INTRODUCTION TO MICROECONOMICS
INTRODUCTION TO MICROECONOMICS ECON 201
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Econ 201 Lecture 16 The rationing function of price to distribute scarce goods to those consumers who value them most highly The allocative function of price to direct resources away from overcrowded markets and toward markets that are underserved According to Adam Smith s invisible hand theory the carrot of economic profit and the stick of economic loss were the only forces necessary to assure not only that existing supplies in any market would be allocated efficiently but also that resources would be allocated across markets to produce the most efficient possible mix of goods and services Consider a wheat market in which the current price generates 150000yr of economic profit per farm 3 shel Sbushel MC 0 100 millions of bushelsyr 10005 of bushelsyr The existence of positive economic profits attracts new firms shifting supply outward Price falls making each firm s economic profit smaller than before 3m shel Sbushel MC S C Economic profit 68000yr 1 3n 4 00 3 30 Price 220 D 0 8 millions of bushelsyr 10005 ObeShCISYr As long as price remains above the minimum value of ATC profits lure new entrants Supply continues to shift out until price falls to min ATC At that point economic profit is zero and there is no further incentive to enter b Shel b shel MC A c 5 Price 2 m on D i 85 65 10005 ofbushelsyr millions of bushelsyr Present Value and the Time Value of Money Example 161 Suppose the annual interest rate on bank deposits is 10 percent If you deposit 100 on January 1 of this year how much will it be worth by January 1 of next year 100 110 110 For any given interest rate the present value of a sum of money that you will receive at a specific time in the future is the amount of money you would have to put in the bank today at that interest rate in order to have exactly the required sum on the future date Example 162 If the annual interest rate in 10 percent what is the present value of110 to be received one year from now As we saw in the previous example 100 deposited today at 10 percent interest will be worth 110 a year from now So the present value of110 a year from now is 100 Example 163 If the annual interest rate is 5 percent what is the present value of 5250 a year from now Let PV the present value of 5250 to be received in 1 year PV 105 5250 so PV 5250 105 50 If you put 50 in the bank today at 5 percent interest in a year39s time you will have 5250 More generally when the interest rate expressed as a proportion is r the present value of M one year from now is given by PV MHr Example 164 When the annual interest rate is 10 percent what is the present value of a payment of 121 to be received 2 years from now PV 121112 100 Put 100 in the bank today at 10 percent interest After one year 10011 110 After two years 110 110 100 112 121 Example 165 Jones can enter a business whose revenues and costs occur through time as follows Revenues Costs now 0 300 1 year hence 0 0 2 years hence 363 0 3 years amp more 0 0 1f Jones enters this business and the interest rate is 10 percent per year what is the present value of his economic profit Present value of economic profit present value of revenue present value of costs 363112 300 300 300 0 Example 166 Should Jones enter this business if the interest rate is 12 percent Enter only if PV of economic profit gt 0 At 12 percent PV ofrevenue 3631122 28938 PV of economic profit 28938 300 1062 lt 0 so don39t enter Example 167 Should Jones enter if the interest rate is 8 percent PV ofrevenue 3631082 31121 PV of economic profit 31121 300 1121gt 0 so Jones should enter Almost all investment projects require that costs be incurred in the short run in order that benefits accrue in the long run The higher the interest rate the lower is the present value of benefits received in the future So as a general rule an investment project is less likely to be worthwhile when interest rates are high than when interest rates are low Stock Prices A stock is an ownership claim to the accounting profits in a company If you own 100 of a company39s 1000 shares outstanding you own onetenth of the company39s earnings Example 168 A company39s accounting profits are 100000 per year If the annual interest rate is 10 percent what is the present value of this firm39s accounting profit PV 10000011 100000112 100000113 1000000 Ifyou put 1000000 in the bank at 10 percent you would generate a flow of earnings of 100000yr Example 169 If this company has 1000 shares of stock outstanding how much will each one sell for 10000001000 1000share Example 1610 Suppose accounting profit from the firm in the preceding example were to double How would the value of its stock price change PV of profit 2000000 Price per share 20000001000 2000share An Application of the Invisible Hand The Ef cient Markets Hypothesis E onomists are strongly united in their belief that the stock market is efficient By this we mean that the price of a stock embodies all available information that is relevant to its current and future earnings prospects To illustrate consider a hypothetical example involving Genentech a relatively young highly successful genetic engineering company Suppose that on the strength of its earnings prospects the current value of a share of Genentech is 1000 Now suppose that one of Genentech39s researchers suddenly stumbles onto a miracle cure for cancer The discovery is simple and easy to patent The company is certain to win government approval for its discovery at which point its revenues will soar dramatically But because of bureaucratic red tape the approval process never takes less than three years You read in Newsweek about Genentech39s discovery and decide to buy stock in the company Is this a shrewd move on your part e answer is almost certainly no but not because the company does not have the rosy future that has been forecast for it The difficulty according to the efficient markets hypothesis is that the value of the new discovery will be almost instantaneously bid into the market price of its stock By the time you hear about it the rise in price for which it is responsible will have long since occurred Critics of the efficient markets hypothesis often object that it refers to a frictionless ideal world In the real world they argue it may take considerable time for new information to disseminate and so its effect on stock prices may be gradual and protracted Thus they conclude if the news of the Genentech discovery is only a few weeks old there will still be plenty of room for stock prices to keep growing on the strength of it This view is almost certainly wrong The difficulty is a confusion that arises because new information often comes not in the very sure form assumed in the example but in highly uncertain form In practice it would be much more common for example for the market to learn at first only that a Genentech researcher had a promising lead on a cure for cancer This more limited information would justify a much smaller boost in the company39s stock price which would then be followed by further increases if the development continued to show promise But it would be followed by a plunge in stock prices if the development were to fizzle In either event however the full value of the information at hand would be re ected in the stock price of the moment But because information about new profit opportunities usually emerges gradually many observers erroneously conclude that the market39s response to the new information is also gradual Unlike the conditions in our hypothetical example in the real world it is usually hard to quantify exactly what information becomes available at specific times Moreover there is almost always latitude for differences in interpretation of any given piece of information For these reasons it is extremely difficult to verify the efficient markets hypothesis empirically Nonetheless most economists believe that it is correct If the hypothesis is impossible to verify directly what accounts for the strength of economists commitment to it The answer is that the alternative hypothesis namely that stock prices don t embody all the available inform ation leads to conclusions that we find so difficult to accept To illustrate consider our cancer cure example again and suppose the market did not immediately bid up the price of the stock to re ect the higher future profits implied by the new discovery Then you or 1 could simply pick up the phone and instruct our stockbrokers to buy as many shares in Genentech as we could afford We could then sit back and wait for the market to bid up our shares to their full market value reaping a substantial gain in the process The one belief that economists hold more deeply than any other is that the only way to reap such gains is by some combination of talent hard work and luck But if we deny the efficient markets hypothesis there can be examples like this one in which there is cash just sitting on the table for the taking We need no talent39 we needn39t do any hard work39 and because the information is certain we don39t even need to be lucky We just call our brokers and wait for the money to roll in There is an ample supply of people who would be delighted to earn their livings in this painless way That it seems generally impossible to do so is all the confirmation most economists need for the efficient markets hypothesis Example 1611 The Ace Investment Advisory Group has put together a special stock fund that includes only shares of 4 monopolies that earn profits at least 50 percent higher than the overall industrial average If you invest in this fund do you expect to do better than if you had invested in nonmonopolies If investing in monopolies yielded a higher payoff the prices in their stocks would be bid up until the return was brought into balance with the return on stock in other companies Example 1612 Consider a perpetual bond that pays l20yr to its owner a perpetual bond entitles the bearer to the same annual payment forever By how much would the price of this bond rise if the interest rate fell from 10 percent to 5 percent The price at 10 percent is l20010l200 At 5 percent the price will be l200052400 so the rise in price is 1200 More Applications of Invisible Hand Theory Price Supports as a Device for Saving Family Farms Example 1613 Family farms tend to have higher costs than large corporate farms As more and more family farms give way to corporate farms lower costs lead to lower prices which result in economic losses for family farms To ease the plight of the family farmer Congress has passed legislation that pegs prices of farm products higher than marketclearing levels Will this policy help tenant farmers in the long run When the price of farm products rises farms that were earning zero economic profit will now earn positive economic profit The lure of positive profit causes others to bid for agricultural land which causes land prices to rise The longrun effect of agricultural price supports was thus to drive up the rent for farmland which does nothing to assure the survival of tenant farmers A much more direct and efficient way to aid family farmers would be to reduce their income taxes or in the case of more extreme need to give them outright cash grants The Adoption of CostSaving Innovations Perfectly competitive firms can do nothing to alter the market price but they can often take steps to reduce their costs Example 1614 A trucker gets 5000 for driving a trailer full of cargo from New York to San Francisco a trip that takes him one week The rent for his rig is 3000wk and he spends 1000 on gas Meals and other expenses come to another 500wk His alternative employment is to work as a local deliveryman at a salary of 500wk a task he finds equally attractive as trucking What is this trucker39s economic profit Total revenue 5000 Total cost 3000 1000 500 500 5000 Economic profit 5000 5000 0 Example 1615 Now suppose the trucker from the previous example installs an airfoil on the roof of the cab of his rig resulting in a fuel savings of 25 percent If the airfoil rents for 50wk what is the trucker39s new economic profit am an 1970 1985 Total revenue 5000wk the same as before Total cost 5000 250 50 4800 So economic profit 5000 4800 200 Example 1616 Suppose all truckers but one have installed the airfoil described in the preceding example What will be the economic profit of the lone holdout s more and more truckers install the airfoils costs go down and this places downward pressure on trucking prices By the time all truckers save one have installed the airfoils trucking rates will have fallen by the full 200 in net cost savings made possible by the airfoil Thus the lone trucker without an airfoil will suffer an economic loss of 200wk Moral Early adopters of costsaving innovations tend to earn positive economic profits Late adopters tend to earn negative economic profits Econ 201 Lecture 24 Communication Between Potential Adversaries When a toad and his rival vie for the same mate each faces an important strategic decision Should he fight for her or set off in search of another To fight is to risk injury But to continue searching has costs as well At the very least it will consume time And there is no guarantee that the next potential mate will not herself be the object of some other toad39s affections In deciding between these alternatives each toad39s assessment of the other39s fighting capabilities plays an important role If one s rival is considerably larger the likelihood of prevailing will be low and the likelihood of injury high so it will be prudent to continue searching Otherwise it may pay to fight Many of these decisions must be made at night when it is hard to see Toads have therefore found it expedient to rely on various nonvisual clues The most reliable of these turns out to be the pitch of the rival39s croak In general the larger a toad is the longer and thicker are its vocal cords and hence the deeper its croak Hearing a deep croak in the night a toad may reasonably infer that a big toad made it Indeed experiments have shown that the common toad is much more likely to be intimidated by a deep croak than a highpitched one The seller for example sometimes has an incentive to overstate the quality of his product The buyer likewise often has an incentive to understate the amount she is willing to pay for it And the potential employee may be tempted to misrepresent his qualifications for the job Bridge partners by contrast clearly share common goals When a bridge player uses the standard bidding conventions to tell his partner something there is no reason for his partner not to take the message at face value Neither player has anything to gain by deceiving the other Communication here is a pure problem of information transfer A message need only be decipherable Error aside its credibility is not in question A very different logic applies however when the interests of wouldbe communicators are in con ict or even potentially so Suppose for example the bridge player whispers to the opponent on her left quotI always bid conservatively What is the opponent to make of such a remark It is perfectly intelligible Yet if all parties are believed to be rational the relationship between them is such that the statement can convey no real information If being known as a conservative bidder would be an advantage that would be reason enough for a player to call him self one true or not The statement is neither credible nor incredible It simply contains no information Example 241 A street vendor in lower Manhattan is offering what he claims are genuine Rolex wristwatches for sale for 19995 a normal retail value he says of 9000 Q Is his claim credible Example 242 The Springer family jewelry shop has been a successful local business for 40 years In their annual sale they are offering Rolex wristwatches for only 7000 a normal retail value they advertise of 9000 Q Is their claim credible The CostlytoFake Principle For a signal between adversaries to be credible it must be costly or more generally difficult to fake If small toads could costlessly imitate the deep croak that is characteristic of big toads a deep croak would no longer be characteristic of big toads But they cannot Big toads have a natural advantage and it is that fact alone that enables deepness of croak to emerge as a reliable signal This castlyIafake principle has clear application to signals between people It is at work for example in the following episode from Joe McGinnis39s Fatal Vision Captain Jeffrey MacDonald an Army Green Beret physician has been told he is suspected of having killed his wife and daughters The Army has assigned him a military defense attorney Mean while however MacDonald39s mother recruits Bernard Segal a renowned private attorney from Philadelphia to defend her son When Segal calls MacDonald in Fort Bragg NC to introduce himself his first question is about MacDonald39s Army attorney quotAre his shoes shinedquot quotWhatquot MacDonald sounded incredulous Here he was all but accused of having murdered his own wife and children and in his very first conversation with the Philadelphia lawyer who presumably had been hired to set things right the first question the lawyer asks is about the condition of the other lawyer39s shoes Segal repeated the question quotAnd this timequot he said later quotI could almost hear Jeff smiling over the phone That was whenI first knew I had a client who was not only intelligent but who caught on very quickly He said no as a matter of fact the lawyer39s shoes were kind of scruffy I said 39Okay in that case trust him Cooperate with him until I can get down there myself The point being you see that if an Army lawyer keeps his shoes shined it means he39s trying to impress the system And if he was trying to impress the system in that situation the system being one which had already declared a vested interest just by public announcement of suspicion in seeing his client convicted then he wasn39t going to do Jeff any good The unshined shoes meant maybe he cared more about being a lawyer quot The condition of the attorney39s shoes was obviously not a perfect indication of his priorities in life Yet they did provide at least some reason to suspect that he was not just an Army lackey Any attorney who wore scruffy shoes merely to convey the 2 impression that he was not looking to get ahead in the Army actually wouldn t get ahead So the only people who can safely send such a signal are those who really do care more about their roles as attorneys Product Quality Assurance Example 243 Company A sponsors an expensive national advertising campaign on behalf of its television set claiming that it has the clearest picture and the best repair record Company B makes similar claims but does not advertise its product Q With no additional information which company39s claim is more credible Choosing a Hardworking Smart Employee Example 244 Microsoft is looking for a hardworking smart employ to manage a new division There are two applicants Smith and Jones who seem alike in every respect but one Smith is an honors graduate from CalTech Jones graduated with a C average from Podunk University Whom should lLicrosoft hire The FullDisclosure Principle 1 some individuals stand to benefit by revealing a favorable value of some trait others will be forced to disclose their less favorable values Example 245 Why do the smaller toads croak at all thereby revealing how small they are Suppose croak pitch is measured from 0 to 10 with 0 the lowest and that toads are distributed uniformly along this scale And suppose that all toads with a pitch higher than 6 remain silent thereby not to reveal their small size You are a frog with a pitch of 61 What will other frogs think of you if you remain silent Initial croaking threshold Croak lt gt Don t croak 012345678910 Lowest Pitch Highest Pitch Will it be in your interests to remain silent Product Warranties Producers of products with high quality can disclose that fact by offering liberal guarantees because of the costlytofake principle Example 246 The Acme Television Company guarantees its television sets for 14 days against defects in materials and workmanship This suggests to buyers that its sets are of low quality Why does it call that fact to buyers attention Why not just offer no warranty at all Regulating the Employment Interviewer Example 247 Congress enacted a law that prohibits employers from asking about marital status and plans for having children Before the enactment of this legislation employers routinely solicited such information particularly from female job candidates The information is roughly correlated with the likelihood of withdrawal from the labor force and the employer39s motive in asking for it was to avoid investing in the hiring and training of workers who would not stay long Since the demographic information is costly to fake few people would refrain from marrying in order to appear less likely to drop out of the labor force it can be a signal between parties whose interests might be in con ict The purpose of the legislation was to prevent employers from favoring job candidates on the basis of demographic status Q Is the legislation likely to achieve its desired purpose The Stigma of the Newcomer The full disclosure principle also suggests why it might once have been more difficult than it is now to escape the effects of a bad reputation by moving In the current environment where mobility is high a dishonest person would be attracted to the strategy of moving to a new location each time he got caught cheating But in less mobile times this strategy would have been much less effective For when societies were more stable trustworthy people had much more to gain by staying put and reaping the harvest of the good reputation they worked to develop In the same sense that it is not in the interests of the owner of a good car to sell it was not in the interests of an honest person to move In generally stable 3 environments movers like used cars were suspect Nowadays however there are so many external pressures to move that the mere fact of being a newcomer carries almost no such presumption Choosing a Relationship Most people want mates who are kind caring healthy intelligent physically attractive and so on Information about physical attractiveness may be gathered at a glance But many of the other traits people seek in a mate are difficult to observe and people often rely on behavioral signals that reveal them To be effective such signals must be costly to fake Someone who is looking say for a highly disciplined partner might thus do well to take special interest in people who run marathons in less than two and a half hours Even the degree of interest a person shows in a prospective partner will sometimes reveal a lot Groucho Marx once said he wouldn39t join any club that would have him as a member To follow a similar strategy in the search for a relationship would obviously result in frustration And yet Groucho was clearly onto something There may be good reasons for avoiding a seemingly attractive searcher who is too eager If this person is as attractive as he or she seems why such eagerness Such a posture will often suggest unfavorable values for traits that are difficult to observe The properties of effective signals thus make it clear why coyness within limits is so adaptive It is very difficult apparently for eager persons to disguise their eagerness The same properties also have 39 quot 39 for the 39 39 39 under which people search for partners An oft decried difficulty of modern urban life is that heavy work schedules make it hard for people to meet one another In response commercial dating services offer to match people with ostensibly similar interests and tastes Participants in these services are thus spared the time and expense of getting to know people with whom they have few interests in common They also avoid uncertainty about whether their prospective partner is interested in meeting someone And yet while marriages do sometimes result from commercial dating services the consensus appears to be that they are a bad investment The apparent reason is that without meaning to they act as a screening device that identifies people who have trouble initiating their own relationships To be sure sometimes a participant39s trouble is merely that he or she is too busy But often it is the result of personality problems or other more worrisome difficulties People who participate in dating services are indeed easier to meet just as the advertisements say But signaling theory says that on the average they are less worth meeting Conspicuous Consumption as Ability Signaling Example 248 Suppose that you have been unjustly accused of a serious crime and are looking for an attorney to represent you And suppose your choice is between two lawyers who so far as you know are identical in all respects except for their standard of consumption One of them wears a threadbare polyester suit off the rack and arrives at the courthouse in an 8 yearold Geo Metro The other wears an impeccably tailored Armani suit and drives a new BMW 745i Which one would you hire The importance of consumption goods as signals of ability will be different for different occupations Earnings and the abilities that count most among research professors are not strongly correlated and most professors think nothing of continuing to drive a 10yearold automobile if it still serves them reliably But it would be a big mistake for an aspiring investment banker to drive such a car in the presence of his potential clients This example makes it clear that a person39s incentive to spend additional money on conspicuous consumption goods will be inversely related to the amount and reliability of independent information that other people have about his abilities The more people know about someone the less he can in uence their assessments of him by rearranging his consumption patterns in favor of observable goods This may help explain why consumption patterns in small towns which have highly stable social networks are so different from those in big cities The wardrobe a professional person quotneedsquot in Ithaca for example costs less than half as much as the one that same person would need in Manhattan or Los Angeles Similarly because the reliability of information about a person increases with age the share of income devoted to conspicuous consumption should decline over time The more mature spending patterns of older people may say as much about the declining payoffs to ability signaling as about the increasing wisdom of age Note that conspicuous consumption as an ability signal confronts us with a prisoner39s dilemma The concept of a tasteful wardrobe like the notion of a fast car is inescapably relative To make a good first impression it is not sufficient to wear clothes that are clean and mended We must wear something that looks better than what most others wear This creates an incentive for everyone to save less and spend more on