographic Impact of Immunization Programs

Percentage of children age 1-2 years fully Percentage of children age 1-2 years outside of
immunized treatment villages fully immunized
27.2%
40.0% 30.0%
36.9%
30.0%
20.0%
17.5%
20.0%
10.0% 8.4%
5.3%
10.0%
5.3%
00.0%
0%
0.0%
Control Villages Camp Villages Camp & Control Villages Camp Villages Camp &
Encouragement Encouragement
Villages Villages
36

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Fall 2012
Economics 115
Economics 115
Lecture 24: Global Distribution
12/5/2012

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Announcements
This will be review only Come with a
This will be review only. Come with a
question…

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Outline for Today

Outline for Today
• Global distribution of income and welfare

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Poverty and Welfare

Poverty and Welfare
• Poverty
100% is Sweden.

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Broader measures
Broader measures
• United
• Geometric average of (a) a standard of living
Geometric average of (a) a standard of living
index (based on gni/pop); (b) long and healthy
schooling now, current enrollment rates)
S l db 0 d1

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Measuring Poverty
Measuring Poverty
• Poverty headcount ratio
• Poverty Gap
G
• Poverty Gap, with weighting of some sort
– Rawlsian extreme case

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How the poor spend:
Income effects
Called “Engel Curves”
10

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Engel Curve for Food
11

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Percentage of Household Budget spent on Food
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Rural Rural Rural Rural Urban Urban Urban Urban
$1 $2 $2-$4 $6-$10 $1 $2 $2-$4 $6-$10
12

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Health and Income: p(death w/in 5
years|alive
| l at age 50))
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Indonesia <$2 Indonesia $2-$4 Indonesia $6-$10 Vietnam<$2 Vietnam $2-$4 Vietnam $6-$10
13

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% HHs with
any Festival
Entertainment Festivals Expenditure
Living on less than $1 a day
Rural
Cote d'Ivoire 0.0% 1.3% 59.9%
Guatemala 0.1% 7.7%
India - Udaipur 0.0% 14.1% 99.4%
I d
Indonesia
i 0 0%
0.0% 2 2%
2.2% 80 3%
80.3%
Mexico 0.7% 0.0% 2.7%
Nicaragua 0.0% 0.0% 1.8%
Pakistan 0.3% 2.4% 64.8%
Panama 0.6% 0.0% 0.0%
Papua New Guinea 0.2% 1.5% 21.7%
Peru 0.0%
South Africa 0.1% 3.2% 90.3%
Timor Leste 0.0% 0.0% 49.0%
14

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How the poor earn

How the poor earn
• Farming, agriculture
Farming agriculture
• Through self‐owned businesses
– Do they fit our image of “entrepreneurs”?
D th fit i f“ t ”?
• Many have multiple occupations, especially in
rural areas
• Most work is unspecialized/unskilled
• On a small scale, with few employees and few
assets
15

lOMoARcPSD|1876427

• Jeffrey Sachs, “The End of Poverty”
– Aid works
– Give more
– Poverty traps require “big push”
– Mill
Millennium Villages @ 500k/year as demonstration
i Vill @ 500k/ d t ti
• Bill Easterly, “White Man’s Burden” ; Dambisa Moyo, “Dead Aid”
– Aid fails (mostly due to corruption & misguided policies)
• “Top
Top down
down” bad: difficult to know what is going on on
bad: difficult to know what is going on on the ground, what is needed,
the ground what is needed
etc.
– Let markets work
– Handouts destroy incentives
• Recommended holiday reading:
– Esther Duflo and Abhijit Banerjee: Poor Economics
– Dean Karlan, More Than Good Intentions
16

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Understanding Policy Effectiveness

Understanding Policy Effectiveness
• Three Examples
Three Examples
– Immunization
– Microcredit
– Schools
17

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Example: Immunization against
childhood disease
h ldh d d
• Only about 60% of kids get DTP vaccine
Only about 60% of kids get DTP vaccine
• Why not?
– Supply? (lack of clinics)
S l ? (l k f li i )
– Demand? (externalities, cost, knowledge)
18

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Why is this hard to figure out?

Why is this hard to figure out?
• Can
Can we just compare immunization rates in
we just compare immunization rates in
villages with health centers (supply) to villages
without (no supply)?
without (no supply)?
– Why do some villages have health centers?
Demand?
19

lOMoARcPSD|1876427
• A way to find out
• Experiment in Udaipur, Rajasthan
• Fixingg supply
pp y (60
( villages)
g )
– Regular immunization camps, every month
• Encouraging demand (30 or those 60)
– Small incentives for immunization (one packet of
lentils a month)
• Control group (60 villages)
• The
Th kkey isi the
h randomness:
d these
h villages
ill are
identical, on average, except for the ‘treatments’
20

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Impact of Immunization Program Geographic Impact of Immunization Programs

Percentage of children age 1-2 years fully Percentage of children age 1-2 years outside of
immunized treatment villages fully immunized
27.2%
40.0% 30.0%
36.9%
30.0%
20.0%
17.5%
20.0%
10.0% 8.4%
5.3%
10.0%
5.3%
00.0%
0%
0.0%
Control Villages Camp Villages Camp & Control Villages Camp Villages Camp &
Encouragement Encouragement
Villages Villages
21

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Microcredit
• Basic argument:
– Information asymmetries prevent poor from borrowing
– Which keeps them from profitable investments
Which keeps them from profitable investments
– Which keeps them in a poverty trap
• Solution:
– Improve lending methods so that banks can recoup
funds
• Fundamental questions:
q
– Do people borrow rationally?
– How much better off are they?

