Economics Lecture Three

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A "free market" is one where there is no interference with price and quantity of goods sold. Government does not regulate the price in a free market, or limit the quantity. If there is a wage and price control imposed by government, then it is not a free market. Some of the "global warming" legislation, such as the proposed "cap and trade," would limit the supply of energy and thus would not result in a free market. But most of this course assumes we are in a free market.

In a free market, supply equals demand for both price and quantity sold. That is one of the beauties of free enterprise. It is efficient, productive and minimizes waste. The supply and demand reacts almost immediately to changing needs and circumstances. The free market reacts much more quickly than government can. For example, government offices like the Post Office close at 4:30 or 5pm, but the free market is always working 24 hours a day.

Prices change daily due to continual changes in supply and demand. During your next few trips to the supermarket, notice how much the prices fluctuate. This is because both supply and demand are constantly changing. Supply changes due to problems or improvements in manufacturing and shipping, or different yields in crops. Labor costs change over time, which also affects supply. Demand is constantly fluctuating also. Every day people lose or switch jobs, which affects their buying decisions. The changing of the seasons also affects demand, as do variations in personal tastes.

Five to ten years ago there was tremendous demand for Beanie Babies, driving up the price. Now there is far less demand, so the price has fallen. The same could be said about any fad.

Greed also plays a role. The suppliers of goods and services would like to increase their prices without losing sales, so that they can make more money. Before Wal-Mart made price-cutting so popular, it was routine for suppliers to increase their prices every year. Everyone expected it.

Imagine yourself as president of a company that makes "widgets" (a "widget" is an imaginary good), and you are having a meeting to discuss your product. Inevitably an employee suggests increasing the price on the widget so that the company will make more money. People who have never studied economics think that increasing the price will always result in increased revenue from sales, because revenue is price times quantity sold. If quantity sold is constant, then increasing the price should have the effect of increasing the revenue from sales.

But suppose you have an employee who had taken this economics course in your meeting. He or she points out that an increase in price will reduce the demand, because the demand curve is usually downward sloping. You will sell fewer goods if you raise the price: your "quantity sold" will decrease if in you increase your price, and your overall revenue may decrease too.

As owner, you then ask, “how much fewer sales will result if I increase the price?” If sales decline by a smaller percentage than the price increased, then overall revenue (price times quantity sold) will increase. If, however, sales decline by a larger percentage than the price increased, then overall revenue will decline.

Price Elasticity of Demand

The “price elasticity” of demand is the percentage change in quantity demanded divided by the percentage change in price. It is usually negative but the sign is dropped so that price elasticity is always a positive number.

More simply, price elasticity is responsiveness to changes in price. Think of a rubber band. How easily can you stretch it any point? The issue is the same for the public’s response to a change in price. Will the public pay the higher price without complaint, or will they tend to refuse?

Let’s take an example. Suppose the local NFL (football) team wants to make even more profit than it does already. The owner decides to increase the ticket prices by 20% for next season. Because watching football is an obsession for many fans, most are likely to pay the higher prices. Maybe only 5% will choose not to renew. The quantity demanded changed little despite a large increase in price. This means the elasticity of demand is low. To be precise, it is the percentage change in quantity demanded divided by the percentage change in price: -5%/20% = -1/4. The sign is dropped so the elasticity is expressed as “1/4”. This low elasticity encourages the supplier (the football team owner) to repeatedly increase the price. Low inelasticity is described as an “inelastic demand” by economists.

How much more revenue does the team make by increasing the price? Revenue is price times quantity. If its original price was P and its original quantity Q, then initial revenue is PxQ, or PQ. After the price increase, the revenue is (1.20 x P) x (.95 x Q) = 1.14PQ. Revenue has thus increase 14% simply by increasing the price. Nice business, if you don’t mind the silliness of watching it!

Let’s take another example. Suppose that airlines increase the price on their flights from New York to Florida from an average of $300 per seat to $500 per seat. That is a 67% increase. What would that do to the tourist traffic to Florida from New York? It only takes a day and a half to drive to Florida, which incurs gas charges of less than $100 and a hotel charge of perhaps $80. Tourists would likely drive rather than pay the higher fares. The demand for these higher-priced tickets could fall by 75%, assuming that business travel is only a small percentage of that traffic.

