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Economics Lecture Eleven

2007-05-27T19:57:43Z

Yhbt: /* So you want to make some money? */

{{Economics_Lectures}}

Twelfth Lecture – Interest, Rents and Profits

Instructor, Andy Schlafly

==Introduction and Review==

The mid-term exam should become your guide to filling in gaps in your understanding of economics. Make sure you fully understand the concepts in the questions that you missed. Be prepared to apply those same principles correctly to new problems.

Take the time to review all the concepts featured in the exam. Also, spend time asking yourself questions about businesses that you encounter in your daily lives. For example, what are the costly inputs and sources of revenue for a newspaper? A movie theater? A book? How elastic are the demands in those markets? How competitive or monopolistic? The more you quiz yourself, the better you will learn the principles.

Let’s review “returns to scale.” Imagine using a scale of one foot in measuring the dimensions of a room. Then change to a scale of inches. All dimensions increase by a factor of 12, because there are 12 inches to a foot. That is what “scale” means: it affects everything. In economics, changing the scale means changing all inputs by the same proportion. Increasing the scale means increasing all inputs. The “returns to scale” are then what happens to the output of a company when all inputs are increased. Is bigger better for the business?

“Increasing returns to scale” means that when you increase all the inputs, then your company’s output increases by an even greater proportion. For example, if you double your inputs then perhaps your output triples. That would be extremely profitable for your business. Your costs only double, but your revenue triples. Your profits skyrocket. It is a formula for success.

Wal-Mart’s “secret” to its success would, among the choices, be “increasing returns to scale.” The bigger it gets, the more efficient it becomes, the cheaper it can buy goods for (because it is obtaining volume discounts), and the more output it can produce.

Meanwhile, there is nothing special about constant returns to scale, which is to be expected. Decreasing returns to scale is a disaster for a business that is growing. So is diminishing returns to labor. If bigger is better, and it is for Wal-Mart, then the correct answer is “increasing returns to scale.”

Remember how I asked about the returns to the scale of the world population? It likely has increasing returns to scale. Twice as many people may mean more than twice as much output. Humans are creative, and twice as many humans would probably mean more than twice as many inventions like the light bulb, as people build on the work of others.

So, then, what is the Law of Diminishing Returns? That is a rule that applies to ONLY ONE input. It is when a company keeps its assembly line and factor size constant, for example, but keeps hiring more and more of one input, such as labor. Eventually each added employee will have less and less to do. The returns on the additional employees declines. But if all inputs were increased at the same time, then the Law of Diminishing Returns does not apply. Then it is a question of returns to scale.

Consider this question:

“The more someone has, the more he wants to make to be satisfied!” What economics principle would best explain that phenomenon?

(a) Law of Demand

(b) Law of Diminishing Returns

(c) Law of Diminishing Marginal Utility

(d) Coase Theorem

Choices (a) and (d) can be eliminated immediately, but selecting between (b) and (c) is more difficult. The key here is that “marginal utility” refers to consumer satisfaction, while “returns” refers to output of a company. The question is geared towards consumer satisfaction, not output by a firm. It refers to what someone wants, not what a company produces. The correct answer is therefore (c).

Know these concepts like the back of your hand, and learn from your mistakes. There will be a final exam when you can prove how much you learned.

By the end of the course, make sure you understand the concepts in the problems that you missed. Make sure you answer them correctly on the final exam.

==So you want to make some money?==

Traditionally there were four ways to make money:

(1) Perform labor to earn wages. This is how most people make most of their money.

(2) Invest capital to earn interest. This is what you can do once you save up some money.

(3) Allow someone to use your land in exchange for rent.

(4) Start a new business to earn profits. But watch out here: 9 out of 10 new businesses fail!

Sounds simple enough, right? Look around you, and you’ll see people earning money each of the four above ways. Mostly, you’ll see the first way: get a job and earn some wages. That entails the least risk and is the easiest for most people. Adults and teenagers often follow the path of least resistance, and often imitate others. In economics, that means getting a job to work for a company. It’s great until the job becomes tiresome or the boss fires you. Then it’s not so great anymore. But as a teenager you can earn money from someone else while you are learning how business works. You need experience and savings before you can even try to make money the other three ways.

Economists have their own terminology which, as you’ve seen in this course, is often different from common usage. In economics, the basic terms of wages, interest, rent and profit are all redefined. Ughhhhhh! Here we go:

“[[Economic wages]]” are payments for the worker’s opportunity cost of time. When Charles earns $7 per hour working for a dry cleaners, those wages are payments for his opportunity cost of time. He could be working someone else making money. The market rate of $7 implies that his time is worth that much at this stage in his life.

“[[Economic rent]]” is the payment for a perfectly inelastic input. If increasing the payment does not increase the supply of the input, then this is a “rent”. It is similar, but not identical, to rent paid on scarce land. Increasing the rent does not increase the supply the land. The supply is fixed. Don’t worry if you don’t understand this yet. We’ll spend more time on it below.

