Economics Lecture Twelve

Economics Lectures - [1 - 2 - 3 - 4 - 5 - 6 - 7 - 8 - 9 - 10 - 11 - 12 - 13 - 14]

There are three lectures remaining, including this one, and then there will be our final exam. As we did last, week, we will review some important concepts first, and then learn some new ones. The review will help you prepare both for the final exam and, if you choose, the CLEP exam.

But first let's address a superb question asked by a student last week. He wondered whether the "economic rent" (the extra amount charged by a company above its costs, perhaps because it is a monopoly) is the same as the "deadweight loss." The answer is "yes": "economic rent" is a type of deadweight loss. Any time the price of a good is raised above its price in a perfectly competitive market, there will be buyers who will not pay the higher price and thus will lose out on the consumer surplus between the higher price and lower, competitive price. That loss in consumer surplus is a deadweight loss.

When the price is increased due to taxes, then both the buyers and the sellers lose out, and there is a deadweight loss that is even greater because it includes both a consumer surplus lost by the buyer and a producter surplus lost by the seller. So while higher prices due to monopolies are bad, higher prices due to taxes are even worse. Feel free to review the lecture and graph that discussed consumer surplus and producer surplus to understand this further.

To show you how recent the theories of economics are, the term "rent seeking" behavior was introduced only 40 years ago. It describes actions by firms to increase their prices and obtain economic rent above the free market, cometptitive price. Such behavior is not good for the public, because it causes a deadweight loss (lost consumer surplus).

With that challenging introduction, let's have our review.

Economic graphs on the CLEP exam

On the CLEP exam, slightly less than 10% of the questions are about graphs. To answer them correctly, it helps not to be overwhelmed or give up too quickly. The questions simply test and retest a few basic principles in economics, such as where a monopolist sets his price:

• A monopolist has no supply curve, because he is the only supplier. There is only a demand curve, a marginal revenue curve, and some cost curves for a monopolist. If given a graph with these curves, simply find where the marginal revenue curve intersects the marginal cost curve, and that determines the quantity Here are some graphical questions to be able to answer:

Here are some more common graphical questions:

• consumer surplus (only occurs where demand curve is higher than price paid, because buyers paid less than they would have)
• curves for monopolist (no supply curve; output set by MC=MR, price sent by demand curve at that output)
• deadweight loss: the lost consumer surplus AND (in the case of a tax) the lost producer surplus
• optimal market price: where supply meets demand, or (for a monopolist that has no supply curve) where MC intersects demand curve (MC=P)
• comparing price and curves for ATC, AVC and MC, and realizing that maximum profits occur when MC=P; the firm shuts down in the long run when ATC>P; and the firm shuts down in the short run when AVC>P, but keeps operating in the short run when AVC<P but P<ATC (remember: "variable cost" is a short run issue; "total cost" is a long run issue)

Review: Government Policy

As mentioned in a prior election, 10% of the CLEP iexam is on government policy. With an ear tuned for political bias, student can rack up many correct answers here. But if the student's ear is slightly off-key, he can lose far more points here than he should.

• market distribution of income (Lorenz curve)
• market failure and imbalances in information

Production Possibilities

Nearly 5% of CLEP exam is devoted to questions about "production possibilities." These are easy points to earn.

"Production possibilities, or "Possibilities of production," means all the different combinations of goods a nation can produce. The United States can produce X cars and Y trucks, for example. Or it could produce more than X cars and fewer than Y trucks. We could graph the number of cars on the Y-axis and the number of trucks on the X-axis, and draw a “production possibility” curve through all the possible combinations. It would be downward sloping: more cars means less trucks, and vice-versa. The opportunity cost of producing more cars is the loss in production of trucks. In the production possibility curve for cars and boats shown in Figure A (below), the opportunity cost of moving from point A to point B is 100 cars.

The shape of the production possibilities curve is dictated by the high opportunity cost of trying to convert a nation's factories from making one type of good to making another type. Imagine having a car factory and a truck factory, and then trying to convert the entire truck factory such that it makes only cars. At a fixed level of expense, the truck factory is not going to be able to make as many cars as the trucks it was designed to make. So converting the nation from, for example, a level of 500 cars and 500 trucks to as many cars as possible will probably not be able to reach a level of 1000 cars and zero trucks. Instead, it will probably top off at a number less than 1000, and hence the tapering of the production possibilities curve near the two axes.

