Lecture 003 Supply and Demand: Markets Connor Lennon 08 April 2020 Admin Admin Assignments This Week Smartwork Assignments, Inquizitive Chapter 2 are due today by 11:59 p.m. If you're late with the homework assignments, you can still turn them in, but at a 33%/day point reduction. Future Assignments due next week: Supply and Demand Inquizitive and Smartwork due Saturday the 18th. 3 / 62 Admin Upcoming Today: Covering Covering the assumptions required for functional markets and how supply and demand interact. Readings Today through next week Finish Mateer/Coppock Ch3 Next week Mateer/Coppock Ch. 4 4 / 62 Review Review Couple of things: I forgot to mention that consumers ALSO will anticipate price shocks. Consumers are just as smart as suppliers so generally if they know prices are going to go up tomorrow, they'll buy more today. A good example of this is the whole toilet paper debacle. Everyone heard that toilet paper went out of stock in China, so they decided they, their neighbors and also the entire population of bangladesh needed to be bought a year's supply of tp before prices could rise/stocks could run out 6 / 62 Review Couple of things: Also, if the number of buyers increases, demand also increases. This is a less-relevant fact in a micro-economics course, but this is important when considering the importance of population growth in long-run economic growth. Adding more consumers will necessarily grow GDP/market demand. 7 / 62 Equillibrium Equillibrium Back where we left off Remember, I had just started to set up a market at the end of the last class. Let's bring that graph back up - 9 / 62 Equillibrium Where we left off What exactly is represented by the supply and demand curves? They are letting us know how much is either being supplied or demanded for any given price. Let's start by thinking about what happens when our price is like the one we see above. For a given price, quantity demanded is equal to quantity supplied. In other words, suppliers sell all of their stock and buyers get everything they want at the market prices. 10 / 62 Equillibrium Let's mess with this a bit. Let's say that there was a decree that all sandwiches, will cost P > P dollars. 2 1 11 / 62 Equillibrium Sellers are super happy about this new price, right? Well maybe at rst they are. Great! We can now make a ton of sandwiches and sell them for P ... quantity supplied increasesbut they aren't happy about it forever. Why is that? Well let's look at quantity demanded 2 Buyers are distinctly not happy about this, and will likely choose to buy other foods. quantity demanded will fall. This means quantity demanded < quantity supplied. This, in markets, is called a surplus. 12 / 62 Equillibrium If you go to your local grocery store and you see piles and piles of discounted bread under the manager's special area, that is a surplus in action. They're selling stuff for which there was less quantity demanded than they had stock. So what so they do? They lower prices. Of course, as soon as they lower prices, more people start buying. Maybe one producer/supplier does this rst, and then everyone follows. 13 / 62 Equillibrium 14 / 62 Equillibrium Now consumers are happy, right? They're getting the sandwiches they wanted for way cheaper now! Unfortunately, no. Why not? The market is now in a shortage. When prices are below the point where q = q then suppliers will decrease their output and consumers increase their consumption. demanded suppled Now, there are lines out the doors of the sandwich shops and the shops are running out of goods to sell. 15 / 62 Equillibrium What do you think happens when shops start routinely running out of stuff to sell early? They try to produce more sandwiches. But in order to do that, because of diminishing marginal returns, they need to raise prices. You can start to see the pattern - if prices are too high, rms will be forced to lower them due to having an over-supply, and if prices are too low, rms will be forced to raise the price. So where does this process stop? the price such that quantity demanded = quantity supplied. We call this the equilibrium 16 / 62 Equillibrium 17 / 62 Equillibrium If a market price is at precisely P here (or market quantity is at precisely Q ), then prices and quantities won't change, ceteris paribus. eq eq If a seller tries to go rogue, and raise their prices, there are tons of other sellers that will sell goods! No one will buy from them. Right? Right? Well, we were assuming that there were. Let's evaluate that assumption a little. 18 / 62 Markets Markets Imagine our Colombian Market Imagine yourself back in the Colombian market I used to motivate the rst slide of the last lecture. You see around you a plethora of fruit. Now stop. Think about the sellers. Do you have any reason to believe any one of them is necessarily going to give you better fruit? 20 / 62 Markets Think about what you buy Now think about the total collection of the things you buy. For some of the goods you buy, you likely know exactly who made it. What about your computer? I imagine many of you own and use Apple or Microsoft products. Maybe you're a super cognizent clothes buyer and you care a great deal about whose jeans/shirts/dresses/jackets/etc. you are wearing. 21 / 62 Markets Maybe Maybe you're wondering why I'm asking all of these questions and setting up these hypotheticals. How about two more. Well what would happen if Apple increased the cost of their laptops by a signi cant margin. Some of you probably would have still wanted to buy a Macbook Pro. However, if two gas stations; selling identical gallons of gasoline directly across the street from one another, priced their gasoline sigini cantly differently, you would probably just buy the cheaper gas. 22 / 62 Markets Market Power The difference between those two examples is that not everyone can easily substitute away from iOS/apple products. Using a PC/Linux computer after using iOS is just a hard transition to make for many. You can easily transition from one type of gas to another, however, no matter who you are. I mean, don't put diesel in your car or anything, but it's pretty easy to drive across the street to get cheaper gas. This distinction is actually super important when we talk about markets, because one of the critical assumptions is that markets are perfectly competitive, which means the items sold in the market are more or less completely substitutible. 23 / 62 Markets Market Power In order for the material I've already shown you to really work no individual buyer or seller can have any signi cant in uence over the price. Let's think a little bit about why: If I as a business can raise my prices so that I increase pro t at the cost of only some of my consumers, I might be able to make more money overall so long as the lost quantity sold is made up for by per-unit pro ts. We also can't have: 24 / 62 Markets Market Power 25 / 62 Markets Market Power The most extreme cases of this market power is when there is only a single buyer or a seller. When there's just a single seller, we get a monopoly. We'll understand more about monopolies in a lecture after the midterm. When there's just a single buyer, the result is the less-commonly-known monopsony. You see monopsonies show up in small "company-towns" where one business is buying all of the labor and, because they are the only employer, can pay their employees less than market wages. 26 / 62 Markets Market Power For now, we are going to assume that our markets work, and are perfectly competitive. We can break our new toys after the midterm. Perfect competition requires: Many buyers and many sellers Free entry/exit of rms Free entry/exit of consumers No information assymetry between rms/consumers. I call this the 'no snakeoil salesmen rule.' This one only sometimes causes problems, and in a speci c way. That's quite a bit of assumptions there, boyo. 27 / 62 Markets Market Power Well, yes. However, a ton of markets still meet these assumptions. The ones that don't are interesting, but we'll get to those later. For now, let's see what happens to market prices and quantities when our demand and supply curves shift. Remember, we have a variety of reasons to think demand and supply curves might shift. 28 / 62 Effects from Shifts in Supply/Demand Effects from Shifts in Supply/Demand 30 / 62 Effects from Shifts in Supply/Demand Let's actually look at what happens when buyers expect prices for toilet paper to rise. 31 / 62 Effects from Shifts in Supply/Demand Shift in demand Demand has shifted out! Now, at our old price P , our sellers are running out of stock! That lines up well with what we experienced. 1 But what happens in a shortage?Toilet paper prices rise. Why? Sellers move along the supply curve and increase quantity supplied to keep up with demand. 32 / 62 Effects from Shifts in Supply/Demand Shift in demand When demand shifts outwards, given time for the market to adjust, quantities will increase, and prices will increase to help meet that demand. This may seem simple to you - but the fact is that professional journalists misunderstand this all the time. When demand increases, prices increase. This may seem inequitable to you, but no matter how we give out masks, the result is inherently inequitable. If prices didn't rise, there would be fewer items available, and more people wanting them. Who would get those items? The rst in line would. This is a normative judgement - but I can't really say which of those is better, although the price increase will increase quantity 33 / 62 Effects from Shifts in Supply/Demand 34 / 62 Effects from Shifts in Supply/Demand Shift in demand What happens if demand decreases? Well let's think about a different scenario. Let's look at the gasoline Market Let's say, as has been the case in the last few years, that the price of electric vehicles has fallen. Now - let's think about what's happening here. What kind of shifter is the price of electric vehicles for gasoline? This is roughly our bottled-wine/boxed-wine scenario - electric vehicles are almost perfect substitutes for gas powered vehicles... 35 / 62 Effects from Shifts in Supply/Demand Shift in demand Who caught my mistake here? Gasoline isn't a substitute for electric cars. What's really going on? Gas-guzzlin' road-machines are complements for gasoline. Demand fell for the complement, which means, ceteris paribus, there will be less demand for gasoline. of course, both of these shifts will tend to lower prices, and humans have been shown to be remarkably short-sighted when it comes to investing in green technology... 36 / 62 Effects from Shifts in Supply/Demand Shift in demand 37 / 62 Effects from Shifts in Supply/Demand Shift in demand 38 / 62 Effects from Shifts in Supply/Demand Shift in Supply However, supply can also shift, remember? Let's start with an easy shifter - let's say a new technology gets invented that makes it cheaper to manufacture hawaiian shirts. 39 / 62 Effects from Shifts in Supply/Demand 40 / 62 Effects from Shifts in Supply/Demand Shift in Supply Just like with an increase in demand, the rst step of the change will result in a surplus. The mechanics are different though: now, it's easier to make more stuff so suppliers will increase their production. However, demand hasn't shifted here, so there isn't any demand for more hawaiian shirts at P . 1 This leads to a surplus - and in order for suppliers to clear that surplus, they have to scale back production and decrease prices. 41 / 62 Effects from Shifts in Supply/Demand Shifts in the supply curve Of course, decreasing prices leads to: movement along the demand curve (Qty demanded increases) movement along the supply curve (Qty supplied decreases) Let's take a look at our new equilibrium 42 / 62 Effects from Shifts in Supply/Demand 43 / 62 Effects from Shifts in Supply/Demand Of course, supply curves can decrease too... Let's have the Tommy Bahamas factory explode in the middle of the night. Now, capital used to produce hawaiian shirts disappears. 44 / 62 Effects from Shifts in Supply/Demand 45 / 62 Effects from Shifts in Supply/Demand Now, there is a shortage of hawaiian shirts! What ever will authoritydefying casual-friday-goers do now? (I love hawaiian shirts.) Well, because there is a sudden shortage, suppliers will slowly begin to raise their prices to keep up with the old demand levels. This will cause movement along the demand curve, and eventually... you got it, we'll be back at equilibrium. 