clothing But when everyone spends more on clothing relative appearance remains unchanged Econ 201 Lecture 19 Games and Strategic Behavior Thus far we have viewed economic decision makers as confronting an environment that is essentially passive But there exist many cases in which relevant costs and benefits depend not only on the behavior of the decision makers themselves but also on the behavior of others Example 191 Should the prisoners confess wo prisoners X and Y are held in separate cells for a serious crime that they did in fact commit The prosecutor however has only enough hard evidence to convict them of a minor offense for which the penalty is say a year in jail Each prisoner is told that if one confesses while the other remains silent the confessor will go scot free while the other spends 20 years in prison If both confess they will get an intermediate sentence say five years These payoffs are summarized in the payoff matrix below The two prisoners are not allowed to communicate with one another If the prisoners are rational and narrowly selfinterested what will they do Prisoner Y Confess Remain Silent C f 5 years 0 Vears for X on egg for each 20 years for Y Prisoner X 20 years for X 1 vear Remam Sllem 0 years for Y for each Their dominant strategy is to confess No matter what Y does X gets a lighter sentence by speaking ou if Y too confesses X gets five years instead of 2039 and if Y remains silent X goes free instead of spending a year in jail The payoffs are perfectly symmetric so Y also does better to confess no matter whatX does The difficulty is that when each behaves in a selfinterested way both do worse than if each had shown restraint Thus when both confess they get five years instead of the one year they could have gotten by remaining silent And hence the name of this game prisoner39s dilemma Example 192 Why do students have to wait in line overnight to buy Cornell hockey tickets Each year Cornell announces a time at which its ticket window will open for the sale of a limited number of hockey tickets for students Students show up more than 24 hours in advance to wait in line for these tickets even though no more tickets are available that way than if everyone had shown up only 1 hour in advance Suppose that if everyone shows up one hour in advance everyone has a 5050 chance of getting a ticket and that the odds of getting a ticket are the same if everyone shows up 24 hours in advance If you show up 24 hours in advance and everyone else shows up one hour in advance you are sure to get a ticket But if you show up 1 hour in advance and others show up 24 hours in advance you have no chance to get a ticket The same applies to other students Waiting only one hour has no cost to you But you would be willing to pay 40 to avoid having to wait 24 hours A 5050 chance of getting a ticket is worth 50 to you and a 100 percent chance of getting a ticket is worth 100 Other students value these outcomes just as you do What will happen Others Arrive 24 Arrive 1 hours early hour early Arrive 24 hours early 10 60 You Arrive 1 50 hour early 0 Everyone39s dominant strategy is to come 24 hours early and so this is the equilibrium outcome of the game But it would be better if everyone came one hour early Example 193 Why do hockey players vote in secret ballots for helmet rules even though they choose not to wear helmets when there is no rule Consider two hockey teams say the Bruins and Rangers each of whose players can choose to wear helmets or not Not wearing a helmet increases the odds of winning perhaps by making it slightly easier to see and hear or perhaps by intimidating opposing players on the view that it is not safe to challenge someone who is crazy enough to go without a helmet At the same time not wearing a helmet increases the odds of getting hurt If players value the higher odds of winning more than they value the extra safety explain why they will choose not to wear helmets even though the odds of winning when players on both sides wear helmets are no different from the odds when no one wears helmets Bruins Wear Don t Wear Helmets Helmets Wear second be Best for Bruins Helmets for 63011 Worst for Rangers Rangers Don39t WeaI Best for Rangers Third begt Helmets Worm for Bmlns for each The dominant strategy for each team is to go without helmets even though this combination of choices is worse for both teams than the alternative in which each team wears helmets Helmet rule tyranny of the majority No failure to have such a rule quottyranny of the individual quot Example 194 What kind of pistol will a duelist choose In centuries past a European gentleman39s response to a profound insult was to challenge the offending party to a duel Accompanied by their seconds the antagonists would typically assemble at dawn for their contest which was governed by several formal rules One specified the physical distance between the antagonists at the actual moment of the duel itself It called for them to stand back to back then march off a given number of paces before each turned to fire A second rule governed the characteristics of the guns employed Among other things it specified that the barrels of the guns must be smooth as opposed to having spiral grooves and it called for weapons that fired only a single shot Why these restrictions Your Opponent Multishot Singleshot revolver pistol Multishot Third best Best for you revolver for each Worst for 01313011th You Singleshot Best for opponent Second best pistol Worst for you for each The dominant strategy is for both to use multishot revolvers Yet the probability of dying is higher for both in that case than if each had used singleshot pistols and in each case their claim to have acted honorably is equally strong Example 195 Why do people shout at cocktail parties Whenever large numbers of people gather for conversation in a closed space the ambient noise level rises sharply After attending such gatherings people often complain of sore throats and hoarse voices from having to speak so loudly to be heard If everyone instead spoke at a normal voice level at cocktail parties they would avoid these symptoms and because the overall noise level would be lower they would hear just as well as when they all shout at one another So why do they shout Other Conversation Pairs Speak normally Speak more loudly Second best Best for others S k 11 pea norma y for you and others Worst for you You and your partner S k 1 d1 Best for you Third best pea more on y Worst for Others for you and others The dominant strategy for everyone is to speak more loudly But when all follow their dominant strategies we end up in the lower right cell of the payoff matrix a worse outcome than if everyone had continued speaking normally Nash equilibrium a combination of strategies such that each player39s strategy is the best it can choose given the strategy chosen by the other player In prisoner39s dilemmas the Nash equilibrium occurs when each player plays his dominant strategy Many games have a Nash equilibrium even though not every player has a dominant strategy Example 196 Should American spend more on advertising Suppose that United Airlines and American are the only carriers that serve the ChicagoSt Louis market and that their payoff matrix for their advertising decisions is as given below Does United have a dominant strategy Does American If each firm does the best it can given what it knows about the incentives facing the other what will happen in this game TWA Leave ad Raise ad spending spending the same Raise ad 3000 for United 8000 for United spending 8000 for TWA 4000 for TWA United LeaVe ad 4000 for United 5000 for United agendng 5000 for TWA 2000 for TWA e saIne American 39s dominant strategy is to raise its ad spending United however does not have a dominant strategy But since United can predict that American will follow its dominant strategy United39s best move is to leave its own ad spending the same Example 197 Should Michael accept Tom39s offer Tom and Michael are subjects in an experiment The experimenter begins by giving 100 to Tom who must then propose how to divide the money between himself and lLichael He can propose any division he chooses provided the proposed amounts are integers and he offers Michael at least one dollar Suppose he proposes X for himself and 100X for Michael Michael must then say whether he accepts the proposal If he does they each get the amounts proposed But if Michael rejects the proposal each player gets zero and the 100 reverts to the experimenter If Tom and Michael both know that they will play this game only once and that each has the goal of making as much money for himself as possible what should Tom propose The game tree for this example looks like this X for Tom 100X for Michael Michael accepts A B Tom proposes X for himself Michael refuses 100X for Michael 0 for Tom 0 for Michael 110mst aptsmonth Suppose Tom proposes 99 for himself 1 for lLichael 99 for Tom 1 for Michael Michael accepts A B Tom proposes 99 for himself Michael refuses 1 for Michael 0 for Tom 0 for Michael 110mst aptsmonth This is the most advantageous offer Tom can make and at point B Michael39s best bet is to accept it Michael39s problem is that he cannot make a credible threat to refuse Tom39s onesided offer Example 198 Should the business owner open a satellite of ce The owner of a thriving business wants to start up a satellite of that business in a distant city If she hires someone who manages the new office honestly she can afford to pay a weekly salary of 1000 a premium of 500 over what the manager would have otherwise been able to earn and still earn weekly financial return of 1000 for herself The owner39s concern is that she will not be able to monitor the behavior of the satellite manager and that this person would therefore be in a position to embezzle heavily from the business The owner knows that if the satellite office is managed dishonestly the manager can earn 1500 while causing the owner a financial loss of 500 per week If the owner believes that all managers are selfish incomemaximizers will she open the new office The game tree for the satelliteoffice game is shown below Manager manages honestly Owner gets 1000 manager gets 1000 C Owner opens Manager manages dishonestly A B satellite office Owner gets 500 manager gets 1500 Managerial candidate Owner does not promises to manage open satellite office honestly Owner gets 0 Manager gets 500 by workin elsewhere mm aptsmonth At point A the managerial candidate promises to manage honestly which brings the owner to point B where she must decide whether to open the new office If she opens it the manager is hired and we reach point C where the manager must decide whether to manage honestly If his only goal is to make as much money for himself as he can he will manage dishonestly bottom branch at point C since that way he earns 500 more than by managing honestly top branch at C So if the owner opens the new office she will end up with a financial loss of 500 If instead she had chosen not to open the office bottom branch at point B she would have ended up with a financial return of zero And since zero is better than 500 she will choose not to open the satellite office Econ 201 Lecture 25 Wage and Salary Determination Example 251 Brady39s Brick Company is one of hundreds of small firms that hire labor to mould bricks out of clay which are then sold in the world market for ten cents apiece Brady39s only costs are its labor costs and it has two brickmakers John and Sue Sue makes 40 bricks per hour and John makes 30 If the labor market for brickmakers is competitive how much will Sue and John be paid per hour The value of the extra bricks that Sue makes is 400 per hour and this will be her wage under perfect competition Any firm that paid her less would risk having her bid away by a competitor Any firm that paid her more would lose money by employing her Likewise the competitive equilibrium wage for John is 300 per hour In competitive labor markets workers are paid the value of what they add to the employer39s revenue In many production processes when a firm39s capital and other productive inputs are held fixed the productivity of each worker declines as the firm hires more workers This pattern is often called The Law of Diminishing Returns It explains why the world39s population cannot be fed by the amount of grain grown on a single acre of land now matter how many farm workers we employ Example 252 The Acme Widget Company sells widgets for 100 each and hires workers in a competitive labor market at a wage of 250hr The number of widgets varies with the number of workers as follows of workers widgetshr extra widgetshr 0 0 l 10 10 2 l6 6 3 20 4 4 22 2 5 23 1 How many workers should Acme hire Hiring the third worker adds 4 widgets per hour which boosts Acme39s revenue by 400hr Thus the benefit of hiring the third worker 400hr exceeds the cost 250hr Hiring the fourth worker adds only 200hr which is less that it costs So Acme should hire 3 workers Note that the number of workers hired depends not only on the amount of goods or services a worker produces but also on the extent to which buyers value those goods or services Example 253 Suppose the price of widgets rises to 2 each in the preceding example How many workers should Acme hire of workers widgetshr extra widgetshr 0 0 l 10 10 2 l6 6 3 20 4 4 22 2 5 23 l 6 23 0 Now the fourth worker makes 400hr worth of extra widgets so he should be hired The fifth worker adds only 200hr worth of widgets which is too little to cover his 250hr wage rate So Acme should now hire 4 workers instead of three Wgtllt D pIice X marginal product of labor Lgtxlt L Minimum Wages When the law prevents employers from paying a wage less than Wmin the result is for employers to demand fewer workers Unemployment results The workers who keep their jobs earn more than before Those who lose them earn less Whether workers as a whole earn more or less depends on the elasticity of demand for labor If elasticity is less than 1 workers earn more If more than 1 workers earn less gigs Unemployment D 39 Employment Lost surplus due to minimum wage Employment Example 254 In the labor market whose supply and demand curves are as shown by how much will the imposition of a minimum wage of 8hr reduce employer surplus By how much will it increase worker surplus w l hr D price x marginal product of labor 400 600 1200 L Person39hISda With no minimum wage both employers and workers receive a surplus of 1800day W 35 hr Employer surplus 1800day S Worker surplus 1 BOOday D price x marginal product of labor 600 1200 L personhrsday Following implementation of the 8hr minimum wage employer surplus falls to 800day while worker surplus rises to 2400day Employers thus lose 1000day while workers gain only 600day W gm E oner surplus 800day S 8 W rker surplus 2400day 6 g W l r l D price X marginal product i of labor l 400 600 1200 L personhrsday Example 255 Describe an alternative to the minimum wage that would make both workers and employers better off Employers could pay a tax of 800 per day which could be used to support an earnedincome tax credit of 800day for workers The minimum wage could then be removed which would restore the original equilibrium wage and employment lifted Net of the tax and credit workers would have a surplus of 2600day and employers would have a surplus of 1000dayior 200day more for each group than under the minimum wage Surplus with Surplus with Income Transfers Minimum Wage and No Minimum Wage Compensating Wage Differentials Example 256 There are two summer jobs open to the 20 Cornell undergraduates who live in a small Northeastern city lifeguards at the local beach 10 positions and garbage collectors for the municipal sanitation department 10 positions Skill requirements for the two jobs are the same and all 20 summer job seekers view the lifeguard job as the more desirable of the two What will happen if the city posts the same wage rate for the two jobs since the skill requirements are the same There will be 20 applicants for the lifeguard job none for the garbage job Example 257 If wages respond to supply and demand in the usual way how will the equilibrium wages for the two jobs differ The wage rate will be lower for lifeguards than for garbage collectors Compensating Differentials for Status Assumptions lWorkers value having high rank relative to their coworkers 2 No firm can force a worker to work for it Conclusion Lowranked workers in each firm will receive compensating wage differentials that re ect the burden of their low status Holmes can make 100 bricks per hour lO centsbrick He would be willing to sacrifice up to 30 percent of his pay to have high rank or to avoid having low rank among his co workers Watson can make 50 bricks per hour and would be willing to sacrifice up to 30 percent of his pay to have high rank or to avoid having low rank Working alone entails neither high rank nor low rank Holmes and Watson could each work alone and earn lOhr and 5hr respectively Would they be willing to work together at those wages Holmes would agree because he not only gets paid his VMP 10hr but he also gets to enjoy high rank for free Watson would refuse because he suffers the burden of low rank without any extra compensation He can escape low rank by working alone for 5hr Is there a better arrangement than for each to work alone and earn his VMP Holmes is willing to pay up to 03 X 10hr 3hr to enjoy top rank So his reservation wage in a firm in which he enjoyed high rank would be 7hr Watson would be willing to accept a payment as little as 03 X 5hr 150hr for occupying low rank Watson s reservation wage in a firm in which he had low rank would be 650hr The sum of their reservation wages in a firm consisting of the two men is thus 7hr 650hr 1350hr This is less than the sum of their VMPs lOhr 5hr 15hr Working together thus creates a gain of 15hr 1350hr 150hr Suppose Holmes and Watson work together and share the resulting squlus equally Holmes lOhr 3hr 075hr 775hr Watson 5hr 150hr 075hr 725hr Compared to the alternative of working alone each man enjoys an extra squlus of 075hr mummy The Wage Structure When Local Rank Matters Compensating Differentials for Morally Satisfying Work Example 258 After graduating from Cornell you plan to pursue a career in advertising You have two job offers one to write ad copy for the United Way the other to write copy for Camel Cigarette ads aim ed at the youth market Except for the subject matter of the ads working conditions are identical in the two jobs If the two jobs paid the same which would you choose Six hypothetical career decisions Ad copywriter for Camel Cigarettes Ad copywriter for the American Cancer Society Accountant for a large petrochemical co Accountant for a large art museum Language teacher for the CIA Language teacher for a local high school Recruiter for Exxon Recruiter for the Peace Corps Lawyer for the National Ri e Assn Lawyer for the Sierra Club Chemist for Union Carbide Chemist for Dow Chemical Reservation Pay Premiums for Sacrificing the Moral High Ground Percent choosing Median pay premium Average pay premium for switching for switching Amer Cancer Soc 882 15000yr 24333yr Artmuseum 794 5000yr 14185yr High school 824 8000yr 18679yr Peace Corps 794 5000yr 13037yr Sierra Club 941 10000yr 37129yr Dow Chemical 794 2000yr 11796yr Excludes one response of 1000000000000yr 1989 Starting Salaries for Private and Public Interest Lawyers lstYear Public Interest Lawyers American Civil Liberties Union New York 28000 Center for Constitutional Rights New York 29000 People for the American Way Washington DC 25000 Public Citizen Litigation Group Washington DC 21000 Source National Law Journal March 26 1990 6 lstYear Associates in Private Law Firms Millbank Tweed Hadley amp McCoy New York 83000 Skadden Arps Slate Meagher amp Flom New York 83000 Arent Fox Kintner Plotkin amp Kahn Washiington DC 66000 2000 signing bonus Dow Lohnes amp Albertson Washington DC 67000 Econ 201 Lecture 2 The Economic Naturalist Example 21 Why driveup 39 umuriue nave Braille dotsquot EllTjoa Example 22 Why are child safety seats required in cars but not in airplanes Greg Balet A mother cannot legally drive her 6monthold son to a nearby grocery store without first strapping him into a govemmentapproved safety seat Yet she can y with him from Miami to Seanle with no restraining device at all Why this difference In case of an accidentiwhether in a car or an airplaan infant who is strapped into a safety seat is more likely to escape injury or death than one who is unrestrained But the probability of being involved in a serious accident is hundreds of times higher when traveling by car than when traveling by air so the bene t of having safety seam is greater for trips made by car Using safety seats is also far more costly on plane trips than on car trips Whereas most cars have plenty of extra room for a s ety seat par t 39 ee to purchase an extra ticket to use one on an airplane Most parents appear unwilling to pay 600 more per trip for a small increment in safety either for themselves or their children Example 23 Why are Australian lms so good Br aker Morant Picnic at Hanging Rock The Lait Wav Strictly Ballroom Priscilla Queen of the Desert W Brilliant Career WMax Lantana Rabbit Proof Fence The Year of Living Dangerourly Marie 5 Wedd39 Shine Criteria for choosing a film to see 39 y a wellknown director Does it feature a favorite actor or actress s 39 dia Ha it gotten rave reviews in the me d of m Only Australian lms with a 39 in the IT 39 H good u m and word of mouth Example 24 Why do brides spend so much money on wedding dresses while grooms olten rent cheap tuxedos even though gro ms could potentially wear their tuxedos on many other occasions and brides will never wear their dresses again Jennil er Dulski T is is my alltime favorite economic naturalist question In attempting to answer it Ms Dulski began with the assumption that distinctive attire matters more for women an for men on important social occasions This might strike many as a heroic assumption but evolutionary biologism tell us that in largely monogamous s 39 su uman likely to be found on males than on females Ms Dulski reasoned that if men need not wear distinctive clothing on special 2 occasions a rental company could serve their fashion needs at relatively modest prices Thus by focusing on only a few variants of the standard men s tuxedo a company could maintain a sufficiently large inventory to accommodate clients of a wide variety of sizes at rental prices that average roughly onequarter of the garment s purchase price If the goal were to appear in distinctive attire however it would be necessary to hold an inventory in which numerous different styles were available in all different sizes Since this would require an inventory possibly dozens of times larger than the corresponding tuxedo inventory to serve a given volume of rentals a rental price that covered costs would have to be perhaps three or four times a garment s purchase price And this she concluded is why women buy and men rent A ain I stress that whether this is the correct explanation for the observed pattern is less important than the fact that Ms Dulski s question itself is interesting and that her proposed answer is economically plausible mainland to Hawaii Karen Hlt tl Most people whose trips originate on the mainland are on vacation when they fly to Hawaii Ms Hittle reasoned while those whose trips originate in Hawaii are far more likely to be business or other nonleisure travelers The distinction is important because while trips taken on business typically entail destinations that are dictated by external circumstances vacation trips present travelers with an almost inexhaustible choice of destinations As a result the price elasticity of demand tends to be higher for leisure than for business travelers And this according to Ms Hittle is what accounts for the higher prices on flights that originate in Hawaii Example 25 Why are roundtrip fares from Hawaii to the mainland higher than the corresponding fares from the e Another airline example Example 26 Why do airlines charge much more for tickets purchased at the last minute while Broadway theaters follow exactly the opposite practice Gerasimos Efthimiatos In both cases firms face downwardsloping demand curves and thus stand to gain if they can segregate buyers with high reservation prices from those with low reservation prices But why would lastminute purchases be associated with lower reservation prices in the case of theater tickets but with high reservation prices in the case of airline tickets The answer according to Mr Efthimiatos stems in part from how a buyer s reservation price case is linked to her opportunity cost of time By waiting until the last minute to buy a theater ticket someone whose opportunity cost of time is high would risk wasting a valuable evening if a seat turned out to be unavailable and hence her willingness to pay a premium for an advance ticket Although she might also be willing to pay a premium to avoid missing a ight an offsetting factor seems even more important which is that those travelers whose opportunity costs of time are highestibusiness travelers for the most partitend also to be those who most often need to rearrange their travel schedules to accommodate lastminute contingencies By making discounts available only to those who are willing to commit to a specific travel schedule well in advance airlines are thus able to charge higher fares to those business travelers Most remaining business travelers are made ineligible for discounts by what for them proves an extremely effective hurdleinamely the Saturday night stayover requirement Since most vacation trips involve at least a weekend this hurdle is easily cleared by vacation travelers But having been away from their families during the week few business travelers are willing to extend their stay for the weekend just to receive a discount Example 27 Why do many people buy larger houses when they retire and their own children leave home Tobin Schilke Historically the pattern was for couples to move to smaller houses in warmer climates when they retired These days however couples are far more likely to sell the family home and then build or purchase a significantly larger one close by Why this change Mr Schilke speculated that it has been driven in part by changes in family structure It was once the norm for children to have at most four living grandparents With divorce and remarriage occurring at higher rates than in the past however it has become common for any given child to have six eight or even more living grandparents and step grandparents With a larger number of grandparents and essentially no change in the number of grandchildren we see excess demand on the part of grandparents for visits with their grand children By building conveniently located houses with plenty of guest space game rooms swimming pools and other kidfriendly amenities grandparents are in effect paying higher prices to satisfy their demand for visits