“[[Interest]]” is straightforward: it is the cost of the use of money over time. If you borrow $10,000 for your business, then you have to pay interest (say 5%) for using that money. The person who lent you the money wants something for it. He’s not going to give it to you for free.

“[[Economic profits]]” is concept we’ve addressed before. It is total revenues minus total costs, including opportunity costs of time and money in the costs.

==Interest==

“There’s no free lunch,” according to the famous saying. “It costs money to make money” is another aphorism. Most ATMs charge $1.50 just to withdraw cash from your own account.
If you asked me to loan you $1000, then I might answer: why? What’s in it for me? You would then say that you promise to give it back. I would then say why should I give it to you in the first place? If I just keep the money, then I won’t have to worry about your giving it back.

You would then offer to pay me money in exchange for loaning you $1000. We would bargain. You might offer me $25. I might reply that is not enough for me to go the trouble and take the risk to loan you $1000. Then you might offer me $50. I might wonder if I can get a better deal somewhere else. Ultimately we might settle on an amount that makes it worthwhile for me and advantageous for you. Some states have limits on how much interest can be charged. Query: should laws limit the amount of interest that can be charged?

If I agreed to loan you $1000 for an extra payment by you of $50, then the interest rate would be $50/$1000 = 5%. Usually rates are stated in annual terms. If the $50 is paid and the full $1000 must be paid one year later, then the interest rate is 5% per year.

Sometimes people repay money all at once, rather than with interest payments. Suppose I gave you $1000 and you promised to pay me back $1500 in 10 years. Then economists ask what is the “rate of return” or “yield” on that investment by me in your business?

That is more difficult to calculate. I am receiving 50% return on my investment, but ten years from now. At first glance, you may think to simply divide 50% by 10 years to calculate a rate of return of 5% per year. That is a rough approximation, but not entirely precise.

What is wrong with it? The flaw is that it fails to address the time value to money.

==The Time Value of Money==

Suppose I told you that I will be giving you $100, but that you have a choice: either (1) I will give you the $100 today, or (2) I will give it to you in two years. Which would you prefer?

Today, of course. But why? Is the $100 really worth more today than in two years in the future?

Yes, it is. You could take $100 today and invest it, and have it grow to more than $100 in two years. Or you could buy something with it that you could enjoy for the two years. Or you could give it to a charity that could make good use of it for the two years.

Money, like anything else, has an opportunity cost. Just as it is a waste of your time to sit and watch television for a few hours, it is a waste of money to have it sit idle without earning anything for several years. At a minimum, it could be earning interest.

From Matthew 25:14-30 (RSV): “For it will be as when a man going on a journey called his servants and entrusted to them his property; to one he gave five talents, to another two, to another one, to each according to his ability. Then he went away. He who had received the five talents went at once and traded with them; and he made five talents more. So also, he who had the two talents made two talents more. But he who had received the one talent went and dug in the ground and hid his master's money. Now after a long time the master of those servants came and settled accounts with them. And he who had received the five talents came forward, bringing five talents more, saying, 'Master, you delivered to me five talents; here I have made five talents more.' His master said to him, 'Well done, good and faithful servant; you have been faithful over a little, I will set you over much; enter into the joy of your master.' And he also who had the two talents came forward, saying, 'Master, you delivered to me two talents; here I have made two talents more.' His master said to him, 'Well done, good and faithful servant; you have been faithful over a little, I will set you over much; enter into the joy of your master.' He also who had received the one talent came forward, saying, 'Master, I knew you to be a hard man, reaping where you did not sow, and gathering where you did not winnow; so I was afraid, and I went and hid your talent in the ground. Here you have what is yours.' But his master answered him, 'You wicked and slothful servant! You knew that I reap where I have not sowed, and gather where I have not winnowed? Then you ought to have invested my money with the bankers, and at my coming I should have received what was my own with interest. So take the talent from him, and give it to him who has the ten talents. For to every one who has will more be given, and he will have abundance; but from him who has not, even what he has will be taken away. And cast the worthless servant into the outer darkness; there men will weep and gnash their teeth.”

Jesus was concerned with something far greater than money in this parable. But money does have a time value to it. Money tomorrow is not worth as much as the same amount of money today.

How can you compare future money to present money? By calculating the “present value of money.” That is how much one would need in the present which, with investment, would equal the proposed future payment. We use the interest rate to determine how something today should be worth in the future, or how much a payment promised in the future is worth today.

If I promise to give you $100 in 5 years, and the interest rate is 5%, then ask yourself how much you would need today to generate that same $100 in 5 years. It would be less than $100, because you could earn interest on it. In fact, you would only need $100 divided by (1.05) times itself 5 times (i.e, 1.05 x. 1.05 x 1.05 x. 1.05 x. 1.05)

Using a calculator, that comes to $78.35. That’s amazing, isn’t it? Receiving $100 in 5 years is equivalent to only $78.35 today, assuming an interest rate of 5%.