What is the price elasticity of this demand? The percent change in quantity demanded is -75% (3/4) and the percent change in price is 67% (2/3), so the elasticity is -3/4 divided by 2/3 = -9/8. The sign is dropped so the elasticity is expressed as 9/8. It is greater than 1, and thus is described as having an “elastic demand” rather than an “inelastic demand,” which is less than 1. (If it equaled 1, then it would be called “unit elasticity of demand.”)

What does it mean to a company if its goods have “elastic demand”? It means the company should be cautious in raising prices. Look at what happens to the revenue to the airlines due to the elastic demand for seats on their planes. The initial revenue was price times quantity, which is PxQ, or PQ. The revenue after the pricing change is (5/3)(P)(1/4)(Q) = (5/12)PQ. Its revenue fell to 5/12 of its initial revenue due to the price increase. The airlines lost over half of its revenue by increasing its price! Uh oh, that requires laying off many employees, reporting losses to the investors, and firing the persons responsible for that price increase.

In that prior example, however, consider price increases on the same route that are due only to increases in fuel costs. Will they have the same elasticity? (No, because the alternative of travelling by car increases in cost by a similar amount. However, some people will simply stay at home rather than travel.)

Take a straight line demand curve and consider what the shape the total revenue has as a function of price. It has the shape of a semi-oval opening downward: it starts at zero revenue (when quantity is 0) and ends at zero revenue (when price is 0).

Income Elasticity

Once you grasp the price elasticity of demand, you’ll see that you can describe the elasticity (or responsiveness) of many other variables in economics.

Income, like someone’s salary, affects the demand for goods. Many more Mercedes-Benz luxury cars are likely to sell when average income is high than when it is low, for example. So economists find it useful to describe “income elasticity of demand,” which is the percentage change in quantity demanded divided by the percentage change in income.

Most goods sell more when the income of buyers increases. We all tend to go to restaurants more often, buy new clothes more often, and pay more for goods and services when we are making more money. When our income declines, we cut back on our purchases.

Consider the difference between goods we need (e.g., food) and goods we want (e.g., restaurant food). The goods that we need are “necessities”; the goods we merely want are “luxury goods.” Necessities are income inelastic, because they are needed and purchased whether our income is high or low. Whether we have a good year or a bad one in terms of income, we still buy things like daily food, basic clothing, and heating at home. In contrast, luxury goods are income elastic. People do not buy as many yachts and luxury cars and homes when times are tough.

Here are some useful definitions. A normal good is one for which demand increases when income increases. Nearly all goods are “normal” goods. Income goes up, then more of it is purchased. Occasionally a good can be found that is “inferior”, such that demand actually decreases when income increases. Can you think of one? (Margarine is an example. Can you explain why?) So when the income elasticity is positive, then the good is “normal”. When the income elasticity is negative, then it is an inferior good.

A necessity is a good that has a positive income elasticity that is less than 1. A luxury is a good that has an income elasticity greater than 1.

Minor Point about Calculating Elasticities

Warning: for honors students only!

There is an ambiguity in calculating the percentage change in price or quantity. What should be used as the denominator in deriving the percentages? If $100 increases to $110, then the percent change could be described as $10/$100 x 100% or $10/$110 x 100%. Above we used the initial price and quantity as the denominator, but we could have used the final price and quantity as the denominator instead.

Economists resolve this by typically using the average overall value as the denominator in calculating the elasticities. So if the price changes from $20 to $30, the percentage change in price is $10 divided by the average of $20 and $30, which is $25. The percentage change is thus $10/$25, which is 40%. This is also known as the “arc elasticity” because it is a more accurate depiction of the “arc” or curve of demand. Use this method when doing specific calculations on homework in order to obtain the precise result.

Complements and Substitutes

A complement of a good is something that is used with it. Compact disks (CDs) are complements of CD players. Hole punchers are complements to three-ring binders. Monitors are complements to desktop computers. Gasoline is a complement to cars. Bread is a complement to sandwich meat.

