Econ 201 Textbook Notes Chapter 2 Outsourcing relocating products once made in US to other nations; insourcing is opposite Production

does not just depend on price of labor/wages. Facilities, technology, etc. Reason why centering all production in 1 poor country is a bad idea. Globalization integration and development of world economies. Globalization forces firms to specialize their craft Comparative advantage crucial to higher wages Exchange rates and lack of innovation pose threat to wages Law of one price workers of same status in different countries tend not to have radically different wages Outsourcing isn t bad; what needs to be mastered is the timing of trade benefits Trade and outsourcing have benefited US largely Hidden costs are everywhere; no free lunch Economics AKA the dismal science. XXX Chapter 3 Market economy based on private property and the market in which individuals decide how, what, and for whom to produce. Socialism initially hypothetical, then put into economic practice in 1900s (welfare system is trademark) Today, economies differentiated based on extent of market influence, not whether they are capitalist, socialist, etc. Feudalism tradition rules Three sectors: Business, Household, and Government

House to business = factor market Business to household = goods market Business private production units Extra cost of hot dog at game is in distribution 72 percent of business is proprietorships, 8 percent partnerships, 20 percent corporations; corporations dominate market with 80 percent of receipts corporations are owned by stockholders; can legally avoid taxation; limited liability table on page 61 gov t provides institutions and rules promotes effective competition corrects externalities (effect of decision on third party not considered by decision maker) ensures economic growth provides goods adjusts for bad market results prevents excess monopoly ozone destruction = externality private good = apple public good = national defense free rider don t contribute but benefit demerit goods/activities = drugs merit goods/activities = whole grain bread no global gov t to regulate global corporations Group of Five; Group of Eight; meet to discuss negotiations in economics, etc. Chapter 4 Law of demand quantity demanded rises/falls as price falls/rises, other things constant Demand curve graphic rep. Demand going down isn t exclusively related to price

Demand vs. quantity demanded Demand shows how much bought at various prices QD shows how much bought at specific price Movement effect of change in price on QD Demand shift anything besides price changing demand (society s income, prices of other goods, tastes, expectations, taxes) Inferior goods price reduces command (ex. Mass transit systems) Complements (movies + popcorn) Demand shifts important, but price most important Good example on page 85 under A Review Time dimensions often crucial Market demand curve horizontal Sum of all individual demand curves (lots of people!) Major phenomena: (1) lower prices? Existing demanders buy more (2) lower prices? New demanders enter market Supply 2 factors 1. analyze production factors to households and firms 2. analyze process by which firms turn production factors into usable goods and services law of supply QD up with price up; QD down with price down (other things constant) supply curve (supply curve going up; demand curve going down) LOS and LOD can be violated! Caused by other factor Supply schedule of quantities a seller wants to sell per unit of time at various prices (x per y) Quantity supplied specific amount supplied at specific price (x) Movement along supply curve rep. of effect of change in price on quantity supplied Shift in supply/shift factor Shift factors: Price of inputs (affects firm s ability to output) Technology Expectations Taxes/subsidies Related to price = movement along supply curve

Related to shift factor = shift in supply Supply curve rep s minimum price sellers will accept for goods Market supply curve = horizontal sum of all individual supply curves Equilibrium S and D cancel each other out Equilibrium quantity amount bought and sold at equ. Price Equilibrium price price toward which invisible hand drives market When S and D equal, you have equilibrium Equilibrium is NOT state of world because economy isn t the only operating force; it s a characteristic of the model (car at 100 mph compared to a stationary rock, then compared to another car going 100 mph) Fallacy of composition what s true for a part is true for a whole (FALSE) When firms supply, they create demand for goods. Chapter 5 Mostly a series of examples; good supply and demand review chapter Price ceiling generally below equilibrium price Rent control price ceiling on rents; set by gov t Chapter 6 Models = glue of economics; simplified rep. of problem that captures issue Heuristic model models expressed informally in words Modern economists use wider range of models Economists emphasize advantage of simplicity and ease of testing. Single, easy-to-apply model is most useful What one has influences what one wants Endowment effects people value things just because they have them (parents loving their children and thinking they are perfect)

Chicago approach = maintaining traditional (not behavioral) economic analytical practices (Gary Becker) Modern behavioral economists don t want to rid of traditional (ex. Supply/demand), but they don t explain everything. Models using these principles explain more completely. Traditional vs. behavioral Landsburg s sex model based on traditional block of strong self-interest Car insurance: Ithaca vs. Philly Make people get insurance means lower rates for everyone; sacrifice of freedom for long-term benefit Regression model statistically relates one set of variables to another Larger coefficient of determination, better fit of line in regression model Another name for regression model is pattern-finding models Economists, unlike social scientists, rely on empirical methods Modern econ defined by using quantitative data to make an argument Early simple model example supply/demand Modern not just 2-D graphs; Table 6.2 on page 143 Can have many equilibriums; changes in variables; system can be in equilibrium, individual parts NOT; relationships can be nonlinear Keep It Simple, Stupid! Self-confirming equilibrium equilibrium in which people s beliefs become selffulfilling Butterfly effect small belief change = major change Final 5 pages of Chapter 6 Empirically tested models use hypothesis first and obtain data; heuristic is opposite. Empirical model cannot be a mere test of the model itself; there is no formal model to test. One needs to test the model s implications against many sets of data.

Hedge funds represent the investments of rich investors with little restriction on what they can buy Supply/demand is just the beginning for modern economics; crucial, but not all encompassing. Theorem results that follow logically from a model Precepts general rules for public policy Traditional growth is good; behavioral growth should be questioned Behavioral seems far more skeptical Behavioral form models around real-world problems and don t have to make as many adjustments as the simpler, traditional economists who rely mainly on the building blocks of economic thought. Chapter 7 Price elasticity of demand is percentage change in quantity demanded divided by percentage change in price Price elasticity of supply is percentage change in quantity supplied divided by percentage change in price Absolute value used Tells us how quantity responds to price change Elastic/inelastic Elasticity works in percentage, not units Pens vs. computers on page 130 Elasticity related to supply/demand curve slope; also changes along straight-line demand and supply curves. Steeper curve at given point = less elasticity Horizontal curves are perfectly elastic (E = infinity) Vertical curves are perfectly inelastic On straight-line curves, the unit elastic (percentage change in quantity is same as percentage change in price) point divides curve into an elastic portion and inelastic portion. More substitutes, more elasticity Substitution and demand 1. time period 2. degree to which good is luxury 3. market definition (transportation vs. transportation by bus) 4. importance of the good in one s budget Time periods relevant to supply: 1. instantaneous period, quantity supplied is fixed/perfectly inelastic 2. short run, somewhat elastic 3. long run, very elastic small geographic areas have more elastic demands Going to a movie theater elastic in short run Raising gas prices inelastic in short run Total revenue of supplier = price charged x quantity sold