We can check our work. If you had $78.35 today and you invested it the bank at an interest rate of 5%, then next year it would be worth 5% more: $78.35 x 1.05 = $82.27

You would do the same thing in the second year, investing it for a return of 5%:
$82.27 x 1.05 = $86.38

And again in year three:
$86.38 x 1.05 = $90.70

And again in year four:
$90.70 x 1.05 = $95.24

And, finally, one more time for the fifth year:
$95.24 x 1.05 = $100

So $100 to be paid five years from now is the same thing as receiving only $78.35 today. That’s due to the effect of the time value of money.

==Investment Decisions==

Using the time value of money, now we can make investment decisions. As an owner of a company or just someone wanting to see your savings grow, you will need to make investment decisions.

Suppose your widget company is considering a new machine that will last for two years and costs $3500. Suppose also that it will be worthless afterwards. Suppose further that it will bring in revenue of $2000 per year, and that interest rates are 10%. Should you invest in the machine?

Ask yourself what the time value of the added income is. It equals:
($2000/1.10) + ($2000/(1.10x1.10)) = $1818.18 + $1652.89 = 3471.07

Look again at its cost. Your decision? Don’t buy it.

==Economic Rent==

There are four equivalent definitions of “economic rent.” Pick the one you like the best and then use it to understand the others:

(1) Economic rent is the increased payment for a (scarce) good due to its very limited supply.

(2) Economic rent is the amount that a payment exceeds the supply cost. The “rent” is the excess of a good’s actual price above the good’s supply cost.

(3) Economic rent is the increased payment for an input that is in perfectly inelastic supply.

(4) Economic rent is the payment of a factor of production in excess of the factor’s opportunity cost or supply cost.

This is one of the most complex concepts of the course. But this should help: economic rent is the amount that a monopoly can charge in excess of the good’s cost. Economic rent is the surplus enjoyed by the recipient, at the expense of the person paying it.

Suppose there is only one house on a peninsula overlooking the ocean out of both sides of the house. The economic rent is the excess in price that the owner can charge due its unique location. The supply is one, and anyone determined to have that house must pay whatever price is charged. Of course, the Law of Demand places a limit on the rent, because people can’t pay what they don’t have, nor will they pay more than what they value something at. But the overcharge due to the uniqueness of the good is what constitutes the “economic rent.”

==Economic Profits==

Remember that “economic profits” include far more than ordinary “accounting profits” or “profits” in the ordinary sense of the term. “Economic profits” are total revenues minus costs that include opportunity costs, time value of money, and other hidden costs missing from most claims about profits. Economic profits are much harder to come by.

Who enjoys true economic profits? Monopolies do, because they can increase their price and reap economic rents. Microsoft garners hefty profits year after year, with no end in sight. But ultimately all monopolies, even Microsoft, fall prey to competition and those economic profits dry up. However, that process can be painfully slow for consumers seeking to realize those competitive benefits now.

Inventors and other innovators can enjoy real economic profits. Thomas Edison did, with his numerous marvelous patented inventions. Patents give the holder an exclusive right to the product for 17 years. Competition is prevented for that time, and enormous economic profits can be obtained without competition driving the price down. AT&T used Alexander Graham Bell’s patent on the telephone to build a highly profitable company for a century. But ultimately its economic profits dried up, too.

==Assignment==

Review your mid-term exam again and understand why you missed certain questions. Then answer the problems below:

===Introductory===

1. Receiving $100 next year is not the same as receiving $100 today because of the _________________.

2. “Free enterprise does not cause interest rates. Impatience does!” Explain both views.

===Intermediate===

3. I agree to pay you $1,000 in one year, if you pay me ______ today. The interest rate is 5%. Fill in the blank, showing your work.

4. Elizabeth owns a clothing store. She can spend $100,000 today to increase her inventory of fancy clothes, which would increase her profits by $104,000 in one year without any further benefit. Interest rates are 5%. Should she make the investment?

5. If total utility is maximized, then

(a) average utility is minimized

(b) average utility is maximized

(c) marginal utility is maximized

(d) marginal utility is zero

Answer and explain.

6. All of the following are fixed costs for starting a new school EXCEPT:
(a) textbooks
(b) electricity
(c) rent
(d) landscaping
Answer and explain.

7. During hurricane season a town’s power plant was completely destroyed. People wanted to buy kerosene to run their emergency generators. But the price of kerosene doubled! What is the effect of the price increase? Should a new law force the price of kerosene down by half?

===Honors===

8. Explain what “economic rent” is in your own words, using your own example.

9. Explain which of these earn economic rent, and how much: Katrina earns $500 for playing her violin at events, but would play for free. Philip collects $800 for renting his basement, which equals the electricity, property, interest and costs of his time collecting the rent. Victoria, because of her special talent, earns $30,000 a year growing soybeans when others like her only make $20,000 with similar land.

10. Explain Jesus’ parable about the talents, using general principles learned during this course.

Economics Lecture Nine

2007-05-22T03:22:45Z

Yhbt: /* Cartel */

{{Economics_Lectures}}

Ninth Lecture – Between Monopoly and Competition

Instructor, Andy Schlafly

==Introduction==

Two weeks ago we studied “competition”. Last week we examined “monopolies”. If you own a business, which would you prefer? Don’t be too hasty in answering.