46 / 62 Effects from Shifts in Supply/Demand 47 / 62 Effects from Shifts in Supply/Demand And that's it. You now know everything there is to know about the dynamics of shifts in competitive markets. However, I want to take a moment to go over the complexities that can emerge when you shift supply and demand at the same time. You could already gure this out with a bit of logic and what you've already learned, so if that's you, feel free to jump ahead to the examples section at the end. 48 / 62 Effects from Simultaneous Shifts Effects from Simultaneous Shifts Past the Basics Now that we're past the basics, we can analyze real world situations through an economic lens. However, most events in the real world are more than simply demand increases or supply increases. Often, real world examples shift both supply and demand at the same time. Let's revist two of our past examples, to see how analyzing real-world events can be complicated 50 / 62 Effects from Simultaneous Shifts information shock let's revisit the toilet paper problem again. Recall, sellers also react intelligently to information. In our example, we only gave our buyers new information. What would happen if everyone expected a price increase? Let's fast-forward to our new equilibrium state. Sellers, expecting price to be higher later, will now restrict supply (decrease supply) so they can sell more toilet paper later. 51 / 62 Effects from Simultaneous Shifts 52 / 62 Effects from Simultaneous Shifts It looks like there's no change in quantity, but a big increase in price. Cool! We're not done yet -unfortunately, shifting both curves makes where we end up very dif cult to determine. For instance: 53 / 62 Effects from Simultaneous Shifts Now we have a small increase in Qty. However, if we did: 54 / 62 Effects from Simultaneous Shifts Now we have a small decrease in quantity! 55 / 62 Effects from Simultaneous Shifts The tricky thing When we shift two curves at the same time, we can only make conclusions about one of our two endogenous variables. That is, depending on the shifts, we can only say stuff about either price OR quantity, not both at the same time. Which one can we gure out? That depends on the direction of the shifts. The book has a great diagram covering this that I am going to use here- 56 / 62 Effects from Simultaneous Shifts The tricky thing 57 / 62 Effects from Simultaneous Shifts If this chart doesn't help you, then I have one other way that's pseudomathy. Let's think about the nal, in-equilibrium effect we get from any single shift. We know, if demand increases then price increases and quantity increases We know, if supply increases then price decreases and quantity increases We know, if demand decreases then price decreases and quantity decreases We know, if supply decreases then price increases and quantity decreases 58 / 62 Effects from Simultaneous Shifts What you can do, here, then, is to add these shifts together. If both shifts increase quantity or price, then you increase quantity or price If there are countervaling effects (that is, one curve decreasing qty, the other increasing) then we can't say for certain the direction or magnitude of the effect. 59 / 62 Examples Examples Q Several oil elds exploded in the middle east, what is the effect on demand? Quantity demanded? A: Destroying oil elds is an example of damaging capital, and will result in the supply curve shifting to the left. This will not effect demand, but Quantity demanded will decrease as prices rise. 61 / 62 Examples Q New developments in factory technology make it cheaper to produce clothing ethically. Consumers are more willing to buy with a clean conscience, and producers can produce more clothing at cheaper prices. What equilibrium effects do we see on quantity and price? A Because both demand and supply are increasing, we can add the effects from both shifts together. From demand: quantity increases and price increases. From supply: quantity increases and price decreases. This means we know quantity will increase, and the impact on price is unknown 62 / 62 Lecture 009 Firms and Production Costs Connor Lennon 11 May 2020 Admin Admin Assignments Future Assignments due this week: Inquizitive for Externalities and Property Rights is due today, May 11th at the normal time. The Smartwork Quizzes from last week are due on Wednesday (for Price Controls) and Friday (for Externalities) this week The Inquizitive for Today's lecture (Production costs) will be due this Saturday. May 16th at 11:59 pm. 3 / 51 Admin Upcoming Today: Covering Covering costs of production. This goes into both short and long run costs for rms, and how the structure of those costs can impact how rms do out in the real world. 4 / 51 Admin Upcoming Readings/Schedule Today through this week Mateer/Coppock Ch. 8 and begin Ch. 9, however, these two concepts are intrinsically interlinked. Business costs is, in a sense, the rst half of the rm picture. The other half is pricing structure (perfect competition) - which is what we'll cover on Wednesday this week and Monday next week. Next week Mateer/Coppock Finish Ch. 9 and we'll start in on Ch. 10 (monopoly). Monopoly is a very special kind of 'market failure' that is observed in the real world. 5 / 51 Review Review Price Controls Price Ceiling Price Floor leads to lower prices and lower quantities leads to higher prices and lower quantities this creates shortages as quantity demanded outstrips quantity supplied this creates surplus as quantity supplied outstrips quantity demanded A black market also crops up, selling goods at higher prices than allowed to take advantage of the shortage A black market also crops up, selling goods at lower prices than allowed to take advantage of the surplus 7 / 51 Review Externalities and Property Rights Externalities are what occur when a market fails due to outside, third-party non participants in a market capture bene ts or costs. This leads to inef ciencies because, ideally, a market will produce a quantity of some output that is precisely such that marginal cost is equal to marginal bene t. If those costs/bene ts fall at all outside of the market, this probably won't occur Well established property rights correct this problem, because it allows third-parties to either demand compensation, or be forced to compensate themselves. 8 / 51 Review Externalities and Property Rights 9 / 51 Production Costs Production Costs Why Study Costs Outside of being a business analyzing their own costs to optimize their choices, why study them? The amount a business has to pay to produce a good inherently impacts what kind and what size of businesses ourish in a given sector Further, the size of the business impacts how resilient it is to different kinds of shocks. How big and successful a business is also impacts the happiness of the owners and their employees. For these reasons, understanding the nature of business costs is important not only to the businesses itself, but also to welfare results. 11 / 51 Production Costs The Production Function However, before we enter into costs themselves, it's important to understand exactly how rms make goods that people purchase How do rms really 'produce'? They take one set of goods, and turn them into another set of goods. For instance - a car producer takes steel, workers' labor and a factory (plus the technology in that factory) and produces cars out of the other side. A production function takes one set of inputs and then tells us what the rm chooses to produce, outputs. 12 / 51 Production Costs Factors of Production Primarily, rms use three types of inputs to produce. Depending on the rm, the mixes of these three things changes labor. In economics, this is the most exible of the three goods, it can be decreased, increased almost at will. Capital. Capital consists of all the stuff rms use to produce output. Land is a relatively more recent addition to the pile - and in general isn't considered in most simple production functions. Urban economics cares particularly about land. These are the dials we can use for our rm production model 13 / 51 Production Costs Factors of Production A production function looks like: fp (l, k, L) = output This looks complicated, but really what it is saying is 'give me a level of labor (l), capital (k) and land (L) a rm puts in, and I'll give you some output quantity.' The letter p indicates this changes depending on the rm. Obviously, each rm and type of rm will use different combinations of the elements on the previous slide. These differences in rms will determine how successful, productive and responsive they are 14 / 51 Production Costs Factors of Production (eg) Fast food restaurant - the workers and the time they provide make up the 'labor' inputs to the production function. The goods used to produce the food is capital, including the building they rent/buy to sell from. The land on which the restaurant sits is considered in the land category. Law Firm - the workers are of a 'higher skill' than those in the fast food restaurant (usually translates to more educated/more productive). They use relatively little capital - mostly paper, books and computers, and little land (the oor-space in the high-rise they rent.) It is probably obvious at this point how changes in how a company produces stuff changes things about the wages (payments to workers) and 15 / 51 Production Costs How do we think about the Production Function We have to pick a dial to start with - and generally the fatest thing a rm can adjust is the number of hours their employees (including themselves) works. So we start by xing capital (K) and land (L) in place. Essentially - the only choice a rm can make is to change how many hours their employees work. f (l, K̄, L̄) = output This is what's called the short run production function. What this means is that costs in the short run come entirely from uctuations in prices of inputs, and then rms adjust hours to optimize. Let's walk though what this looks like. 16 / 51 Production Costs Total Product Curve Let's talk about some assumptions here We assume: Workers are in perfectly competitive labor markets, that is, the rm has little ability to set wages (wages are exogenous) Diminishing Marginal Product in the short run 17 / 51 Production Costs Total Product Curve 18 / 51 Production Costs Total Product Curve 19 / 51 Production Costs Marginal Product Curve 20 / 51 Production Costs Marginal Product Curve 21 / 51 Production Costs Marginal Product Curve 22 / 51 Different Types of Costs Different Types of Costs Total Costs In all, there are two broad categories of costs that rms can incur while producing goods Explicit costs: These costs make up the actual cost the rm must pay to produce. For a fast-food place, this would be rents, wages to workers and cost of making the food Implicit Costs: These costs are the opportunity costs of production functions - that is, what ELSE could you do with the materials and time that might make you better off. This is close to if not THE biggest differentiator between how business analyzes rms and how economics does. Economics cares primarily about the use of resources so being sure those resources are being used 24 / 51 optimally in a society is critical to understanding this. Different Types of Costs Total Costs Examples of explicit costs: The wages of workers, rent on the land. For a lemonade stand, this is the cost of the mix and the water and whatever you pay your friends to help you out. Examples of Implicit costs: The time the owner puts into a business to get it up and running, the amount of money the owner could make at a food stand with the same equipment. For the stand, these are your time manning the stand, the money you could make telling your friends to make mud pies instead, using the lemonade stand as a squirt-gun fort. 25 / 51 Different Types of Costs Total Costs Breaking these costs down further, these costs can be variable or xed. Variable costs are those that change as output choices change, such as the cost for asking workers to work longer hours, or using more electricity to keep the lights on for longer. These are represented by the lemonade powder, the water and how many friends you loop in on your business. Fixed costs (also referred to as overhead) are those costs which do not change (in the short run.) These are things like rent, purchases of all the equipment needed to run the business etc. This is the cost of building yourself a lemonade stand, the cost of making a lemonade stand sign. 26 / 51 Different Types of Costs What is the goal of a business While Economists and Business Schools typically agree that businesses aim to maximize pro t, there are actually two different types of pro t. Accounting Pro t: Total Revenue - Total Explicit Costs. Businesses traditionally target this sort of pro t. This is a very concrete type of number - however economics is a little more leniant than that Economic Pro t: Total Revenue - (Total Explicit Costs + Total Implicit Costs) From here on out, in this class, if you hear the term 'pro t' I'm referring to the second one. Economics is inherently interested in how to address gains from production when compared to their best alternative. You should remember this difference - it's important. 