Demand perfectly inelastic at price zero Price discrimination charging more or less to certain customers depending on their elasticity of demand Income elasticity of demand is percentage change in demand divided by percentage change in income Cross-price elasticity of demand is percentage change in demand divided by percentage change in price of a related good Complements goods used in conjunction with other goods (burger prices fall, ketchup demand increases) When should suppliers not raise prices? More elastic supply and demand, less price will change for given percentage change in both S and D 1. price rises significantly; quantity hardly changes. Supply highly inelastic; demand shifts out. 2. Price remains almost constant; quantity increases enormously. Demand highly elastic; supply shifts out. 3. Price falls significantly; quantity hardly changes at all. Demand is highly inelastic; supply shifts out. Basically, elastic means price pulls strongly on quantity. Inelastic? Little pull on quantity. Round 2 Before Test on 9/27 Chapter 1 Economics coordinating wants and desires given society, decision-making, etc. 1. what and how much 2. how to produce 3. for whom to produce scarcity our wants AND our means of fulfilling those wants new wants are constantly developing; cannot eliminate scarcity forever coercion limiting wants and increasing work needed to fulfill them create consistency in wants is major goal of economics costs and benefits are major in economic thought people do what is in their best interest financially according to Levitt decisions made by comparing costs and benefits marginal cost cost to you over and above the cost already incurred tuition = sunk cost; marginal cost = time lost going to class marginal benefit (additional benefit) is zero if you already know everything in chapter one economic decision rule if marginal benefits exceed costs, do it (vice versa) opportunity cost the value of the next best alternative that you didn t choose economic forces reactions to scarcity market force economic force given relatively free reign in market invisible hand price mechanism that guides our actions within the market people don t try to buy dates because social forces prevent it (p. 10) political force USPS has mail monopoly

more power given to suppliers who supply something scarce 3 forces: economic, political, social economic models take theories and apply them in a more acute economic setting invisible hand theory market economy through price mechanism will tend to allocate resources efficiently try to translate theories into stories micro each individual cell and build up macro whole body to discover nature of individual cells Economic institutions labor unions, banks (in some countries like Germany, etc.) Economic policy gov t intervention Policies that change institutions directly offer the most gain Art of economics using the positive to achieve goals in the normative realm Chapter 2 Production possibilities table Inputs Outputs Opportunity cost within a table (3 point rise in history means opportunity cost is 2 point deduction in econ) PPC downward curve represents fact that relationship is inverse between the two inputs Principle of increasing marginal opportunity cost in order to get more of something, you have to give up increasing quantities of something else; graph is therefore bowed out (bowed out because of comparative advantage) Comparative advantage better suited to produce one good than another (relief pitcher example; only need one, send in the best; need more, have to keep sending in worse and worse relievers) Productive efficiency as much output as possible Efficiency achieving a goal with as few inputs as possible/as cheaply as possible Inefficiency less output from inputs that would produce more output Technology enables us to attain previously unattainable points on PPC Efficiency varies within societies based on social standards/morals In our society, more is better than less. This makes productive efficiency and efficiency almost identical Comparative advantage: someone who is friendly and warm has a CA in human resources Smith s Wealth of Nations claims that humans tendency to trade leads us to use comparative advantage. Only man says I am willing to give this for that. We expect our dinner from a butcher s regard to his own interest. Smith Trade can be facilitated with relatively little gov t intervention The economy exploded when markets that facilitate trade + the spread of democracy were introduced to the world in a major way. Markets direct people to use comparative advantage because both people involved in transaction can benefit. Pakistan and Belgium on pages 33 and 34

Key: trade allows countries to consume beyond their PPC. Economists generally support free trade. Combining production possibility curves useful for analyzing effects of trade Slop of combined PPC determined by country with lowest opportunity cost Lowest cost rules producing where costs are lowest to gain from trade PPC becomes smoother with more countries contributing with their comparative advantage Bangladesh has textiles; we have computers and airplanes Outsourcing production of goods moves from US to another country Insourcing is opposite Insourcing being overwhelmed by outsourcing If one country has a comp. advantage, so too must another. US has higher wages because of technology, institutional structure, specialized knowledge Globalization increasing integration of economies, cultures, institutions around the world For firms, winning globally is much bigger than winning domestically, but it s harder to stay in business in a global market According to Smith, globalization increases SOL for everyone Overtime, we can expect the US to lose some of its comp. advantage New advantage could be nanotechnology in US Still, exchange rates are worrisome Competition drives wages towards equality Law of one price wages of workers in similar fields in different yet overall-wealthwise similar countries are not going to differ significantly (textiles in Sudan and Bangladesh) US has avoided law of one price since WWI US has lived luxuriously because of trade and IOUs NO FREE LUNCH PPC represents tough choices societies have to make Chapter 3 (Don t forget the Appendix at the end of Chapter 2) Other countries have markets, but still lower standards of living Markets are largely products of social and cultural institutions Institution formal and informal rules that constrain human economic behavior History of the US economy/evolution: Market economy based on private property and the market in which, in principle, individuals decide how, for whom, and what to produce Gov t must establish private property rights for market to work (gov t necessary for market facilitation) Markets work through rewards and payments Price fluctuations coordinate desires Economists aren t asking if a market should be used, but how (in terms of gov t intervention/involvement)