You would want perfect competition in the markets from which you buy your inputs, including your supply materials and your labor. That way you could keep your costs down. But you would want a monopoly for your company in the market in which you sell your good or service. That way you could charge more and make higher profits.

In reality, there is almost never perfect competition. Complete monopolies are also rare. The business world is typically somewhere between perfect competition and a monopoly, depending on the market. Some markets are more competitive than others. Some companies enjoy more of a monopoly than others.

This lecture is devoted to all those situations in between perfect competition and true monopoly. The spectrum looks like this:

# Monopoly (MC=MR is how the price is determined)
# Cartel
# Oligopoly
# Monopolistic Competition
# Perfectly Contestable Markets
# Perfect Competition (P=ATC, average total cost, is how price is determined)

As a seller, you make more money the higher you are on the list. As a buyer, you save more money the lower you are the list. Let’s introduce each term:

===Monopoly===
A single seller of a product having no competition or close substitutes. The seller comprises the entire industry.

===Cartel===
A group of producers that band together to raise prices, restrict output, or allocate market share. OPEC, a group of mostly Arab oil producers attempting to keep profits high, is the most famous cartel.

===Oligopoly===
A few producers that dominate a market without fixing prices or output. If the good is identical among the companies, then it is a perfect or pure oligopoly. Examples include the steel and cement industries. Cement is cement, period. If the good is not identical, then it is an imperfect oligopoly. Examples are the car or soap industries. Cars are not identical to each other, but the auto industry is an oligopoly.

===Monopolistic Competition===
This has more sellers than an oligopoly and more competition too. But companies are able to increase their prices without losing all their customers. Why? Because in monopolistic competition there are “differentiated products.” An example is the haircutting or hairdressing industry. Cutting hair is a service that is not a perfect substitute for other haircutting services. One with a loyal customer base can increase her prices without losing her business.

===Perfectly Contestable Markets===
This is where there is no barrier to entry into the market and no start-up costs. There are only a few sellers, or maybe only one seller, but competition is always threatened. A newspaper vendor in a shopping mall is an example. He may be the only one, but it is so easy for another competitor to start selling newspapers that he always keeps his prices as low as he can.

===Perfect Competition===
A large number of sellers and buyers have full knowledge and perfect mobility of resources. The good or service is homogeneous. Competition is ruthless in keeping prices down. Price (P) equals Marginal Cost (MC) equals Average Total Cost (ATC). This is what happens when Wal-Mart moves in next door!

There are other terms worth knowing in this area. “Monopsony” is a “buyer’s monopoly.” It consists of a single buyer of a good or service. In a one-company isolated town, where one company employs most of the people, the company is nearly a monopsony with respect to labor in that town. Note that the more it hires, the greater its wage costs will become. But perfect monopsonies are difficult to imagine. Can you think of another one?

Understand all the above concepts? We’ll review the most important ones now in greater detail.

==Oligopoly==

There are only a few firms in oligopoly. There are also high barriers to entry so that new companies cannot enter the industry and compete with existing firms. Each firm produces similar products.

Memorize the conditions: (1) few companies, (2) high barriers to entry, and (3) similar goods.

The car industry is a good example. General Motors, Ford, Toyota, Daimler-Chrysler, and so on. All the car companies in the world could be listed on one sheet of paper. There are only two American-owned car companies: GM and Ford. So this satisfies the first condition: few companies.

Is there a high barrier to entry? Yes. It is not easy or cheap to start a new car company. I have not heard of new American car company being started in the last ten or fifteen years. John DeLorean was the last one to try, and his effort went bankrupt. So condition two is satisfied.

Are cars similar goods? Yes again. There are differences, of course, but they all have four wheels, an engine, and run on gas. They take you from point A to point B. When you need to drive somewhere, you usually do not care what type of car is available. Any one will typically do. So condition three is satisfied.

Thus the car industry is an oligopoly. Can you think of other oligopolies?

In some ways oligopolies are like monopolies, and in other ways they are not. Oligopolies are like monopolies in that the high barriers of entry keeps new competitors out. With less competition, it becomes possible to earn greater profits. Both oligopolies and monopolies can do this. But note that both are constrained by the downward-sloping demand curve.

The major difference between the oligopolies and the monopolies are that there is at least some competition in an oligopoly. Ford could cut prices on its cars to attract customers from GM. The pricing decisions of one company in oligopoly shift the demand curve for the other companies. When Ford raises its prices, for example, this causes the demand curve to shift upward for GM, to its benefit.

You can see an oligopoly at some street corners. How? If there are two gas stations at a street corner and no other ones nearby, then that has some characteristics of an oligopoly. Not a monopoly, because there are two of them. But not perfect competition either, because there are only two and they may end up raising their prices in imitation of each other.