27 / 51 Different Types of Costs Graphing Total Costs Let's think about our graph of output for a minute. If we're a perfectly competitive rm here, then we have no say in dictating our input prices. This means total costs = (total output ∗ cost per unit) + f ixed costs From a graphical perspective, let's look at this. 28 / 51 Different Types of Costs Graphing Total Costs 29 / 51 Different Types of Costs Total Costs However, what was our pillar I said was one of the most important to remember? Marginal Thinking. We likely care about how cost changes as our producers create increasingly large quantities of output This means we need to nd a way to graph average total cost, average variable cost (to make sure we even want to open), and marginal cost However, we should probably understand what each of those things are rst, and what uses they have as analytic tools 30 / 51 Different Types of Costs Costs Let's start with total cost types, we have total variable cost (TVC), total xed cost (TFC) or FC, and then Total Cost itself (TC). The other costs we'll be looking at are: TV C Average V ariable Cost (AV C) = Qty T F C/F C Average F ixed Cost (AF C) = Qty TC Average T otal Cost (AT C) = = AF C + AV C Qty change in total cost M arginal Cost = change in Qty 31 / 51 Different Types of Costs Costs We care about AVC because it tells us how costly on average our production is to operate, regardless of any unavoidable costs We care about ATC because it can inform us how much, per unit, our rm is paying to produce We care about Marginal Cost because it tells us how costly our last unit of production was, and tells us the optimal choice for production. Let's walk through a table so I can show you how you might go about calculating these from tabular data 32 / 51 Different Types of Costs Costs 33 / 51 Different Types of Costs Costs In general - we can learn the following general identities: Average xed cost always falls, because FC doesn't change Average Variable cost falls at rst while we gain from specialization. Remember our PPF? Our law of increasing opportunity costs? This will eventually take over, and it will take more input to add one more lemonade to our lemonade stand Average Total Cost, being the sum of AVC and AFC, falls, and then increases, however, at a slower rate than AVC. 34 / 51 Different Types of Costs Graphing Business Costs 35 / 51 Different Types of Costs Important Aspects Notice: as the MC curve rises above the AVC and ATC curves, those curves begin to increase. This is because MC is plotting the exact cost of the last unit produced, and AVC/ATC could be written as... Σ I i=1 MC = T C Thus, adding a new, more costly to produce item to our set of produced items will make our ATC go up! This means MC will always pass through the Minimum of the ATC and AVC curves. 36 / 51 Costs in the Long Run Costs in the Long Run Long Run In the long run, land and capital can be adjusted as companies expand their factories, restaurants and other businesses to ll whatever market conditions exist This makes the long run considerably more complicated to understand than the short run - however, graphically and interpretation wise it's not much different. The rst thing we need to understand is ef ciency. 38 / 51 Costs in the Long Run Long Run The way we will move our economic levers here is to: Set up our model so in the short run, our rm always adjusts to the place where ATC are at their minimum. We'll learn why this is the case next lecture. Set up capital (K) and land (L) so that after these adjustments are made, the rm can adjust to the point described above given the new inputs. What this means is that each point in our 'long run' story consists of one point from our short-run story from the previous slides. 39 / 51 Costs in the Long Run Lemonade Let's tell a few stories of you, the psychic, future-simulating lemonade tycoon. Basically, imagine you are Dr. Strange except you sell lemonade. In the rst, you project ahead, and determine that you could get every child in the US together to sell lemonade on every corner. You notice that as you scale up your operation... your marginal costs seem to fall in the long run. You can buy powder for cheaper in bulk, there is an endless supply of suckers who will buy your yellow water. 40 / 51 Costs in the Long Run Lemonade In the second, you determine that, essentially, after a point, you don't really start making much more money per sold lemonade. You buy your lemonade powder from costco, but it doesn't really get cheaper as you buy more than a at of it your negotiations with the water board won't get you any cheaper water. Your workers also pretty much sell the same amount, no matter how many you hire 41 / 51 Costs in the Long Run Lemonade In the last, you see that as your lemonade tycoon dreams expand, your business begins to do worse and worse. You have a terrible time trying to oversee the other children all over the world- some of them steal money from the stands as you buy more powder, it becomces expensive to ship it to all of these locations and, getting consistently high-quality water to the stand is expensive. 42 / 51 Costs in the Long Run Lemonade These three stories are all examples of different kinds of scale. Economies of Scale: Our rst story describes an economy of scale - as a rm produces more, costs fall and thus becomes more ef cient. Think about the sparkling alcohol drink, White Claws. Constant Returns to Scale: (CRS) Our second story describes CRS - no matter the capital/land investment, ef ciency doesn't change (after a point) diseconomies of scale: Our last scenario represents diseconomies of scale - as more is produced, our output falls. A good example of this is in the craft beer market. Big breweries have begun to buy small, agile breweries to compete in the craft beer market. 43 / 51 Costs in the Long Run LRATC We can use our model described a few slides ago to see what these different scales look like. 44 / 51 Costs in the Long Run What type of Market Now, we can understand how business structure itself can impact the makeup of a market If we expect economies of scale, we're likely to live in a world with few large rms If we expect diseconomies of scale, we will likely see many, agile, smallscale rms. 45 / 51 Review Review For Review I am going to give you a set of quiz questions to answer in a minute, and then go over them. to serve as a self-check of conceptual understanding. Q For your lemonade rm, which of the average cost curves does NOT increase once MC is higher than it? A AFC 47 / 51 Review For Review Q What is the formula for Average Total Cost? A AT C = TC Qty or, AT C = AV C + AF C Q True/False: Marginal Cost is always increasing? A False 48 / 51 Review For Review Q Given it costs 100 cents to produce 10 marshmallows, and it costs 110 cents to produce 14 marshmallows, and 115 cents to produce 18 marshmallows, what are the MCs, and are we increasing or decreasing in MC? A MC 1 = 110−100 14−10 = 5 2 , MC 2 = 115−110 18−14 = 5 4 , decreasing. 49 / 51 Review Nicely Done! I will see you guys next time - we will be talking about rms function in a perfectly competitive market This means we'll be bringing pro t into the picture, and looking at how cost structures impact the market as a whole. 50 / 51 Review 51 / 51 Lecture 012 Monopoly, Oligopoly and Market Power Connor Lennon (Thanks to Kyle Raze as well) 20 May 2020 Admin Admin Assignments Future Very little in the near-future. Don't forget - you have homework due one week from today and then also an extra-credit point you can earn by lling out a short teaching feedback survey. There aren't any main assignments, but please do ll out the survey telling me which grading rubric you'd prefer. I will automatically assume you want the 30% weighting on your midterm unless you tell me otherwise. 3 / 75 Admin Upcoming Today: Covering Why do monopolies arise? What happens if rms can have an in uence over the price? What does this mean for ef ciency? Is Monopoly always bad? Oligopoly: Monopoly with a twist! 4 / 75 Admin Upcoming Readings/Schedule Today through this week Mateer/Coppock Ch. 9 was Monday, today we're covering chapter 10. Technically, some of the material we covered would be in chapter 13, but how the book deals with Oligopoly is just a runway to introducing game theory. Next week Mateer/Coppock Ch 16. This is consumer behavior. We've already talked about this a little - but we should go into a little more depth as to the logic behind Consumer behavior before we dive into how observed behavior is actually different. 5 / 75 Admin Overview 1. What gives rise to a monopoly? Monopoly is a spectrum What issues can arise when monopolies exist in markets? How can our policies x these? 1. Natural Monopolies Are there any places where monopolies are likely to exist? Are all Monopolies bad? 6 / 75 Admin Overview 1. Oligopoly Collusion between few rms Anti-trust laws 7 / 75 Review (short) Review (short) How does a perfectly competitive rm choose output in the short-run? 9 / 75 Review (short) What happens for rms in the Long Run? Q When does a rm operate? When does it exit? Because we are in the long run, we don't actually have any xed costs anymore. This means that rms won't tolerate losses anymore. 10 / 75 Review (short) Competitive Markets 5 Conditions 1. Many buyers and sellers. 2. Identical, undifferentiated products. 3. Free entry and exit. 4. Each rm is small relative to the market. 5. Input prices to industry do not change as the market expands 11 / 75 Review (short) The Long Run "Story" 1. We start at equilibrium, where q = q1 , and price = pricelong run 2. Demand is shocked! Demand increases! 3. D increases ==> price rises ==> rms earn an economic pro t 4. Attracted by the economic pro t, new rms (entrepreneurs) enter the market 5. Increasing number of rms increases supply, until price = price but quantity is now higher. long run 12 / 75 Market Failures Market Failures What does it mean when a market "fails" A market 'fails' when inherently self-interested buyers and sellers does not result in the socially optimal outcome. Some examples: 1. Standard Oil, run by Rockefeller in 1880's, owned 88% of the oil re nery capacity at its peak, and 64% of the re nery capacity when broken up in 1911. This allowed Rockefeller to say 'buy in or pay the price.' 2. Carbon emissions. I, as a homo-economicus, am not motivated to reduce my emissions. 14 / 75 Market Failures Why is a market failure bad? As we learned, any choice of quantity that's more or less than the socially optimal quantity will result in deadweight loss. This is a net loss when compared to our normal state of an 'ef cient' market. They can also cause problems with growth paths. We'll get to that today. 15 / 75 Market Failures Causes 1. Absence of property rights. Externalities. Public goods/common pool resources etc. 2. Market power. e.g., monopoly (today) Oligopoly (also today - but you'd need a full game-theory class to really understand it) 3. Asymmetric information. We'll get to this in the last week of the class! 