Detailed Summary_Principle of Economics

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Ten principles of Economics

How people make decisions

The four principles of individual decision making are:

(2) The cost of something is what you give up to get it

(3) Rational people think at the margin

1 People face trade-offs: To get one thing we like, we usually have to give up another thing that we like For example you have to choose between going to the cinema with a friend or work in a supermarket for money

2 The cost of something is what you give up to get it: Suppose you’re going to college and you want to calculate your costs It is tempting to only include tuition, books, room and board This is a bit misleading, because even if you weren’t going to school you had to pay for food and housing Second, this calculation ignores the largest cost of going to college; your time! During the time you were studying, making homework or attend classes you could have earned money with a job These costs are called opportunity costs The opportunity cost of an item is what you give up to get that item

3 Rational people think at the margin: first of all we have to define what rational people are People are considered rational if they consistently do their best they can to achieve their objectives Second, we will always assume that people or firms think at the margin The marginal change is an incremental adjustment to a plan of action If a firm decides whether to produce an extra unit of some good, it will always look at the cost of producing 1 extra unit versus the benefit of producing 1 extra unit If the benefit/revenue is higher than the cost, it will decide to produce an extra unit

4 People respond to incentives: An incentive is something that induces a person to act Consider, for example a government which imposes a higher tax on cigarettes This causes people to stop smoking.

How people interact

As we go about our lives, many of our decisions affect not only ourselves but other people as well The next three principles concern how people interact with one another:

(5) trade can make everyone better off

(6) Markets are usually a good way to organize economic activity

(7) Governments can sometimes improve market outcomes

5 Trade can make everyone better off: Countries as well as families benefit from trade by specializing in the things they are good at This results in lower prices for goods and a more efficient production process

6 Markets are usually a good way to organize economic activity: In a market economy decisions are made by millions of firms and household A firm decides how many workers to hire and household decide what to buy for their income

7 Governments Can Sometimes Improve Market Outcomes: The government can impose important laws to stimulate economic activity One way to establish this goal is by means of property rights Property rights are defined as: the ability of an individual to own and exercise control over scarce resources A singer wouldn’t produce any music if he knew everybody could get an illegal copy of his music

Another reason why government can be important is in the case of a market failure This occurs when a market fails to allocate recourses efficiently Consider the case when you are the only one who is able to produce and sell eggs in a town You can basically ask any price for your eggs, since you have a lot of market power In this case a government can choose to intervene and to set a maximum price for your eggs Another possible cause of market failure is an externality, which is the impact of one person’s actions on the well-being of a bystander Suppose your firm is producing a lot of pollution, which has a negative effect on the region, the government can choose to set rules for the maximum amount of pollution.

How the Economy as a whole works

The last three principles concern the workings of the economy as a whole:

(8) A country's standard of living depends on its ability to produce goods and services (9) Prices rise when the government prints too much money

(10) A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services: Society Faces a Short-Run Trade-off between Inflation and Unemployment

8 A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services: There is a big difference between annual incomes for countries around world Why is there such a big difference? The answer is that some countries can

9 produce much more with 1 unit of labour input than other countries We call this a difference in productivity, which is the quantity of goods and services produced from each unit of labour input In western-Europe we can make a lot more with 1 unit of labour compared to Nigeria

9 Prices rise when the government prints too much money: Almost every year we see that prices rise, but in some countries much faster than in other countries The general term to indicate an increase in the overall price level is inflation What causes inflation? In almost all cases of large or persistent inflation, the culprit is growth in the quantity of money When a government creates large quantities of the nation’s money, the value of the money falls

10 A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services: Society Faces a Short-Run Trade-off between Inflation and

Unemployment Most economists describe the short-run effects of monetary injections as follows:

• Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services

• Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services

• More hiring means lower unemployment

Hence, for society there is a decision to make: Choosing for lower unemployment and higher inflation or vice versa

Thinking like an Economist

The economist as a Scientist

Economists try to address their subject with a scientist’s objectivity They approach the study of the economy in much the same way a physicist approaches the study of matter and a biologist approaches the study of life: They devise theories, collect data, and then analyse these data in an attempt to verify or refute their theories Let’s discuss some of the ways in which economists apply the logic of science to examine how an economy works

The first model we will explore is the circular-flow diagram, used to represent an economy that shows how dollars flow through markets among households and firms The inner loop represents the flows of inputs and outputs, whereas the outer loop represents the corresponding flow of dollars Note that in this model we did not include the government and international trade This model is used to give you a basic understanding of how an economy works; later on we will include import, export and government spending

Our second model concerns the production possibilities frontier This is a curve that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology Let’s assume an economy is only producing 2 goods; refrigerators and cars (a bit unrealistic but just to keep things simple) Below you see the points A, B and C on the curve which represents the amount of refrigerators and cars produced in the economy Note that

12 the curve is downward sloping, so that if we decide to produce more cars we can produce fewer refrigerators All points which lie on the curve (A, B and C) are considered efficient since if we want to produce more cars we can produce fewer refrigerators Point X is considered inefficient since we can decide to produce more cars without producing fewer refrigerators This is perhaps due to widespread unemployment Point Y is considered unattainable since we cannot reach this point given our available resources

Although point Y is unattainable now, it does not mean that we can never reach that point An increase in technological progress might shift the ppf curve upwards, so that we are able to produce according to point Y

Although economics can be studied on various different levels, we usually subdivide it into 2 broad subfields; Macroeconomics and Microeconomics Macroeconomics is the study of economy wide phenomena, including inflation, unemployment, and economic growth Whereas Microeconomics is the study of how households and firms make decisions and how they interact in markets Despite the inherent link between microeconomics and macroeconomics, the two fields are distinct Because they address different questions, each field has its own set of models, which are often taught in separate courses

The economist as a policy advisor

In economics there are thousands of different theories and opinions When economists are asked to explain causes of economic events, they usually give different answers depending on their background For example, we distinguish between the role of an economist as policy advisor and an economist as scientist This, in turn, leads us to the definition of normative and positive statements

When economists discuss various topics we have to make a distinction between normative and positive statements Normative statements are claims that attempt to describe how the world should be For example if you say: “Government should raise the minimum wage.” This is different from a statement like: “Minimum- wage laws cause unemployment.” This is an example of a positive statement A key difference between positive and normative statements is how we judge their validity

We can, in principle, confirm or refute positive statements by examining evidence, whereas normative statements often involve our view on ethics, religion or political philosophy

Interdependence and the gains from Trade

A parable for the modern Economy

In a world of limited resources, individuals encounter trade-offs while navigating their financial constraints The production possibility frontier defines the attainable combinations of goods and services within a given budget However, the introduction of trade empowers individuals to specialize in specific areas, maximizing their efficiency and unlocking the potential to acquire points beyond the existing production possibility frontier.

Consider the following situation: We have a farmer and a rancher both producing potatoes and meat The farmer can produce 1 ounce of meat per hour or 4 ounce of potatoes per hour The rancher can produce 3 ounce of meat per hour or 6 ounce of potatoes per hour We see that the Rencher has an absolute advantage in producing both goods He can produce more meat and more potatoes in one hour Initially the farmer is producing 16 ounce of potatoes and 4 ounce of meat for himself, whereas the rancher is producing 24 ounce of potatoes and 12 ounce of meat At first glance it may seem that the Rancher cannot benefit from trade, because he is more productive in both goods

But the rancher has thought deep about the situation and offers a deal to the farmer:

"Suppose you devote all your time to produce potatoes, then you can produce 32 ounce If you give 15 ounce to me and I'll give you 5 ounce of meet, then you can consume 17 ounce of potatoes and 5 ounce of meet, which is more than you would have if you worked for yourself!”

The farmer is doubtful and asks: "This sounds great, but what are your benefits then?”

Rancher: "If I devote 6 hours of my time to produce meat and 2 hours to produce potatoes, then I have 18 ounce of meat and 12 ounce of pot I'll give you 5 ounce of meat and you give me 15 ounce of potatoes, so after trade I can consume 13 ounce of meat and 27 ounce of potatoes, more than I would have without trade!

This example is used to illustrate that both people can gain from trade even if someone is more productive in both goods Recall that their initial consumption is a point on the production possibilities frontier After trade both the Rancher and the Farmer are able to obtain a point above the ppf curve, which was unattainable without trade The term indicating that the farmer devotes all his time producing potatoes is known as specialization.

Comparative advantage: The driving force of Specialization

The one who has the comparative advantage determines who specializes in what product This is because the one who has the comparative advantage can produce

Mutual trade unlocks the potential for both parties to consume more goods and services than they could produce individually By specializing in producing goods where they have a comparative advantage, countries can trade with each other to obtain goods that they lack This allows them to move beyond the production possibilities frontier and reach a higher level of consumption.

Recall that absolute advantage was defined as: the ability to produce a good using fewer inputs than another producer In the example of the previous paragraph we noted that the Rancher had an absolute advantage over both goods In that example the only input is time, which is then the only cost

In chapter 1 we defined another type of costs, namely opportunity costs These costs play a crucial role in the understanding of trade If the farmer decides to devote 1 hour extra of his time to produce potatoes, he is giving up 1 ounce of meet Put differently, if the farmer produces 1 ounce of potatoes extra, he is giving up 1/4 ounce of meat So his opportunity cost of potatoes is 1/4 ounce of meat Similarly his opportunity cost of meat is 4 ounce of potatoes

Now let's look at the rancher, if he is producing 1 extra ounce of potatoes he is giving up 1/2 ounce of meat So his opportunity cost of potatoes is 1/2 ounce of meat and the opportunity cost of meat is 2 ounce of potatoes

If we compare the rancher and the farmer we note that the farmer's opportunity cost of potatoes are lower, namely 1/4 ounce of meat vs 1/2 ounce of meat In this case we say that the farmer has a comparative advantage over potatoes Comparative advantage is the ability to produce a good at a lower opportunity cost than another producer Again we note that the rancher has the comparative advantage over meat since his opportunity cost is only 2 potatoes vs 4 potatoes for the farmer Although it is possible for one person to have an absolute advantage in both goods (as the rancher does in our example), it is impossible for one person to have a comparative advantage in both goods Because the opportunity cost of one good is the inverse of the opportunity cost of the other, if a person’s opportunity cost of one good is relatively high, the opportunity cost of the other good must be relatively low Comparative advantage reflects the relative opportunity cost Unless two people have exactly the same opportunity cost, one person will have

17 a comparative advantage in one good, and the other person will have a comparative advantage in the other good

The gains from specialization and trade are based not on absolute advantage but on comparative advantage When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises This increase in the size of the economic pie can be used to make everyone better off We can also look at the gains from trade in terms of the price that each party pays the other Consider the proposed deal from the viewpoint of the farmer The farmer gets 5 ounces of meat in exchange for 15 ounces of potatoes In other words, the farmer buys each ounce of meat for a price of 3 ounces of potatoes This price of meat is lower than his opportunity cost for an ounce of meat, which is 4 ounces of potatoes Thus, the farmer benefits from the deal because he gets to buy meat at a good price

The market forces of supply and demand

Markets and competition

The terms supply and demand refer to the behaviour of people as they interact with one another in competitive markets A competitive market is one with many sellers and many buyers There are other types of markets which we will examine in later chapters

A market encompasses a group of buyers and sellers transacting a specific product or service Buyers collectively influence demand, while sellers determine supply Market structures vary based on the good or service, with some markets being highly organized (e.g., agricultural commodities) while others operate with less organization (e.g., the ice-cream industry).

Although every market is different, economists distinguish markets in different groups The type of market structure we treat in this chapter is a competitive market; this is a market with so many buyers and so many sellers that each has a negligible impact on the price The ice-cream market is an example of this Sellers do not charge less than other sellers, because they would make a loss and neither can they charge more since customers would choose to buy their ice-cream somewhere else Similarly, a buyer does not influence the price because they only buy a small amount

In this chapter we will assume a market is perfectly competitive, which is the highest form of competition For a market to be perfectly competitive it must have 2 characteristics:

1 The goods offered for sale are exactly the same

2 There are so many buyers and sellers such that no party has any influence on the price

The wheat market is an example of a perfectly competitive market Other type of market structures include monopolies, in which there are many buyers but very few sellers.

Demand

The demand curve is downward sloping There are many factors that determine the quantity demanded such as: income, prices of related goods, tastes, expectations and the number of buyers

In the picture you see what happens if demand increases or decreases Suppose some medical doctors have shown that eating ice-cream makes you live longer, then certainly demand for ice-cream will increase and the demand curve would shift to the right Suppose that instead doctors have shown that eating ice-cream is actually bad for your health then demand would decrease and hence the demand curve would shift to the left This means that at any given price you purchase less than before

There are many factors that influence market demand; here we list the most important causes:

 Income: If you would lose your job, you have less money to spend, so, for example, you would buy less ice-cream A lower income means that you have less to spend in total, so you would have to spend less on some—and probably most—goods If the demand for a good falls when income falls, the good is called a normal good Not all goods are normal goods If the demand for a good rises when income falls, the good is called an inferior good A good example of an inferior good is a bus ride If you have enough money, you can go by car, but if you get fired then you might take the bus more often

When the price of a related product changes, it can impact the demand for other similar products For example, a decrease in the price of frozen yogurt may increase its consumption while reducing demand for ice cream, as both are substitute goods often used interchangeably Conversely, complementary goods are consumed together, so a price reduction in one (e.g., a DVD) can lead to decreased demand for the other (e.g., a DVD player) This relationship highlights the interplay between the prices of related products and how they can influence consumer preferences.

 Tastes: Every individual has different tastes If you really like ice-cream, you are likely to buy a lot of it and vice-versa Economists do not try to explain people's tastes, but rather what happens when tastes changes

 Expectations: Your expectations about the future may affect your demand for a good or service today If you expect to earn a higher income next month, you may choose to save less now and spend more of your current income buying ice cream and vice-versa

 Number of buyers: If there are more people who want to buy ice-cream, the quantity demanded in the market would be higher at every price, and market demand would increase

The actions of buyers and sellers naturally move markets toward the equilibrium of supply and demand To see why, consider what happens when the market price is not equal to the equilibrium price If the price is the above equilibrium price, firms supply more than what people demand Hence there is a surplus; suppliers are unable to sell all they want at the going price A surplus is sometimes called a situation of excess supply Firms then respond by cutting their prices, therefore demand increases and we move to the point of equilibrium Consider now the case when there is a shortage; i.e there is more demand than supply Firms will respond by raising their prices, thereby reducing demand and we again move to the point of equilibrium

Recall from the previous chapter that the law of demand says that falling prices lead to an increase in demand The price elasticity of demand measures how much the quantity demanded responds to a change in price We say that a good is elastic if a change in price leads to a substantial change in demand If demand for good does not change much after a change in price we say that the good is inelastic Some goods may be elastic and some may be inelastic, but what factors determine the elasticity of a product? There is no universal answer to this question, but based on experience economists have come up with some rules of thumb to say something about elasticity

Availability of close substitutes: If a product has close substitutes, it tends to be more elastic Consider butter and margarine If butter gets more expensive, people will switch to margarine so the demand for butter will decrease substantially If a product does not have any close substitutes, like eggs, then it tends to be more inelastic A big change in the price of eggs will not substantially differ the demand for eggs

Necessities versus Luxuries: Necessary goods, like medicines or gas, are usually more inelastic because people can't miss it If gas becomes more expensive, you still have to buy it to drive your car so demand won't change much Instead if you look at luxury items such as sailboats, they tend to be more elastic since you do not necessarily need

Definition of the Market: Narrowly defined markets are more elastic than broad defined markets If we look at the food market (very broad), then we see that it is quite inelastic because there are no close substitutes readily available If instead you look at the Vanilla Ice-cream market, you'll see it's very elastic because there are so many substitutes available (chocolate, strawberry banana tastes)

Time Horizon: Goods tend to be more elastic over a longer period of time If the price of gas rises, it won't influence the price that much in the first couple of months, but after a year, people will buy fuel-efficient cars or maybe consider the bus as a good alternative.

Supply

According to the law of supply, the quantity supplied increases when the price increases This explains why the supply curve has positive slope There are various causes that can shift the supply curve such as: input prices, technology, expectations and the number of sellers

The quantity supplied of any good or service is the amount that sellers are willing and able to sell There are many determinants of quantity supplied, but once again, price plays a special role in our analysis Just as in the previous chapter we will take the ice- cream market as a guiding principle If the price of ice-cream is high, it means it is profitable to sell ice-cream and consequently the quantity supplied is large By contrast, if the price is low, the business is less profitable so sellers produce less ice- cream This positive relation between quantity supplied and price is known as the law of supply Note the difference between the law of supply and the law of demand, since the law of demand gives a negative relation versus the positive relation of the law of supply We can also state the law of supply in a different form; the quantity supplied of a good rises when the price of the good rises We can, just like in the previous paragraph, graph the relationship between the price of ice-cream and the quantity supplied The sketched curve is known as the supply curve

Because the market supply curve holds other things constant, the curve shifts when one of the factors changes For example, suppose the price of sugar falls

Sugar is an input into producing ice cream, so the fall in the price of sugar makes selling ice cream more profitable This raises the supply of ice cream: At any given price, sellers are now willing to produce a larger quantity The supply curve for ice cream shifts to the right What other causes might shift the supply curve?

 Input prices: Ice-cream makers need various products to produce ice-cream, for example sugar If the price of sugar rises, producing ice-cream becomes less profitable and firms supply less ice-cream Thus, there is a negative relation between input prices and supply

 Technology: The technology for turning inputs into ice cream is another determinant of supply The invention of the mechanized ice-cream machine, for example, reduced the amount of labour necessary to make ice cream By reducing firms’ costs, the advance in technology raised the supply of ice cream

 Expectations: If a firm expects the price of ice-cream to rise in the future, it might store its current production to sell it in the near future This reduces the current supply

 Number of sellers: Market supply depends on the number of sellers If Ben or

Jerry were to retire from the ice-cream business, the supply in the market would fall.

Supply and demand together

All governments—from the federal government in Washington, D.C., to the local governments in small towns—use taxes to raise revenue for public projects, such as roads, schools, and national defence The tax burden is referred to the how the burden of a tax is distributed among the various people who make up the economy Taxes can shift the demand curve, the supply curve or both

Suppose the government wants to hold an annual ice-cream event with a parade, fireworks and speeches To raise some money for the event, the government decides to introduce a tax of $0.50 on each cone sold The question is, who is going to pay for the tax; sellers or buyers? The Association of ice-cream eaters wants the sellers to pay for the tax, because the price is already quite high, but the Organization for Ice-cream makers wants the buyers to pay for the tax Both parties have opposite interests and therefore the mayor proposes that half of the tax should be paid by the buyers and half of the tax should be paid by the sellers

When the government levies a tax on a good, who actually bears the burden of the tax? The people buying the good? The people selling the good? Or if buyers and sellers share the tax burden, what determines how the burden is divided? And is it possible to split the tax into 2, just like the mayor suggested, or is the division determined by more fundamental tax forces? The tax burden is referred to the how the burden of a tax is distributed among the various people who make up the economy

First we consider the case when taxes are fully paid by sellers When we analyse the effect of a tax we have to do 3 things:

1 We decide whether the tax affects the supply or the demand curve

2 We decide which way the curve shifts

3 We examine the new equilibrium price and quantity

To be specific, suppose that the government levies a tax of $0.50 on ice-cream cones This tax definitely influences the supply curve, since sellers have to pay $0.50 to the government for every cone they sell This results in a shift of the supply curve to the left, because sellers supply less at any given price (business is less profitable The situation is shown below

Now suppose that the new equilibrium price is $3.30 (the equilibrium price before tax was $3) This means that both sellers and buyers are worse off, because buyers have to pay more for their ice-cream and sellers are worse off because the effective price is only $2.80 ($3.30 - $0.50) This means that a tax makes both sellers and buyers worse off, even though the tax is fully paid by the sellers

Now we look at what happens when buyers pay for the tax We again follow the 3 steps mentioned above When a tax of $0.50 is levied on the buyers, what happens to supply and demand? Clearly, this tax only influences demand and therefore the demand curve shifts to the left which results in a lower equilibrium price and less ice- cream being sold To be specific, price decreases to $2.80 and only 90 cones are being sold (instead of 100) The new price is $2.80, but the effective price is $3.30 because of the $0.50 tax Notice the similarity between tax levied on buyers and tax levied on sellers Taxes levied on sellers and taxes levied on buyers are equivalent In both cases, the tax places a wedge between the price that buyers pay and the price that sellers receive The wedge between the buyers’ price and the sellers’ price is the same, regardless of whether the tax is levied on buyers or sellers

The question remains how the tax is exactly divided between sellers and buyers To answer this question we again need the concept of elasticity If demand is less elastic than supply, consumers have less alternatives to switch to, and hence they keep on buying the product Therefore they pay the biggest part of the tax since they have less willingness to leave the market The same holds for the opposite, if supply is less elastic Then producers have less incentive to leave the market, because of limited alternatives and therefore they pay the bigger part of the tax burden To summarize: tax burden falls more heavily on the side of the market that is less elastic

Elasticity and its Applications

The Elasticity of Demand

To measure how much consumers respond to changes in prices, economists use the concept of elasticity The elasticity of demand depends on the availability of close substitutes, on the type of good and on the market structure A good is said to have unit elasticity when the changes in price and quantity are equal We also consider the cross price elasticity, which measures the change in quantity of product X, when the price of good Y changes

Recall from the previous chapter that the law of demand says that falling prices lead to an increase in demand The price elasticity of demand measures how much the quantity demanded responds to a change in price We say that a good is elastic if a change in price leads to a substantial change in demand If demand for good does not change much after a change in price we say that the good is inelastic Some goods may be elastic and some may be inelastic, but what factors determine the elasticity of a product? There is no universal answer to this question, but based on experience economists have come up with some rules of thumb to say something about elasticity

 Availability of close substitutes: If a product has close substitutes, it tends to be more elastic Consider butter and margarine If butter gets more expensive, people will switch to margarine so the demand for butter will decrease substantially If a product does not have any close substitutes, like eggs, then it tends to be more inelastic A big change in the price of eggs will not substantially differ the demand for eggs

 Necessities versus Luxuries: Necessary goods, like medicines or gas, are usually more inelastic because people can't miss it If gas becomes more expensive, you still have to buy it to drive your car so demand won't change much Instead if you look at luxury items such as sailboats, they tend to be more elastic since you do not necessarily need it

 Definition of the Market: Narrowly defined markets are more elastic than broad defined markets If we look at the food market (very broad), then we see that it is quite inelastic because there are no close substitutes readily available

If instead you look at the Vanilla Ice-cream market, you'll see it's very elastic because there are so many substitutes available (chocolate, strawberry banana tastes)

 Time Horizon: Goods tend to be more elastic over a longer period of time If the price of gas rises, it won't influence the price that much in the first couple of months, but after a year, people will buy fuel-efficient cars or maybe consider the bus as a good alternative

We have discussed some determinants of elasticity, but we didn't include how to calculate it Here is the formula for the price elasticity of demand:

Suppose the price of ice-cream cones rises with 10% and demand changes by 20%, then the elasticity of cones is 20%/10% = 2

There is only 1 problem with our formula Suppose we have at point A a price of $4 and quantity demanded of 120 and at point B we have a price of $6 and quantity demanded is 80 If we calculate the price elasticity from point A to B we get that the price elasticity is 33/50 = 0.66 If, instead, we were to calculate the elasticity from point B to A we find that the elasticity is 50/33 = 1.5 This difference arises because the percentage changes are calculated from a different base

In order to avoid this problem, we use the midpoint method Usually, when we compute percentage change, we divide the change by the initial level When we use the midpoint rule, we divide the change by the midpoint/average of the initial and final level In our example, if price rises from $4 to $6, we get that the price change according to the midpoint rule is (6-4)/5 = 0.4 Note that we divide by 5 since 5 is the average of 4 and 6 In this way we avoid the problem of different bases

Economists classify demand curves according to their elasticity Demand is considered elastic when the elasticity is greater than 1, which means the quantity moves proportionately more than the price Demand is considered inelastic when the elasticity is less than 1, which means the quantity moves proportionately less than the price If the elasticity is exactly 1, the quantity moves the same amount proportionately as the price, and demand is said to have unit elasticity

In addition to the price elasticity of demand, economists use other elasticities to describe the behaviour of buyers in a market For example, we can look at how much quantity demanded changes when incomes changes by a certain amount This is called the income elasticity of demand and it's given by the following formula:

(Percentage change in quantity demanded)/(Percentage change in income)

This is basically a measure of how much the quantity demanded for a good changes when income changes by a certain percentage

The last form of elasticity we'll discuss is cross-price elasticity A measure of how much the quantity demanded of one good responds to

32 a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good Here is the formula:

(Percentage change in quantity demanded of good 1)/(percentage change in price of good 2)

The Elasticity of Supply

The elasticity of supply measures the change in quantity supplied after a change in price A supply curve is perfectly inelastic if a change in price does not have any influence on supply In the other extreme case, when the supply curve is horizontal, we say that supply is perfectly elastic

The elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price Moreover, the formula for the elasticity is given by:

(Percentage change in quantity supplied)/(Percentage change in price)

For example, suppose that an increase in the price of milk from $2.85 to $3.15 a gallon raises the amount that dairy farmers produce from 9,000 to 11,000 gallons per month Using the midpoint method, we calculate the percentage change in price as = (3.15 – 2.85) / 3.00 × 100 = 10 percent Similarly, we calculate the percentage change in quantity supplied as = (11,000 – 9,000) / 10,000 × 100 = 20 percent In this case, the price elasticity of supply is 20%/10% = 2

Just like with a demand curve, we also have a variety of different shapes of supply curves A supply curve is perfectly inelastic if a change in price does not have any influence on supply In this case the supply curve is a vertical line In the other

33 extreme case, when the supply curve is horizontal, we say that supply is perfectly elastic, which means that a small change in price results in a very large change in supply

Supply, Demand and government policies

Control on prices

Government intervention in the market through price floors and ceilings aims to regulate prices within specific ranges When prices exceed the price floor or fall below the price ceiling, these price controls become non-binding This means that market forces are allowed to determine prices freely without government interference.