There are several models for what the demand curve looks like for an oligopoly. One famous model is the “kinked” demand curve. In this scenario, if one firm raises its price then the other firms do not have to imitate it. The firm that raises its price sees a sharp falloff in demand. Its demand curve has a lower slope (e.g., more like a horizontal line) than the demand curve for the industry. The change in slope causes the “kink” in the curve. However, if a firm lowers its price, then the other firms must lower their price also to keep their customers.

The other model for an oligopoly is when there is a dominant firm that sets the price for the entire industry as the “price leader.” There can be many smaller firms or companies, but they follow the pricing of the dominant firm. If they don’t, then the powerful firm can punish them with price-cutting. If the demand is relatively inelastic, then the dominant firm sets a high and profitable price. The smaller companies must follow it in order to avoid being punished for underselling it.

==Cartel==

A cartel takes an oligopoly one step further. In a cartel, the companies have an actual agreement among each other to raise prices, reduce supply, or otherwise reduce competition. This is illegal. Agreements by companies to reduce competition are prohibited by federal law. The federal government can prosecute and convict anyone who agrees or conspires to reduce competition.

Even if the federal government does not get involved, private individuals or companies can sue to recover damages that result from agreements to limit competition. The penalties are harsh: they include treble (triple) damages plus an award of all the attorneys fees of any plaintiff who proves a restraint of competition or trade. These laws are called the antitrust laws, passed in the late 1800s and famously enforced by President Teddy Roosevelt in the early 1900s.

So if it is illegal, then why study it? First of all, important producers in foreign countries ignore our laws. The biggest and most dangerous cartel is the “Organization of Petroleum Exporting Countries,” or “OPEC”. Check them out on the internet at http://www.opec.org . It has eleven member countries: Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela. The website includes many facts about those countries and their oil production.

You may be wondering why we care what these foreign countries do with their oil production. The problem is that they control a substantial percentage of the production of oil in the world. When they agree to raise prices or reduce output, it directly affects the price of gasoline in America. Some have suggested that the federal government should use antitrust laws and sue this cartel due to its impact on American consumers.

In a cartel, there are (1) relatively few companies, (2) high barriers to entry, and (3) price and output determined by agreement so that all companies act alike. But isn’t that similar to a monopoly, with the only change being a few companies acting as though they are one?

There is one key difference: in a cartel, there is an incentive for each company to cheat. Iran can agree to the price and output of the OPEC cartel, but then secretly sell more oil at a slightly reduced price to maximize its profits. Other ways to maximize profits in a cartel include offering rebates or providing additional services or higher quality. This maximizes the profits of the cheating company, and reduces the profits of other members of the cartel.

Conservative economists, such as the late Milton Friedman, often predict that cartels cannot survive long-term. The profit incentives to violate the agreement cause the companies to go their different ways. Eventually, competition returns.

In a sense this has even happened to OPEC, the most powerful cartel of all. That cartel was able to cause a fourfold increase in oil prices after we helped Israel in the Yom Kippur War. There were enormous lines at gas stations in 1973 due to the oil crisis. Your parents would remember it. It was known as the 1973 Energy Crisis. In some areas of the United States, drivers of cars with odd-numbered license plates were only allowed to purchase gas on Monday, Wednesday and Friday, while even-numbered plates were assigned to Tuesday, Thursday and Saturday. People were prohibited from buying less than certain amounts at gas stations to prevent hoarding and try to reduce lines. But what would be the real cause of any shortage?

Think back on what you have learned earlier in the course. There is one major cause of shortages, and it is not the invisible hand. It is government price controls. In 1973, the government imposed certain price controls on gas, and that caused the shortages and inefficiently long lines at gas stations.

Milton Friedman would say that eventually the invisible hand does prevail. OPEC does not still have so much power over oil prices today, and it faces competition from Russia, Mexico, the United States, Canada, and other non-OPEC nations.

==Monopolistic Competition==

Finally, we need to explore the concept of “monopolistic competition.” It has four conditions: (1) many buyers and sellers, (2) goods that have differences among each other, (3) sufficient knowledge about the market, and (4) free entry into the industry by new companies.

Earlier we mentioned barber or hairdresser shops as an example. They have relatively small start-up costs (low barrier to entry), and there are many buyers and sellers. The services are not identical. They are not perfect substitutes for each other, so differentiation is possible. Each company is able to develop a loyal clientele. Knowledge is fairly high about the market.

Each company asks like a mini-monopoly over its loyal customer base, and it also competes against the other mini-monopolies.

Can you think of other examples? Perhaps CDs by popular singers, or books by popular authors?

==Nash Equilibrium==

Here is the insight that won John Nash a Nobel prize in economics and led to a popular, Academy-Award winning movie called “A Beautiful Mind.” This is called the [[Nash equilibrium]]. It applies in particular to oligopolies.

When you have a small number of sellers, as in an oligopoly, the Nash equilibrium occurs when no seller can benefit by changing his price while the other sellers keep their prices unchanged.

The most famous example of the Nash equilibrium is the “Prisoner's dilemma,” where two accused persons are separated and interrogated. If neither confess, then no crime is proven and they must be released. If both confess, then they receive harsh sentences. If one confesses and the other does not, then the confessor is released but the other receives even harsher punishment.