Socialism society answers the 3 main economic questions (in principle); based on people s goodwill towards their neighbors Capitalism market based; production means ownership lies with a few individuals Socialism benevolent family that meets basic needs Capitalism expected selfishness; socialism tried to contour desires around what was available This was the hypothetical socialism; real socialism based on central planning/strong gov t Planners, not prices, coordinated people s actions Socialism definition changed; market nations like Sweden considered socialist because of life-long welfare and high taxation Nowadays, countries economies differentiate in the extent to which they embrace the market system, not whether they are or are not a market system Feudalism tradition rules Mercantilism gov t doles out rights to undertake economic activities Industrial revolution led to capitalism because technology disadvantaged small producers and favored capitalists Japan and Korea sometimes considered Neomercantilist Market economies = households, businesses, gov t Factor market the contribution of families and how businesses pay them Goods market goods and services sold to households and gov ts by businesses Connection of an economy to the world economy made up of flows of goods and money Gov t redistributes income and oversees business and household interaction (Factor and goods markets) Business (private producing units) responsible for 80 percent of production Businesses decide the answers to the 3 economic questions Entrepreneurship ability to organize and achieve goals Distribution, services, goods Services = 80 percent of US economy Consumer sovereignty, profit Sole proprietorships (72%; one person), partnerships (20%; unlimited liability), corporations (8%; treated as a person; not liable for actions of the entire thing; owned by stockholders; get all kinds of tax breaks) Equity capital proceeds from stock sales Limited liability liable only for stock held in company; Makes Corporation attractive for investors (put in $100, you can only lose $100); initially to separate owners from management Chart on p. 61 Financial assets stocks and bonds (these help corp s finance expansions and new investments) E-commerce: B2B; B2C; C2B; C2C (Business, Consumer) B2B most important Brick and mortar becoming bricks and clicks B2B increasing 5 percent a year for firms (already at 15) 1 percent of transactions made on internet at this point for normal consumers

no geographic boundaries with e commerce e-commerce adds pressure to lower costs and prices Households are most powerful (group of people living together and making joint decisions) Stockholders have to accept what a corporation does unless they have substantial stock in the company Consumer sovereignty generally reigns, but it s an open question Households often passive income recipients whose input is contributing labor Largest household income source is wages and salaries Gov t as actor 80 percent of revenue from deductions from paychecks (social security tax and income tax); employ over 21 million; federal system; spend almost $2 trillion Check charts on page 65 Gov t as a referee regulates interaction between business and household 1. Businesses can t hire whomever they want. 2. Safety rules, wage rates, overtime, etc. 3. Businesses can t agree amongst each other on changing prices 4. Some businesses require union membership to work certain jobs Specific roles: 1. providing stable set of institutions and rules (necessary regulations and enforceable contractual obligations set on consumers and businesses) 2. promoting effective and workable competition (generally against monopoly; balance between competition and requiring licenses) 3. correcting for externalities (externality is unintended effect of decision on some seemingly uninvolved 3rd party; positive and negative; doesn t always work out) 4. ensuring economic stability and growth (1946 Employment Act; macroeconomic externalities with unemployment, inflation, or whole economy; ex: people spending less causes unemployment) 5. providing public goods (private good an apple that I ate that no one else can eat, too; public good national defense which is for everyone and is not cheapened if one person has it such as roads, parks, etc.; a free rider benefits but doesn t contribute) 6. adjusting for poor market results (income redistribution; gov t has to decide what s best for people like in the case of illegal drugs; demerit goods and activities are those that the gov t thinks are bad for the people even though the people engage in them; demerit goods are the opposite) Gov t and market failures (gov t is when gov t intervenes and makes things worse) Global Institutions: US comprises 20 percent of world output and consumption Global corporations: focus for firms now more global; consumer sovereignty also more globally focused; no global gov t to regulate a global corporation UN, World Bank, World Court, International Monetary Fund (ex: repayment plans for indebted nations) WTO, NAFTA (US, Mexico, Canada) and European Union try to reduce trade barriers Group of Five/Eight (US, Japan, Germany, Britain, France, Canada, Italy Russia) Membership in these is not mandatory; their power lies in moral tradition

Chapter 4 Supply and Demand Demand People demand less than they want Quantity demanded and price inversely related (law of demand, other things constant) p. 82 figure 4.1 Demand schedule of quantities of a good that will be bought per unit of time at various prices QD specific amount that will be demanded per unit of time at a specific price Think of this comparison in terms of Demand as the whole demand curve on the graph Movement along demand curve QD (points on curve) Shift in demand Demand (whole curve) Shift factors page 84 Normal vs. inferior goods Khakis and jeans are substitutes Movie tickets and popcorn are complements Expectations: if you expect your income to rise Anything except price is a shift factor Need a time dimension to make a demand curve graph useful Remember: analysis assumes that all else is held constant Market demand curve horizontal sum of all demand curves Firms estimate the market demand; they obviously can t add each individual sum At lower prices, current demanders buy more and new demanders enter the market Supply For produced goods supply depends on individuals decisions to supply factors of production but also on firms ability to transform those factors of production into usable goods. 2 parts of analyzing produced goods: supply of factors of production to households and to firms; analysis of process by which firms transform those factors of production into usable goods/services law of supply: quantity supplied rises as price rises/quantity supplied falls as price falls opportunity cost of not supplying a good rises as the price rises results in higher profits supply curve goes upward highlighted example on page 89 supply vs. quantity supplied (point on supply curve) movement vs. shift (just like demand) shift factors page 90 competing sellers essentially sets a price cap

market supply curve Supply and Demand interaction Equilibrium upward and downward pressure on price are equal; QS = QD Equil. Quantity amt. bought and sold at equil. Price Equil. Price price toward which invisible hand drives market Equil. Could be seen as an equilibrium OR a disequilibrium at the same time (a car going 100 mph compared to one going 60 and one going 100) Equil. Isn t necessarily good or bad (2 nuked nations) Often times an increase in price brings equilibrium by increasing QS and decreasing QD Interconnectivity of S and D makes it extremely difficult to accurately analyze a situation (things aren t usually held constant) Fallacy of composition what is true for a part is true for a whole (individual good vs. whole economy) Other-things-constant basically doesn t hold in macroeconomics. S/D analysis is a good step, but still only a step Chapter 7 Elasticity Price elasticity of demand/supply percentage change in quantity demanded/supplied divided by percentage change in price Elastic if percentage change in quantity is greater than the percentage change in price Price of land rises; you can t really make more land Price of pencils rises; supply more pencils! Calculate elasticity on page 130-132 End-point problem do you view change as rise or decline? Steeper slope means it s less elastic Horizontal perfectly elastic Vertical perfectly inelastic Unit elastic percent change in quantity = percent change in price Perfectly inelastic QS doesn t respond to price change Longer time period? More elastic Luxury? More elastic Broad market definition? Inelastic 3 time periods: instantaneous, short run, long run elasticity estimates probably higher in specific region vs. the US-at-large Gasoline remains inelastic in both short and long run, whereas movie tickets don t Toothpaste is perfectly elastic until product runs out and becomes perfectly inelastic Price discrimination Income elasticity of demand percent change in demand divided by percent change in income