with their grandchildren Example28 Why did paper towels replace hotair hand dryers in public restrooms in the 1970s Directions 1 Shake excess water from hands 2 Push start button 3 Rub hands together under hot air Push In the 1950s and 1960s paper towel dispensers were replaced by electric hotair hand dryers in many public restrooms More recently however it is the hotair dryers themselves that are being replaced by paper towel dispensers e explanation for these movements naturally has to do with the costs and benefits of the different methods of drying hands The hotair dryers made their original appearance on the heels of a steady decline in the price of electricity When power became cheap as it did in the 50s and 60s electric dryers became less expensive to operate and maintain than the traditional paper towel dispensers With the Arab oil embargoes of the 1970s however the price of energy rose dramatically making paper towels once again the handdrying method of choice ome economic naturalists may also find it amusing to speculate about why the paper towel dispensers of today are so different from the earlier ones Most current designs feature a continuous hand crank The paper is inside on a roll and the longer you turn the crank the longer sheet of paper towel you get Older designs also had a roll of paper inside but you had to pull the paper out by hand Most of the older models would also release only a limited amount of paper with each pull To get more you had to reset the release mechanism by pushing a button on the front of the dispenser The advantage of the older design from the establishment39s point of view was that it induced people to use less paper Indeed if your hands were wet enough it was difficult to get any paper at all because when you pulled the wet paper would simply tear away in your hands But if establishments saved on paper with the old design why have they switched to the new The answer is that saving on paper is not their only objective They also want satisfied customers Incomes are higher now than they were 30 years ago and customers are willing to pay more for a more convenient way of drying their hands The current design may use a little more paper but it is so much less frustrating that customers seem happy to pay more for their meals or their gasoline in order to cover the extra costs Some people may respond that the old design infuriating though it was was better because of its papersaving property These people feel that it is wrong to waste paper and that we ought to be willing to tolerate plenty of inconvenience to avoid doing so The same people also often lament the thousands of trees that must be cut down in order to print each Sunday39s New York Times But trees are a renewable resource which means there is no reason to treat them differently from any other scarce but renewable resource When the demand for paper is high we cut down more trees to be sure But the market also provides a strong incentive to plant new ones The irony here is that the more paper we use the more trees we have If every metropolitan newspaper were to cease publication tomorrow we would ultimately have fewer acres of forest not more Example 29 Why is airline food so bad 7 7 Everyone complains about airline food Indeed if any serious restaurant dared to serve such food it would go bankrupt in an instant Our complaints seem to take for granted that airline meals should be just as good as the ones we eat in restaurants But why should they The costbenefit perspective makes clear that airlines should increase the quality of their 4 meals if and only if the benefits would outweigh the costs of doing so The benefits of better food are probably well measured by what passengers would be willing to pay for it in the form of higher ticket prices If a restaurantquality meal could be had for a mere 5 increase in costs most people would probably be delighted to pay it The difficulty however is that it would be much more costly than that to prepare significantly better meals at 39000 feet in a tiny galley with virtually no time It could be done of course An airline could remove 20 seats from the plane install a modern wellequipped kitchen hire extra staff spend more on ingredients and so on But these extra costs would be more like 50 per passenger than 5 For all our complaints about the low quality of airline food few of us would be willing to bear this extra burden The sad result is that airline food is destined to remain unpalatable because the costs of making it better outweigh the benefits Many of us respond warmly to the maxim quotAnything worth doing is worth doing well After all it encourages a certain pride of workmanship that is often sadly lacking As the airline food example makes clear however when the maxim is interpreted literally it makes no sense It is completely unmindful of the need to weigh costs against benefits To do something well means to devote time effort and expense to it But time effort and expense are scarce To devote them to one activity makes them unavailable for another Increasing the quality of one of the things we do thus necessarily means to reduce the quality of others yet another application of the concept of opportunity cost Every intelligent decision must be mindful of this tradeoff Everything we see in life is the result of some such compromise For Serena Williams to play tennis as well as she does means that she cannot become a concert pianist And yet this obviously does not mean that she shouldn39t spend any time playing the piano It just means that she should hold herself to a lower standard there than in the tennis arena Should I increase the quality of the meals Bx same as in restaurants on the ground Cx much higher than for restaurants on the ground because of space constraints 39t of quality Benefit of an additional unit Cost of an additional unit in the air Cost of an additional unit on the groun Quality Example 210 Why do most manual transmissions have five forward speeds most automatics only four AUZJU39U he more forward speeds a car39s transmission has the better its fuel economy The additional gears act like the quotoverdrivequot of cars of the 1940s conserving fuel by allowing cars to cruise at highway speeds at lower engine speeds Most cars in current production offer five forward speeds on their manual transmissions but only three or four speeds on their automatics Since fuel economy is obviously a good thing why limit the number of speeds on automatics The reason is that fuel economy is not our only objective We also want to keep the price of the car within limits Automatic transmissions are much more complex than manual ones and the cost of adding an extra speed is accordingly much greater in the former The benefits of adding an extra speed by contrast are the same in both cases If car makers 5 follow the rule quotAdd an extra speed if its benefits outweigh its costs then automatics will have fewer speeds than manuals The reasoning in this example also helps make clear why many manual transmissions now have five forward speeds when 20 years ago most had only three and many automatic transmissions only two The benefit of adding an extra speed again is that it increases fuel economy The value of this benefit in dollar terms thus depends directly on the price of fuel The price of gasoline relative to other goods doubled during the l970s and this helps explain why transmissions have more speeds than they used to Example 211 Why does a telecommunications equipment manufacturer offer free BMW sedans to employees with more than one year of service Arcnet Inc a New Jersey company that designs and builds wireless telecommunications systems provides a quotfreequot BMW sedan to every employee with at least one year of service The cars are not really free of course Each one costs the company about 9000 a year in leasing and insurance fees and employees who get one must declare that amount as additional income each year to the Internal Revenue Service So we39re left with a puzzle If the company had given not the car but an additional 9000 a year in salary instead no one should have been worse off and at least some should have been better off After all any worker who really wanted a BMW could have spent the extra cash to lease one Others who happen not to want a BMW would have come out ahead by having 9000 a year extra to spend on other things So why give cars instead of cash Essentially the same question is raised by ordinary gift exchanges among family and friends Why give someone a necktie he might never wear when you know you could trust him to spend the same money on something he really wants Some would answer that giving cash is just too easy and is hence a less effective way of demonstrating affection than taking the time and trouble to shop for a gift That explanation might work for small gifts but is surely a stretch for luxury cars A more promising tack was suggested by Richard Thaler 1985 who observed that the best gifts are often things we don39t dare buy for ourselves Why for example is a man happy when his wife gives him a 1000 set of titanium golf clubs paid for out of their joint checking account Perhaps he really wanted those clubs but couldn39t quite justify spending so much on himself The plausibility of this way of thinking about gift giving is affirmed by the advice it suggests for gift givers For example consider this thought experiment Among each of the following pairs of items costing the same amounts which item would be the more suitable gift for a close friend 20 worth of Macadamia nuts 1 pound or 20 worth of peanuts 10 pounds A 75 gift certificate for one of the nicest restaurants in town one lunch or a 75 gift certificate for McDonalds l5 lunches 30 worth of wild rice 3 pounds vs 30 worth of Uncle Ben39s converted rice 50 pounds For most people the first item in each pair is almost surely the safer choice Arcnet and other employers may be giving away BMWs for essentially similar reasons An employee might find it awkward to explain to his depressionera parents why he had bought a car costing almost twice as much as a Honda Accord Or he may worry that buying a new BMW might make his neighbors think he was putting on airs Or perhaps he really wants to buy the new BMW but his wife insists on remodeling the kitchen instead A gift car from his employer erases all these concerns and more Further examples Why despite the proliferation of electrical appliances in the last century do electrical outlets in newly built houses still have only two receptacles Beth Wollberg Why do top female models earn so much more than top male models Fran Adams Why aren t NFL kickers paid the same as leading scorers in other sports Ed Kline Why didn t anyone sign up for Thanksgiving dinner Anita Lee Why won t the Chicago Cubs ever win a World Series Paul Snyder Seven Important Ideas The Scarcity Principle Having more of one good thing usually means having less of another The CostBene t Principle Take no action unless its marginal benefit is at least as great as its marginal cost The N otAllCostsMat terEqually Principle Some costs eg opportunity and marginal costs matter in making decisions other costs eg sunk and average costs don t The Principle of Comparative Advantage Everyone does best when each concentrates on the activity for which he or she is relatively most productive The Principle of Increasing Opportunity Cost Use the resources with the lowest opportunity cost before turning to those with higher opportunity costs The Equilibrium Principle 6 A market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gains achievable through collective action The Ef ciency Principle Efficiency is an important social goal because When the economic pie grows larger everyone can have a larger slice Econ 201 Lecture 27 Public Goods Public goods are those goods or services that possess in varying degrees the properties of nondiminishability and nonexcludability Nondiminishability any one person39s consumption of a public good has no effect on the amount of it available for others Ex mples WVBR s radio signal National defense Nonexcludability it is either impossible or prohibitively costly to exclude nonpayers from consuming the good Examples WVBR s radio signal National defense Goods that have high degrees of both of these properties are often called pure public goods like the radio and defense examples given Goods that have only the nondiminishability property are sometimes referred to as collective goods Example Payperview TV programs Collective goods are sometimes provided by government sometimes by private companies Most pure public goods are provided by government but as in the case of the radio example profitseeking companies often find ways to provide them Example 271 Jones and Smith are the only two residents of their village There is a security device that will alert them to the presence of trespassers on their respective properties which are contiguous The cost of the device is 100 Its value to Jones who is poor is 30 its value to Smith who is rich is 90 Would either person be willing to purchase the device individually No Its cost is higher than the value to either individual Example 272 Is it efficient for the two together to purchase it Yes because its total value 120 exceeds its cost 100 Unfortunately it is often impractical for private citizens to negotiate for the joint purchase of goods or services This is especially likely when large numbers of people are involved Communications costs The freerider problem each individual39s contribution is an insignificant part of the total required Each thus has an incentive to hold back in the hope that others will contribute Bargaining problems Even when only few people are involved it may be difficult to reach agreement on what constitutes a fair sharing of the total expense When these problems arise governments may use tax revenues to buy public goods on the public39s behalf Even when government acts as the public39s purchasing agent political agreement must be reached on how public purchases are to be financed Example 273 Suppose there is a quotgovernmentquot in charge of providing the security device of Example 271 Suppose also that the government is not empowered to collect more in tax revenues from any one citizen it does from any other If citizens must approve all government spending projects by majority vote will this government be able to provide the security device that Smith and Jones want If the government must tax all citizens equally it would have to raise 50 from Smith and 50 from Jones But since the device is worth only 30 to Jones he will vote against this project thus denying it a majority Example 274 Jones who is poor proposes that the government raise revenue by imposing a proportional tax on income For example if the tax rate is 05 and the incomes of Jones and Smith are 5000 and 15000 their tax bills will be 25 and 75 respectively Will Smith support J ones39s proposal Yes because if he doesn39t the two would repeatedly fail to get public goods whose benefits exceed their costs Example 275 Suppose Julie earns 100000yr while her husband Bruce earns only 15000 Given her income Julie as an individual would want to spend much more than Bruce would on housing travel entertainment and the many other items they consume in common What will happen if the couple adopts a rule that each must contribute an equal share toward the purchase of such items The result will be to constrain the couple to live in a small house to take only inexpensive vacations to skimp on entertainment dining out and so on And so it is easy to imagine that Julie would find it attractive to pay considerably more than 50 percent for jointly consumed goods thereby to enable both of them to consume in the manner their combined income affords 262 As in the case of private goods the willingness to pay for public goods is generally an increasing function of income The rich on the average assign greater value to public goods than the poor do not because they have different tastes but because they have more money A tax system that taxed the poor just as heavily as the rich would result in the rich getting smaller amounts of public goods than they want Rather than see that happen the rich would gladly agree to a tax system that assigns them a larger share of the tax burden It would be missing the point to criticize such a system by saying that it is unfair because it enables the poor to enjoy the services of public goods for a smaller price It does have this property to be sure39 but from the viewpoint of the rich its terms are still attractive because the tax payments of the poor though small mean the rich end up paying less than if they had to finance public goods all by themselves The Optimal Quantity of a Public Good Example 276 If the marginal cost and marginal willingnesstopay curves for public television programming are as shown in the diagram what is the optimal quantity of programming 1000s Marginal 1W Cost 70T Marginal 40 E Willingness l tquotPay i H Hours of Public TV Private Provision of Public Goods vernments are not the exclusive providers of public goods in any society Substantial quantities of such goods are routinely provided through a variety of private channels If it is impractical to exclude people from consuming a public good the pressing question is how can the good be paid for if not by mandatory taxes Funding by Donation Gifts to private charities Volunteer wor Painting your house Mowing your lawn Planting a flower garden Sale of Byproducts Radio and television advertising Example 277 In a given time slot a television network faces the alternative of broadcasting either the Jerry Springer Show or Masterpiece Theater If it chooses Springer it will win 20 percent of the viewing audience but only 18 percent if it chooses Masterpiece Theater Suppose those who would choose Springer would collectively be willing to pay 10 million for the right to see that program while those who choose Masterpiece Theater would be willing to pay 30 million And suppose finally that the time slot is to be financed by a detergent company Which program will the network choose Which program would be socially optimal The sponsor cares primarily about the number of people who will see its advertisements and will thus choose the program that will attract the largest audience here the Springer Show The fact that those who prefer Masterpiece Theater would be willing to pay a lot more to see it is of little concern to the sponsor But this difference in willingnesstopay is critical when it comes to determining the optimal result from society39s point of view Because the people who prefer Masterpiece Theater could more than compensate the Springer viewers for relinquishing the time slot Masterpiece Theater is the efficient outcome But unless its supporters happen to buy more soap in total than the Springer viewers the latter will prevail The difficulty with reliance on advertising and other indirect mechanisms for financing public goods is that there is no assurance that they will re ect the relevant benefits to society Development of New Means to Exclude NonPayers Scrambled TV signals But note that while the outcome of payperview TV is more efficient in the sense of selecting the programs the public most values it is less efficient in one other important respect By charging each household a fee for viewing it discourages some households from tuning in And since the marginal social cost of an additional household watching a program is exactly zero it is inefficient to limit the audience in this way Which of the two inefficiencies is more important free TV39s inefficiency in choosing between programs or pay TV39s inefficiency in excluding potential beneficiaries is an empirical question 0C0ntracting Condominiums and Cooperatives Painting gardening and other maintenance are provided under the terms of the standard contract RentSeeking As a practical matter the gains from public projects are often large and concentrated in the hands of a few whereas the costs while also large are spread among many e prospective beneficiaries of a public program thus have powerful incentives to lobby government in favor of it while each of the prospective losers has too little at stake to bother about The result all too frequently is that projects are approved even when their benefits do not exceed their costs A related difficulty arises in the case of similar projects whose benefits do exceed their costs Because there are large gains to be had from the project private parties are willing to spend large sums in order to enhance their odds of being chosen as its beneficiaries Pursuit of these gains goes by the name of rentseeking consequence of rentseeking is that the expected gains from government projects are often squandered by the competition among potential beneficiaries Example 278 A dollar bill is to be auctioned off to the highest bidder The minimum bid is 5 cents and succeeding bids must exceed the previous high bid by at least 5 cents When the bidding ceases both the highest bidder and the second highest bidder must give the amounts they bid to the auctioneer The highest bidder then receives the dollar and the second highest bidder gets nothing Thus for example if the highest bid is 50 cents and the secondhighest bid is 45 cents the winner earns a net payment of 50 cents and the runnerup loses 45 cents How high will the winning bid be on the average Example 279 Three firms have met the deadline for applying for the franchise to operate the cable television system for Cedar Rapids during the coming year The franchise lasts for exactly one year during which time the franchisee can expect to make a profit of 3 million The city council will choose the applicant that spends the most money lobbying city council members If the applicants cannot collude how much will each spend on lobbying If all three applicants spend the same each will have a 1 in 3 chance of earning 3 million in profit which means an expected profit of 1 million 1f the lobbyists could collude each would agree to spend the same small token amount on lobbying But in the absence of a binding agreement each will be strongly tempted to try to outspend the others Once each firm39s spending reaches 1 million each will have expected profits of zero a onethird chance to earn 3 million minus the 1 million spent on lobbying Further bidding would guarantee an expected loss And yet if any one of the three spent 1000001 while the other two stayed at 1 million it would get the franchise for sure and earn a net profit of 1999999 The losers would each have losses of 1 million Rather than face a sure loss of 1 million the losers may well bid 1000001 themselves Where this process will stop is anyone39s guess but it is certain is to dissipate some or all of the gains that could have been had from the project From the viewpoint of any individual firm it is perfectly rational to lobby in this fashion for a chance to win government benefits From the standpoint of society as a whole however such activity is almost completely wasteful The efficient government is one that takes every feasible step to discourage rentseeking for example by selecting contractors on the basis of the price they promise to charge not on the amount they lobby Methods of Income Redistribution Our current welfare programs are meanstested The more income you have the smaller your benefits are The point of this feature is to avoid paying benefits to those who don39t really need them But because of the way welfare programs are administered means testing often has pernicious effects on work incentives Example 2710 Smith is an unemployed participant in four welfare programs Food stamps rent stamps energy stamps day care daycare stamps Each program gives him 100mo worth of stamps which he is then free to spend on food rent 264 energy and daycare If Smith becomes employed and earns income his benefits in each program are reduced by 50 cents for each dollar he earns How will his net income change if he accepts a job that pays 50wk He will lose 25 in benefits from each of the four welfare programs for a total benefit reduction of 100 Taking the job thus leaves him 50wk worse off The Negative Income Tax Milton Friedman has proposed that our current welfare programs be replaced by a single program called the negative income tax NIT Under NIT eve man woman and child rich or poor receives an incometax credit that is large enough to sustain a minim ally adequate standard of living Someone who earned no income would receive this credit in cash People with earned income would then be taxed on their income at some rate less than 100 percent The initial credit and the tax rate combine to determine a breakeven income level at which each person39s tax liability exactly offsets his initial tax credit People earning below that level would receive a net benefit payment from the government while those earning more would make a net tax payment Example 2711 What is the breakeven level of earned income in an NIT program with a tax credit of 4000yr and a tax rate of 50 How large a net benefit would be received by a person earning 4000yr How large a net tax payment would be owed by a person earning 12000yr Aftertax income 35 yr Aftertax income 10000 8000 6000 I I I I 4000 I I 45 I 4000 8000 12 000 Beforetax income SSyr A Problem with the NIT Although the incentive problem is less severe under the NIT than under our current welfare programs it remains a serious difficulty If the NIT is to be the sole means of insulating people against poverty its payment to people with no d income must be at least as large as the poverty threshold And if the payment is large enough to live on it will inevitably induce many people to stop working The importance of this problem was confirmed by Federal experiments with the NIT during the 1970s Although the labor force withdrawals observed in these experiments were smaller than predicted by the NTT39s fiercest critics they were nonetheless substantial Public Employment for the Poor JOBS JOBS government sponsored jobs that pay wages in return for the performance of useful work Completely solves the incentive problem Criticisms of JOBS People will leave private jobs for government jobs thus making the program too expensive Unattractiveness of makework jobs Bureaucratic inefficiency A Combination of NIT and JOBS Too many people leave private jobs Set JOBS wage well below minimum wage Bureaucratic inefficiency Solicit bids from private contractors to manage JOBS program Makework jobs Landscaping and maintenance in parks Transport the elderly and handicapped Fill potholes in city streets Replace burned out street lamps Transplant seedlings in erosion control projects Remove graffiti from public places Paint government buildings Recycle newspapers and aluminum and glass containers Staff day care centers Make NTT grant too small to live on NIT Private J ob NIT Public Job Poverty IIIIIIIIIIIIIIIIIIIIIIIII Threshold Public Job NIT W A NIT with a cash grant far too