The government can impose a maximum on the price, also called a price ceiling The price is not allowed to rise above a certain amount, which is beneficial for customers Suppose, on the other hand that the government imposes a legal minimum for which ice-cream can be sold, then we speak of a price floor

If the government imposes a price ceiling, two things can happen If the price ceiling is set above equilibrium price, then nothing will happen because market forces drive the price to the equilibrium level In this case we say that the price ceiling is not binding It is much more interesting to see what happens if the price ceiling is set above equilibrium level The forces of supply and demand tend to move the price toward the equilibrium price, but when the market price hits the ceiling, it can, by law, rise no further Thus, the market price equals the price ceiling And since firms are not willing to supply as much as what customers desire, there occurs a shortage This situation is displayed graphically in the picture below

At first glance it might seem efficient from the point of view of customers to have a price ceiling, but the real situation is a bit more subtle Perhaps long waiting lines will occur due to the shortage and people have to make a trade-off between standing in line or lie in the sun And, due to the shortage some customers do not get any ice- cream at all, even though they are willing to pay for it! This situations often occurs when government imposes a price ceiling, so that we are lead to the following general

36 result: When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers

Let's now consider the consequences of a price floor Again two things may happen If the equilibrium price is $3 and the price floor is set at $2, then nothing happens and we will have the efficient outcome of $3 If, on the other hand, a price floor is set at

$4, then $4 becomes the price and there exists a surplus Firms are producing more than necessary because of the additional return they receive due to government law This situation is shown in the graph below:

A price floor, represented by the green line, sets a minimum price above the equilibrium point (E) This generally leads to a surplus, as firms become less willing to hire employees, resulting in unemployment For instance, a study revealed that a 10% increase in minimum wage, a common example of a price floor, increases unemployment by 1-3%.

One of the ten principles of Economics states that markets are usually a good way to organize economic activity This principle explains why economists usually oppose price ceilings and price floors To economists, prices are not the outcome of some haphazard process Prices, are the result of million and millions of decisions made by customers and firms Prices have the crucial job of balancing supply and demand and, thereby, coordinating economic activity When policymakers set prices by legal decree, they obscure the signals that normally guide the allocation of society’s resources

Taxes

Taxes affect the outcome of a market The tax burden refers to what part the buyers have to pay and what part of the tax the sellers have to pay It depends on the government which curve shift: the demand curve or the supply curve Moreover, the tax burden depends on the elasticity of supply and demand

When the government levies a tax on a good, it must decide whether to levy the tax on buyers or sellers The tax burden is referred to the how the burden of a tax is distributed among the various people who make up the economy

First we consider the case when taxes are fully paid by sellers When we analyse the effect of a tax we have to do 3 things:

1 We decide whether the tax affects the supply or the demand curve

2 We decide which way the curve shifts

3 We examine the new equilibrium price and quantity

To be specific, suppose that the government levies a tax of $0.50 on ice-cream cones This tax definitely influences the supply curve, since sellers have to pay $0.50 to the government for every cone they sell This results in a shift of the supply curve to the left, because sellers supply less at any given price (business is less profitable The situation is shown below

Now suppose that the new equilibrium price is $3.30 (the equilibrium price before tax was $3) This means that both sellers and buyers are worse off, because buyers have to pay more for their ice-cream and sellers are worse off because the effective price is only $2.80 ($3.30 - $0.50) This means that a tax makes both sellers and buyers worse off, even though the tax is fully paid by the sellers

Now we look at what happens when buyers pay for the tax We again follow the 3 steps mentioned above When a tax of $0.50 is levied on the buyers, what happens to supply and demand? Clearly, this tax only influences demand and therefore the demand curve shifts to the left which results in a lower equilibrium price and less ice- cream being sold To be specific, price decreases to $2.80 and only 90 cones are being sold (instead of 100) The new price is $2.80, but the effective price is $3.30 because of the $0.50 tax Notice the similarity between tax levied on buyers and tax levied on sellers Taxes levied on sellers and taxes levied on buyers are equivalent In both cases, the tax places a wedge between the price that buyers pay and the price that sellers receive The wedge between the buyers’ price and the sellers’ price is the same, regardless of whether the tax is levied on buyers or sellers

The question remains how the tax is exactly divided between sellers and buyers To answer this question we again need the concept of elasticity If demand is less elastic than supply, consumers have less alternatives to switch to, and hence they keep on buying the product Therefore they pay the biggest part of the tax since they have less willingness to leave the market The same holds for the opposite, if supply is less elastic Then producers have less incentive to leave the market, because of limited alternatives and therefore they pay the bigger part of the tax burden To summarize: tax burden falls more heavily on the side of the market that is less elastic

Consumers, Producers, and the Efficiency of Markets

Consumer surplus

In this chapter, we will study the topic of welfare economics, the study of how the allocation of resources affects economic well-being In this paragraph we study the benefit that buyers receive from participating in a market The willingness to pay measures the maximal amount you want to pay for a product The (consumer) surplus you receive is your willingness to pay minus the actual amount Consumer surplus is a good measure of economic well-being

As being said, we want to examine the benefit a buyer receives from participating in a market How can we measure the benefit a buyer receives? One way to do this is to define your willingness to pay This is the maximum possible amount you are willing to pay for a good or service Suppose you like chocolate and your willingness to pay for it is $10, but the price for chocolate is only $4 This is a pretty good bargain since you only pay $4 for something which you were willing to pay $10 The difference between $10 and $4 is what we call consumer surplus ($6 in this case) It is the amount that a buyer is willing to pay minus the amount he actually pays One can imagine that the willingness to pay is different for every individual If you have 3 other friends who also want to buy chocolate, but friend 1 values chocolate at $6, friend 2 values chocolate at $4 and your last friend values chocolate at $3 everyone receives different consumer surplus In this case it is $2 for friend 1, $0 for friend 2 (so he is indifferent between buying chocolate or not) and $0 for friend 3 since he is not willing to buy chocolate for this price

The question remains, how can we measure consumer surplus for a whole market?

We know that the actual price is the point where demand equals supply If we zoom in on the graph we’ll find the willingness to pay of every individual in the market and if we subtract this from the actual price we find the consumer surplus for 1 individual

To find the total surplus we just add up all the small rectangles and obtain that consumer surplus is just the triangle shown below It is the region between the demand curve, the actual price and the quantity sold/produced

In formula form it is (Price-P1)*Q1*1/2

From the picture shown above one can readily verify that a lower price increases consumer surplus First of all, a lower price creates more surplus for the people who are already in the market and it will create additional surplus since new people enter the market who were previously not willing to participate

You can see in this picture that rectangle “a” represents the additional surplus of people who were already in the market and the extra surplus created is “b” which is

44 the surplus from new people entering the market

Now that we know how to calculate consumer surplus, we want to determine whether it is a good measure of economic well-being If you are a policymaker, would you care about consumer surplus? The answer should be yes, because consumer surplus measures the benefit that buyers receive from a good as the buyers themselves perceive it Thus, consumer surplus is a good measure of economic wellbeing if policymakers want to respect the preferences of buyers.

Producer surplus

We now turn to the other side of the market and consider the benefits sellers receive from participating in a market As you will see, our analysis of sellers’ welfare is similar to our analysis of buyers’ welfare Producer surplus is the amount a seller pays for a product minus the cost of providing it Producer surplus is also a good measure of economic well-being in a market

Producer surplus is defined as the amount a seller is paid for the good minus the cost of providing it We can calculate consumer surplus in a market by computing the area of a rectangle between the equilibrium price, equilibrium quantity and the origin as shown below in the picture:

Just like a decreasing price was good for consumer surplus, a rising price is good for

45 producer surplus Firms get more compensation for their product and also new firms will join the market to produce goods We can see clearly that firms and consumers have conflicting interests; firms want a higher price whereas consumers want a lower price.

Market efficiency

Consumer surplus and producer surplus are the basic tools that economists use to study the welfare of buyers and sellers in a market Total surplus in a market is consumer surplus + producer surplus A market outcome is considered efficient when total surplus is maximized This is different from equity, which measures how economic well-being is distributed among the population

Now that we have defined consumer surplus and producer surplus we are ready to define total surplus:

Total surplus = consumer surplus + producer surplus

But we know that consumer surplus = value to buyers – amount paid by buyers and producer surplus = amount received by sellers – cost to sellers From this we obtain Total surplus = value to buyers – amount paid by buyers + amount received by sellers – cost to sellers But amount paid by buyers = amount received by sellers, so this implies that

Total surplus = value to buyers – cost to sellers If an allocation of resources maximizes total surplus, we say that the allocation exhibits efficiency Note that efficiency is something else than equality Efficiency only deals with the size of a pie, not how it is divided among the various buyers and sellers As a policymaker, you are also concerned about how the pie is divided The property of distributing economic prosperity uniformly among the members of society is called equality The question remains, whether, in a free market, equilibrium allocation of recourses is efficient? When we consider free markets we can make the following observations:

1 Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay

2 Free markets allocate the demand for goods to the sellers who can produce them at the lowest cost

The next observation is of crucial importance and shows that a social planner cannot increase total economic well-being by increasing or decreasing the quantity of a good:

1 Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus

This is true, because if the quantity produced were to be below equilibrium level, you could raise economic well-being until the point where the market is in equilibrium The same holds when quantity is above equilibrium level, then you could increase surplus to the point where the market is again at equilibrium level Hence, in a free market without any government intervention, total surplus is maximized

Application: The costs of taxation

The Deadweight loss of Taxation

Because taxation has such a major impact on the modern economy, we return to the topic several times throughout this book as we expand the set of tools we have at our disposal We began our study of taxes in Chapter 6 There we saw how a tax on a good affects its price and the quantity sold and how the forces of supply and demand divide the burden of a tax between buyers and sellers In this chapter, we extend this analysis and look at how taxes affect welfare, the economic well-being of participants in a market In other words, we see how high the price of civilized society can be

From chapter 6 we remember that the outcome of a tax was the same regardless whether it was paid by sellers or buyers How the tax burden is divided among buyers and sellers depends on the elasticity When we analysed the consequences of a tax, we made use of shifts in the supply/demand curve, but to keep things simple and general we won’t bother about shifts in this chapter The key result for our purposes here is that the tax places a wedge between the price buyers pay and the price sellers receive Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax

If a government chooses to implement a tax, 3 parties will be affected: buyers, sellers and the government itself The amount the government earns is shown in the purple box It is the amount of the tax T multiplied by the quantity sold Q

So, clearly, a tax makes a government better off because it receives money which it wouldn’t obtain without tax We can see in the graph above that consumer surplus has decreased and is now only the triangle above Tax Revenue The same holds for producer surplus which decreased and is the triangle below Tax Revenue In fact, consumer and producer surplus decreased more than the increase of tax revenue This loss of potential is called the deadweight loss and is displayed by the red

49 triangles in the figure above So a society as a whole is worse off with tax than without tax This is because in a free market, resources are allocated efficiently, but with government interference price rises for buyers and is lower for producers This gives an incentive for buyers to buy less and for producers to produce less Hence the market outcome is not optimal anymore and this creates deadweight loss.

The determinants of the deadweight loss

The seize of deadweight loss is determined by the elasticity of supply and demand Elastic demand/supply leads to more deadweight loss because a change in price leads to a larger change in demand/supply

All that determines the size of the deadweight loss is the elasticity of the supply and demand curve What is the rationale behind it? Let’s assume demand is relatively elastic, which means it responds more than proportionally to changes in price If the government levies a tax, price changes and quantity demand shrinks even more, so there is more loss of potential i.e deadweight loss

All the 4 situations are depicted above in the figure So the rule is: “The more elastic, the more deadweight loss.”

Deadweight loss and tax revenue as taxes vary

Taxes rarely stay the same for long periods of time Policymakers in local, state, and federal governments are always considering raising one tax or lowering another Here we consider what happens to the deadweight loss and tax revenue when the size of a tax changes

Tax rates may differ from country to country, or even from state to state in the

United States Different tax rates cause different deadweight loss Off course, a higher tax rate causes a higher deadweight loss But how does the deadweight loss compared to the change in tax? The answer is that it changes more rapidly than the

51 change in tax, because deadweight loss is measured by the triangles between demand and supply If the government decides to double the amount of tax, then deadweight loss would not double but quadruple This is because the size of a triangle depends on the height and base and if you were the double the base and the height, the area would rise by a factor 4

Application: International trade

The determinants of trade

The world price determines whether a country will import or export Whether the world price is cheaper than the domestic price depends on the comparative advantage

Imagine a country that does not allow trade, but is on the point of allowing it for the textile market Is the country going to export or import textile? We know from chapter 3 that the comparative advantage determines whether a country will import or export something Suppose that the domestic price of textile is lower than the world price, then the country is willing to export their textile since they receive a higher price abroad On the other hand, if the domestic price is higher than the world price, it is willing to import textile since that is cheaper The moral of the story is: “To see who has the comparative advantage you’ll need to compare the domestic price with the world price.” This is because the domestic price reflects the opportunity cost of textile

The winners and losers from trade

International trade presents advantages and trade-offs Whether domestic producers or consumers benefit depends on the nation's comparative advantage Governments can utilize tariffs to regulate imports Trade advantages include expanded product selection, economies of scale, intensified competition, and heightened exchange of ideas, all contributing to economic growth and consumer well-being.

We first assume that the country which allows trade is a small economy This means that it has no influence on the price whatsoever, i.e it is a price taker All these assumptions are made to further simplify the analysis Initially, we also assume that the world price is above domestic price Thus, when a country allows international trade, the price of textile rises to the world price What happens to total surplus before and after trade? We will show this graphically in the picture below:

Since price rises, consumer surplus decreases, but this loss of consumer surplus goes fully to producer surplus, who receive a higher price for their product So what changes? It is the additional revenue of export, which was not available before trade The triangle which shows the export contributes to producer surplus So, what we gain is an extra triangle of producer surplus which wasn’t available before!

Now we look at a country which has a domestic price above world price This means that it is forced to import textile, because of a lower price abroad Let’s apply the same logic as above Producers this time are worse off, since their product will be sold at a lower price and consumers are better off The loss of producer surplus goes to consumer surplus and consumer surplus gains even more since people, who weren’t previously buying textile, now will buy textile So in every case, society as a whole gains from trade, although there is always a loser, be it consumers or producers

We will now examine the effect of a tariff in a market A tariff is a tax on imported goods We will use the supply and demand curves again to analyse the effect on welfare The change in price affects the behaviour of domestic buyers and sellers Because the tariff raises the price of textiles, it reduces the domestic quantity demanded from and raises the domestic quantity supplied from Thus, the tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade

Here in the picture you see the initial price without a tariff and with trade, which is

$50 If the government imposes a tariff, price rises to $60, which is closer to the equilibrium without trade, namely $70 A higher price results in more producer surplus, less consumer surplus and the government gains an amount represented by the grey rectangle You can clearly see that the two black triangles go to nobody, this is the deadweight loss caused by the tariff So a tariff makes society as a whole worse off, even though some parties gain (in this case the government and the producers) Besides the gains of trade we have discussed below, there are many more benefits such as:

1 Increased variety of goods: German beer is not the same as American beer,

Dutch cheese is different from French cheese One could think of millions of goods which differ from country to country All these goods are available through trade

2 Lower cost to economies of scale: Some goods can be produced at low cost only if they are produced in large quantities—a phenomenon called economies of scale This can only be done in large economies

3 Increased competition: A company operating in a small company has more market power This can cause market failure, but with foreign companies entering the market this externality can be compensated

4 Enhanced flow of ideas: The transfer of technological advances around the world is often thought to be linked to the trading of the goods that embody those advances The best way for a poor agricultural nation to learn about the computer revolution, for instance, is to buy some computers from abroad rather than trying to make them domestically.

The arguments for restricting trade

There will always be people who are opposed to international trade, sometimes they have good arguments The most important arguments are: preservation of jobs, national security, protecting infant industries and prevent unfair competition.

Some people might be opposed to international trade concerning some markets Here we give a couple of arguments why they might be opposed to trade:

 The jobs argument: Labour unions and other organizations might be opposed to international trade They argue that people will lose their job due to imports and international competition Off course, when a country allows international trade some people will lose their job, but this is only one side of the medal Because if you import from other countries, they have more money to spend in your country buying other goods This creates jobs in other type of industries in which your country has a comparative advantage

 The national security argument: If your country is producing steel you might be opposed to trading it with other countries because you can make guns and tanks with it To protect the security of your country the government can impose an export stop

 Infant industry argument: New industries sometimes argue for temporary trade restrictions to help them get started After a period of protection, the argument goes, these industries will mature and be able to compete with foreign firms

 Unfair competition argument: A common argument is that free trade is desirable only if all countries play by the same rules If firms in different countries are subject to different laws and regulations, then it is unfair (the argument goes) to expect the firms to compete in the international marketplace

Externalities

Externalities and market inefficiency

First of all, we will show that externalities cause market inefficiencies, just like taxes The real price of a product should be lower or higher than at the equilibrium point in

59 the presence of an externality The government can move the equilibrium point more to the social optimum by internalizing an externality This happens when the affected people are compensated, for example

We know that in a market without government intervention total surplus is maximized But what happens if there are negative side effects to the production of a certain good? Take for example the aluminium market; firms produce aluminium, but also a lot of pollution This is a negative externality from the standpoint of society, because it can cause illness like cancer At every given height, the supply curve represents the cost to the marginal seller But in fact, the cost to society is larger because of the pollution How can this be resolved? We use supply and demand to show what happens in this case:

We can see that the original equilibrium occurs at Q1, but the socially optimal point is located at Q opt To resolve this problem, the government can choose to levy a tax on each unit of aluminium sold This causes the supply curve to shift upwards and there is a new point of equilibrium at Q opt This is the optimal point from the society point of view The use of such a tax is called internalizing the externality because it gives buyers and sellers in the market an incentive to take into account the external effects of their actions

Besides negative externalities, we also have positive externalities An example of this is education A more educated society tends to make better decisions which results in increasing welfare The government might encourage education to subsidize it This means that the supply curve shifts to the right and results in equilibrium with lower price for education and more people are going to school Again the government has internalized this positive externality, not by a tax, but by means of a subsidy.

Public policies towards externalities

The government has 3 options to solve externalities: it can implement market regulations, corrective taxes and subsidies or it can allow tradable pollution permits.

First of all, the government has several instruments to internalize an externality We list the most important ones:

 Command and control policies: Regulations The government can remedy an externality by making certain behaviours either required or forbidden For example, dumping chemicals in the water supply has been made illegal, because the cost to society far exceeds the benefit to the polluter

 Market based policy 1: Corrective taxes and subsidies Like we saw in the previous examples, a government can choose to levy a tax, or choose to give subsidy In either case the policy of the government in market based, since a firm can still choose what quantity it produces This is contrary to the command and control policies mentioned above Most economists think that marked based policies are better than command and control policies

 Market based policy 2: Tradable pollution permits From an economic point of view, it is efficient to let firms buy pollution permits Just like for any market, supply and demand will determine the price of these permits Firms have different willingness to pay for these permits, since for some it is more costly to cut back pollution The ones with higher costs value the permits higher and will be willing to pay more for them

Private solutions to externalities

Besides government intervention, people can internalize externalities themselves Coase theorem states that people can always solve externalities by negotiating with each other without private cost When people bear transaction cost, Coase theorem can be violated

Besides government policies, private persons can also internalize externalities Take for example littering, the government has laws that prohibit it, but it is often not enforced Still people do not litter because it’s against their moral standards Another private solution to externalities is charity People donate money to non-profit institutions such as Greenpeace, because they care about a cleaner environment One could also think of alumni donating money to universities and colleges, because they think education is important

Besides these indirect methods, people can also negotiate directly with each other to internalize the externality Coase theorem states that if people can bargain with each other about the allocation of resources, they can always reach an efficient outcome on their own Suppose your neighbour has a dog, who is barking every night If your neighbour receives a benefit of $500 from owning the dog, but you incur a cost of

$800 because if the barking, you can offer your neighbour $600 to get rid of the dog Then you were both better off than before Sometimes the interested parties fail to solve an externality problem because of transaction costs, the costs that parties incur in the process of agreeing to and following through on a bargain In our example, imagine that you and your neighbour speak different languages so that, to reach an agreement, they need to hire a translator If the benefit of solving the barking problem is less than the cost of the translator, you and your neighbour might choose to leave the problem unsolved In more realistic examples, the transaction costs are the expenses not of translators but of the lawyers required to draft and enforce contracts

Public goods and common resources

The different kinds of goods

Market outcome heavily depends on the sort of good We have private goods, public goods, common resources and club goods To determine what each good is, we have to know whether it is excludable and whether it is rival in consumption

Market outcomes are determined by the efficiency with which goods and services are allocated to those who value them most Externalities, which are costs or benefits that are not fully accounted for in market prices, can distort market outcomes The effectiveness of a market depends on the specific goods or services being examined.

1 Is the good excludable? That is, can people be prevented from using the good?

2 Is the good rival in consumption? That is, does one person’s use of the good reduce another person’s ability to use it?

Using these two characteristics we can divide goods in four groups:

1 Private goods are both excludable and rival in consumption An example of such a good is an ice-cream cone It is excludable because you can just don’t give it to a person Moreover it is rival in consumption, because if you eat an ice-cream cone, someone else cannot eat the same cone Most goods are private and in the previous chapters about supply and demand we tacitly assumed that the goods were private

2 Public goods are neither excludable nor rival in consumption As an example, you could think of a tornado siren in a small town No one can be prevented from hearing it and the fact that someone else gets benefit of hearing the siren does not mean that your benefit is being reduced

3 Common resources are rival in consumption but not excludable For example, fish in the ocean are rival in consumption: When one person catches fish, there are fewer fish for the next person to catch Yet these fish are not an excludable good because, given the vast size of an ocean, it is difficult to stop fishermen from taking fish out of it

4 Club goods are excludable but not rival in consumption You can think of fire protection as a club good It is excludable since the fire department can just let your house burn down, but it is not rival in consumption Once a town has paid for the fire department, the additional cost of protecting 1 more house is small

Sometimes, it may be difficult to group a good in a certain category because the boundaries are a bit fuzzy Nonetheless, grouping the goods according to the given characteristics will proof helpful in the remainder of the book.