Cross-price elasticity of demand percent change in demand divided by percent change in price of related good Luxury elasticity > 1 Necessity elasticity < 1 Food produced on farms is inferior, thus has negative short-run elasticity Positive cross-price elasticity = goods are substitutes Negative cross-price elasticity = goods are complements Percent change in price when demand/supply shifts = (percent change in demand/supply) divided by (demand elasticity + supply elasticity) Example on page 147 Chapter 6 Thinking like a modern economist (in the 8th edition) Models are the glue of econ. Model simplified rep. of a situation that captures the issue s essential components Building blocks assumptions of models Structure model s form (verbal, graphical, etc.) Heuristic model informal without words Inductive approach understanding from statistically analyzing what is observed in data Deductive beings with self-evident principles from which implications are deduced Most of our models will be applied-policy models Traditional economists simple models, assume rationality and self-interest Behavioral economics people are reasoned (purposeful; care about fairness), not necessarily rational (follow habit and the actions of others) Add in concept of enlightened self-interest people care about others as well as themselves Predictable irrationality people may seem irrational, but changing circumstances can make someone rational in one sense and irrational in another Behavioral economists want to see how people actually behave in the models they analyze Precommitment strategy people setting limits on themselves intentionally for the future to be more prudent Behavioral models depend on specific contexts What one has influences what one wants (behavioral) Behavioral building blocks are broader than traditional Endowment effects people value something more just because they have it Evolutionary models preferences based on what is best for survival; endowment effects make sense b/c of this Chicago approach traditional blocks are the essence of economic analysis/approach Model types heuristic (sex; more sex is safer sex! Traditional building block of strong self-interest; Landsburg) Tipping-point model people can get vastly different results depending on a person s initial choice.

Path-dependent path to equilibrium affects the equilibrium Very few people in Philly have insurance, and the rates for those who do are very high. In Ithaca, many initially bought insurance, more people bought it, and that gives you lower rates. Same deal with health care the left argues that if everyone were forced to have insurance, rates and cost would be much lower. Robert Frank heuristic behavioral economist; cash vs. lampshade (people are enlightened self-interested; don t want the cashier to pay out of her own pocket) Frank s other model Velcro shoes vs. laced shoes (less efficient than Velcro) Heuristic models are near impossible to wholly validate Empirical Economics analysis of data (econometrics came to prominence with the expanded ability of computer power in the 1980s), testable data that s able to be replicated, etc. Empirical research can be based on heuristic models! Build an empirical model around a heuristic one and support the argument with empirical evidence ( let the data speak ) Regression model empirical model that relates one set of variables to another statistically Coefficient of determination examines proportion of variability of data in a statistical model Review page 140-141 regression models (pattern-finding models) with wine and baseball The difference in economists lies largely in their reliance on formal empirical methods. Simple Data Models modern economics based on using quantitative data to make an argument, often with simple charts/graphs Natural experiment a natural event that can serve as an experiment in itself (death penalty example) Table on page 143 Mathematical developments lead to more complicated models KISS Self-confirming equilibrium equilibrium in a model in which people s beliefs becomes self-fulfilling Butterfly effect model small change causes large effect Set theory based on formal logical relationship Game theory strategic interaction of individuals when accounting for likely response of other people to what they do Computational power replaces analytic elegance page 144 Computer simulation is a major tool for modern economists some to estimate results of model that can t be solved analytically; some to solve issues that have such complicated problems that you can t even get a solid equation! This is called an agent-based computational (ACE) model (no equations, computer-based) These allow for multiple equilibriums and many levels of path dependency Could be a major part of the future of economics Heuristic forms hypothesis out of data; an empirically tested one switches this Bring the model to the data ; can we do x to test the model?

Heuristic models have imprecise relationships Heuristic imperial models have only an informal model that lets the data speak first; after you ve heard the data, you can provide an explanation for what you have heard. That explanation will be based on your implicit formal model, but the empirical model cannot be an explicit test of the model since the actual model came from the data. Empirically test a formal model developed from data set, one develops implications of the formal model as they relate to the issue. Price of chocolate rising Traditional Supply rises, demand rises, etc. Hedge funds investment funds rep ing rich investors that can buy almost anything moved investments from real estate to commodities like chocolate X futures right to buy x at a specific price point and point in time in the future Anchor points points toward which people gravitate; can lead to multiple equilibriums For a modern economist, policy does not follow directly from a model Models provide theorems (results that follow logically from a model), not precepts (general rules for policy) Precepts are developed from theorems Differences on page 149 KISS reigns, and most tend to emphasize traditional models. Modern insights are added as modifications and additional info. Remember to read Chapter 5 on Sunday 9/25 to review Supply and Demand Usage Chapter 10 (in 7th Edition) Firms make decisions based on expected costs and expected usefulness of inputs Technical efficiency as few inputs as possible are used to produce a given output. Economic efficiency inputs at lowest possible cost (best in long-run); also the technically efficient method of production that has the lowest cost. Determinants of what is economically efficient in long run are economies (EOS) and diseconomies (DOS) of scale. EOS total costs decrease as output increases in LONG RUN (400 each for 1000 DVDs; 200 each for 4000 DVDs) Indivisible setup cost cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes feasible to use; these create many economies of scale (the textbook!) Minimum efficient level of production amount of production that spreads setup costs out sufficiently for a firm to undertake production profitably Diseconomies of scale when long-run avg. total costs increase as output increases 1. as size of firm increases, monitoring costs (cost incurred by production organizer in making sure employees do what they re supposed to do) generally increase 2. as size of firm increases, team spirit and morale decrease larger organization, more paperwork + checks and balances