small to live on would not encourage people to drop out of the labor force Nor would a governmentsponsored job at subminimum wages lure productively employed workers out of private sector jobs But the combined income from both programs would be sufficient to lift people above the poverty threshold And because of the low pay in public jobs participants would have strong incentives to continue searching for jobs in the private sector Local Public Goods and the Tiebout Model With respect to public goods provided at the local level Professor Charles Tiebout suggested that at least some of the painful decisions about which goods to provide can be avoided if people are free to form communities with others of similar tastes Those who favor high levels of public goods can group together in communities in which they willingly accept the high tax rates necessary to finance these levels And others who favor a more limited menu of public goods and services can form groups of their own and have lower tax rates As an empirical matter local governments do differ widely with respect to the level of public goods they provide Even so there are practical difficulties with the notion of trying to tailor a local environment to precisely one39s own preferences Consider for example the issue of public support for the poor People have legitimate differences over what this level of support should be But those who favor high levels of support often take on more than they bargained for when they enact generous welfare policies at the local level The difficulty is that such policies attract new lowincome beneficiaries from other jurisdictions with lower benefits This in turn makes it necessary to raise tax rates which leads some upperincome taxpayers to leave further exacerbating the fiscal imbalance The ability to form local communities of likeminded voters softens the need to compromise in some areas but by no means eliminates it Econ 201 Lecture 9 The Law ofDemand People do less of what they want to do as the cost of doing it rises The cost of an activity good or service involves not just monetary costs but nonmonetary costs as well Example 91 quotFreequot HaagenDas ice cream To help celebrate the reopening of Beebe Lake the local HaagenDas supplier set up a booth next to the lake and offered free ice cream Who was pleased about this offer Who was displeased quotNeedsquot vs quotWantsquot quotCalifornians don39t have nearly as muchwater as they need quot vs quotCalifornians don39t have nearly as much water as they want when the price of water is very low Rice farming in the Sacramento valle Lush landscaping in San Diego vs sparse landscaping in Santa Fe The Rational Utility Maximizer 1 Utility increases with consumption 2 Beyond some point the additional utility from extra consumption declines De nition The marginal utility from consuming a good is the additional utility that results from consuming an additional unit of the good De nition The law of diminishing marginal utility says that as consumption of a good increases beyond some point the additional utility that results from an additional unit of the good declines Exceptions to the law of diminishing marginal utility The unfamiliar food or melody utilsWk consumption Example 92 How many ostrich burgers should Tom consume each week and how many mango milkshakes Tom derives all of his nourishment from only two foods ostrich burgers and mango milkshakes His utility from consuming each depends on the amount he consumes in the manner shown in the table below Ostrich burgers cost 8 per pound and mango milkshakes cost 4 per pint If Tom has 20 per week to spend on food What combination of the two should he eat Method 1 First list all the combinations of burgers and shakes that cost 20Wk and then see which one delivers the highest total utility Tom s optimal combination is to consume 15 pounds of ostrich burger each week and 2 pints of mango milkshake His total utility from this combination is 50 utils per week more than he could have gotten from any of the other possible combinations De nition The optimal combination of goods is that combination that yields the highest total utility among all the affordable combinations Method 2 To achieve the highest possible utility from a given expenditure divide your purchases among goods so that the marginal utility of the last dollar spent on each good is as large as possible 1f Tom directs his next purchase toward the category with the highest 1U he will end up consuming 15 pounds per week of ostrich burger and 2 pints of mango milkshake When the quantity of each good can be varied continuously we have The Rational Spending Rule pending should be allocated across goods so that the marginal utility per dollar is the same for each good Example 93 Is Sue maximizing her utility from consuming cashews and pistachios Cashew nuts sell for 8 per pound and pistachios sell for 4 per pound Sue has a budget of 800 per year to spend on nuts and her marginal utility from consuming each type of nut varies with the amount consumed as shown in below If she is currently buying 80 pounds of cashews and 40 pounds of pistachios each year is she maximizing her utility Marginal utility of Marginal utility Of ca hews utilslb pist hios utilslb 20 XI 16 I I l l 8 0 iuyr 40 lbyr With 80 pounds per year of cashews and 40 pounds of pistachios Sue is spending her entire 800 annual budget for nuts But because her marginal utility from pistachios is 16 utils per pound and because pistachios cost 4 per pound her current spending on pistachios is yielding additional utility at the rate of 16 utilspound4pound 4 utils per dollar By the same token because Sue s marginal utility for cashews is 20 utils per pound and because cashews cost 8 per pound her current spending on cashews is yielding only 20 utilspound8pound 25 utils per dollar Thus her current spending yields higher marginal utility per dollar for pistachios than for cashews And this means that Sue cannot possibly be maximizing her total utility To see why note that if she spent 8 less on cashews one pound less than before she would lose about 20 utilsl39 but with the same 8 she could buy two additional pounds of pistachios which would boost her utility by about 32 utilsz for a net gain of about 12 utils Under Sue s current budget allocation she is thus spending too little on pistachios and too much on cashews 1 The actual reduction would be slightly larger than 16 utils because her marginal utility of cashews rises slightly as she consumes less of them 2 The actual increase will be slightly smaller than 24 utils because her marginal utility of pistachios falls slightly as she buys more of them In the next example we investigate what happens if Sue spends 16 per year less on cashews and 16 per year more on pistachios Example 94 Is Sue maximizing her utility from consuming cashews and pistachios 11 Sue s total nut budget and the prices of the two types are the same as in Example 93 If her marginal utility from consuming each type varies with the amount consumed as shown below and if she is currently buying 70 pounds of cashews and 60 pounds of pistachios each year is she maximizing her utility Marginal utility 0f Marginal utility of ca heWS utllSlb pist hios utilslb I 1 40 60 WW When Sue increases her consumption of pistachios her marginal utility of pistachios falls Conversely when she reduces her consumption of cashews her marginal utility of cashews rises Note first that the direction of Sue s rearrangement of her spending makes sense in light of Example 93 in which we saw that she was spending too much on cashews and too little on pistachios Spending 16 less on cashews causes her marginal utility from cashews to rise from 20 to 28 utils per pound Spending 16 more on pistachios causes her marginal utility from pistachios to fall from 16 to 8 utils per pound Both movements are a simple consequence of the law of diminishing marginal utility Since cashews still cost 8 per pound her spending on cashews now yields additional utility at the rate of 28 utilspound8pound 35 utils per dollar Similarly since pistachios still costs 4 per pound her spending on pistachios now yields additional utility at the rate of only 8 utilspound4pound 2 utils per dollar So at her new rates of consumption of the two types of nuts her spending yields higher marginal utility per dollar for cashews than for pistachiosiprecisely the opposite of the ordering we saw in Example 93 Sue has thus made too big an adjustment in her effort to remedy her original consumption imbalance Example 95 Is Sue maximizing her utility from consuming cashews and pistachios Ill Sue s total nut budget and the prices of the two avors are again as in Examples 93 and 94 If her marginal utility from consuming each type varies with the amounts consumed as shown below and if she is currently buying 50 pounds of pistachios each year and 75 pounds of cashews each year is she maximizing her utility Marginal utility of Marginal utility of cashews ut11slb pist hios utilslb 24 I I 7395 10 yl 50 lbyr This time Sue has it just right At her current consumption levels marginal utility per dollar is exactly 3 utils per dollar for each type of nut The Rational Spending Rule The Rational Spending Rule can be expressed in the form of a simple formula If we use M39Uc to denote marginal utility from cashew consumption again measured in utils per pound and PC to denote the price of cashews measured in dollars per pound then the ratio MUGPC will represent the marginal utility per dollar spent on cashews measured in utils per dollar Similarly if we use 1IUp to denote the marginal utility from pistachio consumption and Pp to denote the price of pistachios then MlpPp will represent the marginal utility per dollar spent on pistachios The marginal utility per dollar will be exactly the same for the two typesiand hence total utility will be maximizediwhen the following simple equation is satisfied The Rational Spending Rule for two goods MUch MUpPp The rational spending rule is easily generalized to apply to spending decisions regarding large numbers of goods In its most general form it says that the ratio of marginal utility to price must be the same for each good the consumer buys If the ratio were higher for one good than for another the consumer could always increase her total utility by buying more of the first good and less of the second The Rational Spending Rule for two goods X and Y MUXPX MUyPy Suppose MUXPX gt MUyPy Then you can increase total utility by spending a dollar less on Y and a dollar more on X Suppose MUXPX 3 gt MUYPY 2 Then by spending a dollar less on Y lose 2 utils and a dollar more on X gain 3 utils you can achieve a net gain of l util for the same expenditure The Rational Spending Rule for N goods llU1P1 MlzPz lTUNPN 1 Evan 2m Lenin 22 m Tngadyufdlz Cummuns Exampk 221 A v111g1 1111M 111111111 1151 111511111 1111 15511111111111 savmgs 11111111 51511 v1111g11 111s 1W1 1nVestxnent 11111111111111 1 Euy guvemmentbandfm smn 1111151511295 111mm year 1111 11511 W 12111111115111 Eelwezn Had she Sdling Price 1111 Pm lper 51111 Number ufsteexs Pncepex 2rye1p pmmpu 111111 cam 1111 51111 51111 1 12m 211 2 115 15 2 114 14 4 112 12 5 1m 1m Send 51111111111 mly1fpnce 1227y11171111 5122115 11111 112 gt 511114 steers 71111 v1111g1 meame 12 412 5 55111 steers Dump 1 222 1n 1111 preceding 2x 1111911 112111111 111 sacn y 1151111 11111511 12 5mm 111111511 ufsteers p11ng 27y1117 pmmpu 111111 5111111111 1111 51111 51111 1 12m 211 2 115 15 2 114 14 4 112 12 5 Mn 1n Thuswe 111111111 11111 1 1151111 5111 5151151 1111111 7111111151111 522 525 552 9111 11111 5111111511 112111111 111w been amiable m 111 steers already an 1111 5511111115 15 11151 1111 111111111 1125111111111 111111111n11 1111111 111 15 111111111 2 Examples of Tragedies of the Commons Harvesting timber on public land each tree cutter knows that a tree not harvested this year will be bigger and hence more valuable next year But he also knows that if he doesn39t cut the tree down this year someone else will Picking blackberries in a public park each individual knows that the blackberries would taste better if allowed to ripen for another week but each also knows that blackberries not eaten today may not be there next week Harvesting whales in international waters each individual whaler knows that harvesting an extra whale reduces the breeding population of whales and hence the size of future whale populations but he also knows that any whale he fails to harvest today will just be taken by some other whaler Environmental pollution each individual polluter has no incentive to take into account the cost his pollution imposes on others Clearly de ned property rights are one way to solve the tragedy of the commons Weyerhauser doesn39t cut trees down too quickly on its own land People don39t harvest blackberries to soon from their backyard garden People don39t dump toxic wastes into their own swimming pools Regulation also plays a role Fishing licenses limit the amount of fish that can be taken Laws regulate the use of air and water pollutants Zoning laws limit the size and other features of buildings signs landuse patterns etc Taxes force people to account for how their actions affect others Example 224 In the cattlegrazing economy considered earlier suppose there is now a 25 tax on income earned from cattle If people decide individually between bonds and cattle how many steers will be sent onto the commons Number of steers Price per Aftertax profit on the commons 2yearold with 25 tax steer on cattle income 1 120 15 2 116 12 3 114 1050 4 112 9 5 110 750 With a 25 tax on income from cattle grazing individuals will send only 2 steers onto the commons and this is the socially optim al number Total income 312 212 8 68 bonds cattle tax One of the continuing sources of inefficiency in modern economies involves the allocation of resources that no single nation39s property laws and regulations can govern Several species of whales have been hunted to near extinction because international laws of property are insufficient to restrain individual incentives to kill whales The Mediterranean Sea has long had serious problems with pollution because none of the many nations that border it has an economic incentive to consider the effects of its discharges on other countries As the world39s population continues to grow the absence of an effective system of international property rights will become an economic problem of increasing significance Positional Externalities 24hour grocery stores Example 225 Ithaca has seven large supermarkets five of which are open 24 hours a day The convenience of an allnight shopping option could be maintained at lower cost if all but one of these stores were to close during the latenight hours Why doesn39t this happen Most people do the bulk of their shopping at a single store If other factors are equal people will choose the store with the most convenient hours Wegmans Close at Close at Midnight 100 AM Close at Second best BeSt for wegmans Midnight for each Worst for Tops Tops close at Best for Tops Third best 1 00 AM Worst for Wegmans for eaCh In such situations the public might be well served by amending the antitrust laws to permit stores to limit hours perhaps through an agreement whereby each store serves in turn as the only allnight grocery Alternatively local statutes might achieve a similar purpose by limiting business hours Such statutes are often called quotblue lawsquot and remain on the books in many jurisdictions Cosmetic surgery Example 226 There were some two million cosmetic quotproceduresquot done in 1991 six times the numberjust a decade earlier Once carefully guarded secrets these procedures are now offered as prizes in charity raf es in southern California where morticians complain of their crematoria becoming clogged by the noncombustible silicone sacks used in breast augmentation surgery Is the amount of cosmetic surgery socially optimal Self Facelift No Facelift Third best Best for Other 39 f h Facehft or we Worst for Self Other Best for Self I Second best NO Facehft Worst for Other for eaCh Savings Example 227 Smith39s utility is given by U X R where X Smith39s weekly income in dollars 40039 R Smith39s satisfaction from relative position 200 if Smith39s consumption exceeds Jones39s consumption income savings 0 if the two have equal consumption an 200 if Smith39s consumption is less than Jones s and P 100 if Smith has high savings 0 if Smith has low savings If Jones s utility function is symmetrically defined and each must choose between high savings and low savings draw the matrix that gives their utilities for the four possible combinations of choices Jones39s Choice High Savings Low Savings U 500 each U 600 for Jones High Savings Second best 300 for Smith for each Best for Jones Worst for Smith Smith39s Choice U 300 for Jones U 400 each 600 for Smith Low Savings Best for Smith Third best for each Worst for Jones Example 228 If the two decide individually which savings option will they choose The low savings option is a dominant choice for each even though both would do better if both chose high savings Further Examples of Positional Arms Races Advertising Anabolic steroids Human growth hormones Kindergarten redshirts Expanding rosters on sports teams Political campaign spending Positional Arms Control Agreements Steroid bans Roster limits Rules of the duel Campaign finance laws Mandatory kindergarten start dates IvyStanfordMIT Consortium Econ 201 Lecture 6 Markets and Prices Why does Derek Jeter earn more than Sharon Weaver Why do diamonds cost more than water Why do Picasso s paintings sell for more than Leroy Nieman s Is it cost of production that determines prices as Adam Smith thought or is it willingness to pay that determines prices as Stanley Jevons thought Alfred Marshall Principles of Economics 1890 was the first to explain clearly how both costs and willingness to pay interact to determine market prices Supply and Demand Analysis An Overview IDefinition The market for any good or service consists of all actual or potential buyers or sellers of that good or service I The Demand Curve Definition The demand curve for a good or service tells us the total quantity of that good or service that buyers wish to buy at each price The demand curve for lobsters Price lobster D Quantity 1 2 3 4 5 100050flobsteIsday The demand curve is the set of all pricequantity pairs for which buyers are satis ed quotSatisfiedH means being able to buy the amount they want to at any given price Horizontal interpretation of the demand curve If buyers face a price of 4lobster they will wish to purchase 4000 lobsters a day Vertical interpretation of the demand curve If buyers are currently buying 4000 lobsters a day the demand curve tells us that buyers would be willing to pay at most 4 for one additional lobster Demand curves slope downward for two reasons 1 As the good becomes more expensive people switch to substitutes 2 As the good becomes more expensive people can t afford to buy as much of it The Supply Curve Definition The supply curve of a good or service tells us the total quantity of that good or service that sellers wish to sell at each price The supply curve for lobsters Price Mobster 1039 S Quantity 100050f10bstersday 1 Z 3 4 5 The supply curve is the set of pricequantity pairs for which sellers are satis ed quotSatisfiedH means being able to sell the amount they want to at any given price Horizontal interpretation of the supply curvelf sellers face a price of 4lobster they will wish to sell 2000 lobsters a day Vertical interpretation of the supply curve If sellers are currently supplying 5000 lobsters a day the supply curve tells us that the marginal cost of producing the last lobster is 10 One reason the supply curve slopes upward is the lowhangingfruit principle Harvest the lobsters closest to shore first More generally as we expand the production of any good we turn first to those whose opportunity costs of producing that good are lowest and only then to others with higher opportunity costs Market Equilibrium Quantity and Price Equilibrium occurs at the pricequantity pair for which both buyers and sellers are satisfied Price Mobster D 1039 S 8 4 2 s D u u u Qua my 4 5 1000s of lobstersday At the market equilibrium price of 6 per lobster buyers and sellers are each able to buy or sell as many lobsters as they wish to Excess Supply A situation in which price exceeds its equilibrium value is called one of excess supply or surplus At 8 there is an excess supply of 2000 lobsters in this market excess Price Mobster D su ply S 1039 5 4 2 s D u u QUa 39Jty 1 3 4 5 1000s cflcbstersday Excess Dem and A situation in which price lies below its equilibrium value is referred to as one of excess demand At a price of 4 in this lobster market there is an excess demand of 2000 lobsters Price HSlobster D v O I I I Q amity 1 2 3 4 5 1000sof10bstersday At the market equilibrium price of 6 both excess demand and excess supply are exactly zero Example 61 At a price of 2 in this hypothetical lobster market how much excess demand for lobsters will there be How much excess supply will there be at a price of 10 3 exce ss supply Price lobster D excess demand D Quantity 1 2 3 4 5 1000s of lobstersday The Trading Locus When price differs from the equilibrium price trading in the marketplace will be constrained by the behavior of buyers if the price lies above equilibrium by the behavior of sellers if below P39 lbt rice 0 ser D Trading locus Quantity 10005 of lobstersday Movement Toward the Equilibrium Price and Quantity At prices above equilibrium sellers are not selling as much as they want to The impulse of a dissatisfied seller is to reduce his price At prices below the equilibrium value buyers cannot obtain the quantities they wish to purchase Some buyers adjust by offering slightly higher prices Thus when price lies either above or below its equilibrium value there is an automatic tendency for it to adjust toward equilibrium Price lobster D Quantity 1 2 3 4 5 100050flobstersday An extraordinary feature of this equilibrating process is that no one consciously plans or directs it The actual steps that consumers and producers must take to move toward equilibrium are often indescribably complex Suppliers looking to expand their operations for example must choose from a bewilderingly large menu of equipment options Buyers for their part face literally millions of choices about how to spend their money And yet the adjustment toward equilibrium results more or less automatically from the natural reactions of selfinterested individuals facing either surpluses or shortages Example 62 Should Collegetown Rents Be Regulated Suppose the supply and demand curves for twobedroom Collegetown rental apartments are as shown below Monthly Rent apartment Supply 1 00 Demand Quantity 0 thousands of apartmenm per month The city council is concemed that many students cannot afford the equilibrium rent of 1000 per month and is considering a regulation forbidding landlords from charging more than 500 What will be the likely consequences of adopting this regulation Monthly Rent Saplargronent Supply 100 xeess demand2000 apamnents pa month Demand N n Rh 3 thousands of apartments per monm Rent Controls Produce Excess Demand in the Housing Market Responses to excess demand in a regulated housing market finder s fees key deposits required furniture rental excessive damage deposits curtailed maintenance condominium conversion There are much more e ectz39ve ways to help poor people than to give them apartments and other goods at artz cially low prices For example income transfers Wage subsidies Public service jobs Cash on the Table When a regulation prevents the price of an apartment or any other good from reaching its equilibrium level the total economic surplus economic benefits less opportunity costs available for buyers and sellers is diminished At a rent of 500 in the rentcontrol example there were tenants willing to pay as much as 1500 for an apartment Similarly there were for whom the opportunity cost of supplying an additional apartment was only 500 The differencei 1000 per apartmenti is the additional economic surplus that would accrue to any seller who could rent an additional apartment for the price that tenants would be willing to pay Mutually beneficial exchanges are always possible when a market is out of equilibrium When people have failed to take advantage of all mutually beneficial exchanges economists say that there is quotcash on the table 7 our metaphor for unexploited opportunities The socially optimal quantity of any good is the quantity that maximizes total the economic surplus that results from producing and consuming the good Costbenefit principle gt keep expanding production of the good as long as its marginal benefit is at least as great as its marginal cost Socially optimal quantity is that level for which the marginal cost and marginal benefit of the good are the same Does the market equilibrium quantity also maximize total economic sur lus In market equilibrium the cost to the seller of producing an additional unit of the good is the same as the benefit to the buyer of having an additional unit If all costs of producing the good are bome directly by sellers and if all benefits from the good accrue directly to buyers the equilibrium quantity also maximizes total economic surp us When Smart for One is Dumb for All Production of some goods entails costs that fall on people other than those who sell the good Goods whose production generates toxic smoke Goods whose production generates noise 5 In the market equilibrium for such goods the benefit to buyers of the last good produced is as before equal to the cost incurred by sellers to produce that good But since producing that good also resulted in the costs of the associated pollution we know that the full marginal cost of the last unit producedithe seller39s private marginal cost plus the marginal pollution cost borne by othersimust be higher than the benefit of the last unit produced So market equilibrium quantity gt socially optimal quantity Total economic surplus would be higher if output of the good were lower Yet neither sellers nor buyers have any incentive to alter their behavior Increases in production of some goods benefit people other than those who buy them Honey and apples More bees gt more apples More apple trees gt more hone Market equilibrium results in too little production of such goods The Equilibrium Principle A market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gains achievable through collective action Econ 201 Lecture 17 The Perfectly Competitive Firm Is a Price Taker Recap The perfectly competitive firm has no in uence over the market price It can sell as many units as it wishes at that price Typically a quotperfectlyquot competitive industry is one that consists of a large number of sellers each of which makes a highly standardized product An example is com production Profitmaximization for the perfectly competitive rm Profit Total revenue total cost Q How