The Nash equilibrium predicts both will confess, which is not their overall optimal result.

==Questions==

Read and, if necessary, reread the above lecture. NEXT WEEK IS THE MIDTERM EXAM.

Below are review questions that you need not answer to hand in. You may ask questions and possibly review answers [[Talk:Economics|here]] and Model Answers for the course to date are being posted [[Economics:Model Answers|here]].

1. An oligopoly that illegally agrees to raise its prices is called a __________.

2. List three industries that are oligopolies and explain why.

3. As an industry becomes more competitive, what happens to price (P) compared to marginal cost (MC)? Explain.

4. Suppose Daniel’s company sells goods in an industry having a demand curve with this set of Qs and Ps: (1,30), (2, 28), (3, 26), (4, 24), (5, 14), (6,8), (7,2). What type of industry is this, and what type of demand curve is this? If marginal cost equals $20 (MC=20), then what are the output and price in this industry?

5. Suppose you saw three different advertisements in three different industries: (1) “The lowest price in town is at Zack’s!”, (2) “Buy more channels from your cable service provider!”, and (3) Matt is the smartest surveyer in town ... call him to survey your property!” What type of industry would each ad likely represent?

6. What kind of industries are these: (1) one cleaners in town that sends the clothes out to be cleaned, (2) three car mechanics in town with hydraulic lifts and expensive electronic equipment, and (3) many apparel stores with distinctive fashions? Will consumers obtain the best prices?

7. Suppose two students separately own the only widget companies in the entire world. They sell at the same price and have no plans to change that. But they might advertise. If both advertise, then they lose profits due to the advertising expenses. If neither advertises, then they make the largest profit by reducing expenses. But if one advertises and the other does not, then the one that advertised makes phenomenal profits. What happens?

Economics Lecture Four

2007-05-19T21:51:00Z

Yhbt: /* Introduction */

{{Economics_Lectures}}

Fourth Lecture – Theory of Demand

Instructor, Andy Schlafly

==Introduction==

In this course we have covered the supply and demand curves, and examined the economic concept of “elasticity”. Now we turn to focus solely on “demand”.

Demand is determined by price. Generally, the higher the price for a particular good, the lower the quantity demanded. Conversely, as technological advances cause reduction in prices, the quantity demanded increases. Far more people own computers today than when they were first introduced over twenty years ago. Why? One reason is because computers are cheaper today.

The sensitivity of the quantity demanded to a change in price is measured by the elasticity, which we discussed in the last lecture. This time, we are going to focus on other aspects of “demand”.

Let’s examine the price of a good. Does the amount you have to pay for a good at a given time tell the whole story about its price? Is its true price simply the number of dollars and cents demanded by the seller?

Not exactly. It is a bit more complicated than that. The relative price of a good is more important than its isolated price. When you go into a store to shop, you compare prices of different goods before choosing the one you like. Premium gasoline may look a good deal until the customer sees that regular gasoline is selling for 12 cents less.

The real price of a good is its opportunity cost. Recall what the opportunity cost is: it is the value of the best forgone alternative. When someone buys something for $10, the real cost is the best alternative use of that $10. The real price of watching television for one hour is value of that time if you had spent it in the best way possible. The price is thus not $0. The real price of that hour of television watching is your highest hourly wage if you worked, or your future wages made possible by studying now.

Defining real price in terms of opportunity cost avoids the havoc that inflation causes with prices. Back in the late 1970s, inflation was more than 10% per year. What cost $10 one year would cost $11 the next year, and over $12 in the third year. If a good kept the same price during those three years, then its opportunity cost and real price actually decreased. Think about that.

Economists created something called the “Consumer Price Index,” or CPI, to measure changes in basic prices of many goods over time. It looks at the typical purchases by urban (not farming) families and monitors the change in prices of those goods and services from month-to-month. It includes the costs of food, beverages, housing, clothes, transportation, medical care, recreation, education, and even services like haircuts. It then combines all those values into one number. To make it easier to compare, the values are combined in a way that the CPI for the period 1982-84 averaged “100". In January 2004, the CPI was 185.2. You can view all the numbers back nearly a hundred years at:
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

By comparing a change in price of a good to the change in the CPI, you can tell whether the real price of the good is becoming more or less expensive. If the good’s price increases by less than the CPI’s increase, then the good has a real price that is falling.

==Income and Substitution Effects==

When the real price of a good decreases, there are two main economic effects. First, it increases the real income of consumers because they do not have to spend as much on the good. For example, if you drink a gallon of milk each week and the price of that gallon decreases by 25 cents, then you have 25 cents extra to spend on something else. It is as though your income went up by 25 cents. This is called the “income effect.”

Remember how we discussed that an increase in income usually causes people to buy more of a good? Now that you have more income, you may want to buy more milk. Instead of drinking a gallon a week, perhaps you can now afford to drink a gallon and a quart a week. The decrease in price of milk created an income effect (increase in income), which encourages you to buy more milk.