constant returns to scale long run avg. total costs don t change with output increase review pages 222-223 revenue for a good must be greater than the planned cost of producing it entrepreneur sees opportunity to sell product at higher price than it costs to produce it economies of scope when costs of producing interdependent products so it s less pricy to produce one good when it s already producing another good (gas stations + mini-marts) globalization facilitates economies of scope MAD (marketing, advertising, distribution) Nike doesn t produce the shoes; they outsource Learning by doing/technological change! Moore s law cost of computing will fall by half every 18 months Technological change drives costs down and can overwhelm diseconomies of scale Firms factor learning by doing and TC into their production Usually 10 or 20 marginal costs In applying analysis, reasoning, not the specific model, is important Explicit vs. implicit cost explicit can be measured in $; implicit is opportunity cost, time, effort, etc. Depreciation measuring decline in value of an asset over time Economics assumes that all costs are measurable in a single time period Standard economic model provides good framework for cost analysis (not just hard costs), but it can t make you an expert Chapter 10 (Logic of Individual Choice: the Foundation of Supply and Demand) Economists see SELF-INTEREST as foundation Main factors: utility and price Total utility vs. marginal utility 1st units also have marginal utility; if you eat one slice of pizza, MU=TU Rational more is better; maximize satisfaction Principle of rational choice spend your money on goods that give you the most marginal utility per dollar Need to assign a money value to compare choices LDMU operates in reverse Equilibrium marginal utilities per dollar are same for 2 goods How does this relate to S and D? When the price rises, we increase utility of that good by consuming less of it Remember L of D: price down, QD up Income effect reduction in QD because we are poorer Substitution effect reduction in QD because relative price has risen (price of ice cream relative to Big Macs) Differentiate these two on page 181 Substitution effect still active even if you re given money to compensate for the income effect Now, Supply

The more you really, really need something, the higher the marginal utility. Bounded rationality rationality based on rules of thumb (follow the leader, you get what you pay for) Focal point equilibriums goods toward which people have gravitated through luck, advertising, etc. Conspicuous consumption consuming goods to impress people (box logo hoodie) When a need is met, it is replaced by a want, which becomes a need People are utility maximizers Behavioral economics study of economic choice that is based on realistic psychological foundations Fairness and economic rationality guide decisions largely Ultimatum game person only gets money if the other accepts the offer; if he doesn t accept, they both get nothing. Status quo bias actions influenced by current situation that may or may not have anything to do with/be important to the decision Chapter 11 Each person acting in best interest will not necessarily arrive at best of all possible outcomes Game theory formal economic reasoning applied to situations in which decision are interdependent Game theory is the underlying model of the social sciences Game theory models are more flexible, but not as broad as standard ones Game theory is a framework, not a finished set of models Screening question structured in a way to reveal strategic info about the person who answers ( Which tire? ) Prisoner s dilemma two-person game that demonstrates the difficulty of cooperative behavior in certain circumstances Payoff matrix shows outcome of every choice by every player, given possible choices of all other players Game has 3 elements players, strategies, and payoffs Confessing is rational for both prisoners Non-cooperative game game in which each player is out for him or herself and agreements are either impossible or cannot be enforced Cheap talk communication before game is played that carries no cost and is backed up by trust and not by any enforceable agreement. Cheap talk doesn t influence outcome because the players can t trust one another to follow through on their words Sometimes people do have interdependent utility functions (i.e. care about others and themselves) Informal Game Theory depends on empirical evidence of behavior Game theory s power lies in structuring a problem as a strategic interaction problem, not just formal solutions/deductive logic Example of informal game theory with the 3 last Survivor contestants (Rudy, Richard, Kelly) on page 268 Vickrey Auction sealed-bid second-price auction

Game theory allows exploration of degree and nature of people s care for others It seems that if someone is being unfair, people will reduce their own income to make that person pay Ownership increases value Framing effects choosing something based on how it is presented (word usage) Game theory allows for more assumptions than standard theory Based on behavioral economics, people are purposeful but not always rational, show enlightened self-interest, and are boundedly rational It only takes a few people behaving rational because those few can develop businesses and institutions that make people pay for their irrationality and lack of self-interest (taking money off the table/transferring money from the irrational to the rational) An example is advertising mutual funds that emphasize past performance; salespeople present the good past history that is often irrelevant to future performance (this is transferring money from the economically unwise to the economically wise) Economic models offer insight into how people behave and how to think strategically It doesn t necessarily give answers to questions When people act differently than the economic model, we can expect people and firms to figure out ways to take advantage of their behavior Economic theory is constantly changing and taking into account new discoveries

Chapter 12 All supply ultimately comes from individuals Production transforming factors into goods and services Supply of goods that don t already exist (a jacket vs. a house) depends on production Firm organizes factors of production, produces goods, sells produced goods to individuals, business, government Virtual firms subcontract out all production (Perdue doesn t grow chickens, but they hire farms to do so) Most of organizational structures of business are separating from the production process directly Profit = Total Revenue Total Cost Accounting focuses on explicit costs (explicit revenue minus explicit cost) Economists deal with implicit (opportunity costs) and explicit Total cost = explicit payments to factors of production plus the opportunity cost of factors provided by firm owners Total revenue for economists is amount the firm receives for selling product plus increases in asset values of the firm itself

Economic profit = (explicit and implicit revenue) (explicit and implicit cost) Long run firm chooses among all production techniques (all costs are variable) Short run firm is constrained wrt what production decisions it s able to make (some inputs are fixed) These terms refer to flexibility of changing output Production table shows output resulting from combos of factors of production/inputs Marginal product additional output forthcoming form an additional worker (adding 1 worker to 5), other inputs constant Average product output per worker (total output divided by number of workers) Production function relationship between inputs and outputs Marginal productivity is negative at certain points Firms have to stay in the middle to maximize output Law of diminishing marginal productivity as more of a variable input is added to existing fixed input, eventually the additional output one gets from that additional input is going to fall Sometimes called the flowerpot law because if it weren t true, the world s food supply could be grown in 1 flowerpot (adding more seeds) Eventually total output decreases as inputs increase Types of Cost: Fixed costs spent and can t be changed in period of time under consideration No one wants earrings, but you bought the machine and don t have time to alter it to do something else. Cost of the machine is fixed (all fixed costs assumed to be sunk costs in this model). Variable costs that change as output changes Total Cost = FC + VC Total vs. Average: Total divide total amount of cost we re talking about by the quantity we produce ATC = TC/Q AFC = FC/Q AVC = VC/Q ATC = AFC + AVC Most important: Marginal Cost Marginal cost increase/decrease in total cost from increasing/decreasing level of output by one unit Cost curves on page 206-7 Average fixed cost decreases as output increases Falls quickly, then slowly U Shape: How does analysis of production relate to analysis of cost? Laws governing cost and productivity are the same As more of a variable input is added to a fixed input, the law of diminishing marginal productivity causes marginal and average productivity to fall. As they fall, marginal and average costs rise. Productivity falls = cost rises Marginal and average V cost curve are U shaped