A substitute of a good is something that replaces it. Bicycles are substitutes for mopeds. Motorcycles are substitutes for cars. Channel 2 is a substitute for channel 4 on television. One non-fiction book is a substitute for another. Chicken is a substitute for beef.

Elasticity of demand can apply to complements and substitutes. The “cross elasticity of demand” is how the quantity demanded of one good responds to a change in price of another good. Specifically, it is measured as the percentage change in demand for one good in response to the percentage change in price for a different good.

If good “A” sees a 20% drop in demand based on a 20% increase in price of good “B”, then the cross elasticity of demand is -20%/20% = -1. Do you think good A and B are complements or substitutes? They are complements. A negative cross-elasticity in demand means they are complements. Their elasticity is in the same direction as the price elasticity of demand for the good itself.

If, however, good A sees a 20% increase in demand based on a 20% increase in price of good B, then their cross-elasticity in demand is 20%/20% = 1. This positive value means that A and B are substitutes for each other.

Ponder that for a minute.

Trade and the Creation of Wealth

Do you ever wonder how wealth is created? Suppose you are good at fixing cars, and another homeschooler is good at fixing computers. Your computer breaks, but you do not know how to fix it. You could take it to a computer store, but it will want $200 to fix it. At that point your wealth is the value of your computer minus $200.

But the other homeschooler is very good at fixing computers, and offers to repair your computer for only $100. That creates wealth for you; because of your friend, now your wealth is the value of your computer minus only $100.

You realize that your friend is having a problem with his car, which you can fix. You offer to fix your friend's car if he fixes your computer. Now your wealth is the value of your computer minus almost nothing. The "trade" between you and the homeschooler increased the wealth of both of you.

Based on the above example, most economists view trade as as increasing wealth. Whenever two people enter into a transaction in the free market, each side should be benefiting and increasing their wealth. When you buy milk at a grocery store, you are paying less than what the milk is really worth to you, or you would not buy it. That increases your overall wealth. The store is making money from the milk, or it would increase the price. So the store becomes wealthier from the transaction. The overall wealth of society is increased by these transactions. The more transactions, the greater the wealth.

The term "free trade" refers to transactions with foreign countries, such as China. In that case the trade makes the foreign government wealthier, and it may be hostile to our nation and our values. We may also become wealthier from the transaction, but our gain may not be nearly as much as the hostile nation's gain. We may actually end up spending more money defending against the foreign government that we trading with, than benefiting from the trade. Or our money may be used by the foreign government to enslave its people. We may be losing jobs because of our trade with foreign governments, as factories are built in the foreign nations rather than in our nation. For most of the history of the United States "free trade" with foreign nations was not supported, but it has been increasingly used in recent years. Wal-Mart, for example, imports many billions of dollars of low-cost goods directly from China, where they are produced by paying workers very little in wages.

Harmful Goods and Services, and Addictions

The colony of Virginia survived and thrived by turning to tobacco and slavery. Much of the economy, even today, is based on vices and harmful activities. This is sad but true. The largest building west of the Mississippi, which includes all of California and many other states, is located in Las Vegas, built on gambling. In fact, Las Vegas has far more hotel space than any other city in the United States, including even New York. The people staying in those hotels are hurting themselves and losing their money through gambling, which may be an addiction for them.

Abortion is a very harmful activity that exists because some are making millions of dollars from it, and giving some of that money to politicians who support them. Smoking exists because tobacco companies earn big profits from it, even though it kills many people each year. Beer is destroying people’s livers but making billions of dollars for beer companies.

Go into a typical convenience store and you will find that they do a brisk trade in cigarettes, pornography, alcohol and lottery tickets. Those four categories probably account for most of their profits. The people paying for those goods are both losing money and hurting themselves.

In the “underground” (illegal) economy, drug trafficking accounts for an enormous amount of commercial activity. Drugs are extremely hurtful, but drug dealers make money out of getting people addicted to drugs and paying money for them. Often people die of overdoses from drugs.