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Microcredit:
Audacious to Humble
d bl
• Magic bullet against poverty
Magic bullet against poverty
– This claim rarely made anymore
• Lifts millions out of poverty
Lifts millions out of poverty
• Raises poor peoples income and consumption
• Helps poor cope with poverty
• Not about income or consumption, but rather
p ,
about freedom and empowerment

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Two statements often heard

1. Our clients are highly
g y motivated and work
tirelessly to fight their way out of poverty.
2. Roqia secured a loan for US $160,

$ purchased a
sewing machine and basic items, and opened a
tailoring business in her family
family’ss home. With
additional loans, she purchased a second sewing
machine, and is teaching another woman to be a
seamstress She is most proud that she can
seamstress.
provide better, more nutritious food for her
brothers and sisters.

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Well does it?

Well,
• Randomized program placement
– Some communities/villages/slums randomly
selected for program,
program others not
• Spandana, India
• Al-Amana,, Morocco
• Compartamos, Mexico

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Answer?
• South Africa:
South Africa:
– Consumer lending
– More jobs, higher income, lower poverty, lower likelihood
of hunger
– 200% annual interest rate!
• Philippines:
– Risk management, not investment
• India:
di
– Investment in business, but no higher income. Lower
(temptation) consumption
(temptation) consumption.

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Opportunity costs!
Opportunity costs!
• Can’t
Can t spend the same dollar in multiple places
spend the same dollar in multiple places
• Even projects that MUST be good, the
question is: how good?
question is: how good?
• Opportunity costs!
• How do we increase school attendance?

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28

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How to be a Good Economist‐Citizen

How to be a Good Economist Citizen
1 Understand
1. Understand the arguments in favor of
the arguments in favor of
markets
Under perfect competition, p is signal of both
Under perfect competition p is signal of both
marginal opportunity cost and marginal benefit
to consumer: private incentives reflect social
p
benefit and cost.
Contrast with problem of government intervention:
difficult to get appropriate information and
incentives
29

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2. Understand Equity vs. Efficiency
If you object to the market in a particular situation,
is it because of market failure (e.g. externalities
or other cause of lack of efficiency) or equity
h f l k f ffi i ) i
(distribution of Y)
If th
If the second, why not redistribute Y itself rather
d h t di t ib t Y it lf th
than intervene in a specific market. Direct
interventions in markets are usually more
interventions in markets are usually more
distortionary.
Under perfect competition, redistribute Y and
Under perfect competition, redistribute Y and
otherwise let the market work
30

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3. Understand Market Failures
Inefficient outcomes even given the correct
distribution of Y
– Imperfect competition
– Externalities/public goods: costs and benefits to
non‐market participants
– Asymmetric Information: moral hazard, adverse
selection
l
31

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4. Understand Possible Government Action in
Response to Market Failure
– Natural monopoly: regulation?
– Collusion: prison?
– Positive/negative externalities: Pigouvian taxes or
subsidies?
– Pure public good: Public provision
– Asymmetric information – adverse selection:
mandatory coverage
32

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5. Look for Facts and Data
Is something really a public good? What is the
Is something really a public good? What is the
evidence of market failure? Is this an
oligopoly? Is there evidence that this
oligopoly? Is there evidence that this
proposed program works?
33

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6. Understand the Limits of Your Knowledge
A dt k
And take more classes!
l !
• Learn about theory: intermediate micro 121 or 125
• Learn about data: econometrics 131, 132, 135, 136
Learn about data: econometrics 131 132 135 136
• Learn about externalities, public goods, taxes: public
econ 275, natural resources 330, Health 170
• Imperfect competition: Game theory 159; firms and
markets 200
• Labor, poverty: Labor 401, development 325, poverty
280
Lots more: education economic history trade finance
Lots more: education, economic history, trade, finance,
34

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Introductory Economics - Lecture notes - lecture + 1

Introductory Economics (Yale University)

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Outline for Today

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From the syllabus:

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The value of a good in its “next

Monetary and non‐monetary

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Example 3: marginal vs sunk cost

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Example 4: Data for my phone

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Method and Intro to Micro

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The Process of Economic Thinking

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Real vs. Nominal

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The Course Ahead

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The First Model

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The Demand Curve

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Outline for Today

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