ATC curve has same general U shape as AVC curve If MP > AP, then AP is rising If MP < AP, then AP is falling When productivity curves fall, corresponding cost curves rise As productivity falls, cost per unit increases Marginal cost and ATC marginal cost greater than ATC, then ATC rises MC = ATC, then ATC is at its low point MC < ATC, then ATC is falling. Ex: if you get a C and you have a B, then GPA falls If you get a C+, still falls because average is higher than marginal MC > AVC, then AVC is rising MC = AVC, then AVC is at low point MC < AVC, then AVC is falling Review graphs on 207 and 209 If short run marginal cost is only slightly above average variable cost, the average total cost will continue to fall. In other words, once marginal cost is above AVC, as long as AVC doesn t rise by more than AFC falls, ATC will still fall. Chapter 14 Competitive Pricing and Perfect Competition Perfectly competitive economic forces operate unimpeded Conditions? 1. buyers and sellers are price takers (firm or person who takes price determined by market supply and demand as given). It s not just the firms setting the prices; they also take S and D as given. 2. number of firms is large prevents a few firms from getting together, limiting output, and driving prices up. What one firm does has no influence on what other firms do. 3. no barriers to entry (social, political, or economic impediments that prevent firms from entering a market) 4. firms products are identical Coke, Pepsi are a counterexample/are not identical 5. complete information no firm/consumer has competitive edge over another 6. selling firms are profit-maximizing entrepreneurial firms they only seek profit, and the people who make decisions must receive only profit from the firm (no other form of income) Remember that Supply = schedule of quantities of goods that will be offered to the market at various prices Supplier has to be a price taker for this to hold. They ask, because of demand curve, how much should I produce and for what price? Collude firms operating together to get more money for themselves If perfect conditions hold, then a firm s supply curve will be that portion of the firm s short run marginal cost curve above the average variable cost curve. Even if we can t specify a supply curve, supply forces are strong and many insights of the competitive model carry over. Firm demand curve is perfectly elastic

Demand curve for market is still downward sloping Each firm follows its own self-interest MR change in TR with a quantity change MC change in total cost with a quantity change Firm maximizes profit when MR = MC Marginal revenue is the market price Profit-maximizing condition MC = MR = P Adjust output to reach this state Marginal cost curve = firm s supply curve Tells a firm how much it should produce at a given price Lower profit per unit can yield higher total profit Profit represented by distance between total revenue curve and the total cost curve Total profit maximized where vertical distance between total revenue and total cost is greatest. You only need marginal cost to determine a competitive firm s supply curve and to determine output that will maximize profit Profit = TR TC Positions that maximize total profit don t necessarily minimize ATC or AVC MC curve goes through lowest points of both Average Cost curves To maximize profit, a firm must see where curves intersect When the ATC curve is below the marginal revenue curve, the firm makes a profit. When the ATC curve is above the marginal revenue curve, the firm incurs a loss. To determine maximum profit, you must first determine what output the firm will choose to produce by seeing where MC = MR and then determine average total cost at that quantity by dropping a line down to the ATC curve. MC = MR = P both maximizes profit and minimizes loss Supply curve is the part of the marginal cost curve that is above the average variable cost curve As long as a firm can cover variable costs, then it pays to keep producing (could be a smaller loss, not a profit) When AVC = price, Shutdown point! Industry demand curve is downward sloping Remember: firm s supply curve is the portion of the firm s marginal cost curve above the AVC curve Market supply curve is horizontal sum of all firms marginal cost curves, taking account of any changes in input prices that may occur To get this, add quantities all firms will supply at each possible price. More firms enter market? Market curve shifts to the right In the long run, neither economic profits nor economic losses are possible because firms enter the market looking to profit until market price declines to the point of no incentive of economic profits. Here, all firms are earning zero profits. Vice versa when price is lower than price necessary to earn a profit (shift to the left on graph). At zero profit, entry and exit cease. Normal profit amount owners of business would have received in the next-best alternative. Economic profits are profits above normal profits.

Zero profit condition makes analysis of competitive markets far more applicable than a strict application of perfect competition In long run equilibrium, firms make zero profit Even if firms make a profit when demand increases, it won t stay that way for long because other firms will enter the market. Final equilibrium if many firms enter will be a higher market output but with the same price In the long run, firms earn zero profits Long run supply curve is perfectly elastic/horizontal Factor prices don t increase as output increases constant cost industry There are also increasing and decreasing cost industries Factor prices tend to rise when output rises if production factors are specialized Factor price rise increases price at which firms earn zero profit and force costs up for each individual firm In increasing cost industries, Long run supply curve is upward sloping Long run supply curve is vertical when all firms compete to supply a perfectly inelastic resource/factor input. Cost curves shift down in decreasing cost industry. Price at which zero profit condition falls, price at which firms cease to enter the market falls. Long run market supply curve is downward sloping. Long run equilibrium defined by zero profit In short run, price does more of the adjusting; in long run, quantity does more of the adjusting Chapter 15 Monopoly: when one firm comprises entire market Competitive firm s marginal revenue is the market price; monopolistic firm knows that its output affects the price Increasing production doesn t always make suppliers better off In competition, consumers benefit; in monopoly, the firm benefits Monopolists output decision affects price MC curve shows change in firm s total cost as it changes output. MR and D start at same point If avg. curve is falling, marginal curve must be below it Monopolist still uses MC = MR as profit-maximizing rule Charges price that consumers willing to pay for that quantity Equilibrium output different than competitive because MR is below price ATC to price comparison determines profit Price depends on the D curve ATC P (aka average revenue) Profit, no profit, loss dependent on ATC relative to P Patent legal protection of technical innovation giving person holding it sole right to use that innovation Many patented products yield only a loss (self-stirring pot) Why is monopoly undesirable? Society gains opportunity cost of resources freed up from production reduction