What do these harmful economic activities have in common? They exploit addictions. The prices on these goods and services can be increased much more easily than on anything else. Someone addicted to drugs is still going to try to buy it even if the price increases by 10%, 20%, 50%, or 100%. The same can be said for gambling, pornography, alcohol and almost every other vice. They are profitable to sellers who exploit the addiction. Buyers lose their money and ultimately their lives.

Price Discrimination

The term “price discrimination” sounds ugly, but it means selling the same good or service at different prices to different people. It is an attempt by a seller to capture additional money from buyers who are willing to pay more.

Airline tickets are an example. Businesses are willing to pay more for airline tickets for their employees to travel to business meetings than tourists are. Why? Because the businessmen are traveling to make more money for their company, and the airline ticket can be paid out of their profits. If they are flying to do a deal worth $100,000, then they’re willing to pay many thousands of dollars for the airline ticket. Not so for tourists who fly.

The airline wants to sell the same seat at a price low enough for the tourist to pay, and then at a different, much higher price for the businessmen. This is price discrimination, because it distinguishes or discriminates based on who the buyer is. “Perfect price discrimination” sells each unit of a good at the maximum amount each individual buyer is willing to pay.

There are laws against price discrimination, but most sellers find clever ways to do it anyway. Airlines distinguished between business customers and tourists by its “Saturday night stay-over” rule. If the traveller reserves the return flight to include staying over at least one Saturday night, then he is likely a tourist. If he flies out and back in the same week without staying through the weekend, then he is likely a businessman. So the airline tickets were then priced much more cheaply for those who stay over at least one Saturday night.

In general, price discrimination depends on the existence of obstacles to prevent buyers from reselling their goods to other buyers. If the same good is sold at $X to person A and $Y to person B, and X<Y, then person A could buy an extra good and sell it to person B at less than $Y. The price discrimination would collapse due to the resale market.

But some goods cannot be resold. Goods that are personal to the buyer, like a tailored suit or dress, cannot be resold. Price discrimination works fine for personalized goods or exclusive markets, because there is not a resale market to destroy the discrimination.

Tariffs and Quotas

"Imports" are goods shipped into our country by a foreign country, for sale in our country. China imports many goods that are sold in the United States by Wal-Mart, for example.

There are valid reasons to discourage the sale of imports and encourage sale of goods made domestically (made in the United States). The money paid for imports goes to the foreign companies, and support the foreign countries. The sale of imports do not help Americans as much as the sale of made-in-America goods do.

There are two approaches to disfavoring imports. The primary way in history was to impose a tariff on imports. A tariff is a tax on imports. A tariff raises the price of imported goods, and the supplier must then reduce its received price to attain the same level where supply meets demand. This has the effect of reducing supply. Goods made domestically (in the United States) increase their sales due to the decrease in sales by the imports. A tariff on a foreign-made car like the "Honda" would reduce the supply of Honda cars in the market. American car companies would benefit from that, but consumers who want to buy more Hondas might not.

The other approach to limiting imports is the use of quotas. Instead of imposing a tariff on Hondas, our government could set an upper limit (quota) on the total number of Hondas that may be sold in the United States each year. Quotas also reduce supply, but without generating any revenue to the government. Instead, quotas have the effect of increasing the price of the good (Hondas in this case) with the higher price going to the company that sells the Hondas. The government does not obtain any revenue from a quota, while it does obtain revenue from tariffs.

Prior to the passage of the Sixteenth Amendment that legalized the income tax in 1913, and even long afterward, the major source of revenue for our national (federal) government in Washington, D.C. was tariffs. But tariffs have long been controversial, and dividing the North (which liked them because they "protected" the northern manufacturers against competition from imports) and the South (which disliked them because it increased the prices of goods they purchase and caused foreign nations to retaliate by placing tariffs on cotton and other exports from the South). Tariffs were a major cause of the Civil War.

Today tariffs are rarely used and the government relies almost entirely on the income tax for funding.

Minimum Wage and Price Controls

So far we have been talking about economic exchanges in the absence of government controls. But the government does interfere in many ways in our economy. America enjoys more free enterprise than any other large country, but we are still heavily regulated.