Second, the decrease in price of a good causes a “substitution effect”. You may want to buy more of the good instead of something else. In the milk example, its cheaper price makes it more attractive to purchase. You may want to substitute milk for the fruit juice you used to drink.

Both the “income effect” and the “substitution effect” give you an incentive to buy more of the good that decreased in price. The overall increase in quantity demanded for a good that cut its price is the sum of the income effect and the substitution effect. For a normal good, a decrease in its price causes an increase in real income (the income effect) and an increase in substitution for other goods (the substitution effect), which add together to cause an overall increase in demand.

Is that true for all goods? Last class, we mentioned an odd type of good known as an “inferior” good. You may recall that the demand for an “inferior” good actually increases when income decreases. Examples are margarine (because people with declining income can less afford butter). Bankruptcy services are “inferior”, because the greater the decline in income, the more people who file for bankruptcy, and the greater the demand for those services. If a good is inferior, does a decrease in its price cause an increase in quantity demanded?

Ponder that question further. From above, the overall change in quantity demanded is a sum of the “income effect” and the “substitution effect.” The “income effect” when the price decreases is that real income goes up. But for an “inferior” good, an increase in income means a decrease in demand! That’s strange. The price decreases, but the demand due to the income effect of that price decrease also decreases.

However, the “substitution effect” goes up when the price falls. Because the income effect and substitution effect move in opposite directions, it is difficult to predict what will happen to their sum, which is the overall demand. A “Giffen good” is an inferior good for which the income effect dominates, and thus it has the unusual characteristic that a fall in price of the good causes a fall in demand. It is difficult to think of an example.

It is worth defining a “Giffen good” again, this time in terms of a price increase: it is a good which experiences an increase in demand when its price increases. This only happens for an “inferior” good that responds so negatively to an increase in income that the income effect outweighs the substitution effect. In the 1895 edition of the classic “Principles of Economics,” Alfred Marshall wrote: “As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring [British spelling] families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.”

Another textbook example of a “Giffen good” is the potato during the terrible Irish famine of 1846-1849. The theory is that the increase in the potato price during the famine wiped out the real income of the Irish, but the potato was an “inferior” good that saw a surge in demand due to the reduced income. Other economists suggest that tortillas are a Giffen good in Mexico today. But further investigation shows that neither potatoes in Ireland nor tortillas in Mexico actually qualify as Giffen goods. Rice and noodles are now described as Giffen goods among the poor in China. Do you believe it?

Except for the rare and possibly non-existent Giffen good, the “Law of Demand” is this: when the price of a good increases, its demand decreases. When the price of a good decreases, its demand increases. This is one of the most fundamental rules of Economics.

==Utility==

Money isn’t everything. We have many expressions for this concept. “There’s more to life than money.” “It’s only money.” “What’s your job satisfaction?” The basic point is that dollars and cents do not capture our overall happiness or satisfaction as a consumer. You may buy the most expensive music CD on the market, or watch the most popular movie, or buy the fanciest clothes, but that does not mean you will like those items the best. Often our favorite goods are not the most expensive ones.

“Utility” is concept created to address that need. “Total utility” is defined as a consumer’s overall satisfaction. In addition, “marginal utility” is defined as the additional satisfaction of a consumer in buying an additional unit of a good.

Let’s take an example. Suppose you are on a family road trip by car out West. You left your campsite near Phoenix just after you woke up, and you’re driving through the desert to Los Angeles. You have not eaten all day. Hour by hour goes by and you do not see any place to eat.

Finally, at 4 in the afternoon, you see the golden arches of McDonalds appear on the horizon. You drive closer and the arches appear bigger. It’s not a mirage.

When you arrive, you run in and order its famous french fries. You’re famished. When the food arrives, you take your first handful of french fries. They seem delicious to you. Your marginal utility is extremely high. You might have paid $10 for that first mouthful of french fries because you are so hungry. Then you eat your second handful of french fries. Your marginal utility is still high, but not quite as high as the first one. You wouldn’t have paid as much for the second bit either, perhaps. By the time you finish all the french fries, the last few bites were not so satisfying. In fact, you’ve gotten sick to your stomach. The marginal utility of that last french fry was very low. Perhaps even less than zero!

You have just experienced the Law of Diminishing Marginal Utility: the marginal utility of each additional unit (e.g., french fry) always declines (in a given period).

In general, the rational consumer will always try to maximize his or her total utility. How is this done? The consumer always purchases the good with the highest marginal utility in order to maximize the total utility.

Suppose you go to a shopping mall with $80. You can buy food or clothes or anything else you find in a mall. Would you spend it all on food? Of course not. The marginal utility of your food purchases declines as you eat more. Ideally, you wouldn’t even buy enough food to fill your stomach, because you can always eat more cheaply at home. To maximize your utility, you would spend every dollar in a way that has the most marginal utility. Your first purchase would be what you want most, and then your next purchase would be your second choice, and so on. If you really want something that costs $80, then you may spend all your money on that one item.