much output should a perfectly competitive firm produce if its goal is to earn as much profit as possible A It should keep expanding output as long as the marginal benefit of doing so exceeds the marginal cost The marginal benefit of expanding output by one unit is the market price The marginal cost of expanding production by one unit is the firm39s marginal cost at its current production level Example 171 Consider a corn grower whose marginal cost of growing corn is labeled MC in the diagram If this grower can sell as many bushels of corn as he chooses to at a price of 5 per bushel how many bushels should he sell in order to maximize profit bushel Marginal cost of producing corn 6 5 Price 4 Thousands of 9 12 bushels of cornyr O The profitmaximizing quantity for the perfectly competitive firm is the one for which price MC Imperfect Competition Monopoly quotsingle sellerquot Example Time Warner Cable in the Ithaca market for cable TV service Oligopoly quotfew sellersquot Example ATampT Sprint and MCI in the market for longdistance telephone service Monopolistic competition Many sellers each with a differentiated product Example Local gasoline retailing Five Sources of Monopoly 1 Exclusive control over important inputs Example Perrier s mineral spring 2 Economies of Scale Natural monopoly Example Local telephone service 3 Patents Example Polaroid cameras amp film 4 Government licenses or franchises Example Burger King on Mass Pike 5 Network Economies Example Microsoft Windows Most enduring source of monopoly is economies of scale Scale Advantage in the Old Economy Two widget producers Acme and Ajax each have fixed costs of 200000 and variable costs of 080 per widget Acme 39ax annual production 1000000 units 1200000 units fixed costs 200000 200000 variable costs 800000 960000 total costs 1000000 1160000 cost per widget 100 097 Ajax the high volume producer has only a small cost advantage Scale Advantage in the New Economy In the new economy fixed costs are 800000 reflecting the growing importance of the information and ideas in the product Variable costs are only 020widget Acme Ajax annual production 1000000 units 1200000 units fixed costs 800000 800000 variable costs 200000 240000 total costs 1000000 1040000 cost per widget 100 087 Now Ajax has a much larger cost advantage This cost advantage becomes self reinforcing as more and more of the market goes to Ajax Acme Ajax annual production 500000 units 1700000 units fixed costs 800000 800000 variable costs 100000 340000 total costs 900000 1140000 cost per widget 180 067 Monopoly oligopoly and monopolistically competitive firms have in common the fact that the demand curves for their goods are downward sloping Price Quantity For convenience we will refer to any of these three types of imperfectly competitive firms as monopolists The demand curve facing a perfectly competitive firm is a straight line at the market price unit 0 output Market Price Quantity 3 Marginal Revenue The marginal benefit to a competitive firm of selling an additional unit of output is the market price By contrast the marginal benefit to a monopolist of selling an additional unit of output is less than the market price The reason is that it must cut its price in order to sell an extra unit of output and this means that it will earn less on the output is was selling thus far Example 172 A monopolist with the demand curve shown in the diagram is currently selling 3 units of output at a price of 7 per unit What is its marginal benefit from selling an additional unit Price 10 7 6 D uantit A 10 Q y Total revenue from the sale of 3 units 7x3 21 Total revenue from the sale of 4 units 6x4 24 So marginal revenue from the fourth unit is 3 which is less than both the original price and the new price Example 173 A monopolist with the demand curve shown in the diagram is currently selling 4 units of output at a price of 6 per unit What is its marginal benefit from selling an additional unit Price 10 6 5 39 39 quot I A 5 10 Quantity Total revenue from the sale of 4 units 6x4 24 Total revenue from the sale of 5 units 5x5 25 So marginal revenue from the fifth unit is 1 Example 174 A monopolist with the demand curve shown in the diagram is currently selling 5 units of output at a price of 5 per unit What is its marginal benefit from selling an additional unit Price 10 5 4 D 5 6 10 Quantity Total revenue from the sale of 5 units 5x5 25 Total revenue from the sale of 6 units 6x4 24 So marginal revenue from the sixth unit is 1 The Marginal Revenue Curve for a Monopolist For the monopolist in the preceding examples Quantity U For any monopolist with a straightline demand curve Price Quantity For a straightline demand curve P a bQ The corresponding MR curve MR a 2bQ For calculustrained students MR dTlVdQ TR PQ aQbQZ so MR a 2bQ Example 175 Find the marginal revenue curve for the monopolist Whose demand curve is given by D in the diagram Price 8 Quantity Profitmaximization for the monopolist Profit total revenue total cost Q How much output should a monopolist produce if its goal is to earn as much profit as possible A It should keep expanding output as long as the marginal benefit of doing so exceeds the marginal cost The marginal benefit of expanding output by one unit is marginal revenue at the current output level The marginal cost of expanding production by one unit is the firm39s marginal cost at the current output level Example 176 Consider a monopolist with the demand and marginal cost curves shown in the diagram 5 True or False The profitmaximizing level of output for this monopolist is 9 units unit of output unit of output 1 2 Marginal cost Marginal cost Quantity Quantity 9 l8 At 9 units of output marginal cost is 6 and marginal revenue is zero Therefore the gain from contracting output 6unit is less than the loss from contracting output 0unit And this means that the monopolist cannot be maximizing profit at a quantity of 9 units The profitmaximizing quantity for the monopolist is the one for which MR MC in this case 6 units of output At that level of output the monopolist will charge a price of 8unit Example 177 Consider the profitmaximizing monopolist in Example 176 At the profitmaximizing level of output what is the benefit to society of an additional unit of output What is the cost to society of an additional unit Is this situation efficient from society39s point of view unit of output 12 Marginal cost 0 6 l 4 quotmquot i E D Quantity 6 9 18 The marginal benefit to society of an additional unit of output is 8 The marginal cost of an additional unit is only 4 This means that society would gain a net benefit of 4 per unit of output if output were expanded from the profitm aximizing level Note that the monopolist would love to expand output if it could do so without having to sell the current output at a lower price Example 178 If this monopolist maximizes profit by how much will total economic squlus be smaller than the maximum possible economic surplus Pri e 12 MC 18 Quantlty Maximum possible economic surplus CS PS Consumer P surplus 12 Producer MC surplus D 18Q Loss in economic surplus from monopoly Consumer Producer surplus surplus MC Lossin surplus Econ 201 Lecture 18 Does the fact that perfect competition is socially efficient and monopoly is not mean that we should outlaw monopoly Suppose the monopoly in question is the result of a patent that prevents all but one firm from manufacturing a highly valued product Would we be better off without patents Alternatively suppose the monopolist is a natural monopolist Price minu e V AC MC Minutes millions day Efficiency requires PMC But if MCltAC setting PMC means losing money Piice Wminu e Econom1c loss 600000day 008 P005 Minutes 20 MR millions day It is better for a natural monopolist to maximize profit and stay in business than to charge MC and go out of business Price Wm1 me Consumer surplus 015 3500000day Economic pro t 010 3400000day 008 39 AC 005 MC D Minutes 20 MR millionsday The efficiency loss from singleprice natural monopoly stems from the fact that the profitmaximizing price is above marginal cost thereby excluding many buyers who quotshouldquot be in the market because they are willing to pay a price greater than or equal to marginal cost Price m39 nute Output shortfall 0 10 39 AC 005 I MC I D I Minutes 20 40 millionsday But what if the monopolist could devise some means of lowering prices to some buyers while keeping price high for others Price discrimination charging different buyers different prices for the same good or service Example 181 Ram is a monopolist in the market for carved sisalwood bowls in his village a minor tourist stop in Northern India Each day 8 tourists visit his shop and each has a different reservation price for Ram39s standard bowl If these reservation prices are as listed in the table draw the demand curve Ram faces each day Visitor Reservation price A 16 B 14 C 12 D 10 E 8 F 6 G 4 H 2 bowl Quantity Example 182 If Ram has to charge the same price to all buyers and he can produce as many bowls as he chooses at a cost of 3 each and bowls can be sold only in integer amounts how many bowls should he sell each day if his goal is to maximize profit bowl Quantity Expand ifMR gt MC 3 MR from 3rd bowl 839 MR from 4th bowl 439 MR from 5th bowl 039 So keep expanding until Q 4 Example 183 In the preceding example how much profit does Ram make Total revenue 10x4 40day Total cost 3x4 12day Profit 40 12 28day Example 184 In the preceding example is 4 bowls per day a socially efficient level of output Visitor Reservation price A 16 B 14 C 12 D 10 E 8 F 6 G 4 H 2 Visitors AG are willing to pay more for a bowl than the cost of producing one and thus it is efficient that they each should have one Visitor H is not willing to pay the cost of producing a bowl and so should not have one Thus the socially efficient number is 7 bowlsday Example 185 Now suppose that Ram is a shrewd judge of human nature After a moment39s conversation with a visitor he is able to discover the visitor39s reservation price for a bowl 1f Ram then charges each visitor his respective reservation price how many bowls will he sell and how much profit will he make Ram will sell bowls to visitors AG and each will pay his reservation price He will not sell to visitor H Visitor Reservation price Visitor Reservation price A 16 E 8 13 14 F 6 c 12 G 4 D 10 H 2 Total revenue 16141210864 70day Total cost 7x3 21day Profit 7021 49day A monopolist who is able to charge each buyer his or her reservation price is called a perfectly discriminating monopolist For a perfectly discriminating monopolist there is no efficiency loss All buyers are served who are willing to pay a price high enough to cover marginal cost In practice however there are virtually no sellers who know each buyer39s reservation price Price discrimination does occur but it is imperfect price discrimination The Hurdle Method of Discrimination Example 186 Ram39s 8 visitors again have the following reservation prices for carved wooden bowls Visitor Reservation price Visitor Reservation price A 16 E 8 B 14 F 6 C 12 G 4 D 10 H 2 Ram does not know each buyer39s reservation price but he knows that all buyers with a reservation price above 9bowl never use discount coupons whereas those with reservation prices below 9 use them whenever they are available If Ram makes coupons available in the government tourist magazine those buyers who clip and present them get to pay a discount price for bowls Others pay the regular list price for bowls To maximize profit at what levels should Ram set the list price of a bowl The discount price In each submarket the monopolist should expand output as long as MRgtMC Visitor Reservation price Visitor Reservation price A 16 E 8 B 14 F 6 C 12 G 4 D 10 H 2 ListPrice Submarket DiscountPrice Submarket Visitor Reservation price MR Visitor Reservation price MR 16 8 A 16 E 8 12 4 B 14 F 6 8 0 C 12 G 4 4 4 For the list price submarket MR from sale of fourth bowl is 4 gt MC 3 To sell 4 bowls in the list price submarket Ram will choose a list price of 10 At that price all noncoupon clippers buy a bowl For the discount price submarket the MR from the sale of the 2nd bowl is 4 the MR from the 3rd bowl is 0 So Ram should choose a discount price of 6bowl and sell 2 bowls in the discount market b0wl TR28 16 TR36 l4 39 TR40 12 J 10 i 8 39 l 12 6 TR8 2 4 1 0 I 39 Quantity 1 2 3 4 5 6 7 8 List price Discount price buyers buyers Example 187 At a list price of lObowl and a discount price of 6bowl in the preceding example how many bowls does Ram sell and how much profit does he make Is this outcome socially efficient List price Discount Visitor Reservation price Visitor Reservation price A 16 E 8 B 1 4 F 6 C 12 G 4 D 10 H 2 Total revenue 10x4 6x2 52day Total cost 6x3 18day Profit 5218 34day The outcome is not socially efficient because visitor G is excluded even though he is willing to pay more than marginal cost But it is more efficient than the singleprice case Price P1195 QLquot pro t max1mizmg QS profitm aximizing quantity x quantity at list price for singleprice monopolist PL 39 7 P PD QDquot pro t maximizing quantity at discount price 25 MR Examples of the hurdle method of price discrimination Rebate coupons hurdle having to mail the coupon in Temporary sales hurdle having to find out when amp where the sale occurs Hardback books and paperbacks hurdle having to wait for the paperback Evening shows and matinees hurdle having to go at a less desirable time Cadillacs and Chevrolets hurdle having to drive a lower quality car Coach fares and SuperSaver fares hurdle having to stay over a Saturday night Scratch 39n Dent sales hurdle having to buy a blemished appliance In general the more finely the monopolist can partition his market using hurdle methods the smaller the efficiency loss Will be It is common in most firms to see not one but a Whole menu of different discount prices each with a different set of restrictions the deeper the discount the more stringent the restriction Given the Wide latitude many firms have to expand their markets through the use of the hurdle model of differential pricing the efficiency problem of natural monopoly Will often be of only secondary importance The fairness problem The monopolist may earn an economic profit Price Economic profit 400000day m39r1ute 010 008 AC 0 05 MC D Minutes 20 MR millionsday Aside Although the monopolist charges more than marginal cost she may not make an economic profit because she needs extra revenue to cover fixed costs Prlce Economic loss 400000day minute 012 010 C 00 l Iquot D Minute 20 millionsday MR But the monopolist may earn economic profits If she does their source is the list price buyer who could have bought at a discount had he been Willing to jump a minor hurdle How is each dollar of the monopolist39s excess profits distributed Federal corporate income tax 35 cents Dividend or capital gains to shareholders 64 cents Shareholders39 Federal tax ll cents Shareholders39 State income tax 4 cents Sales taxes 3 cents Total taxes 53 cents on each dollar The hurdle method of pricing mitigates efficiency losses associated with natural monopoly On the fairness side the source of excess profits is the listprice buyer These profits are distributed to shareholders many of Whom are not wealthy And 53 of each dollar of excess profits goes to finance various government services many of Which are targeted at lowincome families So the fairness argument against natural monopoly may be less compelling that it might first appear Econ 201 Lecture 20 Resolving Prisoner39s Dilemmas and Other Commitment Problems In games like the prisoner39s dilemma the hockey helmet game the ultimatum bargaining game and the satellite office game players have trouble arriving at the outcomes they desire because they are unable to make credible commitments Thus if both players in the prisoner39s dilemma could somehow reach a binding agreement to remain silent each would be assured of getting a shorter sentence Hence the logic of the underworld code of Omerta under which the family of anyone who provided evidence against a fellow mob member would be killed Likewise the helmet rule results in a better outcome for hockey players by committing them to wear helmets in circumstances in which they would otherwise choose not to do so Example 201 Will the restaurateur pay the waiter extra to provide good service The restaurateur wants his waiter to provide good service so that customers will enjoy their meals and come back in the future If the waiter provides good service the owner can pay him 100 per day But if the waiter provides bad service the most he can pay the waiter is 60 per day The waiter is willing to provide bad service for 60 per day and for 30 extra would be willing to provide good service The owner39s problem is that he cannot tell whether the waiter has provided good service What will happen Restaurateur PaV waiter PaV waiter 100day 60day Provide Second best Best for owner good service for each Worst for waiter Waiter Provide bad Best for waiter Third best service Worst for owner for each Each side has a dominant strategy Restaurateur pay 60day39 waiter provide bad service Outcome is lowerright cell and that is inefficient The tip is a solution to this commitment problem The Mafia s code of silence hockey helmet rules tips for waiters all work by changing the material incentives facing the relevant decision makers But it is not always practical to changes material incentives in precisely the desired ways Example 202 Will Sylvester leave a tip when dining on the road S lvester has just finished a 100 steak dinner at a restaurant on Interstate 81 some 500 miles from home The waiter provided good service If Sylvester cares only about doing the best for himself that he can will he leave a tip Unlike case of restaurant with local patrons waiter in this restaurant has no way to penalize the diner in the future if he leaves no tip Diner Leave Leave 15 tip no tip Provide second best Best for diner good service for eac Worst for waiter Waiter Provide bad Best for waiter Third best vice I Worst for diner for each Dominant strategy for the waiter provide bad service Dominant strategy for diner leave no tip Again a worse outcome for each than if waiter had provided good service and diner had tipped Moral Sentiments as Commitment Devices 1 commitment problems cannot be solved by altering the relevant material incentives it may nonetheless be possible to solve them by altering people39s psychological incentives For example feelings of guilt when they cause harm to others feelings of sympathy for the interests of their trading partners feelings of outrage when they are treated unjustly and so on may lessen the incentive to behave in opportunistic and mutually destructive ways Example 203 In a moral society will the business owner open a satellite office The owner of a thriving business wants to start up a satellite of that business in a distant city If she hires someone who manages the new office honestly she can afford to pay a weekly salary of 1000 a premium of 500 over what the manager would have otherwise been able to earn and still earn weekly financial return of 1000 for herself The owner39s concern is that she will not be able to monitor the behavior of the satellite manager and that this person would therefore be in a position to embezzle heavily from the business The owner knows that if the satellite office is managed dishonestly the manager can earn l500 while causing the owner a financial loss of 500 per week If the owner believes that the managerial candidate comes from a society whose members have been strongly conditioned to behave honestly will she open the new office Suppose that the effect of the conditioning is to cause the managerial candidate to be willing to pay 10000 to avoid the guilt he would feel if he managed dishonestly The game tree for the game then looks like this Manager manages honestly Owner gem 0 0 manager gets 1000 C Owner opens Manager manages dishonestly B satellite office Owner gem 500 manager gets 8500 Managerial candidate Owner does not promises to manage open satellite office honestl Owner gem 0 Manager gets 500 by working elsewhere In this case the best choice for the owner at point B will be to open the satellite office because she knows that at point C the manager39s best choice will be to manage honestly The irony of course is that the honest manager in this example ends up richer than the selfish manager in the similar example we considered in the last lecture Are People Fundamentally Selfish Without question selfinterest is an important human motive Yet narrow selfinterest is surely not the only hum an motive If you were in the second player39s position in the ultimatum game would you accept a proposal of 99 for the first player and only 1 for you A 5050 split is the most common offer Highly onesided offers are almost always rejected Do you tip in restaurants away from home Tipping rates in restaurants patronized mostly by outoftown diners are essentially the same as those in r staurants patronized mostly by local diners Other examples of behavior inconsistent with narrow pursuit of self interest Family feuds Falklands war Rescues Bone marrow donation Return of lost wallets Is Honesty the Best Policy My wife and I used to gather with several friends and our families for dinner at the Glenwood Pines on occasional Friday evenings Our children loved going there because after eating they got to go into the bar with a pocketful of coins to play the pinball machines while their parents linger at the dinner table One evening my son Chris then 9 years old came back to the table with a furrowed brow to report that one of the machines had eaten several of his quarters What did you do about it I asked him I told the bartender and he gave me some extra quarters he responded So what s the problem I asked noticing that he still seemed troubled I think the bartender gave me one more quarter than I lost he said What do you think you ought to do I asked Tell the bartender he replied resolutely As we left Chris went up to the bartender and handed him a quarter explaining what had happened Several people sitting at the bar chuckled at this and one told Chris that he was foolish to have given back the quarter ls honesty the best policy Although armchair and professional philosophers have debated this question for millennia no clear consensus has emerged The answer seems to depend after all on whose perspective we have in mind by the term best If we take the perspective of society as a whole for example most of us would say that honesty clearly is the best policy If forced to choose between living in a society in which everyone was honest including you or one in which no one was honest would it really be a difficult decision Disagreement begins however once we take the perspective of the individual Cynical comments like the one directed at my son re ect the view by no means uncommon that although it would be nice if everyone were honest we live in a competitive world and must seize our opportunities when they arise Others counter that honesty pays dividends even at the individual level Thus they argue that there is always a chance that dishonest persons will be caught and punished39 and they add that quite apart from the material payoffs involved the honest person typically enjoys greater peace of mind To this the cynics respond that there are plenty of opportunities in which the chances of being caught and punished are negligible For instance the bartender would never have known if my son had kept the extra quarter and even if he had known it would have been too costly for him to do anything about it Moreover the cynics add peace of mind doesn t pay one s bills merging science of evolutionary psychology contributes a fresh new twist to this tired debate Evolutionary psychologists begin with the proposition that the human central nervous system is best understood as the product of Darwinian natural selection Thus they argue the details of our cognitive appetitive and emotional repertoires are intelligible only when viewed as adaptations features of the organism that enhance its ability to survive and leave offspring This perspective might appear to place evolutionary psychologists squarely on the side of the cynics in the honesty debate But although some evolutionary psychologists do take essentially this position I will argue that the logic of Darwinian theory is in fact more consistent with the opposite view that honesty promotes not only the interests of the group but those of the individual as well Why a Super cial Reading of Darwin Suggests that Honesty is Not the Best Policy The number of descendants that an organism leaves behind depends in part on its ability to acquire food and other resources necessary to sustain life Any characteristic that enhances that ability thus tends by definition to be favored by natural selection Some traits such as intelligence or keen eyesight are beneficial both to the individuals who have them as well as to the larger populations in which they reside Other traits however pose a conflict between the individual and group Consider for example the tendency for the hackle39s on a dog39s neck and back to rise when he and a rival are about to fight for the same mate This mechanism serves the individual dog39s purposes because by making him appear to be larger it increases the likelihood of his being able to intimidate his rival Evolution saw to it that dogs know better than to fight an opponent who is significantly larger From the perspective of dogs as a group however the hackleraising mechanism is largely wasteful for when all dogs raise their hackles their rank ordering by apparent size is the same as if none had done so The bodily resources required to sustain the hackleraising mechanism could have been put to better uses say by supporting sharper vision or a keener sense of smell One of Darwin s central insights was that selection pressure is almost always more intense at the individual than at the group level Thus even though dogs as a species would fare better if none had hackleraising mechanisms any individual dog that lacked this mechanism would pay a prohibitive reproductive penalty In evolutionary terms his ability to see or smell better is of little consequence after all if it comes at the expense of being able to secure a mate Superficially at least the same Darwinian logic appears to work against the evolution of honesty For the purposes of this discussion suppose we define an honest person as someone who keeps a promise even though it would be advantageous for her to break it The argumentl am about to construct can easily be adapted to other more comprehensive definitions Suppose further that there are many situations in which enforceable promises would be mutually advantageous to all parties involved For the sake of concreteness imagine a situation in which the owner of a business wants to hire a consultant to advise him about strategy for entering what he perceives to be a profitable new market His