During World War II, the government imposed controls to prevent companies from raising prices during the war. The needs of our military for goods increased demand that would ordinarily shift the demand curve and increase prices. But the government prohibited this from happening by limiting price increases.

Controls on prices (and also wages) were also imposed to control inflation in the early 1970s. A war in the Middle East, and assistance in that war by the United States of Israel, caused the Arab nations to reduce their supply of oil to us. That created gasoline shortages and increased energy costs, which then drove up inflation. Price controls were designed to limit the increases.

Today, the government prohibits employers from paying wages below a certain amount per hour, called the “minimum wage.” It is now $7.15 per hour in New Jersey, but only $5.15 per hour nationwide. If you work 40 hours a week for 50 weeks, or a total of 2000 hours, then that translates to a yearly salary of $10,300. It is nearly impossible to support a family that amount in most areas of the country, and many politicians are constantly demanding an increase in the minimum wage.

Unfortunately, it is even more difficult to survive without a job at all, which is what happens to many people (particularly teenagers) when the minimum wage is increased. Employers who would hire someone to work at $4 per hour might not be able to hire them at $5.15 per hour. Isn’t a job at $4 an hour better than none at all?

Moreover, illegal aliens find a wage of even $2 an hour better than what they could make in their homeland. Companies move operations offshore to take advantage of places that do not have minimum wages as high as ours. Alternatively, workers enter this country illegally to work at low wages and displace American workers, according to several lawsuits.

Minimum Wage and Dropping Out of School

Researchers have found that one effect of raising the minimum wage is that more students drop out of school, or do not go on to college, because they can make more money working at jobs than they could before. This can be understood as follows:

Suppose that "x" number of students quit school to work at jobs when the minimum wage is $6 per hour.

If the minimum wage is raised from $6 per hour to $7 per hour, then jobs appear more attractive to students and even more will leave school than before.

Therefore raising the minimum wage causes more students to leave school in order to work at jobs.

Other studies show, however, that the more education that someone has, the higher their average income is. Students who complete four-year colleges make more money on average than students who completely only two-year colleges, for example. Students who complete two-year colleges likewise have higher average incomes than students who end their education after high school.

Raising the minimum wage thus entices students to take advantage of a "short-term" benefit of the higher wage, but they are worse off in the "long-run". They would make more money by staying in school and not being enticed by the increase in the minimum wage.

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:

1. Give an example of a good that has high price elasticity, meaning that a small decrease in price causes a big increase in demand.

2. Donald Trump makes money by "selling" the service of gambling. Donald Trump can keep increasing and increasing his price for the gambling (the losses by the players), and the addicted gamblers just keep on paying to play. Does this describe an "elastic" or "inelastic" service? Explain.

3. Give examples of a complement and a substitute for a hamburger for lunch.

4. A nearly perfectly elastic demand curve is nearly ________ in shape; a nearly perfectly inelastic demand curve is nearly __________ in shape.

5. Why is the name "necessity" given to a good that has a price elasticity of less than one, and the name "luxury" given to a good that has a price elasticity of more than one?

6. What is your view of the minimum wage? Should it be increased?

7. For most of our nation's history it used tariffs rather than taxes on income in order to provide money for the national (federal) government in Washington, D.C. What is the effect on the supply curve for a good imported from China if the U.S. government imposed a $1 tariff on it? Would that cause more or less of that good to be purchased? Why? Now suppose the government uses quotas rather than tariffs. By limiting the amount of a foreign good that can be sold in this country, Americans who make the same good have an easier time selling their good with less competition. What effect does a quota have on the supply curve and the equilibrium price for an imported good? Who makes more money because of a quota, and who loses the most from it?

Honors

Write an essay of about 200 words total on one or more of the following topics:

8. Explain price discrimination, and conclude with your view of whether it should be legal or illegal.

9. Do you support "free trade" because it creates wealth, or do you oppose it for simply redistributing wealth to foreigners, some hostile to the United States?

10. Is economics almost always determinative of the outcome on political issues, such as elections?

11. "A bird in the hand is worth two in the bush." Explain that thought in economic terms.

12.