The rational consumer maximizes utility by spending each dollar in a way to maximize marginal utility for that dollar. For such a consumer, the marginal utility of every good divided by that good’s price must be equal. MUx/Px = MUy/Py=MUz/Pz, where MUx is the marginal utility of good “x” and Px is the price of good “x”. This is known as the Law of equiproportion marginal benefit.

It is impossible for anyone else to measure your utility, or for you to try to compare your total utility to that of other consumers. What you can do is decide for yourself which goods and prices give you the greatest utility, and then buy accordingly. That may include political and religious views in addition to pure dollars and cents. For example, some conservatives boycott companies that fund abortion, regardless of how inexpensively those companies sell their goods. Such a boycott maximizes the participants’ utility, but not their savings. Many other boycotts have occurred in American history based on principles rather than price (“principle, not principal!”).

==Indifference Curve==

In graphing your utility for two goods, you can construct what is known as an “indifference curve.” Let’s take an example. Suppose you are working on the homework for this course with three friends - Chris, Stephanie and Kevin. Someone says they are hungry and go to look for snacks. You see a half-eaten bag of potato chips and you pop a bag of popcorn. However, there is not enough food for everyone, so have to ration who receives what.

You count 24 potato chips and 40 kernels of corn. Uh oh. There are four of you. On average, that’s only 6 potato chips and 10 kernels of corn per person. You tell everyone that.

But Chris likes potato chips more than corn; Stephanie prefers the opposite. To decide how to allocate the food, you ask Chris and Stephanie to draw their indifference curves with potato chips on the y-axis and corn on the x-axis. You learn from the curve that Chris is just as happy with 9 potato chips and 2 kernels of corn as receiving 6 potato chips and 10 kernels of corn. Chris’s utility is same in both cases. Meanwhile, Stephanie is just as happy receiving 18 kernels of corn and 1 chip. Fine, you give Chris 9 chips and 2 kernels and Stephanie 18 kernels and 1 chip.

Was this worth it? You bet: now you have two extra potato chips that you would not have had by splitting everything equally. Chris and Stephanie are just as happy, and you can share the additional chips with Kevin.

==Consumer Choice==

“Consumer surplus” is the net benefit (in dollars) a consumer obtains from buying a good. Thus (consumer surplus) = (total benefit) - (total cost)

Let’s define another term: “demand price.” That is the most someone is willing to pay for something. We saw this in the homework problem about the tickets and scalpers. When you go to see a movie, there is a maximum amount you are willing to pay for a ticket. It varies for different consumers. It obviously depends on what the movie is.

A consumer’s demand price is his marginal benefit. The total benefit in the market is thus the sum of all the demand prices, which is the area under the demand curve.

The consumer surplus is the demand price (the most a consumer would pay) minus the price paid (the amount the consumer actually has to pay). Suppose you were effusive (i.e., very enthusiastic) about a particular movie, and wanted very much to see it. You were so excited that you were willing to pay $20 to see that movie. But if the theater only charges you $8, then your consumer surplus is $20 - $8 = $12.

Consumers stop buying a good when the demand price equals the price paid. For movies, the demand price falls the longer it keeps playing in a theater. After you’ve seen the movie once or twice, you’re not willing to pay so much to see it again. People stop paying to see the movie, and the theater stops playing it and begins showing a new movie instead.

==Assignment==

Read and, if necessary, reread the above lecture. Complete the homework assignments through the level in which you choose to enroll in this course:

===Introductory===

1. The total utility of a good represents the consumer’s _________________.

2. Conservatives say a bad effect of raising the minimum wage is that it causes more students to drop out of school. Why would that happen?

===Intermediary===

3. A student likes swimming and playing the violin. The first hour she swims she improves by 6 units of utility, and then each successive hour she improves by half the rate of the hour before it. The first hour she practices the violin she improves by 4 units of utility, then each successive hour she improves at a rate of 90% the hour before it. In 3 total hours to practice, how should she maximize her utility?

4. How might one’s overall “utility” include religious goals that have nothing to do with money? Be specific.

5. Suppose you manage a golf course for profit. You poll your customers and find that, each month, they value their first game at $30, their second game at $20, their third at $10, fourth at $0, and refuse to play any more in the same month. It is impractical to charge based on whether someone has previously played a round this month. How do you best charge your customers?

6. Bad British economic policies and a fungus wiped out the basic food supply of potatoes in Ireland between 1846 and 1849, killing 500,000 and sending many Irish to the United States. Do you think potatoes might have been an “inferior” good then? What would you expect the income effect of the shortage of potatoes to have been?

===Honors===

7. Do you think a Giffen good really exists? Can you see any possible political bias in the claim that Giffen goods exist? Your views, please.

8. Suppose you are a rational consumer who makes purchases by maximizing marginal utility. One day you hear that the price on a good you purchase (e.g., milk), falls by 30%. The Law of Demand says you should buy more of it. Using only the assumption that you maximize marginal utility, prove the Law of Demand as best you can.

9. Suppose a friend of yours announced that when he has a choice between a cheaper good made in China and a more expensive good made here, he will buy the latter based on his opposition to communism. Is he being irrational?

[[Category:Economics]]