Public goods

Public goods are not excludable nor rival in consumption They are related to several problems such as free riding Free riding means that you benefit from something without paying for it To determine whether a public good is profitable or not, the government should make a cost-benefit analysis

Suppose that a small town has 500 citizens and each citizen receives a benefit of $10 from seeing fireworks The total benefit for the town is thus $5000 and the costs are only $1000 Hence it is beneficial to have a fireworks display Would the private market produce an efficient outcome? Probably not! If an individual takes care of the firework and sells tickets for $8, she probably won’t sell a lot, because people notice that they can see the fireworks from anywhere, so it is not necessary to buy a ticket This type of problem is called free riding It means that you benefit from something without paying for it In this case, the government can take care of the problem by levying a tax of $2 for each citizen and organize the fireworks itself

Since there are so many public goods, we list three very important ones:

1 National defence: If the army prevents a country from being attacked, the whole society benefits from that So it is neither excludable nor rivalry in consumption Almost all people agree that a government should spend money on national defence, although the amounts of money spend varies a great deal from country to country The United States for example, spend a lot of money on national defence

2 Basic research: Governments can stimulate and promote basic research For example, if they fund a program that aims to develop medicines against cancer, a whole society benefits The common knowledge of fighting cancer is a basic good which can be helpful to anyone

3 Fighting poverty: Welfare programs are developed to give money to low- income families Advocates of antipoverty programs claim that fighting poverty

65 is a public good Even if everyone prefers living in a society without poverty, fighting poverty is not a “good” that private actions will adequately provide.

The value of public goods is also more difficult to measure compared to private goods

If a buyer enters the market for a private good, he reveals his value he puts on the product and the same holds for the sellers who produce it When the government is about to construct a new highway, it should make a cost benefit analysis That is, compare the costs to the benefits But since it is very difficult to calculate the benefit people receive from that highway, the government is forced to take other measures into account to reach a decision.

Common resources

Common resources, like public goods, are not excludable: They are available free of charge to anyone who wants to use them Common resources are, however, rival in consumption: One person’s use of the common resource reduces other people’s ability to use it Thus, common resources give rise to a new problem Once the good is provided, policymakers need to be concerned about how much it is used This problem is best understood from the classic parable called the

We know that common recourses are not excludable, but they are rival in consumption Common resources are often subject to what economists call “The tragedy of the commons” That is, since common resources are freely available to anyone, too many people make use of it, and thereby reducing the benefit of the good Consider for example a piece of land surrounding a small town where sheep can graze Everybody is allowed to let their sheep on the land, but as the amount of people grows, more and more sheep come to graze on the land So much that after a time there is no grass left and many of the sheep die This situation because people do not account for the negative externality they cause, namely that if you let your sheep graze on the land, the quality of the land decreases Several regulations can be imposed to solve this situation, for example allowing only a certain amount of sheep on the land Another effective action might be to tax the sheep that graze on the piece of land

In the real world, you often encounter situations similar to the one mentioned above The tragedy of the commons occurs many times when we talk about common resources Below we list some very important common resources:

1 Clean air and water: We saw that pollution is a negative externality You can view clean air and water as the piece of land mentioned above, and pollution is like grazing Environmental d degradation is a modern tragedy of the commons

2 Congested roads: If a road is not congested, it is more like a public good, but if it is congested, it is more like a common resource Since, if you hit the road, it becomes more crowded and people have to drive slower which causes a negative externality To solve this, the government might impose toll roads or other kind of taxes which reduces the amount of cars on the road

3 Fish, whales and other wildlife: The Ocean is one of the few places left in the world which is a regulated common resource People have been fishing so much the last decade such that some species even tend to extinct There is no easy solution to this problem, since the government has nothing to say about it

The design of the tax system

A financial overview of the US government

We give an overview of the US government and how the state and the local government use taxes to provide public goods The government is said to run a budget deficit when government purchases are higher than government revenue such as taxes The opposite of a budget deficit is a budget surplus

Many countries in the world have a tax system based on the height of someone’s income In the US, people pay a higher percentage the higher their income For example, someone who has an annual income of $34.000 pays only 15% tax of his income, whereas someone who’s earning $380.000 pays 35% tax on every dollar extra Concerning the tax rate, the average citizen in the US pays 28% of his income to taxes This is lower than most European countries, but significantly higher than most Asian countries like India or China The rule of thumb is that the richer the country, the higher is the tax rate The tax that the government receives is being spent on national security, income security, welfare, health and many other things In the US, the government is running a budget deficit for years, meaning that it spends more than it receives The opposite of a budget deficit is a budget surplus

Most of the tax paid goes to the federal government, but in the US you have two other institutions which earn taxes, namely the state and local government Just like the federal government, they spend money on public goods, but in smaller amounts and aimed more at smaller regions.

Taxes and efficieny

To examine the efficiency of taxes, we must analyse the effects of a tax before and after it was implemented Taxes are considered efficient when it minimizes deadweight loss Therefore, a lump-sum tax is the most efficient In a lump-sum system, everybody pays the same amount of tax This doesn't cause deadweight loss and there is barley no administrative burden

When the government designs a tax system it has two objectives: efficiency and equity The general conception is that people who earn more should pay more, but how should a government set a tax rate? A proper designed tax system should not

69 only account for the income people transfer to the government, but also for the deadweight loss it creates and the administrative burdens that taxpayers bear A government should at least try to minimize the deadweight loss that tax creates Besides the deadweight loss, people often complain about the difficulty of the tax system and all the rules they are committed to The less administrative burdens, the less time you have to spend to keep track of all your tax purposes such as receipts and less time to fill out all tax forms

When we are measuring the height of taxes paid, we usually distinguish between the average tax rate and the marginal tax rate As you might have guessed, the average tax rate is the total amount of taxes paid divided by your income The marginal tax rate is the extra taxes paid on an additional dollar of income If we are trying to gauge the sacrifice made by a taxpayer, the average tax rate is more appropriate because it measures the fraction of income paid in taxes By contrast, if we are trying to gauge how much the tax system distorts incentives, the marginal tax rate is more meaningful

While the Lump-sum Tax, where individuals pay a fixed amount regardless of income, is administratively efficient with no distortion of incentives, it faces criticism for perceived unfairness This tax system disregards income disparities, leading to the consideration of equity as a primary goal in designing tax policies, alongside efficiency.

Taxes and equity

In the previous paragraph we examined 1 goal of taxes; namely efficiency The other part, which will be considered in this paragraph is equity The benefits principle states that people should pay taxes according to the benefit they receive from government services The ability to pay principle states that taxes should be levied on a person according to how well that person can shoulder the burden

Different views on equity can lead to different kinds of tax systems

How do we judge whether a tax system is fair? There are many tax systems which are designed to address the question of equity; below we examine the most popular ideas

One principle of taxation, called the benefits principle, states that people should pay taxes according to the benefit they receive from government services The tax on gasoline, for example, is often justified using the benefits principle People who drive a lot pay a lot of gasoline tax and this, in turn, is used by the government to build new roads The same argument can be used to argue that wealthy people should pay more taxes than poor Wealthy people have more to loose and thus benefit more from police and fire departments and therefore they should pay more

Another principle of taxation, called the ability-to-pay principle, states that taxes should be levied on a person according to how well that person can shoulder the burden The ability-to-pay principle leads to 2 other important notions of equity; vertical and horizontal equity Vertical equity is the idea that tax payers with more income should pay a greater amount Horizontal equity is the idea that taxpayers with similar abilities should pay the same amount The 3 most encountered tax rates are given below:

 Proportional tax: This means that everybody pays the same percentage of income to tax For example, the tax rate can be 25% for every person

Someone who is earning $10.000 has to pay $2500, whereas someone earning

 Regressive tax: This means that people with higher income pay a lower percentage to the government For example, someone earning $10.000 pays 25%, and someone who is earning $50.000 pays 20%

 Progressive tax: That is, someone who is earning more pays a higher percentage of tax to the government than someone with a low income For example, you earn $20.000 and pay 10%, whereas someone earning $60.000 pays 30%

There is a lot of debate how taxes should be implemented and who pays for it So studying the tax incidence is the central study to equity When a tax is implemented, it is necessary to study the indirect consequences of a tax, such as altering supply and

71 demand People who are not trained in economics might argue that a tax on expensive fur increases equity, because only wealthy people buy it This might not be true, because people can switch to other alternatives, causing the demand for fur to decrease and therefore, the people who make the fur will be more affected by the tax This is contrary to the initial assumption that the wealthy people will be affected most

The costs of production

What are costs?

Profit maximization is a goal for firms, but production involves both implicit and explicit costs Accountants exclude implicit costs, like opportunity costs, while economists include them This distinction leads to a divergence between accounting and economic profit calculations.

Total profit is defined to be total profit = total revenue – total cost Total revenue is the amount of money a firm receives for selling its products Total cost is the market value of the inputs a firm uses in production Hence, to calculate total profit, we need to measure total revenue and total cost Total revenue is easy; it is just the amount of products sold times the market price If you were to sell 100 baseballs for $5 each, then total revenue is $500 The computation of your total cost is more involved

When we compute the total cost we distinguish between explicit and implicit cost Explicit costs are the easiest, because they are input costs that require an outlay of money Examples are wages you pay to your employees or flour you need to buy to make cookies Implicit costs do not require an outlay of money Suppose that you own a cookie factory, but are also skilled in computer science You could have earned $100 per day with programming, but instead you are managing your own factory This $100 is an opportunity cost and you should incorporate it in your calculation of total cost Hence, total cost is the sum of your explicit and implicit costs This calculation highlights an important difference between economists and accountants, accountants only use explicit costs, whereas economists also deal with implicit costs

Another important opportunity cost is that of capital If you invested $300.000 in your cookie factory, you could also deposit $300.000 on your bank account with 5% interest In this way, you could have earned $15.000 every year That is why $15.000

74 is the opportunity cost of your capital Again, this differs from what an accountant will recognize as a cost, because there is no money flowing out

We know that a firm’s objective is to maximize profit, but economic profit differs from

“accountant” profit Economic profit takes into account all the opportunity costs, whereas an accountant only takes into account the explicit cost That is why profit from the point of view of an accountant is larger than that from an economic point of view.

Production and costs

The marginal product of labour is the amount of extra output when you hire 1 more worker The production function shows the relationship between quantity produced and the amount of workers The rate of change of the production function becomes less steeper the more workers you hire This property is known as the law of diminishing marginal return The total cost curve shows the relationship between total cost and the amount of output

In the table below you see the total amount of labour units, total production of sandwiches, marginal product of labour (the amount of sandwiches extra produced if you hire 1 more worker) and the average product of labour The relationship between the amount of workers and the total sandwiches produced can be displayed by means of a graph This graph is called the production function, where the labour units are represented on the horizontal axis the total product is represented on the horizontal axis

Below you see an example of a production function:

Notice the shape of the graph, initially the slope is quite steep, but it declines when you hire more workers This can also be seen from the table above; the marginal product of labour is increases every time by fewer amounts This property is known as diminishing marginal product It simply means that the marginal product of an input declines as the quantity of the input increases

Besides the production curve we also have the total cost curve, which shows the relationship between costs and amount of input The total cost curve gets steeper the more input you use, this is opposite from the production curve, which becomes flatter and flatter The reason is obvious, if you have a lot of cooks, it becomes very expensive to prepare 1 extra meal Therefore the total cost curve becomes steeper the more input you use From a mathematical point of view, this means that the second derivative of the total cost curve is always positive.

The various measures of costs

Fixed costs remain constant regardless of production volume, while variable costs fluctuate with output levels The average total cost, derived by dividing the total cost by the number of goods produced, reflects the cost per unit, encompassing both fixed and variable expenses.

76 produced The marginal cost curve intersects the average total cost curve at its minimum When a firm produces this quantity it is said to operate at efficient scale

There are different kinds of costs related to production One of them is fixed costs; these are costs which do not depend on the number of goods you produce If you own a cookie factory and you have to pay rent every month, then rent is a fixed cost

It does not depend on the amount of cookies produced The opposite of fixed costs are variable costs, these are costs that do depend on the number of goods produced You could think of flour needed to produce cookies The more cookies you produce, the more flour you’ll need.

As the production process continues, you might want to investigate what it cost to make a typical cookie and what it cost to make one extra cookie If you can produce

100 cookies per hour at a cost of $10, then your typical cookie will cost $10/100 $0.10 This is the average total cost of your cookie Since we can divide total cost into fixed and variable cost, we can split average total cost into average fixed cost and average variable cost Average fixed cost is total fixed cost divided by total quantity and average variable cost is total variable cost divided by total quantity In formula form we have:

ATC = TC/Q where ATC = average total cost, TC = total cost and Q is quantity

MC = ΔTC/ΔQ , where Δ represents the change in a variable

When we defined the demand and supply curves, we saw that the demand curve was downward sloping and the supply curve had a positive slope We noted that the more we produce, the more the marginal costs rise Hence, the marginal cost curve is a linear curve with positive slope

Besides the mc curve, we also have the average total cost curve or ATC curve This curve is U-shaped, meaning that in the beginning of the production process, the ATC curve is falling the more goods you produce After a certain point, the ATC curve reaches its minimum and thereafter it’s rising again This is because in the beginning, fixed costs are divided among just a few products If you produce more goods, fixed costs will be divided among more products and therefore average total cost declines

When the ATC curve has reached its minimum, it begins to rise again because variable costs become more dominant than fixed costs The bottom of the U-shape occurs at the quantity that minimizes average total cost This quantity is sometimes called the efficient scale of the firm

Marginal cost and average total cost exhibit an inverse relationship, with the ATC curve descending when MC falls below it and ascending when MC exceeds it This correlation stems from the averaging effect on ATC When MC is lower than ATC, each additional unit of production reduces overall production costs, causing ATC to decrease Conversely, when MC exceeds ATC, each additional unit increases total costs, leading to a rise in ATC.

Costs in the short run and in the long run

Cost in the short run become variable in the long run A company which has a declining long run average cost curve is said to be an economy of scale The opposite is a diseconomy of scale When the ATC stays the same when production grows, a company is said to have constant returns to scale

Cost in the short run differs fundamentally from cost in the long run Consider a car company such as Ford In the short run, Ford cannot close or expand any factories because it takes an enormous amount of time, but this is possible in the long run Hence, factory costs are fixed in the short run, but variable in the long run How fast a company can adjust to economic circumstances, depends on the firm and the products it produces A coffee maker, for example, is way more flexible than a car company

The shape of the long-run average-total-cost curve conveys important information about the production processes that a firm has available for manufacturing a good If the long run average cost curve declines as output increases, we say that they are economies of scale On the opposite side, when long run average total cost rises when production grows, we say that it is a diseconomy of scale The last possibility is that the long run ATC curve stays the same when production grows, we then say that

78 it has constant returns to scale.

Firms in competitive markets

What is a competitive market?

In a competitive market, numerous sellers offer highly similar products, resulting in intense competition Average revenue, calculated as total revenue divided by total output, represents the earnings per unit sold Marginal revenue, on the other hand, measures the additional income generated from selling an extra unit In a competitive market, the marginal revenue is equal to the price, indicating that the market conditions limit the pricing power of individual sellers.

A competitive market or sometimes called perfectly competitive market has two characteristics:

1 There are many buyers and sellers in the market

2 The goods that are produced by the sellers are almost the same

A direct consequence of these two principles is that firms and consumers take the market price as given There is no way for a single firm to affect the market price The market for milk is an example of a competitive market, since there are so many producers and also many customers because almost everybody drinks milk Besides the 2 characteristics mentioned above, there is sometimes a third characteristic ought to characterize a competitive market:

 Firms can freely enter and leave the market

A firm in a competitive market tries to maximize its profit How should this be done? Since firms are price takers, we know that total revenue is equal to P*Q, where P is given First of all, we might ask what the average revenue is for a firm, that is: total revenue divided by the quantity Since total revenue = P*Q and the quantity is Q, we know that average revenue = P*Q/Q = P, hence average revenue equals the price Second, we may look at marginal revenue, the benefit of 1 extra unit of good produced If we produce 1 good extra, the extra revenue is the price of that good, which is given! So marginal revenue = P! One could also note this mathematically to take the first derivative of P*Q with respect to Q If the price for milk is $2, then producing 1 extra unit of milk gives you $2 extra benefit

Profit maximization and the competitive firm's supply

In a competitive market, firms produce at the point where marginal cost (MC) equals marginal revenue (MR), and MR equals the market price (P) This implies that MC equals P Additionally, the average revenue in a competitive market is equivalent to the price Consequently, the price in a competitive market is the minimum point on the average total cost (ATC) curve This equilibrium results in zero economic profit for firms operating in a competitive market.

The central question in this paragraph is: What quantity of goods should a firm produce in order to maximize profit? In the previous paragraph we noted already that marginal revenue was equal to the market price One of the 10 principles of economics stated that people always think at the margin If we apply this principle to firms, the question comes down to this: Should I produce an extra unit of goods? The germ of the answer lies in the comparison between marginal revenue and marginal cost If marginal revenue is greater than marginal cost, it is profitable to produce an extra unit of goods since I then increase my profit Suppose, on the other hand, that marginal cost is greater than marginal revenue, then I have to cut down production, since I make a loss if I produce an extra unit of goods The answer is, hence, that if a firm wants to maximize profit, it should produce until marginal revenue = marginal cost! Notice that, in our analysis of profit maximization, we were quite general, meaning that we did not assume the market was perfectly competitive This means that also in other market structures, such as monopolies, this rule applies If we assume a market is perfectly competitive, we know that marginal revenue = price Hence, in a competitive market, the rule becomes: price = marginal cost Because the marginal cost curve essentially shows the cost of supply of a competitive firm, the marginal cost curve is also the firms supply curve

In our analysis so far, we have been a bit incomplete, because a firm can also make a loss This means that total profit is negative Should a firm stop production? It depends, as we shall see, on total revenue and variable cost If a firm decides to stop production in the short-run, we say that it shuts down If a firm decides to completely leave the market, so that it will also close in the long-run, we say that a firm exits

If a firm shuts down, it loses all its revenue, but it saves the variable cost The fixed costs are already paid and should not be taken into consideration Hence, a firm

81 should shut down if total revenue < variable costs, or in a formula TR < VC This is known as the shutdown condition of a firm If we divide both sides of the inequality we obtain TR/Q < VC/Q, but TR/Q = price in a competitive market Hence, the shutdown condition pins down to the following inequality: P < AVC (average variable costs).So if the price is below the average variable cost curve, it will not produce anything at all So, the supply curve of a firm in a competitive market is the part of the mc curve which lies above the AVC curve The situation is depicted below Note that our analysis has dealt only with the short-run

Now that we considered the short-run decision of a firm, we are ready to explore the long-run What determines whether a firm exits or enters a market in the long-run? In the long-run, a firm not only saves the variable costs if it exits, but also the fixed costs Hence, a firm should exit the market if TR ATC, since it then makes a profit This leads to the following rule: The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost

How can we measure profit/loss in a graph? We know that profit = TR – TC Q*(TR/Q – TC/Q) = Q*(P-ATC) The red rectangle below shows the profit of a firm It produces an amount of Q goods represented on the horizontal axis, the price is P and average total cost is the AC curve The area of the rectangle is the profit you make

The supply curve in a competitive market

The long run supply curve of a competitive firm is horizontal Moreover, in the long run firms operate at efficient scale, because of profit maximization

We distinguish two cases in a competitive market, namely where the number of firms is fixed (short-run) and the case where the number of firms is variable (long-run)

In the short-run, we consider decisions of firms over a short time horizon In a short period of time, it is often difficult for a firm to enter or leave the market, therefor the assumption that the number of firms is fixed in the short-run is appropriate As long as the price is above average variable costs, each firm’s marginal cost curve is the supply curve To find the market demand, we simply add up all the quantities supplies of every firm For example, if there are 1000 firms in a market, each supplying 200 units of goods, then market supply is 200.000

It is more interesting to see what happens in the long-run, when firms are free to exit and enter a market If firms make profit, more firms will enter the market and profit will go down for each firm Similarly, if firms make a loss, some firms will leave the

In a competitive market, as quantity increases, profit decreases until reaching zero With profit expressed as Q*(P-ATC), when profit equals zero, P is equal to ATC Since P also equals MC in a competitive market, it follows that ATC equals MC in the long run The MC curve intersects ATC at its minimum, indicating that firms must operate at their efficient scale As a result, price equals the minimum ATC in the long run, leading to a horizontal supply curve.

The question remains: why would a firm stay in business if it makes 0 profit? The answer is that if a firm makes 0 profit, it is still compensated for all the costs it makes, including opportunity costs Consider a farmer who invested $1 million in his company If he would have deposited the money on a bank account, he could have earned $50.000 per year, moreover if he did not start the company, he could have worked at a restaurant for $30.000 per year Hence, his total opportunity costs are

$80.000 If the farmer is making 0 profit, he is still compensated for this $80.000 Again, notice the difference between economic and accountant profit An accountant, who would look at your balance, would conclude that you made a profit of $80.000, since there is no $80.000 flowing out

Monopoly

Why monopolies arise

A firms is a monopoly when it is the sole seller of a product and the product does not have any close substitutes There are 3 reasons why a monopoly can arise: monopoly resources, government regulation and differences in production

A firm is a monopoly when it is the sole seller of a product and the product does not have any close substitutes The fundamental cause of the existence of a monopoly is the barrier of entry This means that other firms cannot compete with the monopoly This barrier of entry has 3 main causes

1 Monopoly resources: This means that a key resource in order to produce the good is owned by a single firm

2 Government regulation: The government gives some firm the exclusive right to produce some good or service

3 The production process: A single firm can produce output at a lower cost than can a larger number of producers

Barriers to entry are primarily driven by resource monopolies In competitive markets with ample resources (e.g., water wells), prices are driven down to average variable costs However, when a single entity controls a critical resource (e.g., the sole water well in a city), it can manipulate prices to its advantage However, resource monopolies are becoming increasingly rare due to globalization and stricter government regulations, making them less common today.

The second cause was government regulation In the past, kings and queens often granted their friends and allies with exclusive business licenses These created monopolies due to the government, but nowadays the common cause for government created monopolies are patents and copyrights The government has laws for this, because it considers it beneficial for society Consider a pharmaceutical company which has found a new medicine, if the government thinks it is truly original it can give a right to the company to be the only producer The same holds for copyrights, if you write a book then no one is allowed to copy it without your permission Although creating these monopolies bears a cost to society, the benefit of these actions often overshadows the cost

The last form was a natural monopoly You could think of a bridge as a natural monopoly If it is used so infrequently that the bridge is never congested, then it is a club good A toll collector could exclude you from using the bridge, but it is not rival in consumption Often club goods, or public goods give rise to a natural monopoly Again, if the bridge becomes more congested, new bridges might be build and the market structure moves to a competitive one.

How monopolies make production and pricing

A monopoly produces until MR=MC Because the demand curve in a monopolistic market is downward sloping, a monopoly has to deal with 2 effects: the output effect and the price effect In a monopolistic market P > MR This means that a monopoly is able to make profit, even in the long run

The key difference between a monopolist and a competitive firm is that a monopolist can influence the market price If a monopolist chooses a low output, price will be high and a high output results in a low price We also noticed in the previous chapter that market demand for an individual firm was perfectly elastic, if a firm were to higher the price, it would not sell anything The demand curve of a monopolist is linear instead

Because monopolies can influence the price, the analysis for total revenue becomes different from that of a competitive firm A monopoly can increase the amount of goods, but this has two consequences:

1 Output effect: When they increase the amount of goods, more goods will be sold which raises total revenue

2 Price effect: Because a monopoly produces more goods, the price of the good falls This will decrease total revenue

So how does a monopoly determine the optimal output to maximize profit?