If the overall number of workers or investment capital increased, then you could produce more of everything. The entire production possibilities graph (or “production possibilities frontier”) would shift upward and to the right. An improvement in technology would have the same effect. An increase in bureaucracy or administrative costs, however, would have the opposite effect, forcing a contraction in overall production.

There are several assumptions made in constructing a production possibilities frontier. These assumptions are more realistic in the short run than in the long run:

• there are only two goods, and production is a trade-off between the goods: making more of one means making less of the other.
• the economy is efficient and there is no waste; if there is waste, then the point of production is somewhere inside the curve rather than on it.
• the same fixed resources are used for making the same two goods, and technology does not improve
• there is "full employment," such that adding workers requires taking them away from another task

Figures A and B

If there are inefficiencies in a nation's economy, then its production will be inside the production possibilities curve. Due to the inefficiencies, the nation will not be producing as much as it could if it were efficient. Just as an increase in capital or an improvement in technology can cause an increase in the production of all goods, an increase in a nation's efficiency can cause its production to increase for all goods, from a point inside the production possibilities curve to a point on the curve.

Sometimes in politics the trade-off between producing goods is described as “guns versus butter.” The more guns (e.g., military weapons) we make, the less butter (e.g., food and domestic services) we can produce. The idea is that there is a trade-off between spending money on our military and spending it on domestic goods and services.

On a personal level, it is usually impossible to do two things at once. Either you spend the next hour working on this course, or you spend it doing something else. You could graph a production possibility curve for how you spend 24 hours each day. It could be 8 hours sleeping, 1 hour exercising, 1 hour traveling to destinations, 3 hours cooking and eating, 6 hours studying, 1 hour relaxing, and 4 hours working at a job. If you take an hour away from one activity, then you can add it to another. Your production possibility curve would represent all the possibilities.

Review: Types of Competition

• Perfect Competition
• Imperfect competition
• Monopoly
• Oligopoly and monopolistic competition

The Law of Comparative Advantage

There is an interesting concept in economics known as the Law of Comparative Advantage. The CLEP usually asks two questions about it.

The Law of Comparative Advantage states that if one nation can produce two goods more efficiently than another nation, then the first nation should devote all its resources to producing the good that it makes more efficiently and let the other nation produce the second good, and then trade one for the other. This Law can apply to individuals and firms as well as countries.

Note that this is not what you might first expect. YOu might expect the first nation to produce BOTH goods, since it can produce both goods more efficiently than the other nation. But upon closer examination it becomes clear that by focusing on what it does best, and produces more efficiently, the first nation can produce more and then trade for the rest, and be better off. Put another way, "do what you do best!"

In sports, sometimes an athlete is good at one sport (e.g., baseball) but great at another sport (e.g., football). John Elway and Deion Sanders, for example were great at football but only good at baseball. John Elway did what he did best: he played only professional football, and became one of the greatest quarterbacks ever. Deion Sanders played both football and baseball, and perhaps did not achieve as much at either as he could have by focusing what he did best.

Economists observe that utilizing the Law of Comparative Advantage can improve the production possibilities. Suppose your job paid you $9 but you could hire a cook for $6. Then it might make sense for you to work one more hour and hire someone to save you one hour of cooking. In the absence of taxes, you would be $3 better off. Then you could work one-third of an hour less to make the same money (after expenses) as before. That extra one-third of an hour could be added to your sports or relaxation time. You have moved your “production possibilities frontier” (the curve of all possibilities) outward, for greater benefit.

Example

Suppose this is how much in resources it costs the Yankees and Mets to produce great pitchers or outfielders:

		Yankees	Mets
	outfielders	10 resource units	5 resource units
	pitchers	9 resource units	3 resource units

Even though the Mets can produce outfielders more efficiently than the Yankees can, the Mets are better off spending all their resources developing pitchers and then trading with the Yankees to obtain outfielders.

David Ricardo (1772-1823), one of the greatest of the classical (conservative) economists, first developed the Law of Comparative Advantage. Note that "comparative advantage" is not the same as "competitive advantage," which simply means something that gives you an advantage in competition over someone else, such as a better location for your gas station.

Review: Inputs

Until now, when we discussed what a company does, we have usually talked about its output. How many goods will it sell at what price? The price elasticity of its demand, for example, looks at how demand for its output changes based on a change in its price.