16 / 75 Market Failures Market Power Why does market power result in a failure? One of the key requirements for perfect competition is many sellers and many buyers. If we don't have that, selllers (or buyers) can essentially charge higher/lower prices and say take it or leave it. Does this mean monopolists charge the highest possible price? NO! Just like other rms, they produce goods such that they maximize pro t, and charge the highest price they can get away with for that quantity. 17 / 75 Market Failures Conditions for Monopoly We need a way to de ne what we need for a market/ rm to be considered a monopoly: 1. One seller. 2. Unique product without close substitutes. 3. Barriers to entry. Result A monopolist has the ability to in uence market prices. A monopolist is a price maker. 18 / 75 Market Failures Another Thought Monopolists, in a sense, have a harder problem to solve than a perfectly competitive market. When they increase their choice of output, they also decrease the price they receive per unit. For your purposes this means that MR is no longer equal to demand, average revenue and price. 19 / 75 Market Failures Barriers to Entry One of the most important conditions for Monopoly is the barriers to entry condition. This prevents new rms from entering the market and spoiling the fun. A classic example are utilities. How easy is it for you to open your own grand coulee dam? That's a lot of investment that most new businesses don't have access to 20 / 75 Monopoly Monopoly Depends on where you measure from It's a bit hard to determine who is and who isn't a monopolist. (Heads up the book disagrees with me a bit here.) De ne a market. Q: Is the market for cars a market? A: Yes! Q: Is the market for Toyota cars a Market? A: Yes! 22 / 75 Monopoly Depends on where you measure from Q Is Toyota a monopolist on the car market? Nope! Ford, Honda, Ferrari, Volkswagon... Lots of alternatives you could buy. Q Is Toyota a monopolist on the Toyota car market? Yes. This means most 'monopolies' are primarily de ned based on how the boundaries of the markets are drawn. Let's see. 23 / 75 Monopoly Examples? Q: Is Google a monopolist? Why or why not? Most popular search engine by far + huge, vertically integrated company + ability to purchase potential new competitors. Competes with Apple, Amazon, and Microsoft. A: Not a monopolist, but has market power. 24 / 75 Monopoly Examples? Q: Is Comcast a monopolist? Why or why not? Sole internet provider in many areas + huge, vertically integrated company + high barriers to entry. Competes with Verizon in some areas. A: Depending on where you live, certainly. Worldwide? Not as much. 25 / 75 Monopoly Examples? Q: Is the only hardware store in a small town a monopolist? Why or why not? No direct competitors in town + small size of market deters entrants. A grocery store might carry some of the same products. No explicit barriers to entry. A: Yes, provided that there suf ciently few indirect competitors. 26 / 75 Monopoly Examples? Q: Utilities? Barriers to entry? check! Market Power? check! This is about the only example where you could nd universal agreement a utility has a monopoly over its xed consumer-base, but they still sell power to other regions, so there still is some competition. 27 / 75 Monopolists vs. Competitive Firms Monopolists vs. Competitive Firms Consumers of a particular rm's product have fewer alternatives in a monopolistic market than in a perfectly competitive market. This means that a monopolist faces a set of price-quantity pairs they have to choose from to maximize their revenue Because consumers can't go somewhere else, consumers will buy from the monopoly so long as marginal bene t of the next unit they consume is greater than the price This also means that rms are sensitive to the elasticity of the market - ie, that conversation we had about elasticity? This is where that matters. Let's see how that plays out... 29 / 75 Monopolists vs. Competitive Firms This means rms face decreasing marginal revenue, average revenue, and prices. Monopolist Perfectly Competitive Firm 30 / 75 Monopolists vs. Competitive Firms Price effect: As price decreases, existing customers pay less. Output effect: As price decreases, new customers purchase goods. Output effect > price effect ==> price cut increases revenue. 31 / 75 Monopolists vs. Competitive Firms Price effect: As price decreases, existing customers pay less. Output effect: As price decreases, new customers purchase goods. Output effect = price effect ==> price cut does not change revenue. 32 / 75 Monopolists vs. Competitive Firms Price effect: As price decreases, existing customers pay less. Output effect: As price decreases, new customers purchase goods. Output effect < price effect ==> price cut decreases revenue. 33 / 75 Monopolists vs. Competitive Firms Marginal Revenue Def'n Change in total revenue that arises from a marginal increase in output Let's calculate Marginal Revenue, just so we know what we're doing. Price Quantity Total Revenue Marginal Revenue $50.00 1 $50.00 - $40.00 2 $80.00 - $30.00 3 $90.00 - $20.00 4 $80.00 - 34 / 75 Monopolists vs. Competitive Firms Marginal Revenue Def'n Change in total revenue that arises from a marginal increase in output Let's calculate Marginal Revenue, just so we know what we're doing. Price Quantity Total Revenue Marginal Revenue $50.00 1 $50.00 $50.00 $40.00 2 $80.00 $30.00 $30.00 3 $90.00 $10.00 $20.00 4 $80.00 -$10.00 35 / 75 Monopolists vs. Competitive Firms Marginal Revenue Price Quantity Total Revenue Marginal Revenue $50.00 1 $50.00 $50.00 $40.00 2 $80.00 $30.00 $30.00 3 $90.00 $10.00 $20.00 4 $80.00 -$10.00 Do you notice anything? Marginal Revenue is ALWAYS below the price (except for the very rst unit.) What does this look like on our graph? 36 / 75 Monopolists vs. Competitive Firms Marginal Revenue De nition Change in total revenue that arises from a oneunit increase in output. 37 / 75 Monopolists vs. Competitive Firms Marginal Revenue A monopolist faces a downward-sloping MR curve. MR > $0 --> increasing revenue. MR = $0 --> maximum revenue. MR < $0 --> decreasing revenue. 38 / 75 Monopolists vs. Competitive Firms Pro t Maximization Q How does a monopolist maximize pro t? A. The same way everyone else does, with a twist! Two steps! Step 2: Set PM on the demand curve. Pro t = (PM - ATC) × QM = ($16 - $10) × 4 = $24. 39 / 75 Monopolists vs. Competitive Firms Competitive Market Monopoly 40 / 75 Monopolists vs. Competitive Firms Competitive Market Monopoly 1. Many rms. 1. One rm. 2. No rm can earn long-run economic pro ts. 2. Monopolist can earn long-run economic pro ts. 3. Each rm is a price taker --> no market power! 3. Monopolist is a price maker --> signi cant market power! 4. Each rm produces ef cient level of output --> i.e., where P = MC. 4. Monopolist produces inef cient level of output --> i.e., where P > MC. 41 / 75 Monopolists vs. Competitive Firms Social Consequences Inef ciency Monopolies fail to maximize total surplus. QM < QC ==> deadweight loss. 42 / 75 Monopolists vs. Competitive Firms Social Consequences Inef ciency Monopolies fail to maximize total surplus. QM < QC ==> deadweight loss. Monopolies reduce consumer surplus. 43 / 75 Social Consequences Social Consequences Limited choices for consumers Monopolists face few incentives to compete for customers. Result: Fewer product lines and, generally speaking, + lower quality. Example: Cable companies and bundled services. Rent seeking Monopolists can use political processes to preempt competition or secure new monopolies. A form of competition, but not the good kind. Example: Lobbying Congress for trade protections. 45 / 75 Social Consequences Exclusive control of resources A rm can keep out potential competitors by buying up essential resources for production. Examples Early 1900s: Aluminum manufacturer ALCOA owned 90% of the global bauxite supply. De Beers owned most of the world's raw diamonds until the mid-2000s. 46 / 75 Social Consequences Dif culty raising capital Incumbent monopolists are often large --> new competitors would need a lot of money to compete effectively! Chances of competing against entrenched monopolist are low --> risky investment for lenders. Example: Operating systems. Supplanting Windows 10 as the leading operating system for PCs would require vast amounts of capital. A lender would pick Microsoft over your start-up to develop the next big operating system. 47 / 75 Social Consequences Economies of scale Some industries feature immense upfront xed costs, but low marginal costs thereafter. Tendency for consolidation over time. Examples: Natural monopolies. Electricity and water. Cable internet and television. Railroads. 48 / 75 Social Consequences Licensing Governments establish monopolies with licensing requirements. Licensing requirement = legal barrier to entry. Rationale: Minimize negative externalities or exploit economies of scale. Examples Trash collection. Taxi medallions. Occupational licenses. 49 / 75 Social Consequences Patents and copyright law Governments issue exclusive rights to sell a particular good or service for a xed amount of time. Exclusive rights --> monopoly. Tradeoff: Market power vs. innovation. Examples New prescription drugs. Music and movies suffer when someone can essentially recreate the music for free - the most costly portion of music/entertainment is the R&D, so to speak. 50 / 75 Oligopoly Oligopoly Oligopoly Recall from our competition lecture that Oligopoly means: Competition amongst only a limited number of rms. eg, Pepsi vs. Coke, Miller-Coors vs. Annheuser-Busch, Apple vs. Microsoft etc. It may seem obvious to you that Oligopoly will result in the same outcome as monopoly, but the truth is more complicated than that. 52 / 75 Oligopoly Firms Goal I've asked you this so many times. What is a rm's goal? Blues Clues Chorus: Maximize Economic Pro t! So this rule will continue to apply in our oligopoly case. This makes achieving the stated result of market power more complicated. Why should I agree to work together with another rm? Only if it gets me more economic pro t. 53 / 75 Oligopoly Roadblocks to Collaboration Strictly speaking, it is against the law to deliberately coordinate with another business to gain market power over prices. Therefore, all legal collaboration must be done through tacit means. Tacit? Tacit: Understood or implied without being explicitly stated. So Tacit collaboration is unspoken coordination. 54 / 75 Oligopoly Roadblocks to Collaboration Remember, our consumers want to maximize their own welfare, so they will buy the cheapest available good on the market if they can This requires: Undifferentiated Goods/Fairly Substitutible Goods Our oligopolists, then, may be tempted to undercut their competition by just a hair to get all of the pro ts from the market for themselves. OR they may be willing to work with them to jointly produce just enough output such that... Qf irm1 + Qf irm2 = Qmonopoly 55 / 75 Oligopoly Roadblocks to Collaboration The problem is, rms WANT to sell more than that. So they have a choice - they follow along, or, They get punished by having their competitor undercut them. 56 / 75 Oligopoly Roadblocks to Collaboration To understand how a rm makes this choice, we'd have to get into game theory which I would love to do, but we don't have enough time. Instead, I want to show you what it looks like after a rm has agreed to collaborate. 1. Competitors don't care if you don't produce as much as your quota, or charge higher prices than p but... 2. They will 'punish' you by cutting prices if you lower yours. M This leads to a kinked demand curve. 57 / 75 Oligopoly Kinked Demand Curve Our oligopolists face two types of demand, D_1, as if they were a monopolist, and D_2 if they are being punished. 58 / 75 Oligopoly Kinked Demand Curve Our oligopolists face two types of demand, D_1, as if they were a monopolist, and D_2 if they are being punished. This new demand has a new MR curve (in light green) 59 / 75 Oligopoly Kinked Demand Curve Our oligopolists face two types of demand, D_1, as if they were a monopolist, and D_2 if they are being punished. This new demand has a new MR curve (in light green) But they only get punished when they lower the price 60 / 75 Oligopoly Kinked Demand Curve Our oligopolists face two types of demand, D_1, as if they were a monopolist, and D_2 if they are being punished. This new demand has a new MR curve (in light green) But they only get punished when they lower the price. 