Completely analogous to the previous chapter, it will produce until marginal revenue equals marginal cost We know that in the case of a competitive firm, this rule also implied that price was equal to marginal cost This is not the case for a monopoly In fact, for a monopoly we have P > MR = MC So a monopoly determines the output such that MR=MC, but how does it set the price The price is equal to the height of the demand curve corresponding to the optimal quantity We will show that the price is crucial in understanding the cost to a society Again, given the demand and cost curves of a monopoly, we can measure profit according to the following formula: Q*(P-ATC).

The welfare cost of monopolies

The main cost to society of monopolies so deadweight loss Deadweight loss occurs because prices are set above marginal revenue From this point of view, monopolies can be seen as a private tax collector

As we have seen, a monopolist charges a price higher than his marginal cost This means that the price is higher than in a competitive market, which is bad from the standpoint of the buyers, but good from the standpoint of sellers since it increases profit If you were a social planner, you would set the quantity produced at the point where total surplus is maximized We know that total surplus is equal to the value of the good to consumers minus the costs of the good to producers The willingness to buy is measured by the demand curve and the cost of a firm is measured by the marginal cost curve Hence, the socially efficient quantity is found where the demand curve intersects the marginal cost curve But a monopoly produces less, since it produces at the quantity where MR=MC Hence, from the standpoint of society, a monopoly does not maximize total surplus Instead, it creates deadweight loss, since some customers do not buy the product, because the price is too high

The situation is shown above The yellow triangle represents the deadweight loss This deadweight loss is the same as with taxation A monopoly is like a private tax collector; because of its market power it can charge a higher price than necessary The fact that a monopoly does charge a higher price does not mean it reduces economic welfare, it only means that a larger part of the economic pie goes to producers.

Price discrimination

Price discrimination is prevalent in the economy Monopolies use it to increase profit Examples of price discrimination include movie tickets, discount coupons, financial aid and quantity discount Perfect price discrimination barely occurs because it is too costly to investigate everyone's willingness to pay

So far, we have assumed that monopolies charge everyone the same price, but this assumption is often violated in reality Price discrimination means that a firm charges different prices to different persons, even though the costs of production are the same A firm must have some market power in order to apply price discrimination; otherwise customers won’t buy your product anymore, since they think the price is too high Suppose that you are the owner of a book publishing company and your best author has just written a new book You pay the writer $2 million to get the

89 copyright of the book Research has shown that there are 100.000 die-hard fans who want to pay $30 for the book and there are 400.000 less interested readers who want to pay $5 for the book What price should you charge? Simple arithmetic shows that you have to charge $30 to make most profit But suppose now that the die-hard fans all live in the US and the less interested fans all live in Australia Moreover, it is difficult to get a book from the US if you are living in Australia Then you can charge

$30 in the US and $5 in Australia This increases profit by $2 million! This might seem a bit unrealistic, but this happens a lot

Price discrimination maximizes profit through customized pricing based on individual willingness to pay However, its effectiveness relies on the prevention of arbitrage, a practice that undermines price disparities Surprisingly, price discrimination reduces deadweight loss, as seen in the example of a book in Australia By offering a lower price, monopolists eliminate the loss that would occur if they sold at a uniform, higher price While measuring the exact profit increase can be challenging, it is evident that price discrimination benefits monopolists by raising their profits.

We will now list some common examples of price discrimination:

 Movie tickets: Many movie theatres charge lower price for seniors and young children This is because these 2 groups are less likely to go to the cinema

 Airline prices: Most airlines charge lower prices for people who make a round- trip between 2 cities if they stay over a Saturday night This is because an airline wants to distinguish 2 groups: Business men and tourists Business people often have a higher willingness to pay, so they have to pay more money

 Discount coupons: Rich people are less likely to cut out a coupon and use it in the shop because they have enough money, whereas poor people are more

90 likely to cut it out and use it Since rich people have a higher willingness to pay, this is a successful price policy

 Financial aid: Universities often offer financial aid to students who cannot afford it, or are very bright This separates rich people from the poor ones, since rich people have I higher willingness to pay for college

 Quantity discount: A donut company might charge $0.50 for a donut, but $5 for a dozen This is often a successful policy, because people tend to buy more

In this way, people who buy more are positively discriminated

Public policy toward monopolies

In response to monopolies, governments have various options They can enforce antitrust laws to prevent the formation or break up of monopolies Alternatively, governments can regulate the market, setting rules to promote competition and protect consumers Governments may also choose to do nothing and let market forces determine the outcome Another strategy is public ownership, where the government provides essential goods and services like electricity and water directly.

We have seen that monopolies are not desirable from the standpoint of a society Policymakers can respond to monopolies in 4 ways:

• By trying to make monopolized industries more competitive.

• By regulating the behaviour of the monopolies

• By turning some private monopolies into public enterprises

• By doing nothing at all.

One way to make monopolized industries more competitive is to implement antitrust laws Suppose Coca cola and Pepsi want to merge, which would make the company the biggest soft drink supplier in the world The government (US) could prevent this based on antitrust laws These laws permit the government to prohibit the merging between the two companies Antitrust laws are aimed to preserve economic freedom and competition in a market

Another way of dealing with monopolies is by means of regulation The government can simply forbid companies to sell products above a certain price It can go even

91 further, namely that the government sets the price Although this might seem quite successful, in practice you’ll encounter a lot of difficulties For example; what price should a government set? You would think that the price should be set at the level where it equals marginal cost, because it maximizes total surplus But if that price is below average total cost, the monopoly will incur a loss and would exit the market The government might compensate the monopoly with extra money to cover the loss, but then the government has to raise taxes in order to pay that money That itself will cause deadweight loss!

Instead of setting all these rules, the government could simply choose to run the monopoly itself This type of measure is called public ownership Economists usually prefer private ownership to public ownership This is because a private company cares about the costs it incurs, whereas a government regulated company would care less because it is heavily subsidized

The last thing you could do, is do nothing Because all policies have their drawback, some economists argue that doing nothing is the best thing

Monopolistic competition

Between monopoly and perfect competition

There are 2 market forms which lie between monopoly and perfect competition: oligopoly and monopolistic competition An oligopoly is a market with few sellers

93 and many buyers A monopolistic competitive market is one with many sellers with similar but not identical products

In chapter 14 and 15 we analysed to extreme cases of market forms: competitive and monopolistic markets In reality, such extreme market forms are rarely encountered More often, market forms lie between competitive and monopolistic markets One such market form is an oligopoly; a market with a few sellers and many buyers The second type of market structure is called monopolistic competition In such a market there are many sellers with similar but not identical products Therefore these firms have a downward sloping demand curve, although they compete for the same customers To be more precise, a market with monopolistic competition adheres to the following principles:

• many sellers: There are many firms competing for the same group of customers

• Product differentiation: Each firm produces a product that is at least slightly different from those of other firms Thus, rather than being a price taker, each firm faces a downward-sloping demand curve

• Free entry and exit: Firms can enter or exit the market without restriction Thus, the number of firms in the market adjusts until economic profits are driven to zero

Examples of this type of market structures include: the DVD market, computer games or restaurants In reality, it is often hard to distinguish fuzzy terms like few or many, and whether a market is regarded as monopolistic competition often depends on more factors.

Competition with differentiated products

Two features describe a monopolistic competitive firm in the long-run: price exceeds marginal cost and price equals average total cost This means that such a firm does not make profit in the long run A monopolistic competitive market can cause 2 externalities: the product variety externality and the business stealing externality

How sets a firm in a monopolistically competitive market the quantity produced in order to maximize profit? First, let’s consider the short-run Since a firm faces a downward sloping demand curve, it sets the quantity produced at the point where

94 marginal revenue equals marginal cost (MR=MC) This is the same as for a firm in a monopolistic market, but different from a firm in a competitive market, because they face a horizontal demand curve The price is consequently found at the height of the demand curve which corresponds to the produced quantity

Let’s now consider the long-run If firms are making profit, there is an incentive for new firms to enter the market Incumbent firms consequently experience declining profit, since demand falls The opposite happens when firms make a loss; they will leave the market and demand increases In either case, this process goes on until firms make 0 profit! Notice the similarity with a competitive market

Because profit is driven down to 0, long run demand and average total cost must be equal This is because demand represents the price and in the long run price equals average total cost This happens also at the point where MR=MC, this is off course not a coincidence, since this is the point where profit is maximized

To sum up, there are two characteristics that describe long-run equilibrium in a monopolistically competitive market:

 As in a monopoly market, price exceeds marginal cost This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downward-sloping demand curve makes marginal revenue less than the price

 As in a competitive market, price equals average total cost This conclusion arises because free entry and exit drive economic profit to zero

There are two main differences between monopolistic and perfect competition:

1 Excess capacity: We saw that a firm in a monopolistic competitive market produces at a quantity where price is above marginal cost This is a key difference between perfect competition, where price equals marginal cost Moreover, firms in a monopolistic competitive market do not produce at the point which minimizes average total cost This is because profit would decline if they were to produce at this quantity

2 Mark-up over marginal cost: In both markets, we saw that in the long run firms would make 0 profit This does not imply that price has to equal marginal cost; it only means that firms produce the quantity where price equals average total cost In fact, for a monopolistically competitive firm, price is higher than marginal cost This induces a difference in behaviour; a competitive firm would not care to get an extra customer, since it would make 0 profit on that extra customer, but for a monopolistically competitive firm it does matter since it would gain additional profit

The cost to society of monopolistic competition are harder to measure and is often more subtle compared to monopolies or competitive firms We know that in a competitive market total surplus is maximized and in a monopoly market deadweight loss is created Also with monopolistic competition, deadweight loss is created because price is unequal to marginal cost It is not easy to regulate this problem as a policymaker, because different firms sell different products (although similar)

Regulating all these firms would create a huge administrative burden, which offsets the gain to society Another problem associated to monopolistic competition is that there may be either too few or too many firms This has two causes:

1 Product variety externality: Consumers get additional surplus if a new product enters the market Therefore, the entry of a new firm conveys a positive externality

2 The business stealing externality: Other firms lose business if new firms enter

Depending on which externality is larger, a monopolistically competitive market could have either too few or too many products.

Advertising

Advertisement has pros and cons Critics argue that advertisement can lead to a reduction in competition and can give a wrong message about the product itself Advocates argue that advertisement leads to better products and an increase in competition

It is almost impossible these days to spend a day without being bombarded with advertisements Some economists are pro advertisement, others are against it Critics of advertisement argue that firms manipulate the tastes of people Most commercials don’t tell anything about the price or quality of their product They just show a bunch of happy people drinking their soft drink If you watch the commercial, you might think that drinking a certain brand also gives you a lot of friends This way your taste gets influenced Also, criticizers argue that commercials impede competition Often, firms give a message that their product is truly different from all the other ones, when it is not the case This too can influence consumers in a negative way

But, there are also many arguments in favour of advertising Consider for example big brands like McDonalds or G-Star These brands are so huge that they are known all over the world, this is partly due to extensive advertisement Because these companies are so huge, they have a great incentive to work according to the rules If someone finds out that McDonalds is using contaminated meat or that G-star is using children to produce their clothes, they will lose a great amount of money Bad publicity is the last thing a company wants and the big firms have a lot to lose

Oligopoly

Markets with only a few sellers

Oligopolies are best off when they operate like a monopolist, but self-interest drives them to a point closer to perfect competition When oligopolistic make agreements about prices they are said to collude Because the government wants to increase competition, colluding is often prohibited When oligopolies have reached a point where they do not want to change, they have reached the Nash equilibrium

Because there are only a few sellers in the market, all firms have quite some market power It would be the best for the sellers to cooperate and act like a monopoly,

98 because then they earn the most revenue Yet because each oligopoly cares only about its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the cooperative outcome

Let’s consider a concrete example Suppose John and Jack both own a well in a small town These are the only 2 wells in town, so we say that the market for water is a Duopoly In the table below, total demand is shown for water is shown together with the corresponding price and total revenue

Quantity Price Total Revenue and Profit

Before we look at what happens with John and Jack, we first study the 2 extreme

99 cases if the market was perfectly competitive or monopolistic If the market was perfectly competitive, Price would equal marginal cost Since we assume that the marginal cost of pumping an additional gallon of water is 0, the price would also be zero and the quantity produced would be 120 gallon Suppose on the other hand that the market was a monopoly, then a firm would set the quantity at which profit is maximized From the table we see that this happens at 60 gallons of water

Since John and Jack together serve the market, there are several outcomes possible One possibility is that John and Jack make an agreement about the quantity produced and the price Such an agreement among firms over production and price is called collusion, and the group of firms acting in unison is called a cartel If this happens, the market is basically a monopoly and the rules of a monopolistic market apply John and Jack together produce 60 gallons of water and profit is maximized They still have to make an agreement over what amount each has to produce If they both produce 30 gallons, each receives a profit of $1800

This outcome seems plausible, but in reality it’s not Antitrust laws often forbid this type of behaviour of firms and firms often cannot agree on the amount produced by each member As so, we will consider what happens of John and Jack act individually John reasons: “If Jack produced 30 gallons, I could do the same Then my profit would be $1800 (30*$60) Alternatively, I could produce 40 gallons, then the price falls to 50 and my profit will be $50*40 = $2000 > $1800.” Hence, John will produce 40 Gallons

If Jack applies the same logic, he too will produce 40 Gallons and the total quantity produced will be 80 gallons with a price of 40 Therefore the total profit of each firm is $1600 The reason why both firms do not reach the monopolistic outcome is that both have an incentive to change their level of production If this is the case, why don’t they reach the perfectly competitive outcome of 120? If John applies the same logic, he reasons as follows: “If I were to increase my production to 50 gallons, price will drop to $30 Then my profit will be 50*$30 = $1500 < $1600.” Hence both firms do not have an incentive to change their level of production Such a situation is called a Nash equilibrium, named after the great mathematician John Nash It is a situation in which both players have no incentive to change Nash proved that such an

100 equilibrium always exists in a certain type of game In summary: If an oligopoly individually chooses the quantity it produces, then the price will be less than in the case of a monopoly, but higher than in the case of perfect competition

Hence, if an oligopoly decides what quantity it produces, it has to account for 2 effects:

 The output effect: Because price is above marginal cost, producing 1 extra unit of good gives profit

 The price effect: Raising the total production will decrease the price This, in turn, affects profit

If the output effect is greater than the price effect, an oligopoly should increase production and vice versa As a final result, we mention the following conclusion: As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

The economics of cooperation

The prisoners dilemma shows why self-interest drives people to make other decisions than when they would cooperate A dominant strategy refers to a strategy which is best in each case, no matter what your opponent is doing The prisoners dilemma has a dominant strategy for both players

A nice example of why cooperation might not work is called the prisoners dilemma The situation is depicted in the matrix below Two prisoners are being suspected of a robbery and face a long sentence to jail The numbers in the matrix represent the years they go to jail if they either talk or lie (the left coordinate corresponds to prisoner 1) For example, if prisoner 1 lies about the robbery and prisoner 2 confesses, then prisoner 1 gets 10 years of prison whereas prisoner 2 goes free

The question is: What will be the outcome of this situation? If the prisoners could cooperate, the outcome would be that both lie about the robbery They would both get 1 year of prison But if they could not cooperate, for example they are separated from each other, then the outcome would be different Prisoner 1 reasons as follows:

“If prisoner 2 were to confess, then I should confess too But if prisoner 2 would lie, the best thing for me to do would again be to confess!” Hence, in either case, prisoner

1 should always confess The same logic applies to prisoner 2 Therefore, the outcome will be that both prisoners confess which gives them both 8 years of prison

In this case, we say that confessing is a dominant strategy, because it is the best strategy for a player regardless of what the other player can do

The type of game described above applies to many situations, for example the oligopoly market where Jack and John operated Producing 40 gallons of water was a dominant strategy for both players and hence that was the outcome in the end This illustrates why oligopolies have trouble maintaining monopoly profit There is a mutual incentive to cheat

Since the prisoners’ dilemma applies to so many situations in real life, we can ask what the benefit is to society In the case of an oligopoly, we saw that the incentive to cheat moved both firms closer to the competitive outcome, which is positive from the standpoint of society Put differently, the invisible hand guides markets to allocate resources efficiently only when markets are competitive, and markets are competitive only when firms in the market fail to cooperate with one another

Still, in real life, some people still choose to cooperate This may happen if some type of prisoners’ dilemma is played very often Consider again the example of Jack and John If they could only once decide what quantity to produce, self-interest will drive them to produce 40 gallons each But if they had to decide every week what quantity to produce, they could make a threat against the other to not cheat John could say to Jack: “We both produce 30 gallons each week! If you produce 40 gallons in a certain week, then after you did that I will produce 40 gallons forever!” If both guys make this threat against one another, then both remove the incentive of cheating.

Public policy toward oligopolies

As we have seen, cooperation between oligopolies leads to undesirable outcomes One of the ten principles of economics said that the government can improve market outcome Therefore, the government should prevent oligopolies from working together in order to produce a socially more desirable outcome There are 3 types of controversial market behaviour which the government forbids: Resale price maintenance, predatory pricing and tying

We will now examine public policies towards oligopolies One way to discourage cooperation is through common law Again, antitrust laws play a key role in enforcing these laws The government can prevent oligopolies from acting together in ways that would make their market less competitive Among economists, there is a general consensus that price fixing agreements should be illegal But over time, antitrust laws prohibited other kinds of market behaviour, which is considered controversial

We consider 3 examples of such market behavior:

 Resale price maintenance: Imagine that Super-duper Electronics sells DVD player for $300 to retail stores If Super-duper requires the retail store to sell the product for $350, it is said to engage in resale price maintenance At first this might seem anticompetitive, yet some economists defend resale price maintenance on 2 grounds First, they argue that less competition is not in the interest of Super-duper Electronics This would reduce the quantity sold, and

SA MP LE hence, give less profit to Super-duper Second, economists believe that resale price maintenance has a legitimate goal Super-duper may want its retailers to provide customers a pleasant showroom and a knowledgeable sales force Yet, without resale price maintenance, some customers would take advantage of one store’s service to learn about the DVD player’s special features and then buy the item at a discount retailer that does not provide this service

 Predatory pricing: Predatory pricing is a way of eliminating competition

Suppose you have the monopoly over airlines, but another company enters the market and wants to compete To eliminate your competitor, you would make the price so low that your opponent goes bankrupt After this, you raise the price of flying again Some economists argue that predatory pricing is never a useful strategy, because if you would make the price below your costs, you’d make a loss

 Tying: Suppose Moviemakers produced two films: Tarzan and Home Alone If

Tying, or selling two products together at a single price, is often deemed illegal as it allows firms to extend their market power through profitable products to less profitable ones However, economists argue that this is not always the case, citing the example of a theater's willingness to pay a certain amount for a blockbuster movie like "Tarzan" regardless of the profitability of a bundled unprofitable movie like "Home Alone." The practice of tying may arise due to price discrimination, where different theaters are willing to pay varying amounts for the same products, allowing studios to maximize their profits.

$5000 for Home Alone, and another theatre is willing to pay $5000 for Tarzan and $15000 for Home Alone, then a firm could charge $15.000 for every film and it would make $30.0000 revenue Yet, if they were to ty the two films for

$20.000 each, then both theatres would by it and a firm would make $40.000 revenue

The markets for the factors of production

The demand for labor

The labour market, like any other market, is governed by the forces of supply and demand Although price and quantity are changed into wage and quantity of labour respectively You could think of the number of apple pickles on the horizontal axis

105 and the wage on the vertical axis The marginal product of labour is the extra output resulting from hiring 1 extra worker The marginal product of labour is diminishing, just like the marginal cost A firm hires people up to the point where the value of the marginal product of labour equals the wage

First, we will consider firms in a competitive market, for both goods and labour One could think of an apple producer, who owns an apple orchard He sells his apples in a competitive market, so there are many apple sellers, and he buys the labour in a competitive market, meaning that there are many apple pickers Hence, the firm has little influence on the price and only cares about profit maximization

Labor Output Marginal product of labor

Value of marginal product of labour Wage Marginal profit

The marginal product of labor represents the additional output generated with each additional unit of labor By multiplying the marginal product of labor by the prevailing market price, we obtain the value of the marginal product of labor Firms seeking to maximize profits should determine the optimal labor quantity where the value of the marginal product equates the marginal cost of labor, which is typically the wage rate This principle aligns with the MR=MC rule, as employing additional workers is beneficial if their marginal contribution exceeds their marginal cost (wage).

106 product is above marginal cost Hence, in our example above, the firm should hire 3 workers This is also why, in a competitive market, the firms labour demand curve is the value of marginal product of labour curve, since at every given price this curve gives you the quantity of labour demanded

The demand curve for labor is influenced by several factors, including product price and technological advancements Changes in product price directly impact the value of labor, leading to increased labor demand with higher prices Technological progress, despite potential job displacement in specific sectors, has overall driven increased labor demand This phenomenon, known as the "productivity paradox," explains rising employment even in the face of wage increases.

150 percent during the last half of the century, firms nonetheless increased the amount of labour by 87% A third cause for changes in labour demand is the supply of other factors A fall in the supply of ladders, for instance, will reduce the marginal product of apple pickers and thus the demand for apple pickers.

The supply of labor

The labour supply is upward sloping, since a higher wage encourages more people to work Several causes can shift the labour supply curve: A change in tastes, changes in alternative opportunities and immigration

Individuals participate in the labor market by offering their skills to firms in exchange for monetary compensation This decision stems from the fundamental trade-off between work and leisure Individuals must weigh the opportunity cost of leisure, calculated as their hourly wage, against the value they derive from non-working time By working an hour and earning $15, an individual forfeits the opportunity to engage in leisure activities that could have otherwise provided them with equivalent satisfaction.

TV at home, then your opportunity costs were $15 It is worth noticing that the labour supply curve need not be upward sloping, if you earn more, you might choose for

107 more leisure than before, because you can better afford it Again, there are many causes that shift the labour supply curve A change in tastes is one of them Forty years ago, there was just a small fraction of women willing to work Now that fraction has risen to 59% This change is partly due to a changing attitude towards women and work Changes in alternative opportunities are another cause If the wage of pear pickers were to rise, some apple pickers might decide to change business, which in turn, increase the supply for labour in the pear picking market A third possible cause of changes in labour supply is immigration In most European countries, more and more immigrants come to Europe, thereby increasing the supply of labour, whereas the supply in their home countries falls There is much debate going on about how this affects equilibrium wage

18.3 Equilibrium in the labour market

Equilibrium in the labour market occurs where labour supply equals labour demand The wage serves as the tool to balance supply and demand For a specific market, the wage always equals the value of the marginal product of labour

So far we have established two facts about how wages are determined in competitive labour markets:

• the wage adjusts to balance the supply and demand for labour

• The wage equals the value of the marginal product of labour

These two facts immediately lead to the following observation: Any event that changes the supply or demand for labour must change the equilibrium wage and the value of the marginal product by the same amount because these must always be equal

Suppose that due to immigration, labour supply for apple pickers increases Therefore, the labour supply curve shifts to the left and as a result, workers earn less wage but more people are employed Since the number of workers increases, the marginal product of labour decreases and consequently also the value of the marginal product of labour

Besides the changes in labour supply, it is also possible that labour demand changes

If, for example, apples suddenly become more popular, the price of apples will rise Hence, it is more profitable to produce apples and labour demand will increase In this case, marginal product of labour will not change, but the value of it does change, because of a higher price Again, we see that the value of the marginal product of labour changes with the labour demand As a result of the increase, more workers will be hired and they earn a higher wage

18.4 The other factors of production: Land and capital

Besides labour, land and capital can be used to produce products In analogy with the marginal product of labour, we define the marginal product of land and capital The cost of land is the rental price and the cost of capital is the purchase value

We have seen that firms hire workers to produce their product, but there are two other factors of production that can be used to produce a certain good: Land and Capital The definition of land is clear; if someone wants to produce apples he needs land to produce them on The definition of capital is trickier

Economists use the term capital to refer to the stock of equipment and structures used for production For example, an apple producer also needs ladders to climb the trees, trucks to transport the apples and buildings used to store the apples

Like in the labour market, we can look at equilibrium in the capital and land market Before we do that we must distinguish two prices: the purchase price and the rental price When you purchase a piece of land or capital, then that is yours forever If, instead, you were to rent a piece of land or capital, then you pay to use it for a limited amount of time It is important to make this distinction, since both prices are determined by different market forces But the analysis for the capital and land market is completely analogue to the labour market The demand for capital and labour is determined by the value of the marginal product of the factor of production

In equilibrium, the value of the marginal product equals the factors price

The marginal product of any factor, in turn, depends on the quantity of that factor that is available Because of diminishing marginal product, a factor in abundant supply has a low marginal product and thus a low price, and a factor in scarce supply has a high marginal product and a high price As a result, when the supply of a factor falls, its equilibrium factor price rises.