Monopolies charge price higher than marginal cost; therefore, people s decisions don t reflect true cost to society. Price exceeds marginal cost, and choices are distorted. Marginal cost of increasing output is lower than marginal benefit of increasing output. Thus, there is a welfare loss. Price-discriminating monopolies can increase profit substantially Examples: movie discounts to children and seniors; automobiles sold under list price; a health care agency getting discounted computers Market demand is made up of distinguishable individuals who have different demand elasticities Barriers to entry: natural ability, economies of scale, government restrictions (3 important ones) Whether monopolies are just or unjust is a normative question; monopolies either exist because a firm is naturally better at producing a good, or they used cheap tactics to drive other firms out and then jack up the price Natural monopoly industry in which single firm can produce at lower cost than can two or more firms Telephone service used to be a natural monopoly (why have more than 1 phone line?) Can yield a welfare gain because 1 firm is crazy efficient Example: many towns have one water department supplying water to residents In natural monopoly, can t have perfect competition because ATC are not covered where MC = P. When output restriction is necessary to make production feasible, the public often prefers government-regulated monopolies. Government-created monopolies: Though some may hate monopolies, most cats are down with patents Monopolies may transfer income in a way the public doesn t like Causes rent seeking in which people spend resources to gain monopolies for themselves AIDS example: development cost affects ATC curve of researchers, not the MC curve. They charge high price for cheaply produced drugs Even drug providers seek profit; that s why they spend billions on research to get large returns Price discrimination example: making AIDS drugs available to patients in poor nations at lower prices Maybe the gov t should buy out the patents? This also causes problems Chapter 16 Monopolistic Competition and Oligopoly Market structures change overtime; perfect competition and monopoly don t describe real world markets well Market structures physical characteristics of the market within which firms interact Monopolistic competition man firms selling differentiated products and few barriers to entry

Oligopoly a few firms, firms explicitly take other firms likely response into account Monopolistic comp characteristics 1. Many sellers Irish Spring, Dove, Old English, etc.; these firms are assumed to act independently; makes collusion difficult 2. Differentiated products Irish Spring soap is slightly different than Dove soap; monopolies in this realm are based on advertising to sway consumers; firms must make decisions as if they had no effect on other firms 3. Multiple dimensions of competition advertising, perceived attributes, service and distribution outlets (still comparing marginal costs and benefits and making these two equal) 4. Easy entry of new firms in the long run Monopolistic competitor faces down sloping demand curve. MR curve is below price MC < P at profit maximizing output Competition implies zero economic profit (determined by ATC in long run) in the long run Difference between P and ATC at given quantity = profit/loss Differences between perfect and monopolistic competition P comp has perfectly elastic demand curve and produces at minimum of ATC curve where MC curve = P. P comp produces where MC = P = ATC. Here, ATC is at minimum Monopolistic comp produces where MC = MR (ATC not at minimum here) Perfect comp s don t worry about increasing output or market share. Monopoly vs. Monopolistic comp Monopolist ATC curve can be below price so they make a long run economic profit. ATC curve or monopolistic comp must be tangent to demand curve at price and output chosen by monopolistic competitor (no long run economic profit is possible) Advertising can help, but also shifts ATC curve up ATC for monop comp includes advertising and cost of differentiating products Oligopoly Firms are mutually interdependent and can be collusive or non-collusive Explicitly take other firms actions into account when making decisions (strategic decision making) No definitive oligopolistic model. We ll look at the cartel model and the contestable market model. Cartel combination of firms that acts as if it were a single firm; a shared monopoly Cartel model assumes that oligopolies act as if they were monopolists that have assigned output quotas to individual member firms of the oligopoly so that total output is consistent with joint profit maximization Often times in cartel, one firm takes command and fringe firms follow suit regardless of their interest in the matter; this only happens if smaller firms face barriers to entry or if the dominant firm has significantly lower cost conditions.

Implicit collusion multiple firms make the same pricing decisions even though they have not explicitly consulted with one another (not illegal) Social pressures stabilize prices in oligopoly Cartels can encourage technological improvement that reduces demand for its monopolized product They perceive a kinked demand curve MC curve needs a gap when D is kinked Kinked demand curve is a theory of sticky prices Model 2 contestable market model barriers to entry and exit, not market structure, determine firm s price and output decisions; price charged will exceed cost of production only if new firms can t exit and enter market (higher barriers, more price exceeds cost). Without barriers, price an oligopolist sets will be equal to competitive price. An industry that looks like an oligopoly could set competitive prices and output levels. The most explicit we can be with oligopolies is that equilibrium of oligopolies with weaker social pressures and less ability to prevent new entry is closer to perfectly competitive solution. Oligopoly s price will be somewhere between competitive price and monopolistic price Law prevents absurdly high pricing by colluding firms like in Japan where they don t have laws against collusion ( preme in Japan, preme in the US) Big industries can add more competition than small town businesses US firms colluding leads to international firms entering a market (an example of national limit on cartelization) A cartel without barriers to entry faces highly elastic long run demand curve With oligopolies, chances of price wars are likely. Predatory pricing also can happen (Microsoft taking out other firms by offering systems for free and jacking up price after it becomes the industry standard) Review chart on page 293 Classification of markets is very difficult. What is the relevant market? What is to be included? Narrower definition, fewer the firms Rule of thumb: if 2 goods have cross price elasticity greater than or equal to 3, they are in the same market. NAICS industry classification that categorizes industries by type of economic activity and groups firms with like production processes.

Concentration ratio value of sales by top firms of an industry stated as a percentage of total industry sales (ex: a four firm concentration ratio of 60 percent tells you that top four firms in industry produce 60 percent of industry s output) Herfindahl index index of market concentration calculated by adding squared value of individual market shares of all firms in the industry (gives more weight to firms with large market shares than does the concentration ratio measure because it squares market shares); used by dept. of justice to determine if a merger is permissible between 2 large firms Less than 1000? Dept. assumes industry is sufficiently competitive and doesn t look more closely at the merger. Conglomerates are firms that span many unrelated industries (shoes and cars) Close relatives of contestable market model are barriers-to-entry, stay-out-pricing, and limit-pricing. These provide a view of competition that doesn t depend on market structure. Lower firm/concentration ratios and Herfindahl index figures, industries more likely to have competitive prices; vice versa yields a monopolized price Contestable market model advocate would say it depended on barriers to entry/exit. Free entry provides a more competitive price; barriers to entry would yield a more monopolistic price. But, a major similarity: barriers to entry are the reason there are only a few firms Chapter 17 Real World Competition and Technology Competition as a process, competition as market structure Firms more concerned with long run, so they spend short run cash to build up their name/reputation Most production takes place in corporations, not small owner-operated businesses Decision maker s income is often a cost of the firm. There are enormous wastes and inefficiencies in US businesses Monitoring problem employee and owner incentives differ Incentive-compatible contract each party s incentives correspond as closely as possible Self-interested managers are interested in maximizing firm profit only if structure of firm requires them to do so. Based on Japan s success and lower wages by 1/5 for high level managers, highly paid managers in the US reflect a monitoring problem inherent in structure of corporations common to all third party payer systems. Lazy monopolists don t push for efficiency but enjoy the position they already hold Firms are less lazy now with global competition X inefficiency firms operate less efficiently than they technically could; they have monopoly, but don t make large profits Owners seldom make operating decisions managers are hired to make decisions for them; managers pay is usually high and often seek perks like jet planes n shit