61 / 75 Oligopoly Punishment This means that unless costs fall substantially, prices will remain relatively unchanged if we start from a place of cooperation. To understand if they cooperate... You'll have to take some game theory. I reccommend it. It's a fun class if you go further on in Economics. 62 / 75 Solutions to Market Power Solutions to Market Power Solutions? 1. Antitrust law. e.g,. breaking up monopolies, blocking mergers, etc. 2. Regulation. e.g., price controls. 3. In the case of monopsony, unions? 4. Wait for technological disruptions. e.g., rise of mobile devices reduced Microsoft's market share. 64 / 75 Solutions to Market Power History of Anti-trust Technological innovations during the 1800s created economies of scale. Result: Consolidation of industries into national trusts.† Example: Standard Oil. Sherman Antitrust Act of 1890 made anti-competitive business practices illegal. Eventually used to break-up trusts like Standard Oil †: Trust = An organization of colluding or jointly-owned companies. 65 / 75 Solutions to Market Power Recent Cases Sandoz inc. - a company that sells generic drugs is under trial for horizontal price xing, ie, oligopoly like conditions except explicit. Starkist - sells packaged seafood. Found guilty for price xing BNP Paribas - bank and prominent sponsor of the BNP Paribas Open Found guilty of price xing for CEEMEA (Central and Eastern European, Middle Eastern, African) currencies 66 / 75 Solutions to Market Power Mergers We might also be concerned if there is an ongoing pattern of mergers. What's a merger? Def'n: A merger is an agreement between two or more companies to join assets and begin operating as a new or existing company. Mergers, by de nition, increase the amount of market power that rm holds. This can potentially turn previously competitive companies into a 67 / 75 Solutions to Market Power History Over time, courts started to rule in favor of small incumbent rms over national entrants. Small incumbents had local monopoly power! Eventually, federal courts adopted the Consumer Welfare Standard. Q: Would a merger increase consumer surplus? If yes, let the merger happen. If no, block the merger. Still governs antitrust law today. 68 / 75 Solutions to Market Power Market de nition Product market Q: Are there substitutes for the merging rms' good? Geographic market Q: Is the market local or national? Bottom line Larger markets make mergers look better. Smaller markets make mergers look worse. 69 / 75 Solutions to Market Power Mergers All else being equal, industry consolidation creates deadweight loss. In some cases, consolidation can reduce marginal costs. Possible to increase consumer surplus relative to original competitive equilibrium. 70 / 75 Regulating Noncompetitive Markets Regulating Noncompetitive Markets Options 1. Mandate marginal cost pricing? Make monopolist/oligopolist choose quantity where price equals marginal cost. 2. Have the government take over the monopoly? Not always better. 3. Subsidize the monopolist? Politically unpopular in most cases. 4. Tax the monopolist? We'll see why this won't work. 72 / 75 Regulating Noncompetitive Markets Q Can a price ceiling at the competitive price eliminate deadweight loss? A Yes! 73 / 75 Regulating Noncompetitive Markets Q: Can a tax eliminate deadweight loss from the monopoly?† A. Yes. B. No. C. Depends. †: Assume that there are no negative externalities. 74 / 75 Regulating Noncompetitive Markets Regulating Natural Monopoly Price Ceiling Some natural monopolies are not pro table under marginal cost pricing. Losses --> monopolist exits --> market ceases to exist --> even less total surplus than before! 75 / 75 Lecture 006 Taxes, Revenue and Deadweight loss Connor Lennon 20 April 2020 Admin Admin Assignments Future Assignments due this week: Elasticity Inquizitive is due today (4/20), Elasticity smartwork due Wednesday this week (the 22nd). The hi-slate[Tax] Inquizitive will be due this Saturday, and the Price control inquizitive will be due a week from today on the 27th. 3 / 72 Admin Upcoming Today: Covering Covering Taxes today, likely Price Controls on Wednesday This week is all about policy intervention in markets! Next Week: Midterm, covering all material and applications in lectures from the beginning of class to Wednesday this week. 4 / 72 Admin Upcoming Readings/Schedule Today through this week Finish Mateer/Coppock Ch. 5 and Ch. 6 Next week Midterm! I'll likely put out a few practice problems that may show up on the midterm short answer section, however I am not going to write or provide answers for those (unless they show up on the exam - and then you'll see answers after.) They're meant to be practice, not a study guide. 5 / 72 Admin Midterm If for some reason you can't make the midterm, please let me know in advance of the test. There are no make-up midterms available - instead, I will distribute the midterm weight to the nal exam so that it is now worth 65% of your grade. The test is open note/open book, but also shorter than the full 1 hour and 20 minutes. You likely won't have time to look up every answer on the exam. 6 / 72 Admin Midterm The format for the midterm will be set up in 2 sections. The rst section will be multiple choice/ ll in the blank/short questions and will be done during class time. be sure to be ready to take the midterm on Wednesday the 29th. You will have 1 hour. to complete 35 questions of this sort. You must begin the midterm by no later than 5:15 PST or you will receive a 0 on the exam. The exam will become available at 3:30 PM on Wednesday next week (PST) 7 / 72 Admin Midterm The second portion of the midterm will be short answer, and will test you on more complex applications of the material, including ones you have not seen before. It will consist of 4-6 longer questions that you will have 24 hours to complete, though the intention is that these can be completed with about 45 minutes of work. 8 / 72 Admin Midterm This portion will be due at 5:30 pm on Thursday, April 30 (4/30/2020). Though this section is take-home, I won't provide answers to these though I will be available to clarify if you give me enough notice. These two sections will be weighted equally towards your nal midterm grade, that is, an 80 on the in-class portion and a 90 on the take-home portion would result in a 85% score on your midterm. 9 / 72 Admin Midterm If for some reason you can't make the midterm, please let me know in advance of the test, or as soon as possible. There are no make-up midterms available - instead, I will distribute 20% of the midterm weight to the nal exam so that it is now worth 55% of your grade. The remaining 10% will be placed on the written assignment, so that is will be worth 15%. The test is open note, but also shorter than the full 1 hour and 20 minutes. You likely won't have time to look up every answer on the exam while you're taking it. 10 / 72 Admin Midterm As stated in the syllabus - if you have a problem with how a question is graded, you may submit a written petition to have your work regraded, with you saying exactly what sections need to be regraded, and why you think you're right. If this petition is accepted, I reserve the right to completely regrade your work. 11 / 72 Review Review Last time we talked ALL about elasticity - how consumers and producers respond to changes in prices or income. Let's do a quick review of what we covered. Price Elasticity of Demand is a ratio of percent change in price and percent change in quantity that ties consumers' responsiveness to exogenous shifts in prices. The values for this typically fall between 0 and −∞ 13 / 72 Review Price Elasticity of Demand We learned that if E > −1 that means the good is called inelastic, and indicates that consumers are relatively less willing/able to respond to changes in price. D We also learned that if E < −1 the good is elastic. This means consumers are relatively more willing/able to respond to changes in price. D As a test- if you were a company, and wanted to increase your revenue, which type of demand curve would you suggest lowering price for? 14 / 72 Review Income Elasticity Of course, people also make consumption choices based on income. Income elasticity measures which direction changes in consumer income increase demand for a given good. If we have a positive value for income elasticity, then the good is a normal good. If it's negative, then the good is an inferior good. If the value for income elasticity falls in the range of 0-1, we have both a normal good, but also a necessity. This is because low-responsiveness to income indicates that it's valuable regardless of how much money you make. An example - internet. The last time this was studied was in the midaughts. At that time, the ndings were that the good was relatively inelastic, but income elasticity of demand found it was a normal good with Income 15 / 72 Review Cross Price Elasticity Of course, there is also Cross-price elasticity. Like income elasticity - this measures responsiveness to changes in prices for some related good For instance, hotdog buns are likely complements to hot dogs. If the price of hotdogs rises, we would expect that people will buy fewer buns. Thus, we can say if price and quantity shift in opposite directions, the compared goods must be complements. If they shift in the same direction, they must be substitutes. 16 / 72 Review Price Elasticity of Supply Swapping out percent change in quantity demanded for percent change in quantity supplied leaves us with a new term - price elasticity of supply, measuring how responsive producers are to changes in price. Producers respond to prices with changing levels of quantity supplied because different goods and suppliers have more or less ability to change their output. This coef cient is very similar to price elasticity of demand, excepting that the sign is reversed. That is, the values of 0 ≤ E ≤ ∞. At the value of 1, the interpretation moves from more elastic, where E > 1, to more inelastic, where E < 1 S S S 17 / 72 Review Let's do a couple of practice problems! Q For both Price Elasticity of Supply and Demand, what does a value of |E| < 1 imply about responsiveness? A This implies demand and supply are inelastic and therefore are less likely to respond to price. Q If I run a cereal company, and I nd that as my consumers' incomes rise, their consumption of my product falls, what is true? A It must be that income elasticity is negative, and my good is an inferior good. This doesn't mean my good has no place, rather, it means I have a good that bene ts the poorer consumers than the rich. 18 / 72 Taxes Taxes Taxes Taxes are one of those things that are inherently unavoidable. They need to be there, because there are important things a government needs money to do. The real question, then, is how do we tax stuff? What's the cost of taxing things? Inherently - taxes are really just the Government saying - you need to pay me x dollars, or x % if you make a transaction. The Government provides a role - stability, that we can't really transact without. 20 / 72 Taxes Taxes Taxes come in a variety of different forms: Ad Valorem Taxes Taxes on stuff we buy and own, ie Property Tax, Sales Tax, VAT, Excise Income Taxes Taxes on income we earn, ie, income tax, payroll tax, capital gains, wealth tax In general - the goal is to gather funds for important government services, while not being overly burdensome to economic activity. This is a hard balance to strike. 21 / 72 Taxes Subsidies Subsidies also exist - subsidies are essentially payments from government to either consumers or producers or both, based on their industry or what they buy. An example of this is the 2008 Farm Bill, ie the Food, Conservation and Energy act. This replaced a 2002 Farm Bill. In fact, there have been a number of farm bills. These subsidies are designed to decrease the price of food in the United States. A kind person, reviewing this information would see that this decreases food costs for Americans, but on the other hand it also makes American food more competitive in the international market. In general though, we can think of subsidies kind of like 'negative taxes.' 