concern is that in order for the consultant to advise him he must give the consultant access to valuable confidential information about his business information that would be worth millions of dollars to the owner39s competitors the owner could find someone who could credibly promise to preserve the confidentiality of the information both the owner and consultant would benefit But if the owner thinks that people are fundamentally dishonest he will predict that the consultant will reveal the confidential information to the highest bidder And this implies that the owner39s best option is not to hire the consultant in the first place To see how Darwinian forces appear to work against the evolution of honesty in situations like these imagine an environment in which situations like the one described above were common and in which an initial population contained some individuals who were genetically predisposed to be honest and others predisposed to be dishonest 1f the proportion of honest people were high enough to begin with it would have paid owners to hire consultants on the chance that they would tuIn out to be honest It is true in this case that an honest consultant would have earned more than someone who was not hired to consult at all But a dishonest consultant would have received a still higher payoff by assumption T e implication is that dishonest individuals will leave more offspring than others causing dishonesty to proliferate 1n the end honest persons would appear destined for extinction even though a population consisting only of dishonest persons would do worse than one consisting only of honest persons A Friendly Amendment As even cynics must concede however abundant evidence contradicts the claim that everyone is dishonest How might the impulses that drive such behavior have survived the ruthless culling of natural selection A simple change in the assumptions of our consultant story suggests one possible answer In that story owners had no practical means to distinguish honest consultants from dishonest ones But suppose that honest individuals bore some identifying marker say a red birthmark in the shape of an quotHquot on their foreheads Owners would then be able to hire honest consultants and avoid dishonest ones As a result individuals with the honesty trait would receive higher payoffs causing honesty to proliferate This time it is the dishonest individuals who appear destined for distinction The assumption of a red birthmark is fanciful of course but there do in fact appear to be statistically reliable signals that distinguish honest persons from dishonest ones The key to understanding the logic of these signals is to recognize that honest behavior is motivated not by rational calculation about advantage but by emotion Thus the person who keeps a promise does so not because she calculates that she will be better off if she keeps it but because she feels sympathy to the interests of the promisee or because she would feel guilty if she broke her word As Darwin himself first pointed out in his 1872 book The Expression afEmaiian in Man and Animals such emotions have characteristic signatures that are visible to all For example when my son reported to me that the bartender had inadvertently given him an extra quarter his concern was evident not just in the words he chose but also in the expression upon his face The stickfigure face below represents my attempt to capture the essence of that expression the eyebrows elevated at the bridge of the nose and slanting downward toward the edge of the face the furrows at the center of the brow This expression is produced by a complex combination of facial muscle contractions principally of the pyramidal muscles at the bridge of the nose and the corrugator muscles at the center of the brow This combination is extremely difficult to summon willfully1 If you are skeptical sit before a mirror and try it Yet the expression appears spontaneously on the faces of subjects who are experiencing the emotions of sadness concern or perhaps even guilt Subjects living in any culture on earth can reliably identify the emotions that correspond to this simple drawing In addition to facial expressions there are other statistically reliable signals of affect Thus posture and other elements of body language the pitch and timbre of the voice the rate of respiration and even the cadence of speech are systematically linked to underlying emotional states2 Because these linkages are beyond conscious 1 See Paul Ekman Telling Lies New York W W Norton 1985 2See for example Paul Ekman Wallace Friesen and Klaus Scherer quotBody Movements and Voice Pitch in Deceptive Interaction Semiotica 16 1976 2327 control in most people it is difficult to conceal the experience of certain emotions And it equally difficult to feign the characteristic expressions of these emotions on occasions when they are not actually experienced We are therefore able to employ such clues to form estimates of the emotional makeup of others and to form judgments about their character3 I we were able to make perfectly reliable character judgments we could always avoid dishonest persons in ventures that require trust Such persons would therefore earn lower payoffs than honest persons and according to Darwinian theory would eventually be driven from the population Evolution has been going on for billions of years That so many dishonest persons remain among us suggests that perfectly reliable character judgments are either impossible or at least costl Consider the implications of this last possibility that if we incur the costs of scrutinizing potential trading partners we can make accurate character judgments about them Would it pay to incur these costs That would depend on how likely it is that a randomly chosen trading partners is dishonest If that likelihood is high then it pays to be vigilant just as it pays to install an expensive security system in a house located in a highcrime neighborhood But if the overwhelming majority of one s potential trading partners are honest then extreme vigilance will simply be wasteful hese observations suggest a tendency for populations to gravitate toward a stable mix of honest and dishonest persons Because populations that consist almost exclusively of honest persons would discourage vigilance in the choice of trading partners opportunities would be ripe for dishonest persons in those populations And this would mean that the share of dishonest persons would grow Conversely because populations with only a small minority of honest persons would strongly reward vigilance in the choice of trading partners honest persons would avoid interacting with dishonest persons and the resulting higher payoffs to honest persons would cause their share of the population to grow At some intermediate mix of the two types these countervailing forces will be in balance and the composition of the population will therefore tend to stabilize The Problem of Mimicry For honest individuals to be able to survive in competition with dishonest individuals there must as noted be some means by which honest individuals can identify and interact selectively with one another But if there is advantage in being honest and perceived as such there is even greater advantages in appearing to be but not actually being honest After all a liar who appears trustworthy will have better opportunities than one who glances about furtively sweats profusely speaks in a quavering voice and has difficulty making eye contact Indeed he will have the same opportunities as a genuinely honest person but will get a higher payoff because he exploits them to the fullest The behavioral clues we employ to reach character judgments are obviously far from perfect Even experienced professional polygraph experts cannot be sure when someone is lying If the ability to mimic the signals of trustworthiness were perfect the mechanism that sustains the evolution of honest individuals simply could not work Fortunately for honest individuals however instances of perfect mimicry do not appear to exist in nature Consider the monarch butterfly has a whose foul taste that protects it from predators who have learned to associate the objectionable taste with the monarch s distinctive wing markings The similar wing markings of the viceroy butterfly provides it with a measure of protection against the same predators even though the viceroy has not incurred the cost of producing the bad taste The protective cover provided by the monarch depends of course on the continued presence of sufficiently many monarchs in the environment to keep predators on guard against the foul taste But if the viceroy were able to mimic the monarch39s wing markings perfectly and without cost the protective power of these markings would soon decay for if the viceroy s wing markings were a perfect copy of the monarch s it would be just as likely as the monarch to escape predation even though it hadn39t expended the bodily resources to manufacture the foul taste The viceroy39s share of the population would grow because of this advantage and predators would eventually lose their incentive to avoid the wing markings But this has not happened leading us to conclude that perfect mimicry either takes time or entails significant costs The fact that the bearer of the genuine trait has the first move in this game will often prove a decisive advantage The monarch s wing markings are themselves evolving and it is more difficult to hit a moving target than a stationary one Similar logic applies to those who would mimic emotional traits If the signals we use for detecting these traits had no value we would have long since ceased to rely on them The inevitable result is an uneasy balance between people who are really honest and others who merely pretend to be 3Observable expressions of emotion are of course not the only reliable clues to character For a discussion of the role of reputation and other factors see chapter 4 of my Passions Within Reason The popular impression of Darwin39s contribution is that nature is quotred in tooth and clawquot that only the opportunist can survive the ruthless pressures of natural selection Even many sophisticated Darwinians cling to the belief that honesty in oneshot encounters with strangers cannot survive these pressures This view collapses however if people are able to make reasonably accurate character assessments In the end the question of whether people have this ability is an empirical one Elsewhere Tom Gilovich Dennis Regan and l have shown that even on the basis of brief encounters involving strangers experimental subjects are adept at predicting who will cooperate and who will defect in prisoner39s dilemma games4 Thus in one version of our experiments the base rate of defection was only 26 percent but the accuracy rate of predicted defections was more than 56 percent It seems reasonable to expect that predictions regarding others whom we know well would be even more accurate If you lost an envelope containing 1000 in cash at a crowded concert can you think of someone you feel sure would return it to you if he or she found it If so then you accept the central premise of my friendly amendment to the traditional Darwinian account of honesty As long as it is possible for honest individuals to identify at least some others who are also honest and to interact selectively with them such individuals can survive in competitive environments If this does not quite imply that honesty is the best policy at the individual level it does say that honesty is a policy that individuals can live with 4 See Robert Frank Thomas Gilovich and Dennis Regan quot The Evolution of OneShot Cooperation Ethology and Sociobiology 14 July 1993 247256 Econ 201 Lecture 1 Should there be twelve sections of Econ 101 or only one Students learn more effectively in smaller classes But smaller classes are also more expensive Some relevant costs Faculty salary 60000 per course Per student faculty salary cost one section 60000300 200 twelve sections 6000025 2400 If you were currently in a class with 300 students would you be willing to pay 2200 to switch to one with only 25 students The Scarcity Principle Also called the NoFreeLunch Principle Although we have boundless needs and wants the resources available to us are limited So having more of one good thing usually means having less of another Microeconomics entails the study of how people choose under conditions of scarcity The Rationality Assumption People have goals and try to fulfill them as best they can Costbene t analysis Shouldl do activity x Cx the costs of doing x Bx the benefits of doing x If Bx gt Cx do x otherwise don39t Example 11 Should I turn down my stereo You have settled into a comfortable chair and are listening to your stereo when you realize that the next two tracks on the album are ones you dislike If you had a compact disc player you would have programmed them not to play But you don39t and so you must decide whether to get up and turn the music down or to stay put and wait it out Suppose Cx l00 the minimum amount it would take to get you out of your chair Bx the maximum you would be willing to pay someone to turn down the volume If Bx gt l then turn your stereo down If Bx lt l then don39t The CostBenefit Principle An individual or a firm or a society should take an action if and only if the extra bene ts from taking the action are at least as great as the extra costs Can costbenefit analysis help you make better decisions Example 12 You are about to buy a 20 alarm clock at the campus store when a friend tells you that Kmart has the same alarm clock on sale for 10 Do you drive down to Kmart Example 13 You are about to buy a 2510 laptop computer from the campus store when a friend tells you that Km art has the same computer on sale for 2500 Do you drive down to Kmart Should I drive down to Kmart Bx benefit of driving down to Kmart 10 in both cases Cx cost of driving down to Kmart the same amount in both cases So your answer should be the same in both cases Example 14 Choosing a public health program A rare disease will claim 600 lives if we do nothing We must choose between these two programs Program A save 200 lives with certainty Program B save 600 lives with probability 13 save zero lives with probability 23 Example 15 Same disease as in Example 14 Program C 400 people will die with certainty Program D 13 chance that no one will die 23 chance that all 600 will die Example 16 Losing a 20 bill You have just arrived at the theater to buy your ticket and discover that you have lost a 20 bill from your wallet Do you buy a ticket and see the play anyway Example 17 A lost theater ticket You have just arrived at the theater and discover that you have lost the 20 ticket you purchased earlier that day Do you buy another ticket and see the play anyway In both cases you are 20 poorer than before In both cases the benefit of seeing the play as measured by what you are willing to pay may therefore be slightly smaller but this benefit is the same in both cases In both cases the additional cost you must incur to see the play is exactly 20 Since the relevant costs and benefits are the same in both cases your decision should also be the same Example 18 How much memory should your computer have Suppose that random access memory can be added to your computer at a cost of 050 per megabyte Suppose also that the value to you measured in terms of your willingness to pay of an additional megabyte of memory is as shown in the diagram Dollars per megabyte Value of an additional COSt Of an MB Mt 1 megabyte a 1 10na me ab e 200 g W I rm 0 5 MP 025 i I i i 1000 2000 3000 4000 Megabytes of memory How many megabytes of memory should you purchase 3 quot Should I do Xquot quotHow much X should I buy quot Should I buy an additional unit of Xquot The optimal amount of memory to purchase is the quantity for which the benefit of an additional megabyte its marginal benefit is just equal to its cost marginal cost Here that equality occurs for 3000 megabytes of memory Dollars per Optimal megabyte amount of MB memory 200 l quot l 100 Price0ltn W 025 l I I l 1000 2000 3000 4000 Megabytes of memory Econ 201 Lecture 4 Comparative Advantage The Basis of Exchange y do people exchange goods and services in the first place Why not just produce our own food cars clothing shelter and the like The answer is that we can all have more of every good and service if we specialize in the activities at which we are we are relatively most efficient Example 41 Consider Ted a house painter whose roof needs fixing and Tom a roofer whose house needs painting Although Ted is a painter he also knows how to repair roofs Tom for his part knows how to paint houses The time each requires to perform these tasks is given in the table How should the roofing and painting jobs be allocated among them Painting Roofing Ted 300 hours 400 hours Tom 200 hours 100 hours Note in the table that Tom has an absolute advantage over Ted at both painting and roofing which means that Tom takes fewer hours to perform each task than Ted does At first glance this might seem to suggest that Tom do the roofing and painting jobs for both houses Of course Tom would probably object to this proposal as being unfair But an even more telling objection is that it is inefficient The reason is that Ted has a comparative advantage over Tom at painting which means that he is relatively more efficient at painting than Tom is The word quotrelativelyquot is the key word here For Ted to be relatively more efficient at a task is for him to have a lower opportunity cost of performing that task than Tom has For Ted the opportunity cost of painting one house 075 roofing jobs For Tom the opportunity cost of painting one house 2 roofing jobs Ted thus has a comparative advantage at painting and it makes sense for him to do both painting jobs leaving both roofing jobs for Tom Note that if each person performed both tasks for himself the total time spent would be 700 hours for Ted and 300 hours for Tom By contrast when each specializes in his comparative advantage these totals fall to 600 for Ted and 200 for Tom a savings of 100 hours each I The Principle of Comparative Advantage Everyone does best when each person or country concentrates on the activities in which he or she is relatively most efficient Specialization by comparative advantage provides the rationale for market exchange It explains why each person does not devote 10 percent of her time to producing cars 5 percent to growing food 25 percent to building housing 00001 percent to brain surgery and so on By performing only those tasks at which we are relatively most efficient we can produce vastly more than if we each tried to be selfsufficient Caution Pay close attention to the form in which the productivity information is provided Your goal in each case is to nd each person s opportunity cost of producing the good in question Example 42 Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes Which statement below is true a Arthur has no comparative advantage b Ben should do both tasks because he has an absolute advantage in both c Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats d Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep e None of the above statements is true Arthur s opportunity cost of milking a goat is 10425 sheep shorn Ben s opportunity cost of milking a goat is 632 sheep shorn 2 It is more costly for Arthur to milk a goat than for Ben so Ben has a comparative advantage in milking goats ur s opportunity cost of shearing a sheep is 41004 goats milked Ben s opportunity cost of shearing a sheep is 305 goats milke It is more costly for Ben to shear a sheep than for Arthur so Arthur has a comparative advantage in shearing s eep Correct answer c Example 43 Arthur can milk 10 goam per hour or shear 4 sheep per hour Ben can milk 6 goats per hour or shear 3 sheep per hour Which statement below is true a Arthur has no comparative advantage b Ben should do both tasks because he has an absolute advantage in both c Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats 39 39 quot 39 and Ben has r 39 4 39 henrin heen d Arthur has a r e None ofthe above statements is true Arthur s opportunity cost of milking 10 goats is 4 sheep shom so his opportunity cost of milking 1 goat is 04 sheep s om Ben s opportunity cost ofmilking 6goats is 3 sheep shom so his opportunity cost ofmilking 1 goat is 05 sheep shom It is more costly for Ben to milk a goat than for Arthur so Arthur has a comparative advantage in milking goats Arthur s opportunity cost of shearing 4 sheep is 10 goats milked so his opportunity cost of shearing 1 sheep is 25 goats milked Ben s opportunity cost of shearing 3 sheep is 6 goam milked so his opportunity cost of shearing 1 sheep is 2 goam It is more costly for Arthur to shear a sheep than for Ben so Ben has a comparative advantage in shearing sheep Correct answer d Production Possibilities in a OneiPerson Economy Example 44 Chris can produce 6 sq ydwk of shelter or121bwk offood If Chris is the only person in the economy describe the economy39s production possibilities curve Shelter s q y dwk Production Possibilities Curve All combinations of shelter d food that can be produced with Chris39s labor Food lbwk absolute value of the slope of the production possibility curve is 612 12 For Chris this means that the The opportunity cost ofan additional pound of food each week is 12 sq ydwk of shelter Shelter sq Volwk A 5 Attainable efficient points An unattainable c F point 4 attainablc but inef ciert point 2 E D B Food 12 lbwk Example 45 Dana can produce 4 sq ydwk of shelter and 4 lbwk of food If Dana is the only one in the economy describe the economy39s production possibilities curve Shelter sq ydwk Production Possibilities Curve All combinations of shelter and food that can be produced with Dana39s labor Food lbwk 2 4 For Dana the opportunity cost of an additional pound of food each week is 1 sq ydwk of shelter Production Possibilities in a TwoPerson Economy In the examples above Chris has a comparative advantage in producing food because the opportunity cost of producing food is only half as large as it is for Dana By the same token Dana has a comparative advantage producing shelter Example 46 Chris can produce 6 sq ydwk of shelter or 12 lbwk of food Dana can produce 4 sq ydwk of shelter and 4 lbwk of food If Chris and Dana are the only two people in the economy describe the economy39s production possibilities curve Shelter sq ydwk Production Possibilities Curve All combinations of shelter and food that can be produced with Chris amp Dana39s labor Food lbwk Example 47 Dana and Chris a married couple have decided to consume jointly 6 sq ydwk of shelter and 8 lbwk of food How should they divide the task of producing these quantities Dana has a comparative advantage in producing shelter but even if he spends all his time producing shelter he can make only 4 sq ydwk So Chris will have to produce the additional 2 sq ydwk for them to achieve the desired 6 sq ydwk Since Chris is capable of producing 6 sq ydwk of shelter on her own it will take her only 13 of a week to produce 2 sq yd This leaves 23 of a week for her to produce food which is exactly how much time she needs to produce the desired 8 lbwk Shelter sq ydwk Dana works full time making shelter39 Chris works 13 week on shelter 23 week on food Food lbwk 8 12 16 The Princi le ofIncreasin O ortuni Cost Also called The LawHan in FruiIPrinci le In expanding the production of any good first employ those resources with the lowest cost and on afterward turn to resources with hih Example 48 Chris and Dana are now joined by George whose productionpossibilities curve is shown below What is the productionpossibilities curve for the new economy consisting of Chris Dana and George Shelter sq ydswk 2 George39s production possibility curve Food 1 lbswk George39s opportunity cost of producing 1 pound per week of food 2 sq ydswk of shelter Recall Chris39s 12 sq ydwk of shelter Dana39s 1 sq ydwk of shelter Shelter Sq ydWk Production Possibilities Curve 12 All combinations of shelter and food that can be produced with the labor of Chris Dana and George Food lbWk Example 49 If the economy consisting of Chris Dana and George is to produce 14 lbswk of food and 4 sq ydswk of shelter how should each person39s work time be allocated Shelter sq chwk 1 2 production point Food lbWk Chris 0 sq ydsWk of shelter l2 lbsWk of food Dana 2 sq ydsWk of shelter 2 lbsWk of food George 2 sq ydsWk of shelter 0 lbsWk of food The Production Possibilities Curve for an Economy with Many Workers Intuitive interpretation of its shape Produce the initial units of clothing using the resources that are relatively most efficient at clothing production and only then turn to those that are relatively less efficient at clothing production Food lbsWk Clothing garm entsWk Econ 201 Lecture 23 Information and Search Example 231 Suppose you want a new tennis racquet but aren39t sure which brand amp model to buy Dick s has a large selection so you go there and ask a salesperson for advice After some discussion about your experience and style of play the salesperson recommends the quotPrince Thunder 03 Silver and you buy it for 300 Then a friend tells you could have bought the same racquet online for only 260 How do you feel about having spent 300 How do the costs of the two suppliers differ How do the services they provide differ Were the extra services you got at Dick s worth it The freerider problem and quotfair tradequot laws Manufacturers may want to maintain minimum resale prices so that their retailers can earn enough to provide good service Without resale price maintenance consumers can shop at a full service store for information then order online Fair Trade laws which prohibited resale price maintenance made it impossible for manufacturers to guarantee availability of highservice retailers Optimal Investment in Acquiring Information Keep acquiring more information until the expected marginal benefit equals the marginal cost 39t um Marginal cost of Information Marginal Benefit of Information Units of Information I the optim a1 quantity of information Example 232 You know that different stores charge different prices for the particular HP calculator you have decided to buy Should you buy from the first store you visit or should you search all the stores in your area Suppose you visit the first store and find that they charge 50 Should you buy or continue searching To search further is costly What are the expected benefits If you think 50 is already near the low end of the price distribution then you don39t stand to gain much But additional search will be more attractive if you think 50 is near the high end of the distribution Based on your estimate of the distribution of available prices and the cost of search you should choose an quotacceptance price Then keep searching until you find a calculator priced at least that low Example 233 There is a spinning wheel numbered from 0 to 100 You have won the right to buy a new HP calculator for a price