The other factors of production: Land and capital

Besides labour, land and capital can be used to produce products In analogy with the marginal product of labour, we define the marginal product of land and capital The cost of land is the rental price and the cost of capital is the purchase value

We have seen that firms hire workers to produce their product, but there are two other factors of production that can be used to produce a certain good: Land and Capital The definition of land is clear; if someone wants to produce apples he needs land to produce them on The definition of capital is trickier

Economists use the term capital to refer to the stock of equipment and structures used for production For example, an apple producer also needs ladders to climb the trees, trucks to transport the apples and buildings used to store the apples

Like in the labour market, we can look at equilibrium in the capital and land market Before we do that we must distinguish two prices: the purchase price and the rental price When you purchase a piece of land or capital, then that is yours forever If, instead, you were to rent a piece of land or capital, then you pay to use it for a limited amount of time It is important to make this distinction, since both prices are determined by different market forces But the analysis for the capital and land market is completely analogue to the labour market The demand for capital and labour is determined by the value of the marginal product of the factor of production

In equilibrium, the value of the marginal product equals the factors price

The marginal product of any factor, in turn, depends on the quantity of that factor that is available Because of diminishing marginal product, a factor in abundant supply has a low marginal product and thus a low price, and a factor in scarce supply has a high marginal product and a high price As a result, when the supply of a factor falls, its equilibrium factor price rises

Earnings and discrimination

Some determinants of equilibrium wages

Equilibrium wages are influenced by various factors, including compensating differentials, which refer to wage differences resulting from non-monetary job characteristics These differentials, along with human capital, labor unions, efficiency wages, and individual abilities, play a crucial role in determining wage levels.

Some jobs are more desirable than others This desire does not only depend on the wage earned Here we will examine other determinants that influence the demand and supply of labour Economists use the term compensating differential to refer to a difference in wages that arises from nonmonetary characteristics of different jobs Compensating differentials are prevalent in the economy

Another important factor in the height of your income is human capital Human capital is the accumulation of investment in people such as education In the US for example, students with a college degree earn twice as much as youngsters without a college degree Some economists propose a different theory regarding college degrees They argue that employers do not hire you (with college degree) because you have so many skills, but you give a signal to employer that you have higher abilities For someone with high abilities, they argue, it is easier to get a college degree then for someone with low abilities The fact that you have a degree gives a signal to the employer that you have more abilities and therefore you are hired

Further determinants of wage include ability; this explains why people in the major league get paid more than people who play in the minor league Certainly, higher wage is not a compensating differential, because playing in the minor league is not less pleasant than playing in the major league This is because you have more ability

112 than other player, and because a very high ability is rare in these kind of sports, you get paid a high wage Effort also plays an important role Productive people often get paid a higher wage than laze ones And chance is a very important determinant in the wage Chance also plays a role in determining wages If a person attended a trade school to learn how to repair televisions with vacuum tubes and then found this skill made obsolete by the invention of solid-state electronics, he or she would end up earning a low wage compared to others with similar years of training Although research has shown that in reality ability, effort, human capital and all these other factors contribute to your wage, this only explains 50% of the variation The other 50% is depending on luck and chance

Most differences of wages are explained through the model of supply and demand, where wages are used to bring the market into equilibrium Still, sometimes wages are set above equilibrium level For example, in chapter 6, we saw that the government could set minimum wages, which are usually above equilibrium level A second reason might be that Labour Unions make agreements with employers about the height of the wage Usually, these wages are above equilibrium level Unions have a lot of influence and can threaten with a strike if the employers do not agree with the proposed wages A third reason might be due to efficiency wages; wages are set above equilibrium level to encourage people to work at a particular firm Because people get paid more, they tend to be more productive and hence, in some situations, efficiency wages can be profitable.

The economics of discrimination

Discrimination arises when individuals with comparable characteristics (race, ethnicity, gender, age, etc.) face unequal opportunities in the marketplace Economists strive to examine discrimination impartially, setting aside personal biases, to understand its causes and consequences in an objective manner.

In the US, black men earn significantly less than white men Moreover, women are earning less than the average man You might be tempted to conclude that employers in the US discriminate, but just comparing these broad groups is wrong The

113 difference could also be due to the reasons mentioned in the previous paragraph, for example human capital In the US, whites are 75% more likely to have a college degree than blacks, hence, part of the difference in wage can be attributed to the level in education

Compensating differentials can also partly explain the difference between man and woman For example, women are more likely to work as a secretary, whereas a man is more likely to become a truck driver Because some professions (that are more dangerous) are mainly executed by men, these jobs pay more and therefore this takes away some of the discrimination There is much debate about how much discrimination is contributing to the differences in wage among various groups of people

In competitive market economies, the profit motive serves as a potent countermeasure to employer discrimination When firms prioritize hiring specific demographic groups, such as brunettes over blondes, the lower demand for blondes reduces their wages However, this creates an opportunity for firms to capitalize on the wage differential by hiring blondes at a lower cost, leading to a gradual shift in hiring practices as firms seek to maximize profits.

“blond” firms will enter the market which eventually drives up the equilibrium price.

The validity of the argument that restaurants hiring only brunette waiters would eliminate wage differentials depends on consumer preferences and government regulations If consumers are solely driven by price and food quality, competition from new restaurants hiring blonde waiters would stabilize wages However, if consumers exhibit a preference for brunettes, restaurants relying exclusively on brunette waiters could persist Additionally, government restrictions limiting the employment of blonde waiters as waiters could reduce their demand and support the argument's validity.

Income inequality and poverty

The measurement of inequality

Inequality in a country is measured by the poverty rate The poverty line is an absolute level of income and if you are below this level you are considered poor

Measuring inequality can be difficult due to in-kind transfers When measuring inequality we often distinguish permanent and transitory income Permanent income is your average income, measured over a couple of years Transitory income is just your income measured over a whole year

We begin our study of the distribution of income by addressing four questions of measurement:

• How much inequality is there in our society?

• How many people live in poverty?

• What problems arise in measuring the amount of inequality?

• How often do people move among income classes?

In the US, there is much income inequality among families The poorest 20% of the people received only 4% of total income, whereas the richest 20% received 50% of total income In the previous chapter we discussed some determinants of income inequality But how is income inequality in the rest of the world? Research has shown that Japan is one of the most equal countries, and Brazil is one of the most unequal countries The United States has more income inequality compared to similar developed countries, but less inequality than developing countries such as Nigeria

A commonly used gauge to measure poverty is the poverty rate It is the percentage of the population whose family income falls below an absolute level called the poverty line In 2008, the US government set the poverty line at $22.000 for a family of 4 Research has shown that 13.1% lived in poverty according to that rule During the 50’s and 60’s, the poverty rate has declined, due to a growing economy But since the 70’s the poverty rate stayed almost the same, although the economy has expanded a lot since that time This is because the income of the typical family rose, but the income of the poorest did not grow They were unable to benefit from a growing economy

There are however some difficulties involved in measuring poverty For example, in- kind transfers are transfers to the poor given in the form of goods and

116 services but not in cash Standard measurements of the degree of inequality do not take account of these in-kind transfers Another problem is the standard life cycle of people When they are young, they do not earn a lot because they go to school It is even more common for them to borrow money, to pay for college or buy a new house Once people grow older, they earn more and this declines after people become

65 The fact that their annual income decreases does not mean that your standards of living are declining Most often, when you were around 30, you pay the debts from your youth and start to save for later Hence, the annual income does not properly reflect your standards of living When you retire, it does not mean that you don’t get money anymore There is also a distinction to make between transitory and permanent income If some farmers experience a heavy storm in 1 year, they might get very low income But the year after, the reverse could happen and you would have a very high income Therefore it is more natural to consider permanent income, or average income That is, the income you get over a longer period of time

In the US, there is also great income mobility, meaning that there is a lot of movement from income scale to income scale Studies have shown that 1 out of 4 families will end up in the lowest income scale Yet, only 3 percent stays in that category for 8 years or longer Income can vary a great deal from year to year.

The political philosophy of redistributing income

The question about a "fair" market outcome depends on the type of person

Different political convictions lead to different ideas about justice in a society In this paragraph we examine some popular philosophical movements such as utilitarianism, liberalism and libertarianism

We will study several different political philosophies concerning equality The first is utilitarianism: the philosophy that the government should choose policies to maximize total utility in society Utility can be seen as the amount of happiness of a person The utilitarian case for redistributing income is based on the assumption of diminishing marginal utility If you earn a lot, you do not receive much additional

117 utility of one extra dollar, but if you are poor you will get considerably more utility If Peter earns $80.000 and John $20.000, then Peter does not care much to lose 1 dollar, whereas Peter’s utility of 1 extra dollar increases a lot Hence, they claim that the government should give some of Peter’s money to John This does not mean that their incomes should be made equal, because utilitarian’s accept the principle that

The second political philosophy is liberalism; the political philosophy according to which the government should choose policies deemed just, as evaluated by an impartial observer behind a “veil of ignorance” Important liberalists have taken up the question of justice and argue that a society as a whole can never agree on what justice is Everyone’s opinion would be biased, because it depends on the person you are, where you grew up and many other circumstances Further, they argue that the government should design policies according to the maximum criterion, which says that the government should maximize the well-being of the worst off person in society This is in line with income equality, since persons in the bottom scale should get more money according to the maximum criterion This form of income redistribution can be seen as a kind of social insurance, since no one likes to be born in a poor family By redistributing money from the rich to the poor, this risk is being mitigated

Libertarianism is the political philosophy according to which the government should punish crimes and enforce voluntary agreements but not redistribute income

Libertarians assert that income is earned solely by individuals, not by society as a whole They oppose government intervention in income distribution, believing that any redistribution, regardless of its intended fairness, ultimately undermines individual rights.

Policies to reduce poverty

As we have just seen, political philosophers hold various views about what role the government should take in altering the distribution of income Political debate

118 among the larger population of voters reflects a similar disagreement Despite these continuing debates, most people believe that, at the very least, the government should help the people which are most in need The government can implement minimum-wage laws, negative income taxes or in-kind transfers to achieve this goal

We have seen that there are many different ideas about the government and which role they should play in order to help society But most people would agree that the government should help the ones which are most in need Therefore, we consider some policies the government can implement in order to help these people

One policy is that of minimum wage laws These laws dictate that employers are not allowed to pay their employees a wage which is below the minimum Advocates of a high minimum wage argue that the demand for unskilled labour is relatively inelastic so that a high minimum wage depresses employment only slightly Critics of the minimum wage argue that labour demand is more elastic, especially in the long run when firms can adjust employment and production more fully Also, the government has various programs in order to raise the living standards of the poor with money This broad class of programs is referred to as welfare Critics argue that the government encourages bad behaviour such as laziness or families to break up, since some programs are only meant for single mothers

Another way to redistribute income is by means of negative income tax In most countries, there is a progressive tax system, where high income families pay a higher percentage of income to taxes Advocates of this policy also argue that the government should tax high-income families and subsidize low income families; the negative tax This is another way to redistribute income As we already mentioned in the previous paragraph, are in-kind transfers Instead of giving cash, the government can supply goods and services For example, poor families receive with Christmas food stamps, so that they can buy things cheaper from the store Advocates argue that this policy is more effective than giving money; otherwise drug addicts could buy drugs or alcohol Opponents say that it is disrespectful and that people know better what they need than the government

Another way of helping people is by means of incentives If, in a country, the

119 minimum income needed to have a good life is $20.000 and suppose that the government guarantees such an income, meaning that they would give an amount of money needed to get $20.000 Then a lot of families won’t work anymore because they the government will compensate them This is a bad incentive and other policies can be more effective Inducing incentives is an important economic fact and works often better than more direct policies such as transferring money

The theory of consumer choice

The budget constraint: What the consumer can afford

A consumer's limited income necessitates trade-offs among goods This compromise is visually represented by the budget constraint, a line separating attainable and unattainable bundles Bundles within or on the budget line are possible, while bundles outside the line are beyond the consumer's means.

Consumers have to make thousands of trade-offs per day To analyse consumer behaviour we assume a consumer only faces a trade-off between 2 goods This is a great simplification, but the basic insights gained from this analysis can help us in more involved cases Suppose a consumer only consumes Pepsi and pizza on a regular day Hence, he faces a trade-off between pizza and Pepsi

Above you see a line which represents all combinations possible, for example, the amount of pizza and Pepsi consumed on 1 day This line is called the budget constraint and all points inside and on the line is affordable The slope of the line

122 represents the relative price of the two goods If the slope is 5, then a pizza costs 5 times as much as Pepsi Or in other words, the opportunity cost of 1 pizza is 5 Pepsi.

Preferences: What the consumer wants

Now we look at the various levels of utility/happiness a consumer gets from buying certain goods Indifference curves show all possible combinations of bundles that give the same amount of happiness to a consumer Higher indifference curves are preferred to lower ones, indifference curves are downward sloping, indifference curves do not cross and they are bowed inwards The shape of an indifference curve depends on the type of good Two extreme cases correspond to perfect substitutes and complementary goods

In the aid of our analysis, we need a way of representing the consumer’s preferences When we think carefully about this, we are lead to the definition of an indifference curve This is a curve that shows consumption bundles that give the consumer the same level of satisfaction Below you see such a curve

The point C, A and B all give the consumer the same amount of happiness or utility Notice that point D is preferred to point D, because this is a point where you get more pizza and more shakes than at point A Therefore D is also preferred to B and C

At the same time A is preferred to E for the same reason and hence, B and C are also preferred to E The rate of change of the indifference curve is called the marginal rate of substitution or MRS and it is the rate at which a consumer is willing to trade one good for another Notice that since the indifference curve is not linear, the MRS changes from point to point The rationale behind it is that if you have a lot of shakes, you are very willing to give up some shakes for a pizza and vice versa We will now list

1 Higher indifference curves are preferred to lower ones This is because we assume that a consumer gets more satisfaction if he gets more goods Higher indifference curves represent larger quantities of goods than lower indifference curves

2 Indifference curves are downward sloping: The slope of an indifference curve reflects the rate at which a consumer is willing to substitute one good for another Therefore, if a consumer wants to be equally happy with fewer shakes, he needs more pizza’s and vice versa

3 Indifference curves do not cross: The picture below shows the case where two indifference curves cross We will show why this never happens Since point B is on both lines, a consumer is indifferent between B and S and also between F and B Hence, a consumer is indifferent between S and F, but this is impossible since there are points on the line of F which have more goods of X and more goods of Y than S This is a contradiction with the first axiom

4 Indifference curves are bowed inwards: The marginal rate of substitution

(MRS) usually depends on the amount of each good the consumer is currently consuming In particular, because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little, the indifference curves are bowed inward

An indifference curve always has to satisfy these 4 conditions The curve shown above is the typical form of an indifference curve, but there are 2 extreme cases of indifference curves that depend on the type of good Suppose the goods you are considering are perfect substitutes, such as nickels and dimes Perfect substitutes have straight line indifference curves This is because you would only care about the monetary value of the 2 goods If so, you would always be willing to trade 2 nickels for 1 dime, regardless of the number of nickels and dimes in the bundle Your marginal rate of substitution between nickels and dimes would be a fixed number—2 The typical curve for perfect substitutes is shown on the left in the picture below

The other type of goods that have an extreme form are complementary goods Suppose that the bundles correspond to left and right shoes You would off course only care about pairs So, your happiness would be the same if you had 5 left shoes and 7 right shoes or 5 left shoes and 8 right shoes Such another right shoe does not contribute anything to your happiness, only if you were to have another left shoe The indifference curves of complementary goods are right-angled.

Optimization: What the consumer chooses

Combining the notions of a budget constraint and indifference curves, we can show what the optimal bundle is for a typical consumer It occurs at the point where the budget constraint is tangent to the indifference curve If the budget constraint changes, it depends on the type of good whether you will consume less or more The income effect means that you will consume more of both goods since you have more to spend The substitution effect means that you will consume more of one good and consume less of another good

We have now defined the two tools in order to analyse what a consumer will choose as his optimal bundle, namely budget constraint and indifference curves A consumer wants to attain the highest indifference curve, because he is the most happy there, but he also faces a budget constraint so he cannot buy unlimited amounts of goods The point where his utility is maximized given the budget constraint, is the point where the budget constraint is tangent to the indifference curve

This is because the consumer cannot reach a higher indifference curve, because his budget constraint prevents him from doing so He can reach point D in the picture above, but his utility there is not maximized because he can buy more and reach a higher indifference curve Because the lines are tangent, the marginal rate of substitution equals the relative price of the two goods at this point The relative price is the rate at which the market is willing to trade one good for the other, whereas the marginal rate of substitution is the rate at which the consumer is willing to trade one good for the other At the consumer’s optimum, the consumer’s valuation of the two goods (as measured by the marginal rate of substitution) equals the market’s valuation (as measured by the relative price)

We can now see what happens with the consumption of goods when income rises If income rises, the budget constraint shifts to the right and we are able to attain a point on a higher indifference curve Usually, if income rises, consumers buy more of both goods that is under the assumption that the goods are normal Recall from chapter 4 that there are also goods that one buys less as income rises, these are inferior goods

If pizza is a normal good and shakes an inferior good, the consumer will consume less shakes and more pizza, hence he will attain a point on the indifference curve that is located on the down right of point A

We will now consider the situation when the price changes, instead of income

Suppose that your income is $1000 and you consume only pizza and Pepsi Pepsi is worth $2 per pint and pizza costs $10 So if you spend all your income on pizza, you can buy 100 pizzas, but if you spend all your money on Pepsi, you can buy 500 pints of it This budget constraint is shown in blue

Now suppose that the price of Pepsi drops from $2 to $1 per pint This means that the consumer can buy 1000 pints instead of 500, this budget constraint is shown in red You can see that the new budget constraint rotated and has a steeper slope Two things can happen due to this change in price, but it depends on your own preferences You can either consume more pizza and Pepsi because you are a richer

128 person; this is called the income effect, because you are able to reach a higher indifference curve The second thing that can happen is called the substitution effect; that is, you move along an indifference curve due to a change in price, to a point with a new marginal rate of substitution Both effects are reasonable, a consumer can choose to consumer more pizza and Pepsi because he is a richer person, or he chooses to consume more Pepsi because it is cheaper (substitution effect) The income effect is the change in consumption that results from the movement to a higher indifference curve The substitution effect is the change in consumption that results from being at a point on an indifference curve with a different marginal rate of substitution

Through the tools we just developed, it is possible to derive the demand curve of a consumer We noticed that if the price of a good changes, the quantity consumed of the consumer changes A point which corresponds to an optimal bundle, also corresponds to a point on the demand curve This way we have an analytical way of deriving the demand curve.

Three applications

It may also happen that the demand for a good is not downward sloping, we call these goods Giffen goods When the substitution effect is larger than the income effect, you might enjoy more leisure and vice versa Also, if your income rises you may choose to save more for later This is again a difference in income versus the substitution effect

In all the analysis before we also assumed that the demand for a good is downward sloping, but this is not always the case A good for which demand is not downward sloping is called a Giffen good, named after the economist who first noticed this situation Sometimes, the income effect is so big, that it overshadows the substitution effect If the price of potatoes rises relative to meat, the consumer is poorer and he wants to buy more potatoes and less meat At the same time, the substitution effect causes the consumer to buy more meat because potatoes have become more

129 expensive But if the consumer buys more potatoes, even though the price rises, the income effect is much bigger than the substitution effect

Individuals face a budget constraint between work and leisure time This constraint can be optimized to find a balance that maximizes well-being For instance, a cook may choose to work 40 hours weekly, allocating the remaining 60 hours to leisure Wage increases can impact this balance The income effect suggests that increased earnings may lead to more work hours to enjoy additional leisure time Conversely, the substitution effect suggests that higher wages may prompt individuals to reduce work hours in favor of increased leisure Ultimately, the effect of a wage increase on work-leisure balance depends on individual preferences.

The last trade-off we are going to consider is that between saving for later or consuming now A key role in this analysis is the interest rate Initially you might save

$55.000 for later and consume $50.000 But what happens if the interest rate goes up Two things can happen, depending on your preferences You might save more for later since greater interest gives you more money to spend later (substitution effect)

Or, because you are richer, might consumer more in both periods (income effect) This situation might seem strange, but if the income effect is greater to the consumer he will choose to consume more in both periods

Frontiers of microeconomics

Asymmetric information

Asymmetric information refers to a difference in access to relevant knowledge Moral hazard is a problem related to asymmetric information, because moral hazard refers to someone who engages in undesirable behaviour when he is not monitored

Asymmetric information arises when one party possesses more knowledge than the other, hindering effective transactions Adverse selection specifically refers to situations where the seller holds superior knowledge about the product or service being offered To address this issue, firms can employ signaling mechanisms to convey private information to consumers, thereby reducing uncertainty and fostering trust.

Asymmetric information refers to a difference in access to relevant knowledge, for example, a worker know how much effort he puts in a job and a seller of a used car knows more about the condition of a car than the buyer The first is an example of a hidden action, whereas the second is an example of a hidden characteristic Because asymmetric information is so prevalent, economists have devoted much effort in recent decades to studying its effects We will present some insights that economists gained by studying asymmetric information

The first problem related to asymmetric information is called moral hazard Moral hazard is the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour Examples are prevalent: a worker working for an employer If the employer cannot perfectly monitor the work of his employee, the worker tends shirk his responsibilities When we talk about moral hazard, we often assume there is an agent working for a principal and the phrase moral hazard refers to the risk, or “hazard,” of inappropriate or otherwise “immoral” behaviour by the agent There are various things a principal can undertake to prevent moral hazard, we list some important examples:

 Better monitoring: Parents hiring nannies have been known to implement cameras in their house to catch irresponsible behaviour

 High wages: We discussed the use of efficiency wages before Higher wages encourage agents not to shirk, because if they get caught they might not find another job with such a high wage

 Delayed payment: Principals can choose to pay the agent only after he did the job appropriately One common way to do this is by means of an end-year bonus: companies give the bonus only if employees did a good job This discourages people to shirk, because if they get caught, the penalty for being fired is larger

Asymmetric information also gives rise to another problem, that of adverse selection Adverse selection is a problem that arises in markets in which the seller knows more about the attributes of the good being sold than the buyer does There is the classical example of a seller selling a used car to a buyer The seller often knows a lot more about the vehicles defects than a buyer This can explain why a car of only a few weeks old may be thousands of dollars less worth A buyer might think that the car has some defects and hence is hesitant to buy the car

As a way of conveying private information to consumers, firms may use a way of signalling Signalling refers to actions taken by an informed party for the sole purpose of credibly revealing his private information There are many examples of this: Companies may use advertisements to convince people that they have high- quality products or students revealing that they have high abilities, because they have a college degree Whether signalling is effective, depends on a number of things, but it certainly depends on the cost If the signal would barely cost anything, then anyone could do it and the signal would not be credible Hence, a costly signal contributes to the effectiveness of a signal

So, if an informed party conveys certain information, we call that signalling If uninformed parties take actions to induce the informed party to reveal private information, the phenomenon is called screening Screening happens a lot in today’s economy Driver insurance companies would like to charge high premiums to high-risk drivers and low premiums to low-risk drivers One way to find out whether someone takes a lot of risks or not is by looking at the accidents a driver has caused in the past This is in fact what insurance companies do in the US This way is not perfect though, because of the random nature of car accidents

We already saw that the government can take actions in order to improve market outcomes Markets without government intervention sometimes produce undesirable outcomes, reasons for that are: externalities, poverty, public goods and imperfect competition Asymmetric information might also cause inefficient outcomes, because consumers are afraid to buy a lemon, such as in the case of used cars Besides this, the

133 government itself is not always capable of resolving these issues; we list 3 problems First, the market itself might take care of the difference in information by means of signalling and screening Second, the government often does not have more information than the uninformed party, and it is very difficult to obtain more information Third, the government is itself an imperfect institution.