22 / 72 Taxes Taxes But what are the effects of taxes, really? To evaluate the entire set of taxes would be a monumental and nearimpossible task. Luckily, we can use our economic models hat to evaluate them one at a time! There is a general consensus, both amongst the population at large and for economists, that taxes on markets tend to raise the cost of things we buy This is almost certainly true - and it might even seem obvious to you. However, why do we expect prices to increase when we raise taxes? 23 / 72 Taxes Taxes Evaluating taxes means we need to measure the bene ts against the costs. Particularly - we want to pay attention to the opportunity costs. When a government spends money on a good it provides, the cost is where that money would have gone without it. For now - the taxes we will look at will be primarily what are known as excise taxes. This means we'll be taxing speci c goods and speci c markets. That is, we'll be mostly talking about things like sales tax or taxes on marijuana. The reason for this is because it informs how economics thinks about taxes in general - but also because it's important for interpreting our existing supply and demand models! 24 / 72 Taxes One of the most important components is who pays for the tax. What do I mean? 25 / 72 Taxes Incidence How many of you are familiar with the terms de jure and de facto? For this section - we need to gure out who is paying this tax de facto. When you buy marijuana in Oregon, you pay about 17% for every dollar to the government. Do you? I don't know if you smoke - is there a part of doing state taxes where you send a dollar bill, a quarter, a nickel and a couple of pennies in the mail to the IRS/your state to make sure you paid your marijuana tax? Is that what people mean when they are doing their taxes? No! The dispensary collects those charges, and they send them to the state. De jure, the store is paying the tax, de facto, you are. So you kind of both are paying the tax even though you really aren't paying 26 / 72 the government. Why is that? Taxes Incidence Well if every producer now has to pay 1.33 dollars more per standard purchase of marijuana, they've essentially had a cost increase. Or at least they effectively have. What happens if a producer's costs increase? They are going to adjust their supply! Their willingness to supply goods has gone down for every price level, because now they are paying this extra tax. So if we tax marijuana, are our consumers now going to pay all of this tax? No, in fact, they won't. The market, and in particular supply and demand, will dictate who pays for the tax de-facto. However, you might be interested in learning what the impact of leveraging a tax on the buyer has vs. leveraging a tax on a producer. Wow - what a 27 / 72 good question. Let's see how that works! Taxes Incidence (Consumer Side) The way to think about a graph like this is to set our tax dollar cost equal to 1.33 - and now treat every quantity demanded as if it were demanded at the original demand price, minus 1.33. That is, we have an observed market price paid to a supplier, P and an actual price paid by the consumer, which is P + t where t in this case is equal to 1.33. t t Because price increases causes our demand to decrease, an across the board price increase like this is almost exactly a quanti able demand shock with an impact equal to 1.33. The way this works in a graph is to imagine you have a stick of length t that you're shoving between two demand curves. Let's see what that looks like. 28 / 72 Taxes Incidence (Consumer Side) 29 / 72 Taxes Incidence (Producer Side) What happens if producers have to pay a tax of 1.33? Well, their operating costs just rose by 1.33 per unit - so we'll see a shift in supply! Supply will shift inwards, and this will make goods more expensive in the market. In fact, the process for drawing a supply-shift from the introduction of a supply-side tax is identical to drawing a supply shift from the introduction of a demand-side tax, just reversed. We move every point on our supply curve upwards by the amount of the tax (1.33 here) and we'll see what our new results are. 30 / 72 Taxes Incidence (Producer Side) 31 / 72 Taxes That's interesting... those diagrams look super super similar in terms of results. Let's look at them side by side... 32 / 72 Taxes Which side? It doesn't matter whether we tax suppliers or consumers in a perfectly competitive market! We can tax either and we'll end up having identical market quantities! The market price is different, however, the price paid by the producer and consumers are identical in both graphs. On the supply side, producers receive, after tax, P = P − t dollars per unit sold. Consumers pay P + t = P for this good. This makes sense - what drives behavior around price isn't who is handing over the cash, it has to do with how much consumers and suppliers bene t from participating in this market. s s t t One thing we haven't done yet is to calculate tax revenue. That's fairly easy 33 / 72 actually - let's take a look. Finding Revenue and Ef ciency Finding Revenue and Ef ciency Tax Revenue Theoretically - all of these dollars collected from our tax are going towards valuable government programs, whether that be social security, national defense or maintenance of parks. We need to know how much money our government is making from this change. Tax revenue on a excise tax like this is simply t ∗ Q . So if Oregon sells ~ 1.1 million standard purchases of marijuana a year, times 1.33 per purchase, Oregon makes about 1.5 million dollars a year from taxes like these. t We can do this caculation on our graph too - t is simply the distance between P and the price received by the buyer (if levied on the buyer) or the price received by the seller. t 35 / 72 Finding Revenue and Ef ciency Tax Revenue We can say this because - P here is equal to Q . t + t − Pt = t and we know the quantity sold t 36 / 72 Finding Revenue and Ef ciency But remember - the goal here is to identify our opportunity cost of collecting this revenue! What is the opportunity cost? The lost bene t the sellers and buyers would have received. What is our new Producer Surplus and Consumer Surplus? Well - we know Consumer surplus is the distance between the price the consumer is paying and the willingness to pay, ie the demand curve. The producer surplus is simply going to be the distance between the price received by the producer and their willingness to supply, ie, the supply curve. 37 / 72 Finding Revenue and Ef ciency Producer/Consumer Surplus 38 / 72 Finding Revenue and Ef ciency Deadweight Loss What is that black triangle in our graph? Well - in this market, our producers have started producing less marijuana, and our buyers are buying less marijuana. This is because, effectively, they are sharing the cost of the tax. This means there is some part of our market that isn't being collected by our tax revenue, isn't being collected by our producers, and isn't being collected by our consumers. This area is called deadweight loss. 39 / 72 Finding Revenue and Ef ciency Deadweight Loss Deadweight loss is the area, assuming our market was ef cient before, is going to disappear from our market ef ciency. In a sense, it is the price of implementing the tax on this market. No matter if our tax revenue is replacing the loss to producers/consumers perfectly, we still will create some ef ciency losses by imposing this tax. We can calculate our loss if we plug in some numbers for our quantity change and the magnitude of the price. 40 / 72 Finding Revenue and Ef ciency Calculating Deadweight Loss 1 DW L = Area of triangle = (100 − 90) ∗ t ∗ = 6.65 ∗ 10, 000 = 66, 500 2 41 / 72 Finding Revenue and Ef ciency Calculating Deadweight Loss Of course, this is going to hold regardless of whether we are taxing our suppliers or producers, because the lost sold quantity has changed by the same amount in both cases. 42 / 72 Finding Revenue and Ef ciency Solving the Mystery But the question remains! WHO IS PAYING MORE? We can actually nd the tax incidence of who is suffering most, by splitting the rectangle for tax revenue by the line created by P and adding it to the half-triangle from DWL split by that same line. eq Q: What does that mean? It means that because our sellers and buyers have to agree on a price and quantity to sell/buy, the side of the market that is less able to respond to price tends to bear a disproportionate weight of the tax. Let me show you in the graph, because I think you'll see what I mean there. 43 / 72 Finding Revenue and Ef ciency Who pays what? 44 / 72 Finding Revenue and Ef ciency Who pays what? 45 / 72 Where to Tax Where to Tax Where to (excise) Tax? Well - if we assume our goal here is to increase our revenue, then we are going to want to nd markets that aren't very responsive to changes in price. This is for two reasons: Given DWL comes from changing quantity supplied and demanded, we would ideally like to minimize it, and, Tax revenue depends on still having some quantity sold in the market, so it is optimal to tax markets with relatively inelastic demand or supply. 47 / 72 Where to Tax Incidentally - this is often why taxes are applied to wide categories of goods (which tend to be more inelastic.) Generally you'll see a sweet beverage tax rather than a pepsi tax. Aside from being unfair, the latter would encourage many people to simply buy Pepsi substitutes, and result in fewer tax dollars because of it. 48 / 72 Where to Tax Tax on Perfectly Elastic Demand/Supply If we tax a good that has perfectly elastic demand or supply, then what will happen? Well - we know that perfect elasticity on either side of our market implies that we'll only be willing to pay/sell at one price, for any quantity. This means, for one, only one side of the market will actually pay the tax. That is, the less-elastic half of the market will end up suffering the entire tax incidence. Also, because one of our groups is perfectly elastic, we ought to see a fairly large decrease in Quantity Supplied/Demanded. 49 / 72 Where to Tax Tax on Good with Perfectly Elastic Demand 50 / 72 Where to Tax Perfectly Inelastic Supply Now, what would happen if our tax was instead applied to a market where we had perfectly inelastic demand/supply? Meaning - we taxed something like property on the demand side. We know this is a good candidate for highly inelastic supply, because we can't change the quantity supplied. There is really one price for 'property.' Well - we know that quantity demanded/supplied won't change because of the de nition of perfectly inelastic. This is a bene t on both fronts! Let's look at a property tax where property is supplied perfectly inelastically. 51 / 72 Where to Tax 52 / 72 Where to Tax Bene ts Notice - our tax revenue is now tQ, meaning we don't have any DWL and we get maximum revenue. This is why, generally speaking, taxes get placed on goods that tend to be less elastic. If a good has too many substitutes, then it's easy for consumers to dodge a tax. Similarly, if it's easy to stop selling a good, it makes suppliers too capable of just quitting production, meaning we won't really collect revenue and we may end up harming consumers/producers more than we are willing to. 53 / 72 Where to Tax Subsidies Remember, I said we can think about subsidies as basically 'negative taxes.' That means our conclusions about taxes apply to subsidies as well This means for any given price, if we subsidize a seller by 20$ per unit, that seller will now be willing to sell that good for 20 dollars less than they would have otherwise been able to sell it. On the consumer side, people getting tax rebates will now be willing to pay more for every given level of quantity. Effectively - this graph is almost identical to our tax graph, but we won't experience any deadweight loss in this market. Of course, this money had to come from somewhere so ostensibly there is deadweight loss somewhere else. 54 / 72 Where to Tax 55 / 72 Where to Tax Gained Ef ciency We can't really say this market is more ef cient but we can say that due to increased activity (buying and selling) our market participants are happier. That little triangle we used to label as deadweight loss is now actually gained total surplus! Pretty neat, right? What if we wanted to evaluate the cost of this subsidy? Well, just like with total revenue, we can calculate this by multiplying the quantity sold in the market by the size of the subsidy, that is, Qs ∗ Subsidy 56 / 72 Balancing Market Outcomes Balancing Market Outcomes Evaluating Taxes One thing I haven't talked about is changing the magnitude of our tax, and also income-type-taxes. The reason for this (aside from allowing people to follow along with the book more easily) is because much of what we've done above applies across differing magnitudes of taxes. Income taxes are both similar and dissimilar, because they are kind of like a tax on labor. That is, companies have to pay workers more to offset the bene t you bring them (your wage.) However - I want to add a few concerns to keep in mind when you're analyzing a tax 58 / 72 Balancing Market Outcomes Keep in Mind Remember what happens in the long run for a demand/supply curve? In the long-run, we know that demand and supply are more elastic. Oftentimes, this results in long-term shocks to markets where there would normally be little to no effect in the short run. This makes it super important to be sure that we watch the effects of tax changes over time, because costs at the outset can be considerably smaller than the costs after individuals have time to adjust. 