Marketing and sales also focus on the output of a company. Marketing consists of advertising and promoting the goods. Sales, the most important aspect of almost any company, consist of persuading customers to buy the company’s good or service. The most valued employees of almost any company are its top salesmen and saleswomen. They are the ones that bring in the money to the company.

If we were to hold a dinner with a speaker, the output is the seats at the dinner and the sales effort consists of selling the spots and receiving money in return. In a homeschool course, the output is the lectures and the sales effort consists of selling places in the course. Colleges compete for students who can pay their tuition and fees. Many colleges struggle because they have a difficult time attracting enough students to pay tuition. In fact, very few new colleges have begun in the past twenty years.

But there is another side to every company: its own inputs and the costs they incur. For a homeschool dinner, the inputs include a speaker’s fee, a facility fee, and a catering fee. For a homeschool course, the inputs include a teacher’s fee, perhaps a facility fee, and expenses for materials such as handouts or textbooks. Lowering the costs of those inputs increases the profitability of the project.

This is like offense and defense in sports. The people on offense are the salesmen, trying to score points. The people on defense are the buyers of inputs for the company, trying to keep the expenses down. They are opposite jobs, often requiring opposite personalities. Extravagant people make for better salesmen; frugal people are often better buyers of inputs for a company.

Experienced businessmen will emphasize that profits are made by keeping expenses down. After all, profits are the main goal of a typical business. If a company is buying food from supplier number one and can reduce costs by going to supplier number two, then the rational action is to change suppliers.

Keeping costs down was what made Wal-Mart so powerful. Its marketing and advertising have only been mediocre. But it is the best in reducing costs. It pays its employees relatively little; it opposes unions forming among its workers; and it is ruthless in bargaining down the costs of its suppliers. Wal-Mart has made immense profits as a result.

Does that seem unfair? No one has to supply Wal-Mart goods at a low price. If a supplier does not want to do business with Wal-Mart, then it doesn’t have to.

In general, the demand for inputs by firms is called the “derived demand for inputs,” because it is derived from the consumer demand for the products the company sells. You want to buy gas from a gas station, and your demand in turns creates a demand by the station for its inputs: the gas and labor.

Review: Monopsony

A monopsony means only one buyer. A buyer holds a monopoly on purchases.

The most obvious example of a monopsony occurs in a small town where there is only one employer. If you want a job in that town, then your only place to work is at that company. Of course, very few towns are actually limited to just one employer. But for certain types of jobs, there may be only one employer, and it has a monopsony over those jobs.

A monopsony is different from a competitively hiring firm in one significant way. When a monopsony needs to hire an additional worker, then it has to raise the wages for all its workers at that level to hire an additional one. Its marginal cost for paying for this factor (its marginal factor cost, or “MFC”) is more than the wage of the additional worker. MFC equals the W of the additional worker PLUS the increased wage of all the other workers.

For example, if a monopsony can hire 10 workers at $6 or 11 workers at $7, then its MFC of hiring an 11th worker is $7 + (10 x ($7-$6)) = $17.

For a competitive firm, in contrast, MFC=W because it can hire all the workers it needs at the market wage, without causing the market wage to rise for all its workers.

(Honors Only) Example

Let’s start with this simple equation: Profits = Total revenue - Total cost

That’s easy enough. Now let’s break it down, where P=Price, Q=Quantity, W=Wage, and L=Labor units.

Profits = (P x Q) - (W x L) - other non-labor input costs

Now suppose we add one more worker to our company. We will have to pay him a wage of W, so the marginal factor cost of one more worker is W (assuming a competitive market). What is his marginal benefit to our company? P x MP

When does a company hire that additional worker? When the change in profit is greater than zero.
What occurs when (P x MP) > W

Let’s apply this to an example. Suppose a firm has a declining marginal product for each additional laborer hired, such that:

Labor Units (L)	Marginal Product (MP)

1				20
2				18
3				16
4				14
5				12
6				10
7				8

Suppose the wage W for each employee is $70 and the price the output is sold for is $5. How many workers should you hire?

If you hired just one employee, then you would make 20 x $5 = $100 in revenue. But your cost was only W=$70, so you made a profit of $30! You’ll hire at least one employee.

If you hire a second employee, then you would make (20+18) x $5 = $190. But your cost was only $70 x 2 = $140, so your profit is $50! You’re doing even better, so you hire the second employee.

Skip down to hiring employee number 6. Then you make (20+18+16+14+12+10) x $5 = 90 x $5 = $450 . What’s your cost? 6 x $70 = $420. It’s barely profitable.