Graph on 329 LM s allow cost to rise until firm reaches normal profit level. Competition limits laziness More inefficient than X inefficiency results in going out of business Laziness is relative Lazy monopolists can get crushed in international markets Corporate takeover another firm or group issues a tender offer (one to buy up stock in the company) to gain control and install its own managers. If the takeover is successful, firm needs to make large profits just to cover the interest payments on the debt. Corporate takeovers make managers nervous about losing profit, and if faced with one, they ll often restructure the firm themselves Profit not a motive? Laziness would likely take precedence Drive for profit isn t only one that pushes efficiency: some people gain utility by running an efficient organization, and monitoring can reduce efficiency! Most economists think that most people don t have this sort of will power to not seek profit as a principle motivator Self-interested individuals don t like competition for themselves, but they do for other people Real world competition is a process fight between forces of monopolization and forces of competition Not one nation allows for a competitive agricultural market Laws and customs don t allow for perfect competition because the government emphasizes other social goals besides efficiency. Government prevents competition when it negatively affects these goals Net effect of restricting entry into a market is increase in suppliers income to detriment of consumers Perfect monopoly is just as hard as perfect comp People try to upend monopolies to get some of the profit either legally or economically Patents are dangerous because they enable firms to see what s unique about a product and try to improve on it, thereby rendering a patent worthless Firms want to establish initial presence in a market instead of patents Reverse engineering buying a product, disassembling it, finding out what s special about it, and copying it within the limits of law Competition is fierce and profit opportunities vanish quickly Natural monopoly ATC falls as output increases New technology provides competition to existing firms Political pressure often brought up when comp doesn t work fast enough Regulatory boards make natural monopolies charge a fair price that provides normal, not economic, profit When firms are allowed to pass on all cost increases to earn a normal profit on those costs, they have little or no incentive to hold down costs. Ex: regulated electric companies preferred nuclear power until they learned that some power plant costs could not be passed on.

Regulatory boards are often inexperienced and cannot handle regulation properly; it is a highly bureaucratic process Economists think that regulations make firms lazy and inflate their costs, and that natural forces should be the regulators Regulators divide industries into sub-industries (phone line, directory, caller service, pay phone, etc.) and allow those sub industries to operate competitively; this carves out monopoly characteristics and opens remaining parts to competition! Economies of scale can create natural monopolies (ex: power line industry is natural monopoly aspect of electrical power supply. Only portions of market where competition is likely to exist are being deregulated Competition is dynamic! Firms maintain monopoly by spending money to maintain it; all firms fight competition Firms buy monopoly power until MC of such power = marginal benefit Establishing Market Position: initial competition to establish a monopoly. It is winner take all competition An increasingly large name makes profit inevitable Companies can concentrate on just one aspect of production (specialization; GoreTex and fibers) Dynamic efficiency a market s ability to promote cost reducing or product enhancing technological change Oligopoly provides best market structure for technological advance Four Market Structures 1. Perfect Competition and Technology perfectly competitive firms earn no profits and may not be able to attain funds to develop technology; innovative firms have difficulty recuperating without profit and because they transfer innovation to other firms. 2. Monopolistic Competition and Technology firms have some market power, incentive for more innovation comes from aspirations of attaining more power; eventually, they return to earning normal profits; patents offer incentives to innovate, but a firm with a patent will change the market structure into a monopoly 3. Monopoly and Technology may earn profits to innovate, but don t have the incentive; gov t often gives companies a monopoly, so pure monopolists don t face the threat of new competitors. Monopoly prices higher, and there is less innovation; Europeans have seen this and have cut down on monopolies 4. Oligopoly and Technology the most conducive to technological change; ongoing economic profit to carry out research and development; competitors are all innovating forces = motivation! Companies always want edge on other competitors; Moore s Law states that every 18 months the cost of computer speed is cut by half, example of oligopolistic innovation in the computer industry; some believe that market structure doesn t matter for technological progress it s based on entry conditions; they say that purely scientific discoveries lead to technological advance; businesses sample these and develop them; in short, technological advances lead to oligopolies (good example is cigarette companies)

Network Externalities, Standards, and Technological Lock-In Externality effect of a decision on a third party that is not taken into account by the decision maker. Network externality when greater use of a product increases the benefit of that product to everyone (value of communication of a telephone increases with more people using them; worthless without many people) Network externalities are critical to market structure because they lead to development of industry standards. Examples of standards include different broadcast standards in the US and Europe, building standards (standard door size), and electrical current standards (220 or 110; AC or DC) Implications of NE s 1. Increase likelihood that industry becomes winner take all; need for single standard becomes more important and eventually one standard wins out; the firm with this standard will dominate; deviating from standards reduces benefits of the network externality. Strong incentive to be first to market with a product; willing to have major loss at beginning to set industry standard; first mover advantage accounts for small technology companies sold stocks at high prices even though they were having major losses; if their spending to earn market share works and they become the standard, the losses won t matter and they ll have major profits in the future. 2. Technological Lock-in market may not gravitate toward most efficient standard (QWERTY keyboard pattern initially made to slow typing to avoid key sticking; typewriter technology improved, but the QWERTY standard was firm in place). Technological lock-in: prior use of technology makes adoption of subsequent technologies difficult. Many advocate a nudging hand to aid/protect the economy and the consumer from out-of-control monopolies; some think that neither technological lock in nor natural monopoly justifies gov t interference; healthy competition eliminates monopoly as sufficient forces act against it; gov t interference hinders competition and harms society; Colander thinks that the competitive process doesn t work properly without government setting fair initial rules.