59 / 72 Balancing Market Outcomes Taxing Luxuries Often times when new taxes are proposed, you'll hear a cry to tax things like yachts or expensive cars. However, the problem is that things bought by the very-rich tend to be lush with substitutes, because rich people have a lot of options. This tends to mean that these types of taxes result in relatively few taxrevenue dollars and can result in signi cant job disruption for individuals working in those industries. Without forcing the wealthy to buy those goods, it's dif cult to produce revenue from them. This is one of the reasons why there just aren't that many luxury-speci c taxes. They tend to be impractical. Instead, these are often proxied with a graduated income tax. 60 / 72 Balancing Market Outcomes Taxing Income Out of all tax-types, income tax tends to be the most progressive. This means that, as opposed to sales-tax, which taxes a higher percent of the wealth for poorer people, income tax tends to hit wealthier individuals more This is also true for things that tax capital gains. However, the impact on markets is less-clear. Remember, if we decrease income across the board, we'll move individuals towards inferior goods and away from normal ones. This isn't necessarily a bad thing - just something to keep in mind. 61 / 72 Balancing Market Outcomes Exorbitant Taxes We can also look at taxes at a variety of intensities. As you might expect, increasing the size of the tax will increase the size of the Deadweight Loss. Perhaps less intuitive is that, due to consumers and suppliers decreasing the quantity away from the taxed items, this has an unknown effect on revenue. Let's look at an image depicting a variety of tax levels 62 / 72 Balancing Market Outcomes Exorbitant Taxes 63 / 72 Review Review Alright - let's do 2 quick review questions. We're going to be looking at a couple graphs, and then I'll walk through solving the problem with you. With the following graph, I want you to calculate the consumer surplus and the producer surplus. 65 / 72 Review 66 / 72 Review Our next question is one analyzing a tax. I want you to label, with the following image, what areas are CS or PS before the tax, what areas are CS or PS after the tax, as well as what areas are DWL and which areas become tax revenue. 67 / 72 Review 68 / 72 Review The last question for review will look at a subsidy. Remember, a subsidy functions almost exactly like a negative tax. I want you to identify the CS before the subsidy and after the subsidy, as well as Producer Surplus before the subsidy, and the area that represents the cost to the government of the subsidy. 69 / 72 Review 70 / 72 Review Alright! That's it for today, I'll see you on Wednesday to learn a little bit about price controls. 71 / 72 Review Table of contents Admin Today Upcoming Review Elasticity types .col-right[ .smallest[ Taxes Intro Incidence Deadweight Loss Where to Tax? 72 / 72 Lecture 008 Price Controls Connor Lennon 3 May 2020 Admin Admin Assignments Future Assignments due this week: Price Controls Inquizitive (6) is due on Thursday (5/7) this week, the Market Ineffciency/Property Rights inquizitive (7) will be due on Monday, 5/11. The Smartworks for this section will be due Next week. These will both likely be shorter smartwork assignments 3 / 63 Admin Upcoming Today: Midterm We'll talk a bit about the in-class midterm performance today Covering More policy study: Price controls! These consist of price ceilings and price oors. 4 / 63 Admin Upcoming Readings/Schedule Today through this week Finish Mateer/Coppock Ch. 6 and Ch. 7. We'll be covering how markets break down, and nishing off our analysis of policy options. Next week Mateer/Coppock Ch. 8 (costs, production and rm strategy) and the start of Ch. 9. (Competitive Markets) These chapters begin to dive into what's commonly referred to as 'the theory of the rm.' This will help us analyze how well markets are truly working, and how the structure of a rm can change how ef cient it is. Week After Mateer/Coppock Finish chapter 9, and Cover Monopolies (Ch 10) 5 / 63 Admin Upcoming Also - Another extra credit assignment will get posted this week. Warning Just so you know - many people nd the material we'll begin to cover over the next 3 weeks (Ch 8 - 11) to be the most challenging portions of a 201 course, and this is partly due to the ' rm-level' graph. However - I am spending a bit longer than usual breaking that graph down and hopefully that will help you guys understand what is going on there. 6 / 63 Midterm Midterm (in-class) Midterm statistics Average: 76% about (60/80) Standard Deviation about 11%. I don't curve exams, but I'd say, if things continue as they have been - a test score of 62.5% corresponds to a C-, high 70s corresponds to a B-. High 80's is an A- and so forth. 8 / 63 Midterm Topics Struggled with A lot of people seem to have some dif culty still with interpreting elasticity, and distinguishing between consumer surplus/producer surplus. We'll be working a lot more with similar concepts soon - so hopefully with more exposure you'll begin to get a little more comfortable Topics You did Well with Supply/Demand shifters Taxes (which I was impressed with, nicely done!) 9 / 63 Review Review You guys know your taxes really well! I still want to put up some review, just to go over the concepts. The two most important things to remember about taxes is that 1.) It doesn't matter whether it's consumers or producers are taxed in a perfectly competitive market - both markets will end up with the same 'defacto' results. 2.) Taxes fundamentally convert some total surplus into tax revenue. Let's do some practice: 11 / 63 Review Practice What is the value of total tax revenue? What is the size of the tax? difference between two different demand curves. Usually the easiest place is the difference between price received. T ax = 12 / 63 Review Practice What is the DWL here? Producer surplus? DW L = 1 ∗ 1 ∗ .5 = .5 P S = 6 ∗ 6.77 ∗ .5 = 20.31 13 / 63 Review 14 / 63 Price Controls Price Controls One of the main reasons to learn about economics is to be able have an understanding of how policies will impact your communities and the markets that make them up. One of the more common policies that exist are categorized under price controls In essence, a price control is a legal requirement that forces prices to either sit above or below a given target. These are called price oors and price ceilings 16 / 63 Price Controls Wait This is kind of confusing. Price oors are a policy that prevents prices from falling below them Price Ceilings are a policy that prevents prices from rising too much. If you think of yourself standing in a room - the ceiling is the thing that prevents you from jumping too high, and the oor is the thing that prevents you from going any lower. But the important part here is to understand how each of these policies impact markets, and in particular, the indirect incentives that play out 17 / 63 Price Controls Price Ceilings Let's imagine there was a policy you could vote for said that would prevent rents (for housing) from being above a given price. On the surface this sounds pretty good. We can keep people in houses that they can predictably afford. Let's put on our economist hats. When prices are lower than they would otherwise be, what happens to quantity supplied and quantity demanded? These will indicate that quantity supplied will be less than quantity demanded. 18 / 63 Price Controls Producer incentives The problem here is that all of our "producers" are still ultimately trying to maximize pro ts. Producers/landlords will try to nd ways to lower their expenses/maximize pro ts. This means they will provide their homes/apartments as cheaply as humanly possible. Additionally, they may take their apartments out of the market completely putting them on AirBnB. 19 / 63 Price Controls Consumers At the same time - at the lower prices, our old consumers will be happy but we also will attract new consumers. Quantity demanded will be higher, in particular, those consumers who care less about the cut corners that producers will put in place will be present in higher numbers. These new consumers will generate a massive shortage, because the lower prices have lowered our quantity supplied as rentals begin transferring to vacation rentals/airbnb. So will everyone go homeless? Some may, but that's not where this stops. 20 / 63 Price Controls Black Markets Whenever there is an enforced shortage like this, a black market is bound to crop up. Black Market: an informal market that provides goods outside of the legal context. You probably have an idea in your head that a black market here is like buying guns in an alley from a guy named Vlad, but most 'black' markets are a little less sinister than that. In our rental case - it's likely that some rentals will stay as rentals, but have informal agreements with tenants, probably tenants they can trust, meaning connections will be more able to get you an apartment than they would otherwise. 21 / 63 Price Controls Black Markets The unintended consequence of this of course is that people who know property owners, who likely belong to families or are in social circles that tend to be wealthier will be able to live in rental units, while 'unknown' or 'unproven' outsiders can't nd rental apartments. Further - these "black market" apartments/housing will be able to take advantage of the pent-up demand, and charge considerably higher prices than even an equilibrium price. Of course - the other option that might happen here, is nothing. Why is that? Let's take a look at our supply and demand market, and we should be able to develop some intuition about the effects of a price ceiling. 22 / 63 Price Controls Price Ceiling Model The reason we could have these drastically different results is entirely dependent on the magnitude of the price ceiling. This is analagous to our differing sizes of taxes creating different levels of deadweight loss: If our price ceiling is extremely high, for instance, if our price ceiling for all rents was such that prices over 10,000 dollars per month weren't allowed, markets would essentially continue operating as normal. Maybe one or two units would get slightly cheaper, but for the most part, our market would be stable. What happens if the price ceiling is extremely low? What if rents could not be higher than 3 dollars a month? 23 / 63 Price Controls Price Ceiling Model Well - what happens if prices for an apartment are three dollars a month? We know that our suppliers would stop supplying (rent on Airbnb instead) and there would be a huge demand for three-dollar rentals? This sounds eerily similar to how we were originally conceptuallizing market equilibriums as a series of shortages/surpluses. Let's see what this looks like on a graph. 