Political economy

Democratic voting systems face significant limitations The Condorcet paradox highlights that voting outcomes may not always align with majority preferences Furthermore, Arrow's impossibility theorem demonstrates that democratic voting methods are inherently susceptible to irrationality under specific conditions These shortcomings undermine the reliability and fairness of democratic voting systems.

Political economy is the study of government using the analytic methods of economics As we have seen in previous chapters, there is a role for the government to improve market outcome Yet, there are problems attached to the view that the government can always improve a market outcome A famous example illustrating the shortcoming of a government is called Condorcet paradox, named after the mathematician who came up with this To illustrate the paradox, consider the table below:

A society has to make a choice about what policy the government should implement, there are 3 option labelled A, B and C The table shows three types of voters together with their preferences At first, the government might try some pairwise votes If the

134 government gives the option to choose between B and C, then B will get the most votes If they then ask to choose between A and B, then A will win because the first and third type will vote for A The government might then conclude that A is the winner, since A is preferred to B and B is preferred to C A closer look will reveal that if society has to choose between A and C, then C will win, because type 2 and 3 will vote for C Normally, we expect preferences to exhibit a property called transitivity: If

A is preferred to B and B is preferred to C, then A is preferred to C The Condorcet paradox is that democratic outcomes do not always obey this property One implication of the paradox is that order matters: if society first has to choose between

A and B and then comparing the winner to C produces another outcome than choosing first between B and C and the comparing the winner to A A second lesson from this paradox makes us conclude that majority voting by itself does not tell us what outcome a society really wants

Besides pairwise voting, there are other voting systems For example, you could ask each citizen above to rank the policies: the most preferred policy gets 3 points, the middle policy gets 2 points and the least preferred gets 1 point This is the type of ranking you often encounter in sports If you do the arithmetic yourself for the table above, you see that policy B wins The question remains: Does there exist a perfect voting system? Kenneth Arrow took up this question in 1951 and defined what a perfect voting system would be He assumes that individuals in society have preferences over the various possible outcomes: A, B, C, and so on He then assumes that society wants a voting system to choose among these outcomes that satisfies several properties:

 Unanimity: If everyone prefers A to B, then A should beat B

 Transitivity: If A beats B and B beats C, then A should beat C

 Independence of irrelevant alternatives: If people have to make a choice between A and B, then their choice should not depend on whether a third outcome C is available

 No dictators: There is no person who always gets his way, regardless of the preferences of everybody else

Arrow proved the amazing result that no voting system exists which satisfies the above properties This is known as Arrows impossibility theorem The Condorcet paradox shows that majority voting not always satisfies transitivity Similarly, the sport system fails to satisfy the independence of irrelevant alternatives

According to another famous result, the median voter theorem: majority rule will produce the outcome most preferred by the median voter Suppose that society has to vote about how much money to spend on national defence Some people do not want to spend anything, some want only to spend $5 billion and others might prefer

$10 billion If the average voter wants to spend $10 billion, then this will be the outcome of majority rule voting It turns out that when the voters are picking a point along a line and each voter aims for his own most preferred point, the Condorcet paradox cannot arise The median voter’s most preferred outcome beats all challengers

In this paragraph we focus more on the psychological side of economics, known as behavioural economics Economists have come up with arguments why people are not always rational: people are overconfident, people give too much weight to a small number of vivid observations and people are reluctant to change their mind

Behavioural economics is the subfield of economics which integrates the insights of psychology We will treat some of the insights gained from studying behavioural economics One is that psychologists and also economists sometimes question the rationality assumption; meaning that people react rationally We give some examples in their favor:

 People are overconfident: Often people are too confident about their own abilities Imagine you were asked to guess the number of African countries, but instead of making a numerical guess, you are asked to give an interval for which you are 90% sure that the number falls within Psychologists run these kind of experiments thousands of times, and research indicates that people give too small intervals, that is, they are overconfident

 People give too much weight to a small number of vivid observations: Suppose you want to buy a new car, let’s say a Ford You read in a magazine that out of a

1000 Fords tested 99% percent was good After reading that, you go to a friend who has a Ford and he says the car is a lemon Some people would think it is indeed a bad car because you’re friend told such a vivid story, even though he is negligible compared to the 1000 cars evaluated in the magazine

 People are reluctant to change their mind: Even though there is evidence against the contrary, people often stick to their own opinion

Hence, there are some arguments which indicate that the rationality assumption is not always met Even though this is true, economists still make this assumption because, even if not exactly true, it may be true enough that it yields reasonably accurate models of behaviour

Behavioral economics

Measuring a nation's income

The economy's income and expenditure

We can measure GDP in 2 ways: by adding up everyone's income or by calculating total expenditure This is because they are always equal in an economy

When we measure how someone is doing economically, we usually look at his income

Economic prosperity can be gauged through the Gross Domestic Product (GDP), which represents the total income of a country's population GDP acts as a comprehensive indicator of a nation's economic well-being, capturing the total value of goods and services produced within a specific time period.

(gross domestic product) There is another way how we can measure GDP, namely to look at the total expenditure on goods and services in an economy This is because total expenditure and total income must be equal in an economy If you spend $10 on bread, then the bakery has $10 more income, hence expenditure and income are always equal The real economy is a bit more complicated, since we are now assuming that everyone spends all of his or her income, although you also have to pay taxes or you can save a part of your income But the basic lesson remains the same; a transaction always needs a buyer and a seller.

The measurement of gross domestic product

There are various definitions of national income GDP is the most widely used and is defined as: the market value of all final goods and services produced within a country in a given period of time

We now give the precise meaning of Gross Domestic Product that focuses on total expenditure: Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time

We will give a comprehensive definition of all the words used in the phrase to define GDP First of all the word “market value” This is the value that consumers attach to a good or service This is used to compare everything in an economy For example, if apples are twice as expensive as oranges, then an apple contributes twice as much to GDP as oranges

The words “of all” after market value refer to the broad definition of GDP You want

140 to include as many goods and services as possible in your definition Not only apples and oranges, but also haircuts, pears and books etc Also included in GDP is the rental price for a house, but if you own the house yourself it is more difficult The government then estimates a rental price and assumes you are renting the house from yourself GDP also excludes some goods such as illegal drugs or goods that never enter the market place If you buy vegetables at a supermarket, then it is included in GDP, but if you grow it at home, then it is not included

The term “final” refers to the fact that GDP only includes final goods When

International Paper makes paper, which Hallmark then uses to make a greeting card, the paper is called an intermediate good, and the card is called a final good GDP only includes final goods, because the value of intermediate goods is already included in the prices of final goods Adding the market value of the paper to the market value of the card would double the counting

“Goods and services” includes tangible goods such as cars and bread, but also intangible goods such as a haircut or doctor visits

“Produced” refers to all goods and services currently produced If Volvo is selling new cars, then that is included in GDP But if someone sells his used Volvo car, then that is not included in GDP

“Within a country” means that all goods and services included in GDP must be produced within the geographic confines of a country The wage of a Canadian worker in the US is included in the GDP of the US, whereas a US company operating in Haiti is not included in GDP of the US but in the GDP of Haiti

“In a given period of time” means that we measure GDP over a certain period of time, for example a year or a quarter If the government reports GDP over a quarter, it usually represents the data at an ‘annual rate’, meaning that GDP is multiplied by a factor 4 to make comparison easier Also, statisticians usually modify the data by a procedure called seasonal adjustment This is because in some periods of time,

Holiday seasons, such as December, can significantly increase consumption, potentially skewing data Statisticians often adjust data to account for these variations Measuring GDP through both income and expenditure may yield different results due to imperfect data sources, creating a statistical discrepancy.

The components of GDP

Real versus nominal GDP

Real GDP is nominal GDP minus inflation Economists usually prefer the definition of real GDP because growth in real GDP is attributable to a growth in production, not in prices The GDP deflator is nominal GDP divided by real GDP and measures the rate of inflation in a country

If GDD has grown in some specific year, two things could have happened: (1) the economy is producing a larger output of goods and services (2) goods and services are being sold at higher prices Economists would like to separate these 2 effects and therefore came up with the definition of real GDP That is, the total output of goods and services evaluated at the prices that prevailed in some specific year If we are evaluating production at fixed prices from some specific year, we can see how production of goods and services changed over time Let’s consider an example

Year Price of Hot dogs

First we calculate the nominal GDP in each year:

If we take 2010 as the base year, we can calculate the real GDP:

To sum up: Nominal GDP uses current prices to place a value on the economy’s production of goods and services Real GDP uses constant base-year prices to place a value on the economy’s production of goods and services Hence, the value of real GDP is not affected by a change in price

We can now define the GDP deflator:

 GDP deflator = (Nominal GDP)/(Real GDP) * 100

The GDP deflator measures the current level of prices relative to the prices in the base year This is true because if only production would change and not the prices, then nominal and real GDP would rise by the same amount and hence the GDP deflator would be constant If instead the prices would change too, then the GDP deflator will also change For example, if we calculate the GDP deflator for the year

2012 we find that it is 240 We can use the GDP deflator also as a measure of inflation Inflation is a situation in which the economy’s overall price level is rising We can define the inflation rate as:

Inflation rate year 2 = (GDP deflator year 2 – GDP deflator year 1)/ (GDP deflator year 1) *100 for example, the inflation rate in 2012 = 100*(240-171)/171 = 40%.

Is GDP a good measure of economic well-being?

Despite limitations such as excluding leisure, non-market production, and averaging, GDP remains the most comprehensive indicator of economic well-being available While it may not capture all aspects of societal progress, GDP provides a valuable assessment of overall economic performance Its widespread use allows for comparisons across countries and time periods, enabling policymakers and analysts to track economic trends and make informed decisions based on objective data.

There are many debates about whether GDP or GDP per person is a goof measure of economic well-being Some people argue that it’s not, because GDP does not calculate the health of children, the quality of their education, or the joy of their play One could think of many other things that GDP does not incorporate, but it gives a good indication For example, a society with higher GDP can organize better health care for their children, they can pay for better education and they can give their children a better youth But GDP is not the perfect measure, for example it does not incorporate leisure as a contribution to life Suppose that everyone suddenly has to work in the weekends, then the goods and services produced would rise, but it would be offset by the loss of leisure Also, GDP does not account for products that do not enter the market place If a Chef is cooking a delicious meal at a restaurant, he will get paid and hence GDP rises But if he prepares the same meal for his family, GDP won’t rise Also GDP does not include the environment; if firms could pollute as much as they want, then GDP will rise but again this will be offset by the decrease of health caused by the dirtier environment The last thing is that GDP per person only looks at

145 averages If 100 people have income of $50.000, then GDP per person is $50.000, but a society with 10 people earning $500.000 and 90 people earning nothing would have the same GDP Most people would consider the 2 societies unequal, but they are equal according to GDP

Measuring the cost of living

The Consumer price index

The consumer price index is a measure of the overall cost of goods and services bought by a typical consumer It consists of a fixed basket and economists study the price changes of the goods in this basket The producer price index is used to measure inflation in an economy There are some problems attached to the producer price index such as the substitution bias and the introduction of new goods The consumer price index does not take products into accountant which have just been produced or products that are changed in quality

In this section, we consider the consumer price index The consumer price index is a measure of the overall cost of goods and services bought by a typical consumer We will discuss how the consumer price index is calculated and what difficulties arise in its measurement To see how the consumer price index is calculated, we use a simple model in which consumers only buy 2 goods: hot dogs and hamburgers In the table below you see the price change of hot dogs and hamburgers over time:

Year Price of Hot dogs

1 Fix the basket: The first thing to do is fix the basket with all the goods and services bought by the typical consumer Then you should give weight to every product; products which are bought more often should be given greater

148 weight If the average consumer buys 4 hot dogs and 2 hamburgers, then hot dogs is given a weight of 4 and hamburgers a weight of 2

2 Find the prices: Find the prices of the goods over different periods in time In this case the years 2010, 2011 and 2012

3 Compute the basket’s cost: Compute the cost of each basket in a different period of time:

1 Choose a base-year and compute the index: The choice of the base-year is arbitrary and in this case we choose 2010 as the base-year The consumer price index is then calculated according to the following formula:

CPI = (Price of basket of goods and services in current year)/(price of basket in base year)*100

This gives the following results:

The CPI was 250 in 2012, indicating that the price level in 2012 was 250% of the price level of the base year

1 Compute the inflation rate: Use the consumer price index to calculate the inflation rate, which is the percentage change in the price index from the preceding period For example, the inflation rate in 2011 = (175-100)/100*100

Although we have simplified the reality by assuming there were only 2 products, in reality the calculations work the same only with thousands of goods instead of 2 Economists use other measures of price inflation such as the producer price index This index measures the rising prices for producers and since producer sell their products at a price based on their cost, this index is considered a good measure for

There are however some problems attached to the consumer price index One such problem is called the substitution bias Some products rise proportionally faster in price than other products Therefore, some consumers will by other products if some become relatively expensive Since the consumer price index is only working with a fixed amount of goods, it does not account for this change in products The second problem with the consumer price index is the introduction of new goods When people have a greater variety of goods to choose from, their dollars become essentially more valuable If you could choose between a coupon of $100 at a store with a great variety of products and a coupon of $100 at a store with small variety of products, most people would choose the first coupon even though they have the same value The third problem is the unmeasured quality change If the quality of a good deteriorates from one year to the next while its price remains the same, the value of a dollar falls, because you are getting a lesser good for the same amount of money and vice versa The Bureau of Labour statistics is trying to adjust for a quality change, but it still remains a problem since quality is hard to measure

GDP deflator and CPI differ in their methodologies for measuring price levels GDP deflator captures all goods and services produced within a country, while CPI only accounts for a fixed basket of consumer goods Therefore, changes in prices of non-consumer goods, such as aircraft, affect GDP deflator but not CPI Additionally, CPI includes the prices of imported goods, whereas GDP deflator only includes domestically produced goods, leading to potential divergence in measurements, particularly in volatile markets like oil Moreover, GDP deflator's basket of goods updates automatically based on economy-wide production, unlike CPI's fixed basket.

Correcting economic variables for the effects of inflation

Economic variables are often adjusted for inflation such as the interest rate The nominal interest rate is the normal interest rate, whereas the real interest rate is the nominal interest rate minus the inflation Economists make this distinction because a growth in real variables indicates a growth in welfare or well-being

We can use price-indexes to compute what someone’s salary is worth now compared to years ago Babe Ruth (a famous base-ball player) earned $80.000 per year in 1930 Nowadays, the average New York Yankee player earns $4 million per year

Government statistics show that the price index in 1931 was 15.2 and the price index in 2009 was 214.5 Hence Ruth’s salary nowadays would be $80.000*(214.5/15.2) $1.128.947 This is still 4 times less than the average base-ball player, but this has other causes such as increased standards of living and more spectators

When some dollar amount is automatically corrected for changes in the price level by law or contract, the amount is said to be indexed for inflation For example, long term contracts between firms and unions often include partial or complete compensation for changes in the price index with regard to their wage

As a last thing, we have to distinguish nominal and real interest rate The nominal interest rate is the usual interest rate without the correction for inflation, whereas the real interest rate is corrected for inflation This matters because it affects you purchasing power Suppose you have deposited $100 at a bank and the interest rate is 10%, then after 1 year you would have $110 If a usual t-shirt costs $10, then you could buy 10 t-shirts at the beginning of the year and 11 at the end But if the price of t-shirts would also rise by 10%, then you could buy only 10 at the end of the year In this case we say that the nominal interest rate is 10%, but the real interest rate is 0%, because with the higher prices you don’t earn anything with your interest The following formula establishes the connection between the real and nominal interest rate: real interest rate = nominal interest rate – inflation rate

Production and growth

Economic growth around the world

Countries such as the U.S and Japan have experienced high economic growth over a century, whereas other countries barely grew such as Congo GDP can be used to trace the growth of these countries over a period of time

If we look at growth rates of different countries over 100 years we see that Japan has risen the most Every year, their national GDP grew with 2.71% on average This is quite remarkable since Japan was one of the poorest countries 100 years ago They were on comparable level with Mexico and way behind Argentina The United States has experienced a growth of 1.80% on average and now has average GDP of $46.970 This is almost $10.000 more than the average GDP in the United Kingdom, although they were the richest country a hundred years ago You can see that being the richest country does not give any guarantees for the future One of the poorest countries in the world, Bangladesh, even experienced a decline in GDP per capita; their growth rate over hundred years was about 0.78%.

Productivity: Its role and determinants

Productivity is the most important reason for economic growth The amount of productivity depends on 4 things: physical capital, human capital, natural resources and technological knowledge Countries with higher productivity tend to experience higher economic growth and prosperity Not all determinants of productivity are of equal importance For example Japan has few natural resources but is still one of the biggest economies in the world

Recall that productivity was defined as: the quantity of goods and services produced from each unit of labour input We will see why productivity is so important concerning economic growth and prosperity Remember the story of Robinson Crusoe who stranded on a desert island By studying his small economy we can show why productivity is so important Let’s suppose that Crusoe can do 3 things; producing and

153 consuming fish, growing vegetables and making clothes If Crusoe is very good at all these things i.e he is very productive, he can catch a lot of fish, grow many vegetables and make a lot clothes He’s then able to live a good life on the island Suppose on the other hand that he is not productive, then he cannot produce many fish, vegetables and clothes In this case he is not able to enjoy a good life on the island Hence, we see that for Crusoe it is essential to be productive to live a good life on the island For countries this is the same The US enjoys a higher standard of living than Nigerians because their workers are more productive Japan has grown considerably more than Argentina because the Japanese have experienced more rapid growth in productivity

The question remains how productivity is determined For Crusoe it depends on the amount of fishing poles, whether he is trained in the best fishing techniques, if his island has enough fish supply and if he can invent a better fishing lure Economists call this physical capital, human capital, natural resources and technological knowledge respectively We will examine these notions more closely

Physical capital, the collection of equipment and structures used for production, plays a crucial role in worker productivity By providing tools and machinery, physical capital enables workers to efficiently produce goods and services For instance, the machines utilized by a jewelry manufacturer directly enhance the production of earrings, demonstrating the significance of physical assets in facilitating efficient production processes.

The second determinant of productivity was human capital, which we already encountered before Human capital consists of the education, skills, and abilities possessed by an individual The production of human capital requires the input of teachers and professors, libraries and computers etc Human capital is probably the biggest factor in determining productivity

The third factor, natural resources, is the inputs into the production of goods and services that are provided by nature, such as land, rivers, and mineral deposits

National resources can be renewable and non-renewable A forest is an example of a renewable resource, once you have cut a tree you can plant a new seed, but oil is non-renewable since it takes nature millions of years to produce oil Some countries

154 happen to be rich because they are on top of a large oil pool such as Saudi-Arabia and Kuwait Although natural resources are important, it is not absolutely necessary Japan has few natural resources but happens to be one of the richest countries in the world

A fourth determinant of productivity is technological knowledge—the understanding of the best ways to produce goods and services A hundred years ago farms needed many labour to produce food Nowadays only a fraction of the people works at farms, but they produce enough to feed a whole country This is due to technological advancements in farming We must make a distinction between technological knowledge and human capital, although they are closely related We can think knowledge as the quality of our textbooks, whereas human capital is the amount of time the population has devoted reading them.