in dollars equal to the number you get on the spinning wheel when you spin the pointer You spin and get 50 100 90 0 10 80 20 7 30 60 40 50 Now suppose someone offers you a chance to spin again for a fee of 10 If you end up with a higher number you still pay only 50 But if you get a lower number you pay the lower amount If you accept this offer will you end up better off on the average C cost of spinning again 10 B expected benefits of spinning again 50 of the time the number you get will be greater than 50 and in those cases your benefit is zero 50 of the time the number you draw is less than 50 and in these cases your benefit will lie between 0 and 50 for an average savings of 25 On the average your benefit from spinning again will therefore be B 50 525 1250 gt C 10 So it is worth your while to spin again Search Is a Gamble The fact that you will do better on the average by searching further does not guarantee that your next search will make you better off For instance suppose you spin again and get 60 Then you will have incurred a 10 cost and gotten nothing in return Q If this happens should you spin again A Yes you made a good decision but just happened to get a bad outcome Example 234 Same as Example 233 except now the cost of another spin is 15 Should you spin again This time B 1250 ltC 15 so you should not spin again Moral Be prepared to pay a higher price when the cost of searching is high Example 235 Same as Example 233 except now your first spin lands on 40 Should you spin again 100 90 0 10 80 20 7 30 60 40 50 60 of the time the number you get will be greater than 40 and in those cases your benefit is zero 40 of the time the number you draw is less than 40 and in these cases your benefit will lie between 0 and 40 for an average savings of 20 On the average your benefit from spinning again will therefore be B 60 420 8 ltC 10 So it is not worth your while to spin again Moral If you find a sufficiently low price it will not be worth searching further Exercise What is the highest price for which further search would not pay Example 236 Same as Example 233 except now the price you pay for the television is only ten percent of the number you get on the spinning wheel If you start with a 5 and extra chances cost 10 does it pay to spin again 100 10 90 0 10 0 80 20 7 30 60 40 50 50 of the time the number you get will be greater than 5 and in those cases your benefit is zero 50 of the time the number you draw is less than 5 and in these cases your benefit will lie between 0 and 5 for an average savings of 250 3 On the average your benefit from spinning again will therefore be B 50 525 125 ltC 10 So it is not worth your while to spin again Moral Other things equal additional search is more likely to be worthwhile for expensive items than for cheap items Thus for example you should spend more time searching for a car than for a bicycle D0 quotmiddlemenquot create additional value the same way production workers do Example 237 Jones has a house for sale It is an updated 1895 Queen Anne Victorian with polished walnut woodwork inlaid oak floors and a distinctive corner turret Although he is hoping to get much more Jones39s reservation price for his house is 200000 There are two possible buyers Adams who generally likes modern houses and would be willing to pay up to 400000 for a house that suited his tastes He would be willing to pay only 205000 for Jones39s house39 and aker who generally likes Greek Revival houses and would be willing to pay up to 350000 for a house that suited her tastes She would be willing to pay 250000 for Jones39s house Both Adams and Baker are lthacans and Jones can hope to attract their attention with a classified ad Q If Adams were the only buyer Jones found would he sell to him A Yes because Adams is willing to pay 5000 more than Jones39s reservation price Q Would Jones sell to Baker if Baker and Adams were the only two potential buyers A Yes because Baker is willing to pay 45000 more than Baker Q Obviously Jones would prefer to sell to Baker than to Adams But is it more efficient for this to happen A Yes Since Baker values Jones39s house more than Adams does it is more efficient for Baker to have it If Adams happened to have bought it both he and Baker would be made better off if Adams then sold it to Baker The gain that results is no less valuable than if an additional 45000 worth of goods and services had been produced Example 238 Now suppose there is a real estate agent who has a national computer network that puts her in touch with potential buyers in other cities One such buyer is Cummings who is planning to move to Ithaca soon Cummings is a passionate fan of Queen Ann Victorians and would be willing to pay 400000 for Jones39s which is the only such house in the Ithaca area Q Does the total value of output increase if Jones hires the services of this realtor A Yes because an additional 150000 of value is created when Jones sells his house to Cummings rather than to Baker Here too the gain is equivalent to the production of an additional 150000 worth of goods and services The Market for Lemons George Akerlof 1970 Suppose there are two kinds of cars quotLemonsquot The owner of a used car knows whether it is a lemon but prospective buyers cannot tell Example 239 Suppose 10 of all new cars produced are lemons Good used cars are worth 10000 to their owners and lemons are worth only 6000 If the used cars for sale had the same quality distribution as new cars ie 90 good 10 lemons how much would riskneutral people be willing to pay for a used car P 9010000 106000 9600 Example 2310 If you were the owner of a good used car in the previous example what would your car be worth to you A 10000 by assumption Q Under the assumptions of that example how much would you get if you sold it A 9600 Q Would you sell it A No because it is worth 10000 Q If you had a lemon would you sell it Moral The only used cars for sale will be lemons They will sell for 6000 Moral If you have a chance to buy a good used car for the Blue Book price grab it Suppose there are two kinds of computers Reliable ones Ones that crash frequently Example 2311 Suppose that some fraction 2 of all personal computers are defective The defective ones however cannot be identified except by those who own them Consumers are riskneutral and value nondefective computers at 2000 each Computers do not depreciate physically with use New computers sell for 1000 used ones for 500 What is 2 Because of the lemons principle we know that all of the used computers that are for sale must be defective so the price of a used computer is the same as the value of a new defective one Because consumers are risk neutral the price of a new computer 1000 is simply a weighted average of the values of nondefective and defective computers where the weights are the respective probabilities 1000 500 2 2000 12 which solves for z 23 Econ 201 Lecture 7 When all relevant production costs are incurred by sellers and when all relevant product benefits accrue to buyers the market equilibrium price and quantity are socially optimal When Smart for One is Dumb for All Production of some goods entails costs that fall on people other than those who sell the good Goods whose production generates toxic smo e Goods whose production generates noise In the market equilibrium for such goods the benefit to buyers of the last good produced is as before equal to the cost incurred by sellers to produce that good But since producing that good also resulted in the costs of the associated pollution we know that the full marginal cost of the last unit producedithe seller s private marginal cost plus the marginal pollution cost borne by othersimust be higher than the benefit of the last unit produced So market equilibrium quantity gt socially optimal quantity Total economic surplus would be higher if output of the good were lower Yet neither sellers nor buyers have any incentive to alter their behavior Increases in production of some goods benefit people other than those who buy them Honey and apples More bees gt more apples More apple trees gt more honey Market equilibrium results in too little production of such goods Change in demand vs Change in the quantity demanded Price D Increase in demand 10 Increase in the 8 quantity demanded 6 4 m i D D 2 5 Quantity I Quantity 0 1 2 3 4 5 Newspaper story Producers raised prices and the resulting fall in demand caused prices to fall back to their original level WRONG A rise in price causes a fall in the quantity demanded not a fall in demand If it did it wouldn t An increase in supply At every price there is an increase in the quantity supplied Price Quantity An increase in the quantity supplied For an upward sloping supply curve an increase in price leads to an increase in the quantity supplied Price lobster Quantity 1000s of lobstersday Predicting and Explaining Changes in Price and Quantity An increase in demand will lead to an increase A decrease in demand will lead to a decrease in both the equilibrium price and quan y in both the equilibrium price and quantity P 39 r P 39 rl e D S rl e D S D D39 p i D39 D s i D Q Q39 gt n increase in supply will lead to A decrease in supply will lead to a decrease in the equilibrium price an increasein the equilibrium price d an increase in the equilibrium quantity and a decrease in the equilibrium quantity Price S p be S P St f r 3 PL P r r r r D D r i i Q Q Quantity Q39 Q Quantity gt Determinants of Demand Inc0mes For most goods the quantity demanded at any price will rise with income Goods that have this property are called normal goods P D1 P D0 D0 D1 Q Q Income rises normal good Income falls normal good For inferior goods the quantity demanded at any price will fall with income Example Ground beef with high fat content P D0 D1 Q Income rises inferior good Consumers abandon inferior goods in favor of higher quality substitutes such as leaner grades of meat in the ground beef case as soon as they can afford to OTastes Tastes shift in favor Example Following the release of Jurassic Park and The Lost World tastes in children s toys shifted toward designs involving prehistoric reptiles 0Prices of substitutes and complements Substitutes eg coffee and tea Complements eg coffee and cream Price of Price of tea D0 coffee D1 D1 D0 Quantity of tea Quantity 0f coffee Price ofcoffee falls Price of cream falls Determinants of Supply oTechnology A more efficient lobster trap is invented Price S 839 Quantity OFactor Prices The price of diesel fuel rises Price S S Quantity Interest rates fall Price S 839 Quantity 4 Example 71 Why do the prices of some goods like apples go down during the months of heaviest consumption While others like beachfront cottages go up The seasonal consumption increase is the result of a supply increase in the case of apples a demand increase in the case of cottages B eachfront Cottages Example 72 What Will happen to the equilibrium price and quantity in the fresh seafood market if both of the following events occur 1 a scientific report is issued saying that fish contains mercury which is toxic to humans and 2 the price of diesel fuel falls significantly The equilibrium price Will go down but the equilibrium quantity may go either up right panel or down left panel Econ 201 Lecture 21 Externalities Sometimes costs or benefits that result from an activity accrue to people not directly involved in the activity These are called external costs or external bene ts externalities for short Example 211 Sara is an accomplished classical violinist Her neighbor Tom is a fan of classical violin music and on summer evenings enjoys listening to Sara play in her garden If Sara plays only in response to her own costs and benefits will the amount of time she plays be socially optimal For Tom Sara39s music is a positive externality If Sara plays in response to her own costs and benefits she will continue to play until the marginal benefit of playing another minute is equal to the marginal cost But since Tom also benefits from her playing at that point the total marginal benefit of playing another minute will be greater than the marginal cost It follows that Sara plays too little MB to Tom minute Marginal Cost to Sarah 065 K 0 50 Marginal Benefit to Sarah T Minutes Example 212 Sara is an accomplished classical violinist Her neighbor Harry hates the sound of violin music and on summer evenings becomes distressed when Sara plays in her garden If Sara plays only in response to her own costs and benefits will the amount of time she plays be socially optimal For Harry Sara39s music is a negative externality If Sara plays in response to her own costs and benefits she will continue to play until the marginal benefit of playing another minute is equal to the marginal cost But since Harry also incurs costs from her playing at that point the marginal benefit of playing another minute will be smaller than their combined marginal costs If follows that Sara plays too much MC to Harry minute Marginal Cost 075 to Sarah 050 Marginal Benefit to T Minutes Negative externalities gt too much activity Positive externalities gt too little activity Example 213 Smith can produce with or without a filter on his smokestack Production without a filter results in greater smoke damage to Jones The relevant gains and losses for the two individuals are listed in the table below With filter Without filter Gains to Smith 200wk 245wk Damage to Jones 35wk 85wk If Smith is not liable for smoke damages and if the two parties can negotiate costlessly with one another will he install a filter 2 Note first that the total well being of Smith and Jones together goes up if Smith installs the filter 20035165 gt 24585160 The filter costs 24520045 Smith doesn39t have to install it but if Jones pays him at least 45 he will gladly do so And since the filter results in savings of 843550 for Jones he will pay Smith to install the filter The Coase Theorem 1f property rights are fully assigned and if people can negotiate costlessly with one another they will always arrive at efficient solutions to problems caused by externalities Ronald Coase 1991 Nobel Laureate in Economics It might seem strange that Jones would pay Smith to install a filter on his smokestack since it is Smith39s smoke that is causing the damage to Jones Coase s insight was that externalities are purely reciprocal The smoke harms Jones true enough but to restrain Smith from producing smoke would harm Smith The two parties have a shared interest in achieving the outcome that is least costly overall Example 214 Ted and Bill can live together in a twobedroom apartment for 500mo or each rent a onebedroom apartment for 300mo 1f the rent were the same they would be indifferent between living together or separately except for one problem Ted likes to practice his trumpet late at night and this will disturb Bill39s sleep Ted would pay up to 150mo rather than reschedule his playing Bill would pay up to 80 per month not to have his sleep disturbed Will they live together or separately The question is whether the benefits of joint living exceeds the costs The benefit is the 100 per month reduction in rent The least costly accommodation to the trumpet problem is for Bill to put up with the noise since 80 lt 150 Since this cost is less than the 100mo gain they should live together Example 215 In the preceding example what is the largest rent Bill would be willing to pay if the two were to live together If Bill were to live alone he would pay 300mo and suffer no trumpet noise Since the noise costs him 80mo the most he would be willing to pay for the shared apartment is 300 80 220 Example 216 How should Ted and Bill split the 500mo rent if they agree that each should benefit equally from living together Their total gain from living together is 100 80 20mo 1f Ted pays 290mo and Bill pays 210mo each will be 10mo better off than if he were to live alone It is often impractical to negotiate solutions to the problems created by externalities Hospital patients for example are unable to negotiate with passing motorists about not blowing their horns In such cases the law tries to impose the burden of adjustment on the party that can accomplish it at lowest cost Not blowing his horn is a cost to the motorist but a benefit to the patient Because peace and quiet is especially valuable for hospital patients the law prohibits horn blowing in the vicinity of hospitals Quiet Ho spital Zone 1n nonhospital zones the law is more liberal in its tolerance of noise In Ithaca there are 11 PM noise curfews on weekdays midnight curfews on weekends The Law of Trespass Example 217 Why does the law forbid trespass on urban residential property yet permit trespass on property located along the shore of Cayuga Lake C B A Travel from one point to another in urban areas can be accomplished easily Without crossing another s property It is much more difficult to gor from one lakeshore property to another Without crossing another s property The Right to an Unobstructed View Example 218 Lehman owns a house overlooking the lake from which he enjoys a commanding sunset view Now Martin purchases the property below Lehman39s and is considering which of two houses to build a onestory house that would leave Lehman39s view intact or a twostory design that would completely block Lehman39s view Suppose the gain to Lehman from an unobstructed view is 100 the gain to Martin from having a onestory house is 200 and the gain to Martin from a two story house is 280 If the laws of property let people build houses of any height they chose and if negotiation between property owners were costless which of the two houses would Martin build Value ofview to Lehman 100 Value of second story to Martin 28020080 The increase in Martin39s gain from having the taller house is 80 Which is 20 less than the cost to Lehman from the loss of his view The efficient outcome is thus for Martin to build the onestory house And that is exactly What would happen if the two parties could negotiate costlessly Rather than see Martin build the taller house it will be in Lehman39s interest to compensate Martin for choosing the shorter version To do so he will have to give Martin at least 80 The most Lehman would be Willing to pay is 100 since that is all the view is worth to him For some payment P Where SOSPSlOO Lehman Will get to keep his view uppose however that negotiations between the two parties were impractical Martin would then go ahead with the twostory house since that is the version he values most By comparison with the onestory design Martin would gain 4 80 but Lehman would lose 100 The optimal structure of property rights in this particular example would be to prohibit any building that blocks a neighbor39s view Of course if the valuations assigned by the parties were different a different conclusion might follow If for example Martin valued the twostory house at 300 and Lehman valued the view at only 80 the optimal structure of property rights would be to allow people to build to whatever height they chose In either case the optimal structure of property rights is the one that places the burden of adjustment either the loss of a view or the loss of a preferred building design on the party that can accomplish it at the lowest cost As a practical matter the laws of property in many jurisdictions often embody precisely this principle In cities like San Francisco where the views of the ocean and bay are breathtakingly beautiful strict zoning laws prohibit construction that blocks an existing buildings line of sight Zoning laws in cities where there is less to look at are generally much more liberal in the kinds of buildings they permit But even in cities that have no special view to protect at all zoning laws generally limit the fraction of the lot that can be occupied by manmade structures Most people value access to at least some sunlight and ordinances of this sort make it possible for them to get it Externalities Efficiency and Free Speech Th Coasian principles of efficiency apply not only to the design of property rights but also to the design of constitutions In particular they shed valuable light on the extent to which society has an interest in protecting the right to free speech The First Amendment to the U S Constitution protects most forms of speech and expression even those that cause intensely painful effects on others A man once wrote to a newspaper advice columnist to confess for a cruel act he had committed decades earlier during his senior year in high school He and his friends had leafed through the school yearbook and picked out the photograph of the girl they agreed was the ugliest in their class The letter writer had then called the girl on the telephone to congratulate her on her selection During the ensuing years he had never been able to forget her anguished groan in response He would give anything he said if he could turn back the clock and recant that phone call iven the choice between receiving such a telephone call and being hit sharply on the arm with a stick many people would immediately choose the latter Had the boys hit the girl with a stick they could have been put in jail And yet they were perfectly within their First Amendment rights to make that phone call Why does our constitution prohibit one form of harm but not the other In the Coasian framework the first thing to recognize is that it is highly impractical to negotiate case by case solutions to either type of harmful effect We just cannot imagine the boys and the girl dickering about what she would be willing to pay to avoid hearing a painful remark or for that matter to avoid being struck with a stick The structure of the law must therefore be guided by a judgment about which structure of rights will generate the best outcome where casebycase negotiation is impractical Most people would surely agree that the world would be better if speech like the telephone prank could be prohibited The practical question is whether it is possible to frame a law that would prevent such speech without preventing other speech that we value highly Sadly the answer seems to be no Any law that prevented people from making cruel remarks to others would almost surely prohibit a great deal of highly valuable speech as well The fear of criticism keeps many an otherwise wayward person in line much to society39s benefit If it were practical to write a law that would permit justified criticism but prohibit criticism that is unwarranted or even merely unkind we might be seriously tempted to implement it But so far no one has come up with such a law Even so the First Amendment39s protection of free speech is far from absolute For example it does not protect a person39s right to yell quotFirequot in a crowded theater Nor does it permit people to shout profanities on public streetcorners Nor are we permitted to advocate the overthrow of the government by violent means In such cases we seem willing to say that the benefits of free speech are generally far too small to justify its external costs Taxing Negative Externalities Example 219 Two firms X and Y have access to five different production processes each one of which has a different cost and gives off a different amount of pollution The daily costs of the processes and the corresponding number of tons of smoke are as follows Process A B C D E smoke 4tday 3tday Ztday ltday Otday Cost to Firm X 200 290 700 1300 2100 Cost to Firm Y 50 80 140 230 325 If pollution is unregulated and negotiation between the firms and their victims is impossible each firm will use A the least costly of the five processes and each will emit 4 tons of pollution per day for a total pollution of 8 tonsday 5 The city council wants to cut smoke emissions by half To accomplish this they are considering two options The first is require each firm to curtail its emissions by half The alternative is to set a tax of T on each ton of smoke emitted each day How large would T have to be in order to curtail emissions by half And how would the total costs to society compare under the two alternatives If each firm is required to cut pollution by half each must switch from process A to process C The result will be two tonsday of pollution for each firm The cost of the switch for firm X will be 700day200day500day The cost to Y will be l40day50day90day which means a total cost for the two firms of 590day How will each firm respond to a tax of T per ton of pollution Switching to the next process will cut pollution by 1 ton per day and save tax of Tday If cost of switching to the next process is less than or equal to T it will switch otherwise not T 50ton Firm X would stick with process A Firm Y will switch to process B A tax of 50ton thus does not produce the desired 50 percent reduction in pollution T 9lton X will adopt process B Y will adopt process D Total emissions will be the desired 4 tonsda Cost to firm X will be 290day200day90day Cost to firm Y will be 230day50day180day Total cost for both firms is thus only 270day or 320day less than the cost of having each firm cut pollution by half Note that the taxes paid by the firm are not included in our reckoning of the social costs of the tax alternative because this money is not lost to society It can be used to reduce whatever taxes would otherwise have to be levied on citizens The advantage of the tax approach is that it concentrates pollution reduction in the hands of the firms that can accomplish it in the least costly way The direct regulatory approach of requiring each firm to cut by half took no account of the fact that firm Y can reduce pollution much more cheaply than firm X can Under the tax approach note that the cost of the last ton of smoke removed is the same for each firm Econ 201 Lecture 13 Markets allocate scarce goods and services on the basis of willingness to pay Similarly costbenefit analysis resolves public decisions on the basis of willingness to pay Is that a good thing to do Doesn t willingnesstopay unfairly disadvantage those who don t have much money Example 131 A public radio station currently offers allmusic programming A proposal has been introduced to switch the station s format to all talk All community residents are neutral with respect to this proposal except for the following three A rich resident R who favors the proposal and two poor residents P1 and P2 who oppose it Each of these three feels equally strongly about the issue But because R is wealthy he is willing to pay 1000 to see the switch enacted while P1 and P2 are willing to pay only 100 each to prevent it Should the switch be made Costbenefit analysis says to make the switch because the benefit 1000 exceeds the cost 200 ls willingness to pay W TP the right basis for making such decisions Many social critics say no that WTP gives unfair decision weight to the preferences of the wealthy Recent Presidential executive orders in the US for example have directed agencies to temper costbenefit calculations with distributional concerns These orders militate against making the format switch Yet both rich and poor would benefit if we resolved all such cases on the basis