Should you hire one more employee? That additional employee costs you $70, but only brings in 8 x $5 = $40 in revenue. You’d be losing money on him. DON’T HIRE HIM. Or if you hired him, then fire him and give him a good job reference.

Let’s back up and see if it makes sense to keep employee number 6 around. His marginal cost is $70, and he brings in marginal revenue of 10 x 5= $50. He’s losing money for you also. You don’t want him on your staff.

How about employee number 5? His marginal cost is $70, and he brings in marginal revenue of 12 x 5 = $60. He’s losing money for you also. Fire him too.

Your firm hires four workers and no more. Anyone beyond your fourth employee is a money-loser for you. This is because of declining marginal product of labor.

Review

Monopoly is a single seller.
Monopsony is a single buyer.
If the firm is competitive, then marginal factor cost (MFC) of labor equals the wage of the extra worker: MFC = W.
What is the benefit of that extra worker? Marginal benefit (MB) of L is P x MP (price times marginal product)
What, then, is the marginal profit of hiring one more worker ? It is (P x MP) - W
So when does a competitive firm hire an additional worker? When P x MP exceeds W.

Labor demand:

If Q increases, then labor demand increases.

What causes Q to increase? Increased demand by consumers

For Honors only: what is the effect of consumer demand for output on the labor demand by the company? When consumer demand (demand for output) is more elastic, then labor demand by a company tends to be more elastic. When it is easy to substitute other inputs for labor (such as machines replacing humans), then labor demand also tends to be more elastic. Finally, when other inputs are in more elastic supply, then labor demand tends to be more elastic. And don’t worry if you don’t understand all that.

Assignment

Read, and reread as needed, the above lecture. Then answer 6 out of 7 questions below, which use many concepts from the entire course:

1. A ________________ is one and only one buyer in a market.

2. One useful aspect of a production possibilities curve is to show how:
(a) it is possible for a nation to increase production of all its goods at the same time.
(b) transaction costs cause a trade-off in goods produced.
(c) a scarcity of resources causes a trade-off in goods produced.
(d) in the long run, average total costs can be minimized.
(e) an indifference curve can be expressed in graphical form.

Explain your answer.

3. What is the marginal factor cost of a monopsony when it increases is wage for 10 employees from $11 to $12 in hiring an 11th employee? Show your work.

4. In terms of P, MP, and W, state when a company in a competitive market hires an additional worker at wage W.

5. Max unionized all the employees in an industry and then tried to increase both their wages and the number of people employed. Is this possible? Are there conditions which would make it possible?

4. Look at Figure B (right). If the price of sale falls below P1 then the firm in the short run will (a) increase Q, (b) increase labor, (c) increase price, or (d) shut down. How much profit is it making at a price of P2?

5. Look again at Figure B (right). Assume the firm is perfectly competitive. Explain what AFC is, and use the labels on the graph to describe its amount.

6. Now turn to Figure A (right). What is the opportunity cost of shifting production from B to C?

7. Suppose that is your firm in Figure A (attached). What changes might enable you to move production to point D?

6. Suppose you manage a monopoly, and want to know the short-run and long-run conditions for shutting down. Explain them in terms of average variable cost (AVC), average total cost (ATC) and price (P).

7. Sharon has to pay $10.50 to hire nine workers, and must increase the wage to $11 to hire a tenth worker. But the tenth worker will bring in $13 extra to the firm’s revenue. Does Sharon hire the tenth worker?

Honors:

Figure C

Answer 3 out of 4 questions below:

10. Look at Figure C (right). Assuming it represents the long run, describe what type of industry this is (e.g., monopoly, oligopoly, monopolistic competition, or perfect competition). Explain your answer.

11. Explain why the production possibilities curve is convex (opening downward like the top of a circle) rather than concave (opening upward like the inside of a bowl) or a straight line.

9. If our class is a monopsony with respect to hiring a dinner speaker for a special homeschool dinner we might hold, can we set the fee at whatever we like? If not, why not?

10. Explain: when consumer demand (demand for output) is more elastic, then demand for labor by a company tends to be more elastic.

11. Imagine yourself as a powerful regulator who can set the price of a certain good in a certain industry wherever you want. Suppose that in the free market, competitive equilibrium would have price “P”. Where would you set the price if you diabolically wanted to cause a shortage of goods? Where would you set it if you diabolically wanted to cause a surplus of goods? Explain.