Economic growth and public policy

Capital accumulation obeys the law of diminishing marginal return This is why richer countries experience less economic growth over time, whereas poor countries can experience high growth rates, this is known as the catch-up effect Saving by domestic residents increases the capital stock in a country and therefore also the growth rates Human capital is also very important, rich countries have a high educated society Also, a larger labour force plays an important role The more workers, the more goods and services a country can produce

One way to increase productivity is to invest more in capital We saw that more capital raised the productivity of workers This is not a free lunch though, since if we invest more in capital, we have to give up money that we spend on resources to produce goods and services for current consumption That is, for society to invest more in capital, it must consume less and save more of its current income Eventually, in the long run, this will pay out

So we know that a higher saving rate leads to more capital and hence to an increase in productivity, but his process cannot continue indefinitely This is because capital is

155 subject to the law of diminishing returns: As the stock of capital rises, the extra output produced from an additional unit of capital falls This means that if workers already have a large quantity of capital available, one extra unit of capital will not increase their productivity much The implication of this fact is that in the long-run, the benefit from additional capital becomes smaller and so growth slows down In the long run, the higher saving rate leads to a higher level of productivity and income but not to higher growth in these variables The law of diminishing returns has another implication, namely that it is easier for poor countries to grow faster than rich countries This is known as the catch-up effect

Saving by domestic residents is not the only way to increase capital The other way is by investment from abroad Ford might build a new car factory in Mexico A capital investment that is owned and operated by a foreign entity is called foreign direct investment Alternatively, an American investor could also buy a stock in a Mexican corporation; the Mexican corporation can use the money from the stocks to buy a new factory An investment that is financed with foreign money but operated by domestic residents is called foreign portfolio investment When foreigners invest in a country, they do this because they expect to earn profit Hence, some money flows out of the country to foreign investors Yet, most economists encourage poor countries to higher investment from abroad, because it has considerable effect on the capital stock in a country This can be done by changing laws that makes it easier for foreigners to invest in a country An organization that tries to encourage the flow of capital to poor countries is the World Bank

As we saw, human capital was a very important determinant of productivity Research has shown every extra year you spend at school in the US, you earn 10% more wage Off course, there is a trade-off to make, when you go to school you cannot work, but in the end it will pay you back This is the problem with developing countries; children often drop out of school because they have to help their parents, even though it is more profitable in the end to stay at school Education conveys also many positive externalities; a more educated person has often better ideas how to produce goods and services If these ideas enter society’s pool of knowledge, then everyone can use

156 these ideas There are however also some side-effects of education that are negative for a country A well educated person in a poor country might migrate to a rich country because he can enjoy there a higher standard of living This is known as the brain drain, because well educated people go to other countries, leaving their own country behind with even less educated people

Health and nutrition play also an important role in productivity Research has shown that 200 years ago, 1 of the five people could not work because he was ill or suffered from malnutrition Moreover, Nobel laureate Robert Fogel suggested that good health accounted for 30% of the productivity in a country His research also showed that taller people earn more and because wages reflect a difference in productivity, this suggests that taller people are on average more productive Because health has increased substantially over the past centuries, men have grown by about 3.5 inches

In developing countries health and nutrition are often a big problem Therefore the height of their wages is especially pronounced in poorer countries, where the risk on malnutrition is bigger

An important prerequisite for the price system to work is an economy-wide respect for property rights In western countries we often take property rights for granted, but in developing countries this is not the case Due to a widespread form of injustice, people and firms have less incentive to find out something new Contracts are hard to enforce, and fraud often goes unpunished This has not only influence on domestic citizens, but also on foreign investors, who are more hesitant to invest in such a country This in turn leads to a lower capital stock and hence less productivity

Free-trade is another important aspect of economic prosperity We already saw in previous chapters how a country can benefit from international trade Developing countries tend to implement inward policies, which are aimed to produce goods and services within a country This has many negative side-effects

Most countries in Asia such as Korea and Taiwan have implemented outward policies, which were aimed at international trade These countries experienced much higher

157 growth rates An example of a country with many inward policies is Argentina This country has the same GDP as the city of Philadelphia Another important determinant which makes international trade easier is things such as a harbour Many important cities in the world are located near the sea such as New York, Hong Kong, San

Francisco and Rotterdam Research has shown that a country which has 80% of the citizens living within a distance of 100 mile from the sea earn 4 times as much as countries which only have 20% of the population living near the sea

Research and development also plays a key role The telephone, the transistor, the computer, and the internal combustion engine are among the thousands of innovations that have improved the ability to produce goods and services Hence, nowadays we enjoy a higher standard of living than 100 years ago Countries investing in research and development have proved to be successful The United States has invested in aerospace engineering and is nowadays the market leader in rockets and satellites

Economists and other social scientists have long debated how population affects a society The most direct effect is on the size of the labour force: A large population means more workers to produce goods and services The tremendous size of the Chinese population is one reason China is such an important player in the world economy

Saving, investment and the financial system

Financial institutions in the US economy

At the broadest level, financial markets bring together savers and borrowers Several institutions have emerged due to a growing demand on the financial markets Such institutions include mutual funds and financial intermediaries People can trade in financial products such as stock and bonds The profit that people expect to earn determines the price of stocks Both stocks and bonds are subject to risk, which is another important factor of the price

First we consider the bond market If a huge company such as Intel wants new money to finance a new building it can directly borrow from the public It does this by selling bonds A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond When a person buys a bond, the length of time during which the bond is repaid is specified, this is called the maturity of the bond Also, the interest that will be paid is specified and companies pay this interest periodically If you buy the bond in return for the promise of Intel that they will pay you back, then you are called the agent You can hold the bond until it expires or sell it before

The first characteristic of a bond is the term, the length of time until the bond matures Some have a short term, such as 3 months, other bonds can have a term of

30 years The interest rate on the bond depends partly on the term Long-term bonds pay higher interest since you have to wait longer to be repaid The second important characteristic is the credit risk, it is the probability that the borrower fails to repay his debt When bond buyers perceive that the probability of repayment is low, they demand a higher interest-rate, because they bear a bigger risk The third characteristic is the tax-treatment: the way the tax laws treat the interest on bonds The interest on most bonds is taxable income i.e you have to pay tax over you interest By contrast, when the state or local Government Issue bonds, called municipal bonds, the buyer does not have to pay tax over his interest

The stock market is another way to raise money for a firm or company Stock represents ownership in a firm and is, therefore, a claim to the profits that the firm

160 makes For example, if Intel sells a total of 1,000,000 shares of stock, then each share represents ownership of 1/1,000,000 of the business The sale of stocks to raise money is called equity finance, whereas the sale of bonds is called debt finance Although bonds and stocks are both used to raise money, the two differ substantially from each other When a firm is making a lot of product, stockholder profit more than bondholders since stockholder get paid part of the profit On the other hand, if a firm does badly, then the bondholders have an advantage because they get paid their interest, whereas stockholders receive nothing Stocks bear higher risks but can be more profitable than bonds The owner of shares of Intel stock owns a bit of the company, whereas a bondholder is creditor of the corporation When a company issues stock by selling shares to the public, the shares are traded among stockholders on organized stock exchanges A very important stock exchange in the

US is the New York Stock Exchange The prizes of the shares depend on the perception of the public If they think that a firm will be profitable in the future, prizes will go up, but if they think the firm will do badly, then prizes go down

Beside these direct methods, you can also fund or borrow through financial intermediaries These are financial institutions through which savers can indirectly provide funds to borrowers A bank is an example of a financial intermediary If a small bakery wants to expand, he is unlikely to issue bonds or stocks Instead, he will go to the bank to borrow money Banks pay interest to persons who have deposited their money at the bank and they charge slightly higher interest rates to people who borrow from the bank This is to cover the cost and to earn some profit Banks play a second important role, namely as medium of exchange They facilitate purchases of goods and services by allowing people to write checks against their deposits and to access those deposits with debit cards We will treat this role of banks in later chapters, but for now it suffices to remark that banks are the only financial intermediaries who have this role Stocks and bonds are just a possible store of value for the wealth that people have accumulated

Another financial intermediary that has become increasingly important is a mutual fund A mutual fund is an institution that sells shares to the public and uses the

161 proceeds to buy a portfolio of stocks and bonds A portfolio is a selection of various types of bonds, shares or shares and bonds If the value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss The main benefit from mutual funds is that they allow people with less money to diversify their holdings Investing in only 1 stock or bond is usually reserved only for the rick people A second advantage claimed by mutual fund companies is that mutual funds give ordinary people access to the skills of professional money managers

Saving and Investment in the national income accounts

In a closed economy, there is no export nor import, hence NX=0 National savings denotes the total amount saved in a country and is denoted S We separate national savings in private and public savings Private savings is the amount saved by the people and public savings is the amount saved by the government When public savings is negative, we say that the government runs a budget deficit When public savings is positive we say that the government runs a budget surplus In a closed economy, national savings always equals investment

If we want to understand the behaviour of an economy, we must understand the financial markets that are key to the behaviour of economic variables Our analysis in this paragraph will not focus on behaviour but on accounting Accounting refers to how numbers are defined and how they add up in several ways

Remember the equation for national income: Y = C+I+G+NX We first simplify our analysis by assuming that the economy is closed, that is, there is no trade with foreign countries Hence, net export (NX) equals 0 The new income identity for a closed economy reads: Y = C+I+G We can now subtract C and I from both sides to obtain Y - C-G = I Y-C-G is just the money left after you consumption and government purchases This amount is called national savings or just saving and is denoted as S Hence, the identity gives S = I! That is, national savings is equal to investment To help clarify the meaning of saving we can manipulate the equation for S We denote T by the amount of taxes the government collects minus the amount it pays to welfare Now we get:

Consider the first part of the second equation It is national income minus consumption minus the amount paid to taxes; this is what we call private savings The second part is called public saving, because it is the amount of taxes minus all the purchases of the government If T is bigger than G, we say that the government suns a budget surplus, but if G is larger than T we say that the government is running a budget deficit Now the equation S = I reveals an important fact for the economy as a whole, namely that for an economy, saving must be equal to investment We will see what mechanism lies behind this equation

Saving and investing are distinct concepts in macroeconomics While individuals may perceive deposits as investments, economists classify them as savings This distinction arises from the notion that saving involves accumulating funds without actively seeking returns, while investing entails allocating funds to assets with the expectation of generating returns Larry's $100 bank deposit contributes to national savings, which is the total amount of funds set aside by individuals and entities for future use.

S = I tells us that saving has to equal investment for the economy as a whole, it does not mean that this is true for an individual Banks and other financial institutions make it possible for persons to borrow with the money of someone else.

The market for loanable funds

We assume there is only 1 financial market in the economy: the market for loanable funds The supply comes from the national savings and the demand comes from the amount people want to invest There are several factors that influence supply and demand: saving incentives, investment incentives and government deficits and surpluses The crowding out effect refers to the reduction in investment due to a rising government deficit

We are now ready to analyse the market for lending and borrowing together To keep things simple, we will assume that the economy has only 1 financial market, called the market for loanable funds All savers go to this market to deposit their money and all investors go to this market to borrow their money The assumption of 1 financial

163 market simplifies the analysis, although we have seen that an economy usually has more than 1 financial market

If we consider the supply and demand for money, we can use the tools of supply and demand for the market of goods which we encountered before

The horizontal axis shows the quantity of money demanded and the vertical axis shows the interest rate The supply for money is upward sloping, since a higher interest rate gives a higher return on savings, hence people are willing to lend more Similarly, the demand for money is downward sloping, since a high interest rate makes it expensive to borrow and consequently expensive to invest Therefore there is less demand for money with a high interest rate and vice versa When we talk about the interest rate, we mean the real interest rate, since the real interest rate better reflects the cost of money over time The market of supply and demand will always move to the equilibrium point, because if demand is lower than supply, there is an excess of money and the market will adjust through a lower interest rate and vice versa Notice the analogy between the market for goods and the money market We will now

164 discuss some public policies that affect saving and investment

People in the United States save less than their counterparts in many other countries such as Japan and Germany Economists see this as a big problem, because we saw that a higher saving rate resulted in higher economic growth One of the reasons that Americans do not save that much is because of some incentives that discourage them to save One of the laws that discourages saving is the tax law, because the state as well as the local government tax income, as well as interest and dividend income A higher tax induces people to save less and spend more now In response to this problem, many economists and lawmakers have proposed reforming the tax code to encourage greater saving One proposal is to exclude some money from being taxed such as Individual Retirement Accounts We can look at what happens on the market for loanable funds after the government implements this policy Because people will save more at any given rate, the supply curve will shift to the right As a consequence, the equilibrium interest rate will be lower and the quantity of money supplied and demanded will be higher

By offering tax advantages through investment tax credits, the government can incentivize businesses to invest in infrastructure and equipment This increase in investment demand shifts the quantity of loanable funds demanded to the right, resulting in a higher real interest rate The higher interest rate, in turn, attracts additional suppliers of loanable funds, increasing the quantity of funds supplied.

Policy 3: Government Budget Deficits and Surpluses

A controversial topic in economics is the influence of a budget deficit/surplus on the market for loanable funds Recall that the supply of loanable funds was determined by national saving Suppose the government starts with a balanced budget i.e T=G After some time the government runs a deficit because of the cut in taxes or increased spending Now the government runs a deficit and hence national saving decreases The effect on the market for loanable funds is that the supply curve shifts to the left

165 and consequently the interest rate goes up and the quantity of loanable funds supplied decreases Because of the higher interest rate, potential investors are turned off This is known as the crowding out effect: a decrease in investment that results from government borrowing Hence, if the government is running a budget deficit it decreases economic growth

The basic tools of finance

Present value: measuring the time value of money

The present value of any future sum of money is the amount today that would be needed, at current interest rates, to produce that future sum The higher the interest rate the lower is the present value of a future sum of money

Suppose that someone offers you a deal: Either you get $100 today or $200 in ten years What should you choose? We need some way of comparing the $100 today with the $200 in ten years, so we need the concept of present value The present value of any future sum of money is the amount today that would be needed, at current interest rates, to produce that future sum We can first answer an easier question: What is $100 worth after N years, that is, what is the future value If the interest rate is R, then after 1 year the $100 is worth $100*(1+R) After 2 years this is

$100*(1+R)^2 and hence after N years my $100 is worth $100*(1+R)^N With this in mind, we can also calculate the present value of some amount of money If I get $200 after N years, the present value of that $200 is just $200/(1+R)^N Hence, the present value of some amount of money depends on the number of years and the interest rate In general, we get the following formula for the present value of some amount of money X: X/(1+R)^N If the interest is 5% and I can get $200 after 10 years, then the present value of that $200 is: $200/(1.05)^10 = $123 Hence, if someone offered you $100 now or $200 after ten years, you are better off waiting those 10 years to get $200 This is a decision which many firms face: General Motors is thinking about building a new factory The costs are $100 million now or $200 million after 10 years What should General Motors do? They are better off paying a

$100 million now than paying $200 million in ten years because of the concept of present value.

Managing risk

Risk aversion arises from individuals' aversion to uncertainty To manage risk, people utilize products like insurance and firm-specific risk diversification The relationship between risk and return presents a trade-off, where higher returns necessitate the acceptance of greater risks.

Suppose a friend of you comes up with the following: “If a coin comes up head I have to pay you $1000, but if the coin comes up tail then you pay me $1000” Most people would not accept this gamble because they are risk averse, meaning that they have a dislike of uncertainty Economists have developed the notion of utility, which is a subjective measure of well-being The utility curve declines as the amount of wealth

168 increases, hence, utility is subject to the law of diminishing marginal return This is logical, since you don’t get very much satisfaction of 1 dollar extra if you have acquired a lot of wealth Therefore the decrease in utility of losing $1000 is bigger than the gain in utility of winning $1000 Hence, you are not willing to take the risk Risk aversion provides the starting point for explaining various things we observe in the economy Let’s consider three of them: insurance, diversification, and the risk- return trade-off

One way to avoid risk is to buy insurance Insurance is ubiquitous in life: fire insurance, health insurance or life insurance are all part of today’s economy In most cases, you pay an annual fee and the insurance company bears (a part of) the risk Every insurance contract is a gamble, since you do not know whether you get sick or your house burns down In most cases, you just pay the fee every year, but it may happen that you do get ill Insurance companies are then more efficient in taking the risk, because the amount paid to you buy the insurance company is shared by thousands of people The markets for insurance suffer from 2 problems that impede their ability to spread risk The first is adverse selection: A high-risk person is more likely to get insurance because he benefits more than a low-risk person The second problem is that of moral hazard: people are less careful about their behaviour, because the insurance company will cover the loss

Diversification of firm-specific risk

In 2002 the firm Enron went bankrupt because of fraud accusations Thousands of workers not only lost their job, most of them also lost their savings because they had 2/3 of their retirement funds in Enron stock, which became worthless after the bankruptcy Moral of the story: Don’t put all your eggs in the same basket! If they had spread the risk over different funds, this would not have happened Diversification is the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks This is what often happens in the financial world; people make a large

169 number of small bets, rather than a small number of big bets Diversification can eliminate firm-specific risk—the uncertainty associated with the specific companies But diversification cannot eliminate market risk—the uncertainty associated with the entire economy, which affects all companies traded on the stock market

The Trade-off between Risk and Return

People often have to make a trade-off between risk and return, because a portfolio with low risk offers lower return People still take risks because they are compensated for doing so Research has shown that the average return on stocks was 8%, whereas the average return on short-term government bonds was 3% When deciding how to allocate their savings, people make a trade-off between return and risk Consider the following options:

 A risky portfolio which offers on average 8% return with a standard deviation of 20% This implies that the typical return is between -32% to +48%

 The other option is a short-term government bond offering 3%

A person who is willing to take a risk might prefer the first option, whereas a risk- averse person probably prefers the second option

Asset valuation

A share is said to be undervalued when the price of a share is less than the value of the firm Similarly, a firm is overvalued if the share is more expensive than the firm

To investigate the value of a firm, you have need to have a detailed analysis of the firm, known as fundamental analysis There are 2 conflicting views about the asset market One is the efficient market hypothesis, the other is the market irrationality hypothesis Both have different views about how to avoid risks and what the best way is to choose your shares

To construct a diversified stock portfolio, consider allocating 60% of your savings into investments spread across 20 different stocks When selecting these stocks, prioritize two key factors: the expected potential return and the specific companies you choose to invest in.

170 the value of that share of the business and the price at which the shares are being sold If the price of the share is lower than the value of the business, the share is said to be undervalued If the price is more than the value, the share is said to be overvalued When the share is equal to the value, it is called fairly evaluated You would prefer shares which are undervalued because you are making a good bargain by paying less than the business is worth Hence, you have to know these 2 things

Knowing the price of a share is easy, you can just look it up in the newspaper

Knowing the value of a business is much more difficult The term fundamental analysis refers to the detailed analysis of a company to estimate its value Many Wall

Street firms hire stock analysts to conduct such fundamental analysis and offer advice about which stocks to buy

The value of a stock to a stockholder is the present value of dividend payments and the final sale price Dividend payments and the final sale price both rely on the ability of firms to make profit We saw that making profit depends on a lot of factors such as: demand, the amount of competition and the available capital stock The goal of fundamental analysis is to take all these factors into account to determine how much a share of stock in the company is worth

There is another way to choose 20 stocks for your portfolio: choose them at random! This might seem crazy, but there is an idea behind it That idea is called the efficient market hypothesis There are two reasons for this hypothesis First, you must acknowledge that companies listed on a major stock exchange are followed by many money managers, such as mutual funds Their task is to buy shares when they are undervalued and sell them when they are overvalued The second piece to the efficient markets hypothesis is that the equilibrium of supply and demand sets the market price Hence, there are as many people who overvalue a share as there are people who undervalue it According to this theory, the stock market exhibits informational efficiency: It reflects all available information about the value of the asset Good news about a share causes the price to go up and vice versa One

171 implication of this hypothesis is that the prices of shares follow a random walk i.e they are unpredictable! Hence, it does not matter what share you buy, because one stock is not better than the other The prices reflect all information possible

The efficient market hypothesis, which postulates the rationality of the stock market, faces challenges from economists questioning its accuracy They contend that speculative behavior and emotional fluctuations, such as optimism and pessimism, influence stock prices In speculative bubbles, asset prices exceed their fundamental value due to expectations of further increases, influenced by market sentiment rather than dividend flow The debate between proponents of market efficiency and skeptics acknowledging the role of psychological factors remains unresolved, as both perspectives have valid arguments.

Unemployment

Identifying unemployment

People in the U.S are divided into 3 categories: employed, unemployed and not in the labour force The unemployment rate measures what percentage of the labour force is unemployed The labour force participation rate measures the percentage of people that are in the labour force compared to the whole population Economists distinguish structural and frictional unemployment Frictional unemployment takes a short period of time whereas structural unemployment takes a longer period of time

In the US, the bureau of labour statistics measures the unemployment Based on surveys, the BLS places each adult into 3 categories:

 Employed: This category includes all paid employees, part-time and full-time It also include people who worked unpaid in a family business and people that were temporarily absent from work due to vacation or illness

 Unemployed: This includes all people who were available for a job but didn’t have one They are only included if they tried to find work for the past four years This also included people who have been laid off, but are still waiting to be recalled for their job

 Not in the labour force: This includes all people who didn’t fit the first 2 categories such as full-time students, homemakers and retirees

The BLS uses various definitions to measure unemployment One of them is the labour force, which is defined as the sum of people who were employed or unemployed

Labour force = number of employed + number of unemployed

The BLS defines the unemployment rate as the percentage of the labour force that was unemployed:

Unemployment rate = Number of unemployed/labour force * 100

The BLS also measures the percentage of the adult population which is in the labour force, this is called thelabour-force participation rate.In formula form it reads:

Labour-force participation rate =Labour force/adult population* 100

In 2009, the labor force consisted of 154.2 million individuals, with 139.9 million employed and 14.3 million unemployed, resulting in an unemployment rate of 9.3% The labor-force participation rate, defined as the proportion of the adult population in the labor force, was 65.4% Despite fluctuations in unemployment rates, it is never zero due to factors known as the natural rate of unemployment, estimated at 5% in 2009 The difference between the actual and natural unemployment rates is referred to as cyclical unemployment.

The unemployment rate is not a perfect measure for unemployment Movements in and out of the labour force are common New people entering the labour force might just have finished their study and are looking for a first job or it can be older people who retired but are again looking for work Because so many people move in and out of the labour force, statistics on unemployment are hard to interpret Some people who are out of the labour force may still want to work They are not in the labour force because they couldn’t find a job for a long time, these are called discouraged workers

Economists have devoted much time studying whether unemployment is typically a short-term or a long-term condition They have reached a conclusion which might seem contradictory: Most spells of unemployment are short, and most unemployment observed at any given time is long-term Let’s see how this works in reality Suppose you are surveying unemployment for a whole year at the government’s unemployment office Each week you find that there are 4 unemployed workers Three of them are unemployed for the whole year and 1 is unemployed only for a week and thus changes every week Over a whole year, you meet 55 individuals, of whom 52 are unemployed only for a week This means that 52/55 or 95% of unemployment spells end in 1 week At the same time, on any observed moment, you find that 75% of the people are unemployed for a whole year The same works in the real world

In an ideal world, the supply of labour is equal to demand and therefore there is now unemployment We never encounter this in reality The unemployment rate always fluctuates around the natural rate of unemployment and even if the economy is doing well, there are people unemployed There are several reasons for this One is called frictional unemployment; it takes time for people to find a suitable job For example, it might take a graduate a few months to find a job at a big company

Frictional unemployment is often used to explain short spells of unemployment The next three explanations depend on the fact that supply is higher than demand This type of unemployment is called structural unemployment and is used to explain long spells of unemployment This happens when wages are, for some reason, set above equilibrium level This can be caused by efficiency wages, unions and minimum-wage laws.

Job Search

Frictional unemployment exists because people need time to find a new job The durance of the time depends on sectorial shifts, internet, training programs and unemployment insurance Unemployment insurance gives an unintended incentive to people to search longer for jobs That is why frictional unemployment is sometimes larger in countries with higher unemployment insurance

One of the reasons that economies always experience unemployment is job search If all workers and jobs were the same, job search would not be a problem But since workers differ in their tastes and skills, jobs differ in their attributes and therefore it takes time to fit the right worker with a good job

Frictional unemployment is simply inevitable If consumers decide that they prefer Dell to Apple, then Apple has to cut back in production as well as in workers Dell has to decide which new workers to hire and this process takes time Frictional unemployment also occurs because of production in different regions For example,

Alaska produces a lot of oil and Michigan produces many cars If the price of oil decreases, companies in Alaska has to cut back in production, but because of the decrease in the price of oil, the demand for cars will increase Therefore, firms in Michigan need more workers to hire Changes in the composition of demand among industries or regions are called sectoral shifts Because it takes time for workers to search for jobs in the new sectors, sectoral shifts temporarily cause unemployment

Although frictional unemployment is inevitable, the amount is not Frictional unemployment depends partly on the amount of available information; if a worker knows that an employer is looking for an employee, he can apply for a job interview Nowadays, available information is much bigger than 20 years ago through the introduction of internet The government can also facilitate workers to find a job faster They have employment agencies which give out information about job vacancies Another way is by means of public training programs, which help workers of declining industries to transition to growing industries Most job search in the current economy takes place without government aid

One government program that increases the frictional unemployment, without intention to do so, is unemployment insurance This program is designed to offer workers partial protection against job loss In the US, someone who loses his job gets paid 50% of his former wage for 26 weeks Although this reduces the hardship of unemployment, it also increases frictional unemployment This is because people respond to incentives; since they still get money, even though they are unemployed, people have less urgency to find a new job Moreover, they are more likely to turn down jobs that do not perfectly fit their skills But we must not conclude that unemployment insurance is necessarily a bad policy Some people argue that because people find better jobs that suit their qualities, unemployment insurance is in fact profitable Again, there is no general consensus about the effectiveness of unemployment insurance

Minimum-wage laws

The government can set minimum wage laws to prevent workers from working under a certain salary If minimum-wage is set above the equilibrium wage, it causes unemployment

We already know that minimum-wage laws can cause unemployment It is not the most important factor of unemployment, but it is natural to consider this first because it can explain some other factors of unemployment When minimum-wage is set above equilibrium level, unemployment is caused because labour supply exceeds labour demand Hence, the structural unemployment caused by minimum-wages is different from frictional unemployment Frictional unemployment occurs because it takes time for people to find a new job Contrarily, structural unemployment occurs because demand exceeds labour supply Hence, people have to wait until new jobs open up.