24 / 63 Price Controls 25 / 63 Price Controls Deadweight Loss Just like with taxes, we can calculate deadweight loss from these policies. However, we no longer really have a tax to do our calculations with. So how do we do this? Rather than use the size of the tax - which really just serves to examine the difference between our shifted supply/demand curves, we can use the difference between the price oor and the black market price as our new tax. In fact, we can generate similar outcomes by way of a tax - simply by taxing until tax = price − price and then transferring the revenue to the consumer population black market ceiling 26 / 63 Price Controls 27 / 63 Price Controls Price Ceiling Model What if our policy has a very high price? Well, let's explore what happens in a normal market where our price ceiling is very high 28 / 63 Price Controls 29 / 63 Price Controls To summarize A price ceiling can either be binding or nonbinding If the ceiling is lower than the equilibrium price, then the price ceiling is binding and leads to the new equilibrium sitting at the price ceiling If the ceiling is higher than the equilibrium price, then our price ceiling is now nonbinding. That means our normal forces of supply and demand will dictate the price. 30 / 63 Price Controls However In the case of a binding price ceiling, in fact, we have another issue that can arise. Remember - in the long run, individuals can adapt more to new situations. Let's think about our rental market - if there aren't places to rent, renters will begin to behave as if they didn't need to rent in the rst place, living with their families for longer, nding roommates, etc. Suppliers too, tend to be more adaptable in the long run. Permanently converting a rental that is too expensive for the price ceiling (when it wouldn't be pro table) can be converted into a vacation home, or, if necessary, sold to a business to open small shops instead. 31 / 63 Price Controls 32 / 63 Price Controls Rent This is all well and good in theory but this course was set out to be databased and the hope was to back things up with real examples and data to be sure of our conclusions Unlike some of the other conclusions in this course, price ceilings and in particular rent controls seem to play out in the same way: Rent controlled apartments are in shortage, and in general are occupied for the remainder of the lifespan of the occupants These occupants die, and pass the apartments/homes along to their children - this leads to even bigger shortages Rentals tend to be poorly maintained, so renters who can afford to do their own maintenance tend to stay. 33 / 63 Price Controls Rent So - the primary goal of rent control - that is, to provide affordable housing, is defeated by market forces for the most part in the policy itself. This is why economists pushing for better affordable housing tend to focus on expanding supply rather than rent control. In particular, a good alternative policy is to get rid of zoning laws, and to replace large, expensive homes with larger apartment units close into town. The downside of this, of course, is a loss of welfare from the sudden loss of all of those beautiful big homes. 34 / 63 Price Controls Price Gouging The other price ceiling is a price Gouging ceiling. These policies are put into place to prevent prices from going too high during disasters. Let's start with a de nition: Def'n: Price Gouging is when a price is increased to increase pro ts, particularly in an unfair way, during a crisis, usually to take advantage of increased need. Let's go over the textbook take on this. Since price gouging doesn't occur except during a disaster/other shock to demand, we can assume these laws are nonbinding until a catastrophe strikes. 35 / 63 Price Controls Price Gouging We can model this with tools we already have Combining a) a shock to demand and b.) a price ceiling Let's see what this looks like 36 / 63 Price Controls 37 / 63 Price Controls Price Gouging However - let me play devil's advocate for a minute here. Yes - price gouging laws create a shortage during crises. This is de nitely a bad outcome. What happens when producers expect prices to rise? They hold onto their supplies for the future - so they can sell them under the crisis conditions. This does two things - lowers the quantity of preventative purchases in advance and decreases supply. 38 / 63 Price Controls Price Gouging If preventative purchases are performed optimally then price gouging shouldn't happen to the same extremes, because more consumers will prepare for disasters. This means consumers can avoid panic buying during a disaster If this is true, then those individuals will be less at risk, and citizens should be more robust to disasters. 39 / 63 Price Floors Price Floors Price Floors We've talked about what happens when governments put a limit on how high prices can go, but what about when governments put limits on how low they are? Well - rst off, what would cause a Government to do this? The (slightly) hand-wavy example Economics likes to talk about is minimum wage. I'll come back to minimum wage. I'm going to use a different example - Chicken. Then we'll talk about wages. 41 / 63 Price Floors Price Floors Let's imagine we are a country's leader - and we wanted to protect our local chicken producers. We worry that world prices, far below the market prices we can offer our own citizens, will undercut our producers. So we set a price oor. This will protect our producers, and keep them extremely pro table. Why not do this instead of tariffs? 42 / 63 Price Floors Price Floors However - we live in a globalized world, just because we say price have to be high enough doesn't mean other countries can't sell us chicken too. So what is the result? Our local chicken farmers still sell chicken, but so do all of the cheaper international chicken farmers. Supply has, as much as we wouldn't like it to, expanded. This means that there will be a surplus. Worse still, the local producers we were trying to protect aren't guaranteed to be the ones selling the chicken that IS sold. Let's look at a graph. 43 / 63 Price Floors 44 / 63 Price Floors Price Floors However, just like with price ceilings we can also have non-binding price oors. When price oors are lower than the equilibrium price in a market, then market forces dominate, and the price and quantity will not change. Let's look at that example. 45 / 63 Price Floors 46 / 63 Price Floors Deadweight Loss Just like with taxes and price ceilings, price oors also generate deadweight loss. However: This time it is because consumers are unwilling to pay the higher costs. This leads to a lower market quantity consumed, and thus deadweight loss. 47 / 63 Price Floors 48 / 63 Price Floors Price Floors (Wages) Ok then, quick test of your knowledge. What is a minimum wage? It can be a binding price oor but it's not universal, because not every job is paid the same wage. This is in part due to the fact that humans are not watermelons. What does that mean? Employers pay you, an employee, to produce some bene t for them. So long as you produce a suf cient bene t, there is no issue. However, we can think about labor hours as a sold good on a marketplace. 49 / 63 Price Floors Price Floors (Wages) However - studies of minimum wages have been largely inconclusive. Remember - I mentioned a study of Seattle's minimum wage having little to no effect on grocery store prices? This is important. If unemployment doesn't change, then the costs have to being borne somewhere else, right? Where is the most likely place this would show up? In the products being produced - however, this doesn't seem to be the case. 50 / 63 Price Floors Price Floors (Wages) The only explanation this model has, really, is that the wage must be nonbinding, but that's demonstrably false as well. So what's the answer? We don't really know - humans are weird animals, and as much as we'd like to think of rms and workers as unfeeling robots weighing costs and bene ts according to their perfect expected values often times this isn't the case. I'm getting ahead of myself - let's get back to price oors. 51 / 63 Price Floors Price Floor Black Markets Similar to price ceilings, black markets selling at far below equilibrium price, in order to clear the excess supply can also develop. These actually do exist in our labor market, but the reality is that most of the participants in these black markets are immigrant workers working on farms, whose wages sometimes fall below minimum wages However - some immigrant workers who are very productive do in fact make more than minimum wage. 52 / 63 Price Floors Price Floors in the Long Run Similarly - as with price ceilings, surpluses from price oors tend to expand in the long run. This is due to the exact same mechanics - higher elasticities lead to larger changes in quantity demanded and quantity supplied, and expand the width of the surplus. So these policies have no use? 53 / 63 Price Floors Price Floors (useful ones!) Aside from minimum wages, which seem to be empiracally a mixed bag, there are some successful price oors, but they have different objectives than the chicken price oor proposed above. In Scotland and Australia, there are price oors for alcohol. Rather than attempting to boost their own sales of alcohol, these regulations are in place to help prevent glut of alcohol from increasing alcohol dependence in their countries. In some ways - this type of price oor is more of a health policy than an economic one. Similar things have been proposed for prescription painkillers - however, the issue there is that painkillers are extremely useful for patients who need them, and price oors would be cruel. It would be better to just police over-prescription. 54 / 63 Price Floors Price Controls in Other Settings The rst modern price oors began during the Great Depression in the 1930s. These were put on agricultural goods like chicken and other foods. This was to prevent too many farms from going out of business - preventing recovery. Price oors were also kept on airlines until the 1970s. This is why people talk about ying in the old days being so luxurius! A ight during these times cost upwards of 1100 dollars for a domestic ight - worth about 8500 dollars today. 55 / 63 Price Floors Price Controls in Other Settings However, price controls date far into the past - one of the oldest price controls come from the Early Middle ages. It was illegal to collect interest on debts during the early middle ages. In essence, laws like this correspond to a price ceiling of 0 This led to huge black markets for loans with high interest rates - fueling a nancial criminal organization for many early medieval societies. 56 / 63 Price Floors Price Controls Today Many of the agricultural price- oors have continued today. Particularly, the United States subsidizes and enforces price oors for agriculture. Canada does the same for targeted industries. This makes the US a net-exporter of agricultural goods, but at the same time, many food items in the US are more expensive than they would be elsewhere. In particular, bags of sugar are extremely cheap in Canada, compared to places just across the border. Conversely - there is an entire industry in Bellingham Washington that is dedicated to selling milk to Canadians who drive across the border for cheaper dairy prices. 57 / 63 Price Floors Price Controls Today The other problem with price oors is they encourage rms to not adapt to new technologies. This makes for a more stable economy, but then you also end up with massive sugar farms in Louisiana, while supporting near-slavery conditions in carribean islands because they haven't been forced to adapt to more modern technologies due to long-standing trade deals. These agricultural effects also have tack-on, unintended consequences. By making imports more expensive, producers of products that use these goods tend to place their factories in other locations. This is why many bottling companies choose to locate in Canada rather than the US, where more sugar and avorings are manufactured. 58 / 63 Review Review Let's do a bit of a review quiz for the material we just covered. 60 / 63 Review Let's do a bit of a review quiz for the material we just covered. Do all price controls result in black markets? A.) No - only binding price controls result in black markets. How do you calculate deadweight loss from a price ceiling? A.) You can nd the deadweight loss from a price ceiling by ((priceblackmarket − priceceiling ) ∗ Q) What happens in the long run with a price oor? A.) The surplus expands. 61 / 63 Review Ok - you guys are doing great, and I'll see you on We...
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