Unions and collective bargaining

Unions usually want a higher wage for their workers If this wage is above equilibrium, it causes unemployment The people who are still employed benefit because they have a higher wage, but the ones who get fired incur the cost of the higher wages Unions have a lot of bargaining power because they can threat an industry with a strike The process whereby unions negotiate with employers is called collective bargaining

A union is a worker association that bargains with employers over wages, benefits, and working conditions In the U.S about 12% of the workers belong to a union Most workers in the U.S bargain personally over wage, working conditions and benefits with their employers By contrast, workers that belong to a union bargain as a group, this is known as collective bargaining The union simply tries to reach an agreement about wage and other conditions for you Unions can threaten the firms with a strike; that is the organized withdrawal from of labour from a firm by a union When unions raise the wage above equilibrium level, there is more unemployment At the same time, people who are still employed benefit from the higher wage This is a

178 constant trade-off that a union has to make: choosing between employment and higher wage People who become unemployed because of the higher wage can respond in 2 ways They can either wait until they are being hired and then they can profit from the higher wage or they can work in other industries which experience increasing labour demand When the wage in some sector exceeds equilibrium level, unemployment is being caused and labour supply will be higher in other sectors which are not unionized In other words, workers in unions reap the benefit of collective bargaining, while workers not in unions bear some of the cost

There are both critics and advocates of unions Critics argue that unions cause outcomes that are both inefficient and inequitable Inefficient because wages are set above equilibrium level and hence cause unemployment Inequitable because some people have to bear the cost of the people who profit of the higher wages

Advocates argue that unions decrease the market power of firms Suppose there is only one firm in the region This firm could use its market power to charge lower wages, because people who do not accept the wage have to sit at home without work Therefore, a union could use its own power to make agreements about wages and other factors Moreover, advocated argue that unions are effective for helping firms respond effectively to worker’s concerns When workers make agreements about the job, they have to make choices about wage, overtime, vacation sick leave etc By representing workers’ views on these issues, unions allow firms to provide the right mix of job attributes Even if unions have the adverse effect of pushing wages above the equilibrium level and causing unemployment, they have the benefit of helping firms keep a happy and productive workforce.

The theory of efficiency wages

A fourth reason economies always experience some unemployment—in addition to job search, minimum-wage laws, and unions—is suggested by the theory of efficiency wages Efficiency wages are paid because it increases workers health, turnover, quality and effort

Efficiency wages are in a sense different from minimum-wage laws and union outcomes Minimum-wage laws and unions prevent firms from lowering wages in the presence of a surplus of workers Efficiency wage theory suggests that such constraints are unnecessary since most firms are better off paying a higher wage anyway There are several explanations of why firms are willing to pay higher wages

Firms may be hesitant to cut back wage, because their workers will otherwise suffer from poor nutrition This is a serious problem in developing countries such as Congo Companies profit from workers when they are in good shape and hence they are willing to pay a higher wage so that workers will stay in shape Health concerns are much less relevant in rich countries such as the U.S where equilibrium wage is far above the level needed for an adequate diet

Workers face many trade-offs when they chose for a certain job They may leave a company if they can earn a higher amount of money elsewhere Firms can prevent this by offering a higher wage The reason that firms are scared of turnovers is that hiring new people is costly They first have to be trained and even after that they lack the experience of an experienced worker Companies with many turnovers tend to have a more costly production process

Every firm wants talented workers Talented workers are hard to find When companies have to hire new people, they have to gauge whether someone has qualities or not A way to select more talented people is to higher the wage, because these people are then more likely to apply Conversely, when firms cut back in wage, this will turn more talented people off since they have other good options to choose from

Another reason to higher wage is to increase the effort of workers In many jobs,

180 workers have some discretion over how hard to work Therefore, employers try to monitor the efforts of their workers and if someone shirks, he will be fired But monitoring is never perfect and it is costly too Therefore, employers offer their employees a higher wage If workers are caught shirking, they will be fired, but they cannot find a job which offers similar wages Hence, there is an incentive for employees to work harder and not to shirk

The monetary system

The meaning of money

Money has 4 functions in an economy: it serves as a medium of exchange, it is a unit of account, it serves as a store of value and it is liquid Commodity money is money with intrinsic value like gold, but fiat money does not represent any intrinsic value People accept fiat money because the government declared it to be a legal medium of exchange

Money is the set of assets in the economy that people regularly use to buy goods and services from each other When you have paper money in your pocket, you can pay a meal at McDonalds because paper money is regularly used by people to pay goods and services By contrast, if you own a big Microsoft firm, such as Bill Gates, you are wealthy but you cannot pay with it since people don’t use it as a medium of exchange Money has various functions in the economy We will elaborate on the most important ones

Money serves as a medium of exchange, meaning that it can be used by buyers to

183 give it to sellers when they purchase goods and services When you walk into a store, you are pretty confident that they will accept your money as a medium of exchange Second, money is used as a unit of account, meaning that people use it as a yardstick to post prices and record debts Suppose that a t-shirt cost $30 and a hamburger $3, then 1 t-shirt is worth 10 hamburgers Still, you won’t encounter such prices in a store because the dollar is used as a unit of account Also, money is a store of value, because you can use it to transfer purchasing power from the present to the future If you would have to pay with goods, like a couple centuries ago, then most goods would not be a store of value If you want to pay with milk, you have to do it in a couple of days because after that the milk has become worthless Also, money is perfectly liquid, since it is our common medium of exchange Bonds and stocks are also quite liquid because they can easily be converted into money Houses, to the contrary, are not liquid

In the economy, we distinguish different kinds of money Commodity money is used to indicate money that takes the form of a commodity with intrinsic value Money without intrinsic money is called fiat money A fiat is an order or decree, and fiat money is established as money by government decree This is why dollars can be used as a medium of exchange and monopoly money not The government has declared dollars to be valid money

We will soon see that the amount of money circulating in the economy has a big impact on economic variables The question remains what we should count as money and what not Clearly, paper cash in your wallet is part of the total quantity of money You can use this as your definition of the amount of money in the economy Still, people also deposit their money at banks and they can get access to this at a store by just swiping their credit card or write a check Hence, you could also include demand deposits in the definition of money Once you are led to include demand deposits, you can include a wide variety of deposits that people hold at their bank or other financial institutions Because of this wide variety, economists have different measures of the quantity of money called M1 and M2 M2 includes more assets than M1

The Federal Reserve System

The Fed in the central bank of the U.S It consists of 7 members, including the chairman The Fed has the power to influence the money supply in the economy Monetary policy refers to the decisions made by the Fed to increase or decrease the money supply Monetary policy is made by the Open Market Committee The most important way the Fed can influence the money supply is by means of conducting open market operations

Every country which uses a system of fiat money must have some institution that regulates the system In the US, that institution is the Federal Reserve The Fed is an example of a central bank—an institution designed to oversee the banking system and regulate the quantity of money in the economy The Fed is a big institution and is organized in a very specific way The Fed is run by its board of governors, consisting of 7 members who are appointed by the president The governors each serve a term of 14 years to insulate them from politics The most important person of the 7 people is called the chairman The chairman directs the Fed staff, presides over board meetings, and testifies regularly about Fed policy in front of congressional committees

The fed has 2 important duties The first is to regulate banks and ensure the health of the banking system This job is mostly performed by the regional Federal Reserve Banks They monitor the behaviour of banks in the region and facilitate transaction by clearing checks The Fed can also serve as a lender of last resort, this happens when banks are not able to borrow money elsewhere, then the Fed will lend them money otherwise the bank will collapse The Fed’s most important job is to control the quantity of money that is available in the economy, called the money supply

Decisions by policymakers concerning the money supply constitute monetary policy

Monetary policy is made by the Federal Open Market Committee (FOMC) In this committee are 5 people that get to vote over monetary policy The committee is always attended by the 7 board governors and the 12 presidents of the regional banks The five people that get to vote changes every time, although the president of

185 the New York Fed always gets to vote Through the decisions of the FOMC, the Fed can increase and decrease the money supply We will further elaborate on the tools which are available to the Fed, but for now we mention the open market operations If the Fed wants to increase the money supply, it can buy government bonds from the public The public then has more liquid money available and hence the money supply is increased Decreasing the money supply through open market operations can happen in the opposite way.

Banks and the money supply

Besides the Fed, banks can influence the money supply too Banks are required to hold some money as reserves, but they can lend out the rest This is fractional reserve banking The percentage they hold as reserves is known as the reserve ratio Banks do not only receive money from deposits, but also from issuing equity to its owners, this is called bank capital The way banks create money is by lending it out to other customers, the seize by which they increase the money supply is known as the money multiplier

In our analysis so far, we omitted the crucial role that banks play in the money supply

We will see that banks have a huge influence on the money supply, thereby complicating the job of the Fed to control the money supply The reserves of a bank are deposits received by a bank but not lend out If a bank holds all the deposits as reserves, it does not have any influence on the money supply

Fractional-reserve banking is a banking system in which banks hold only a fraction of deposits as reserves The fraction of total deposits that a bank holds as reserves is called the reserve ratio This reserve ratio is determined by government regulations and bank policy The Fed sets the minimal amount of reserves a bank has to hold, called a reserve requirement In addition, banks can choose to hold more reserves, called excess reserves, so that they are more confident that they can pay their short- term bills We will now show how fractional reserve banking influences the money supply

Suppose you have $100 and you deposit everything at your bank If the reserve ratio is 10%, the bank is only required to hold $10 and can lend out $90 to potential borrowers Now someone else can lend $90 at the bank and the money supply has suddenly increased from $100 to $190! Hence, when banks are required to hold only a fraction of the deposits, it can create money This process can continue, since someone who borrowed $90 can also deposit this at another bank Again, the bank is required to hold only $9, so it can lend out $81 Now the money supply increased to

$271 It turns out that even though this process of money creation can continue forever, it does not create an infinite amount of money If you laboriously add the infinite sequence of numbers in the preceding example, you find the $100 of reserves generates $1,000 of money Mathematicians will recognize this is a geometric series The amount of money the banking system generates with each dollar of reserves is called the money multiplier Notice that in our example the money multiplier was 10, since we started with $100 and ended up with $100 It turns out that the money multiplier is the reciprocal of the reserve ratio, which is 1/R In our example the reserve ratio was 10% or 0.10 and hence the money multiplier is 1/0.10 = 10 Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier More realistic, banks not only receive money from deposits, but also from issuing equity to its owners called bank capital Many businesses in the economy rely on leverage, the use of borrowed money to supplement existing funds for investment purposes Indeed, whenever anyone uses debt to finance an investment project, he is applying leverage Leverage is particularly important for banks, however, because borrowing and lending are at the heart of what they do The leverage ratio is defined as the assets of a bank divided by the capital.

The Fed's tools of monetary control

There are 4 ways how the Fed can influence the money supply: open market operations, lending money to banks, reserve requirements and paying interest on reserves The most important tool is open market operations Paying interest on reserves is a relatively new tool and investigators are not sure what the impact of this new rule is

As we saw earlier, the Fed can conduct open market operations to increase or decrease the money supply If the Fed wants to increase the money supply, it can buy government bonds with dollars These dollars end up either in the pocket or on a bank deposit When people hold $1 in their pocket, the money supply increases by $1, but when people deposit their money at banks the money supply increases by more than

$1 When the Fed wants to decrease the money supply, it simply does the reverse It sells the government bonds in turn for dollars People either pay it with paper money or with money on their bank account Hence, the mechanism of money multiplying reverses

The Fed also lends money to banks, for example when they need to satisfy bank regulators, meet depositor withdrawals, make new loans, or for some other business reason When banks borrow money from the bank, they also have to pay an interest rate, called the discount rate When the Fed sets the discount rate at a high level, banks are discouraged from lending from the Fed and hence the money supply decreases The opposite happens when the discount rate is at a low level

The Fed can also change the reserve ratio of banks A higher reserve ratio means that banks have to reserve a bigger part of their deposits and hence the money supply decreases The Fed can change the reserve ratio in two ways: either by regulating the reserve ratio or through the interest rate that the Fed pays to banks on their reserves

The Fed's reserve requirements determine the reserve ratio, which establishes the minimum reserves banks must hold against their deposits A higher reserve ratio reduces the money multiplier, decreasing the money supply Conversely, a lower reserve ratio allows banks to lend more, increasing the money multiplier and the money supply By altering the reserve ratio, the Fed can effectively regulate the monetary system and the availability of money in the economy.

In 2008, the Fed began paying interest on reserves When the bank deposits reserves

188 at the Fed, the Fed now pays interest on those reserves Hence, a higher interest on those reserves will induce banks to deposit more money This means that they can lend out less money, which means that the money multiplier is lower and hence the money supply decreases Since this is a fairly new tool, economists are not sure how important this is for altering the money supply

The Fed still has problems with controlling the money supply This has 2 causes The Fed does not control the amount of money that people are willing to deposit When people become more pessimistic about a bank, they may choose to withdraw their money and hold it in their pockets Then the money supply decreases without any intervention of the Fed Moreover, the Fed can neither influence the excess reserves of a bank If the economy is doing badly, banks may choose to lend out fewer loans, thereby increasing the excess reserves By doing this, the market supply again decreases

Money Growth and Inflation

The classical theory of inflation

The classical theory of inflation divides variables into 2 categories: real and nominal variables This is known as classical dichotomy The monetary neutrality assumption states that real variables are not affected by growth in the money supply The velocity of money indicates how many times the classical dollar bill changed from owner According to the quantity equation V*M=P*Y Because the real interest rate is not influenced by the inflation rate, the nominal interest rate is directly influenced by the inflation rate This is known as the Fischer-effect

So far, we have viewed the price level as the price of a basket of goods and services Alternatively inflation can be thought of as the price of money Higher prices mean that your money becomes less valuable Suppose P is the price level measured by the consumer price index, then P measures the amount of dollars needed to buy a basket of goods and services But, we can also say that with $1 we can buy 1/P goods and services If the economy produces only 1 good, say ice-cream cones, and the price of a cone is $2 Then P = $2, and hence with $1 we are able to buy ẵ ice-cream cone Hence, when the price level increases, the value of $1 decreases

We already saw that the Fed determines the money supply together with banks They can do this through open market operations for example We will assume that the Fed can set the quantity supplied as a policy without the problems we discussed in the previous chapter Now we consider money demand That is the amount of liquidity consumers want to hold in their pockets Many factors determine money demand, but the most important factor is the overall price level If prices increase, people need more liquid money to pay their groceries Therefore, inflation will cause money demand to increase and vice versa The equilibrium level of supply and demand depends on the time horizon In the short-term, it depends on the interest rate In the long-run the overall level of prices adjusts to the level at which the demand for money equals the supply

Above you see the typical long-run supply curve as the vertical line S together with the quantity of money On the vertical axis we have the value of money and off course the demand curve is again downward sloping This is because an increase in the price level leads to a decrease in the value of cash and therefore to an increase in in quantity of money demanded

The quantity theory of money posits that changes in the money supply directly affect inflation Doubling the money supply, for instance, shifts the supply curve rightward, devaluing the currency and increasing its quantity This inflationary effect is explained by the theory's assertion that price levels are determined by the amount of money in circulation As the money supply expands, the value of each unit decreases, leading to higher prices and inflation.

According to this theory, the quantity of money in the economy determines the value of money and growth in the quantity of money primarily determines the inflation Because people have more money to spend after the money injection, goods and services become more expensive

Classical economists have made the separation between real and nominal values to study changes in price level This is called classical dichotomy The separation of these variables turns out to be important Recall that nominal variables are measured in monetary units whereas real variables are measured in physical units For example, the price of corn, which is $2 a bushel is a nominal variable just like the price of wheat which is $1 a bushel The relative price of corn is 2 wheat This is not measured in

192 money, but in physical units, hence the relative price is a real variable The reason that classical economists made this is distinction is because they thought that real variables are not affected by developments in the economy’s monetary system We tacitly assumed this already when we treated the real interest rate to balance supply and demand for loanable goods and the real wage that balances labour supply and demand This has nothing to do with the amount of money in the economy Changes in the money supply only affect nominal variables according to the classicists The irrelevance of monetary changes for real variables is called monetary neutrality The assumption of monetary neutrality is not always met in the short-run, but it seems to be a reasonable long-term assumption

We can also give another interpretation to the quantity of money in the economy The interpretation depends on how many times per year the typical dollar bill is used to pay for a newly produced good or service This is called the velocity of money and will be denoted by V If P is the price level, Y is nominal GDP and M is the quantity of money we can give the following formula for the velocity of money in an economy:

To see how this works, consider an economy where they only consumer pizzas

Suppose that the economy produces 100 pizzas in a year, that a pizza sells for $10, and that the quantity of money in the economy is $50 Then the V = (100*$10)/$50 20 This means that the average dollar bill changes 20 times from hand We can also rewrite the equation for V to obtain V*M = P*Y This is called the quantity equation, since it relates the quantity of money to the nominal value of output The velocity of money has proved to be quite constant over time, hence as a useful approximation we will assume that it is constant

The question remains why some countries still choose to print so much money that it becomes almost worthless The answer is that countries are using money creation as a way to pay for their spending When the government chooses to create new money, it is said to levy an inflation tax This is because everyone’s wealth decreases, since the value of money decreases In the United States, the inflation tax accounts for only 3% of government revenue, but in other countries like Zimbabwe, the situation is much

193 worse They have Zimbabwe dollar bill of 3 trillion, but it is worth only 3 US dollars According to the principle of monetary neutrality, an increase in the rate of money growth raises the rate of inflation but does not affect any real variable Now consider the equation for the real interest rate again: real interest rate = nominal interest rate – inflation rate

We can rewrite this equation to obtain nominal interest rate = real interest rate + inflation rate

We know that an increase in the money supply lead to an increase in the inflation rate, moreover according to classical dichotomy, the real interest rate is not affected because it is a real variable Hence an increase in the inflation rate account one-to- one for a change in the nominal interest rate This is known as the Fisher effect The Fisher effect need not hold in the short run because inflation may be unanticipated Therefore the Fisher effect can be used to explain the changes in the nominal interest rate over time.

The costs of inflation

Inflation incurs some cost to society such as: shoe leather cost, menu cost and confusion Many of these costs are large during hyperinflation, but the size of these costs for moderate inflation is less clear

If you ask people on the street why inflation is bad, most will answer that it affects their purchasing power and hence the standard of living But further thinking will reveal that this answer is a fallacy When prices rise, people have to pay more for goods and services At the same time sellers will receive more money Because most people earn their incomes by selling their services, such as their labour, inflation in incomes goes hand in hand with inflation in prices Thus, inflation does not in itself reduce people’s real purchasing power The reason that inflation is still experienced as a negative phenomenon depends on other costs that it bears

One of the costs of inflation is called shoe leather cost Because inflation decreases

194 the value of money, more people will choose to hold less money in their pocket and more on their bank account The cost of heaving less money in your pocket is called shoe leather cost because you have to go up and down to the bank which wears your shoes out more quickly Shoe leather costs are not important in countries with low inflation, but it can play a significant role in counties which experience hyperinflation

Another type of cost is menu costs, the cost of adjusting your prices to the overall price level If countries experience high levels of inflation restaurants and other companies might adjust their prices daily This bears costs such as printing a new menu card, deciding what new price to charge, sending the new menu’s to customers and advertising for the new prices In countries as the US most firms adjust their prices once per year, but in countries experiencing hyperinflation firms may adjust daily

Changing prices also bears another cost When companies adjust their prices only once per year and the inflation is 12%, the relative price will be high in the first couple of months and low in the last couple of months Hence, when inflation is high, the relative price changes a lot This is bad because it distorts consumer’s preferences and hence markets are less able to allocate resources efficiently

Moreover, tax laws often do not take inflation into account If you bought a Microsoft share for $10 in 1980 and you sold it for $50, then according to the tax laws you made profit of $40 which you must include in your taxable income But if the price level doubled over time, the $10 you invested then was actually worth $20 Hence, you’re real gain was only $30, but this does not matter according to the tax laws One solution to this problem, other than eliminating inflation, is to index the tax system

Inflation also causes confusion and inconvenience sometimes When you are calculating profit and you have to take into account a different price level for different periods in time, it needlessly complicates your calculations Also, inflation and deflation can redistribute wealth If you borrowed $70.000 from a bank at an interest rate of 3%, then inflation would be beneficial since you have to pay back less and vice versa

Open-economy macroeconomics: Basic concepts

The international flows of goods and capital

A country's export and import determine the trade balance Net capital outflow is the difference between purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners There are many factors that determine net capital outflow such as: real interest rate paid on foreign and domestic assets, perceived economic and political risks of holding assets abroad and government policies that affect foreign ownership of domestic assets An important fact is the NCO=NX Since S = I + NX, this implies that S = I + NCO

International trade involves the exchange of goods and services between countries Exports refer to domestic products sold abroad, while imports are foreign products purchased for domestic consumption Net exports represent the difference between exports and imports, determining a country's trade balance A positive net export (exports > imports) indicates a trade surplus, while a negative net export (imports > exports) indicates a trade deficit When exports and imports are equal, a country experiences balanced trade Factors such as exchange rates, tariffs, and economic policies influence international trade, shaping the flow of goods and services across borders.

• The tastes of consumers for domestic and foreign goods

• The prices of goods at home and abroad

• The exchange rates at which people can use domestic currency to buy foreign currencies

• The incomes of consumers at home and abroad

• The cost of transporting goods from country to country

• Government policies toward international trade

When a US resident is deciding to invest his money, he can buy a Toyota car or he can buy a stock in the Toyota Corporation The first transaction represents a flow of goods, whereas the second transaction represents a flow of capital The term net

197 capital outflow refers to the difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners When US residents purchase foreign goods, capital is said to flow out of the country and the net capital outflow increases Conversely, when foreigners purchase more domestic assets, capital is said to flow in and net capital outflow decreases There are a few factors that determine the net capital flow such as:

 The real interest rates paid on foreign and domestic assets: Higher interest rates give higher return Hence, if you decide where to buy bonds, you look at the real interest rate it pays

 The perceived economic and political risks of holding assets abroad: When you invest in government bonds, you must take into account the probability that the government might default

 The government policies that affect foreign ownership of domestic assets: Governments have the power to affect foreign ownership of domestic assets When these policies turn out to be negative for foreign investors, you might consider investing somewhere else

We already saw that domestic residents can export and import goods, or they can buy and sell financial products such as bonds Net exports measure a type of imbalance between export and import on the world product market Similarly, net capital outflow measures a type of imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners An important identity in accounting is that net export is equal to net capital outflow, i.e

Net capital outflow is always equal to a country’s Net Exports, because the value of net exports is equal to the amount of capital spent abroad (i.e outflow) for goods that are imported It is also equal to the net amount of a country’s currency traded in the foreign exchange market over that time period The value of exports (bananas, ice cream, clothing) produced in a country is always matched by the value of reciprocal payments of some asset (cash, stocks, real estate) made by buyers in other countries to the producers in that country This value is also equal to the total amount of

198 currency traded in the foreign exchange market over that year, because essentially the buyers in other countries trade in their assets (e.g foreign currency) to convert to equivalent amount in domestic currency, and use this amount to pay for export products

We can now look at the influence of net exports on national saving From previous chapters, we know that if we assumed the economy was closed S = I Let’s see what happens in an open economy Recall that:

Y – C – G = I + NX, we know that Y – C – G = S hence we obtain

S = I + NX and because NX = NCO we can rewrite this as S = I + NCO

This equation tells us that every dollar that is saved can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad Notice that our equation for saving is more general than before, because the new equation leads to the old equation when NX = 0.

The prices for international transactions: Real and nominal

Just like prices in ordinary product markets had the important role to balance supply and demand, international prices help coordinate the decisions of consumers and producers as they interact in world markets The nominal exchange rate is defined as the number of units of the domestic currency that can purchase a unit of a given foreign currency Similarly, the real exchange rate is defined as the ratio of the price level abroad and the domestic price level When the dollar increases relatively to another currency, it is said to appreciate When the dollar decreases it is said to depreciate

The nominal exchange rate is defined as the number of units of the domestic currency that can purchase a unit of a given foreign currency For example, 80 yen might be worth $1 This means that if you give $1 to the bank, you get 80 yen in return We can also say that 1 yen is worth $1/80 = $0.0125 In this book we will always express the nominal exchange rate as units of foreign currency per U.S dollar, such as 80 yen per dollar If the exchange rate changes in a way that 1 dollar buys more foreign currency, we say that the dollar appreciates Similarly, if the exchange

Supply and demand for loanable funds and for foreign-currency

Aggregate demand and aggregate supply

How monetary policy influences aggregate demand

The short-run trade-off between inflation and unemployment

Should monetary policy be made by rule rather than by discretion