of pure unweighted willingness to pay using the tax and transfer system to compensate those who would be hurt in the process For instance raise R s taxes by 500 reduce those of P1 and P by 250 each Compared to the status quo R has net gain of 500while P1 and P2 each reap a net gain of 150 Example 132 City Lights Antiques has a 1905 Stickley grandfather clock on display in its showroom Susan a fourth grade teacher and an aficionado of early 203911 century grandfather clocks would LOVE to own it Malcolm a personal injury lawyer has no particular interest in clocksifrom that period or any other But he happened to see the Stickley as he walked by and thought it might look nice in his office waiting room Susan a single mother of two who earns 28000yr is willing to pay up to 5000 for the clock Malcolm earns 950000yr and is willing to pay 10000 for it Who should get the clock The attraction of willingness to pay Yes Susan would enjoy the clock more than Malcolm would But because of her relatively low income she also values other things that money can buy more highly than Malcolm does If she were given the clock her best option would be to sell it to Malcolm Suppose Malcolm buys it from her for 8000 Since the clock was worth only 5000 to her Susan can now buy goods and services that are worth 3000 more to her than the clock Taking the initial distribution of income as given the best attainable outcome entails Malcolm getting the clock If you think the distribution of income is problematic try to change it Meanwhile allocating the clock to the highest bidder is the best we can do Using unweighted willingness to pay results in the largest possible economic pie When the pie is bigger everyone can have a larger slice Total surplus with unweighted Total surplus with weighted willingness to pay willingness to pay 2 Example 133 260 people show up for a ight from New York to LA that has only 250 seats John was the second passenger to arrive An office custodian on his way to visit his seriously ill mother he would have to wait 10 hours for the next available seat to LA He would be willing to pay 200 to avoid missing the ight Eric was the 2553911 passenger to arrive because of a delayed connection to NY A Microsoft vicepresident he can reach his vacation destination in Hawaii via Seattle with only one hour s delay He is willing to pay 1000 to avoid missing the flight Who should miss the flight Total wealth is maximized if scarce seats on overbooked flights are allocated on the basis of unweighted willingness to pay Pre1979 seats on overbooked flights were allocated by airlines on a firstcome firstserved basis Some of those forced to wait suffered large losses as measured by WTP while many others had no pressing reasons to arrive on time again as measured by WTP 1979 Civil Aeronautics Board proposed a new rule that would require carriers to offer cash payments or free tickets to induce volunteers to wait for the next available flight Ralph Nader s Aviation Consumer Action Project ACAP promptly filed a vociferous objection If the new rule were adopted the burden of waiting would fall disproportionately on the poor In yet another domain people with diminished ability to pay would get short shrift Poor airline passenger Run that by me again Ralph How exactly are you protecting my interests by denying me the option of volunteering to earn 400 by waiting Example 134 Illinois needs a new maximum security prison Two locations under consideration Dixon average income 100000yr Moline average income 22000yr Neither community wants the prison Dixon residents are collectively willing to pay 1 million to avoid it Moline residents collectively willing to pay only 100000 to avoid it Where should the prison be built Build the prison in Moline levy 200000 in supplemental taxes on Dixon residents reduce taxes by 200000 in Moline Former Bush Treasury Secretary Paul O Neill The business of government is to make rules that foster the creation of wealth Government has absolutely no business redistributing wealth from rich to poor quotI don39t believe this society should still be operating with a robber baron premise as the basis for how we discuss public policy I think it is really corrosive to have this argument about the rich and the poor It39s not worthy of where we are in our development as a country O Neill and other supplysiders invoke the writings of Richard Posner one of the founders of the law and economics movement Legislators should be concerned principally with protecting people s ability to bargain freely and not with redistributing wealth Indeed redistribution actually decreases total social wealth since it takes something from those who value it and puts it in the service of those who not having transacted for it will not feel the market pressures to wring the most efficient use out of it Posner and O Neill miss important parts of the picture In a democracy singleminded insistence on the illegitimacy of redistribution actually prevents actions that would increase total wea t Recall Example 131 R is willing to pay 1000 for the switch from all music to all talk P1 and P2 are willing to pay only 100 each to prevent the switch If redistribution is ruled out and we settle the issue democratically the switch loses two votes to one But a better outcome is to redistribute and make the switch For example raise R s taxes by 500 reduce those of P1 and P by 250 each Compared to the status quo R has net gain of 500while P1 and P2 each reap a net gain of 150 Refusal to redistribute makes the economic pie smaller Example 135 The energy crisis of 1979 led President Carter to propose a 50cent per gallon tax on gasoline to cut dependence on foreign oil Critics Unacceptable hardship on the poor Carter response Cut payroll taxes by the same amount as the amount raised in additional gasoline taxes Plan was never enacted partly because critics failed to grasp why it would reduce gas consumption Instead gasoline price controls were adopted to ease the burden on the poor Carter s proposal would have been better for both rich and poor Further Examples of Inef cient Responses to Distributional Concerns Rent control laws Farm price sup orts Special access or lifeline rates for public utilities Environmental exemptions for older vehicles Reluctance to adopt congestion pricing Free directory assistance Prior to 1976 calls to directory assistance operators were provide free of charge in New York State as they continue to be today in many other states This policy was inefficient because it resulted in many calls whose costs exceeded their benefits In 1976 the New York Public Service Commission proposed that a charge of ten cents per directoryassistance call be added to each subscriber s monthly bill This proposal was bitterly opposed by public interest groups who insisted that it would weaken relationships in the community by disrupting essential patterns of communications Kahn s solution B 030 010 D If willingness to pay is so great why do people object to its use Objection 1 There are thousands of public decisions made every day It is impractical to assess the distributional consequences of each one and arrange for the necessary transfers Compensation can sometimes be geared to specific cases Negativeintercept term in directory assistance billing equation Granting transferable rights to the status quo ante Denied boarding compensation Vouchers to help landlords buy tenants out of rentcontrolled leases Auctions to determine the siting of prisons and other unattractive facilities Still casebycase compensation has practical limits But the distributional issue arises in the same form in virtually every potential application of costbenefit analysis The problem is that using unweighted willingness to pay biases outcomes in favor of highincome taxpayers generally This problem has a simple solution Compensate not casebycase but once for all but making the tax and transfer system more progressive Give the poor whatever transfers society deems fit in the name of distributive justice plus an additional amount to compensate for the use of unweighted willingness to pay in cost bene t analysis Relative to abandoning willingnesstopay for public decisions this move would create net benefits for rich and poor alike Objection 2 Cost benefit analysis with compensation is fine in principle but realists know that in practice the poor never get compensated because of their lack of political power True political in uence grows with wealth But the claim that we should abandon willingness to pay to protect the interests of the nonwealthy is interesting only if the nonwealthy or their defenders have the political power to force that outcome In a democracy that is a fair assumption 1n the radio format case the two poor citizens can vote down the proposal of the wealthy citizen So if the poor have the political power to block the use of willingness to pay why don t they use that power to bargain for sufficient transfers to compensate for agreeing to the use ofwillingness to pay One possibility The public may tolerate inefficient transfers that are inconspicuous yet resist efficient transfers that are highly visible Canadian trucking rights French diesel subsidies Farm price supports But not always as in the recent adoption of payments to farmers for acreage retired from cultivation lndirect incentive problem Perhaps the level of transfers required to secure agreement on efficiency is simply unpalatable Milton Friedman s negative income tax NIT Public Employment for the Poor JOBS government sponsored jobs that pay wages in return for the performance of useful work Completely solves the incentive problem Criticisms of JOBS People will leave private jobs for government jobs thus making the program too expensive Unattractiveness of makework jobs Bureaucratic inefficiency A Combination of NTT and JOBS Too many people leave private jobs Set JOBS wage well below minimum wage Bureaucratic inefficiency Solicit bids from private contractors to manage JOBS program Makework jobs Landscaping and maintenance in parks Transport the elderly and handicapped Fill potholes in city streets Replace burned out street lamps Transplant seedlings in erosion control projects Remove graffiti from public places Paint government buildings Recycle newspapers and aluminum and glass containers Staff day care centers Make NTT grant too small to live on NIT NIT Private Job Public Job Poverty Threshold Public Job A NTT with a cash grant far too small to live on would not encourage people to drop out of the labor force Nor would a governmentsponsored job at subminimum wages lure productively employed workers out of private sector jobs But the combined income from both programs would be sufficient to lift people above the poverty threshold The low pay in public jobs participants would maintain incentives to continue searching for jobs in the private sector Again the problem confronting the poor is that they have too little money The simplest solution Give them more money Politically palatable redistribution methods exist Again when the pie is bigger everyone can have a larger slice Rather than using decision rules that make the total pie smaller we should give the poor more money and use unweighted willingness to pay in costbenefit analysis So why don t we do it 1 The argument is flawed 2 The argument is sound but people just don t understand it yet The history of tradable emissions permit proposals Econ 201 Lecture 26 WinnerTakeAll Markets People39s incomes differ because of differences in their quothuman capital an amalgam of education training experience intelligence energy and other personal attributes that affect productivity These factors are clearly important but they tell only a small part of the story Thus even though the distribution of human capital has remained virtually unchanged during the last two decades the distribution of income has grown dramatically more concentrated The top one percent of US earners have captured more than 40 percent of all economic growth since 1973 a period during which the median wage actually fell 15 percent and the bottom fifth of earners lost even more CEOs of top corporations now earn more than 500 times as much as the average worker up from only thirtyfive times in the mid 1970s What happened Contrary to what many analysts have said the top earners of today are not better insulated than their predecessors from the discipline of competition Nor are they appreciably smarter or better trained Rather the most important change has been the spread of what we call winnertakeall markets Long familiar in sports and entertainment these are markets in which small differences in talent or performance often translate into enormous differences in economic reward Insight into the nature of winnertakeall markets is afforded by a look at the forces that have transformed the classical music industry At the turn of the century there were more than 1300 opera houses in the state of Iowa alone and thousands of sopranos earned adequate if modest livings by performing before live audiences around the world By contrast most music is consumed in recorded form today and this has enabled a handful of leading sopranos to corner virtually the entire market How many of your friends can name more than four Because millions of us worldwide are willing to pay a few cents extra to hear the best performers these singers command sevenfigure contracts even as their understudies many of them only slightly less talented struggle to get by As in music so increasingly in law investment banking consulting journalism medicine corporate management publishing design fashion and a host of other professions Although the details vary in different spheres the common thread is that technical forces have enabled top performers to serve broader or more valuable segments of their respective markets Inequality is growing both because of the increased leverage of the top positions and because of the escalating competition to hire the most able people to fill them Markets for top talent in the professions have become increasingly like the freeagency markets we see in professional sports Many consequences of this change are positive We clearly benefit for example when technology allows more of us to hear the best singers or to consult with the most experienced diagnosticians But there is a downside as well We suffer not only because of the resulting growth in inequality but also because winnertakeall markets attract talent that could be more profitably deployed in other markets Literally millions of young people forsake careers in engineering manufacturing civil service teaching and other underserved occupations for a shot at one of the top positions in law finance consulting and other overcrowded arenas One might hope that such imbalances would fade as wages are bid up in underserved markets and driven down in overcrowded ones But for two reasons this hope is not likely to be realized The first is illustrated in the next example which shows how winnertakeall markets are analogous to the quotthe tragedy of the commons WinnerTakeAll Markets as Tragedies of the Commons Example 261 A small island nation has five identical individuals each of whom must choose between two occupations 1 Make pots for export in the world market Wage 12yr 2 Compete for a recording contract that pays V gt12yr to the winner 0 to the losers All contestants are equally likely to win Work one year then live one year in retirement Winner39s Payment and Expected Payoffs as Functions of the Number of Contestants Payment to Expected contestants the winner payoff 20 20 2 32 16 3 42 14 4 48 12 5 50 10 If villagers are riskneutral how many will compete for the recording contract Compete if expected reward is at least 12 gt 4 contestants Total income 48 12 60 Example 262 In the preceding example what is the socially optimal number of contestants Number of Payment to Ex ected contestants the winner payoff 1 20 20 2 32 16 3 42 14 4 48 12 5 50 10 Send an extra contestant if the gain in V is at least 12 gt send 2 contestants Total income 32 36 68 singer potters The quality of the winning singer is quottoo high quot A second reason for overcrowding in winnertakeall markets is an informational one The problem is that contestants for top positions tend to be naively optimistic about their odds of winning As Adam Smith observed quotthe contempt of risk and the presumptuous hope of success are in no period of life more active than at the age at which young people choose their professionsquot This characterization of human nature is as apt today as when he made it more than 200 years ago A recent news clip for example reported that more than 60 percent of NCAA Divisionl college basketball starters believe they will eventually start for an NBA team whereas the actual proportion is less than 5 percent Other surveys confirm this pattern For example most people think they are more intelligent than the average person and also better drivers Psychologists call this the quotLake Wobegon Effect Workers asked to rate their relative productivity on a percentile scale responded with an average selfassessment of 77 and more than 90 percent felt they were more productive than the median worker Only 2 percent of highschool seniors reported that they had belowaverage leadership ability Ninetyfour percent of university professors thought they were better at their jobs than their average colleague People see themselves as more likely than their peers to earn a large salary and less likely to get divorced or suffer from lung cancer And although only a quarter of the population thought the economy would do better in the coming year more than half thought that they personally would do better Traditional economic theory says that we get socially optimal career choices when people make well informed selfserving decisions on the basis of market incentives But if people grossly overestimate their prospects in winnertakeall markets as all evidence suggests the resulting career choices will not be socially or even individually optimal On the contrary we can expect a continued glut of contestants in winnertakeall markets We would get higher incomes both individually and as a nation if the marginal contestants were to abandon their quest to become multimillionaire personalinjury lawyers for the more modest but more predictable paychecks of electrical engineers Equity vs Ef ciency The Agonizing Tradeoft Example 263 In the preceding example how many contestants will enter if the winning singer39s income is taxed at a rate of 25 Pretax Payment to Expected Number of payment to the winner aftertax contestants the winner 39 w 25 tax 39 payoff 39 l 20 l6 l6 2 32 24 12 3 42 3150 1050 4 48 36 9 5 50 4750 750 Individuals will enter if aftertax expected return is at least 12 So two people will enter the singing contest and this is the socially optimal number Total income 36 24 8 68 Moral If the highest incomes come from winnertakeall markets then taxing the highest incomes leads to more output not less Positional Externalities in the Labor Market Relative Income and the Job Safety Choice Example 264 Smith39s utility is given by U X R S where X Smith39s monthly income in dollars R Smith39s satisfaction from relative position 200 if Smith39s income exceeds Jones39s 0 if the two have equal incomes and 200 if Smith39s income is less than Iones s and S 100 if Smith39sjob is safe 0 if unsafe If Jones39s utility function is symmetrically defined and both must choose between a safe job at 500mo and an unsafe job at 550mo draw the matrix that gives their utilities for the four possible combinations of choices Jones39s Choice Safe job Unsafe job 500mo 550mo U 750 for Jones SafeJOb U 600 eaCh 400 for Smith 500mo second beSt Best for Jones for eaCh Worst for Smith Smith39s Choice U 400 for Jones Unsafe job 750 for Smith U 550 eaCh 550mo Best for Smith Third best Worst for Jones for each Example 265 If the two decide individually which job will they choose The unsafe job is a dominant choice for each even though both would do better if both chose safe jobs How many hours to work Example 266 Smith39s utility is given by U X R 10H where X Smith39s weekly income in dollars R Smith39s satisfaction from relative position 200 if Smith39s income exceeds Jones39s 0 if the two have equal incomes and 200 if Smith39s income is less than Jones s and H of hours Smith works each week If Jones39s utility function is symmetrically defined and each must choose between a 40 hrwk job that pays 600 and a 60 hrwk job that pays 700 draw the matrix that gives their utilities for the four possible combinations of choices Jones39s Choice 40 hrwk job 60 hrwk job 600wk 700mo 7 U 300 for Jones 40 hrwk job U 7 200 Wh o for Smith 600wk Second best Best for Jones for CECh Worst for Smith Smith39s Choice U 0 for Jones U 100 h 60 hrwk job 300 for Smith C 700m0 Best for Smith Third best Worst for Jones for each Example 267 If the two decide individually which job will they choose The 60 hrwk job is a dominant choice for each even though both would do better if both chose the 40 hrwk job Econ 201 Lecture 10 Substitution is the most important reason for the law of demand When the price of something rises we turn to substitutes When the price of energy rises people form carpools take fewer trips buy 4cylinder cars take public transportation move closer to work turn down their thermostats install insulation amp storm windows install solar heaters buy more efficient appliances Example 101 Who is more likely to buy the more efficient model of window air conditioner the person who wants a machine for the house she lives in all summer or the person who wants a machine for the cottage she visits on summer weekends More efficient air conditioners cost more More sophisticated design More costly components The more efficient machine is more likely to justify its higher price the more one uses it So the person who plans to use the machine all summer is more likely to buy the more efficient machine Example 102 Why do the Japanese live in smaller houses than Americans Cultural differences Yes but why these cultural differences The differences are a simple consequence of the law of demand Market price of all land in Japan about the area of California exceeds the market price of all land in North and South America and Western Europe combined Rational Japanese consumers respond by buying smaller houses Example 103 In the US gravel for road building is made by enormous machines that crush boulders into smaller stones In Nepal grave is made by workers who hammer rocks into smaller stones Why this difference It has nothing to do with the fact that Nepal is too poor to afford the machines used in the US The price of labor in Nepal is low relative to the price of capital whereas the price of labor in the US is high relative to the price of capital Income Example 104 Why do highly industrialized countries typically have less environmental pollution than less highly industrialized countries It might seem more natural to expect the opposite relationship since industrial processes themselves are often the source of environmental pollution But more the more highly industrialized a country is the higher its income typically is And the more income people have the more they are willing to spend on equipment and processes that reduce environmental pollution Pollution Industrialization How the Distribution of Income Affects Demand Example 105 Why has the price of premium wine risen more rapidly than the average price of wine Wealthy people tend to buy fine wines people of average incomes tend to buy wines of average quality Incomes of the top 1 percent of earners have more than doubled in real terms since 1979 a period during which the median earner has experienced no gain in real income at all So demand for wines of average quality has remained stable while demand for premium quality wines has increased Adding Individual Demand Curves To Get Market Dem and Curves Horizontal Addition uppose that there only two buyersiSmith and Jonesiin the market for cashews and that their demand curves are as shown below To construct the market demand curve for cashews we simply announce a sequence of prices and then add the quantity demanded by each buyer at each price to obtain the total quantity demanded For example at a price of 4 per can Smith demands 12 pounds per week and Jones demands 4 pounds per week for a market demand of 16 pounds per week Price Pfice Pfice W 1b Mb 16 16 16 14 14 14 12 12 12 10 10 10 2 2 2 Market 39 demand 4 39 394quot 39 39 39 39 4 I 2 E a 2 2 I 04839 1216 0 4839123916 02 1392139639203924 Smith39s Jones39s Total Quantity Quantity Quantity lbswk lbswk lbswk DEMAND AND CON SUNIER SURPLUS Consumer surplus is the difference between a buyer s reservation price for a product and the price actually paid The term sometimes refers to the surplus received by a single buyer in a transaction sometimes to denote the total surplus received by all buyers in a market or collection of markets Calculating Economic Surplus Example 106 The demand curve below depicts a hypothetical market for a good with 11 potential buyers each of whom can buy a maximum of one unit of the good each day The first potential buyer s reservation price for the product is 22 the second buyer s reservation price is 20 the third buyer s reservation price is 18 and so on D 12 3 4 5 6 7 8 9101112 1m39tSday Suppose this good were available at a price of 12 per unit How much total consumer surplus would buyers in this market reap At a price of 12 6 units per day would be sold in this market The buyer of the sixth unit would receive no economic surplus since his reservation price for that unit was exactly 12 the same as its selling price But the first five buyers would reap a surplus for their purchases The buyer of the first unit for example would have been willing to pay as much as 22 for it but since she would pay only 12 she would receive a surplus of exactly 10 The buyer of the second unit who would have been willing to pay as much as 20 would receive a surplus of 8 The surplus would be 6 for the buyer of the third unit 4 for the buyer of the fourth unit and 2 for the buyer of the fifth unit Adding all the buyers surpluses together we get a total of 30 of consumer surplus each day Price unit 24 22 1 12 Consumer Surplus 16 30day 14 12 10 4 3 2 1 Example 107 How much do buyers benefit from their participation in the market for cashews whose demand and supply curves are shown below Price p ound 1 2 1 0 8 6 2 Quantity 10005 of 2 4 6 8 10 12 poundsday The last unit exchanged each day generates no consumer surplus at all For all cashews sold up to 4000 pounds per day buyers receive consumer surplus For these buyers consumer surplus is the cumulative difference between the most they would be willing to pay for cashews as measured on the demand curve and the price they actually pay Total consumer surplus received by buyers in the cashew market is thus the shaded triangle between the demand curve and the market price in the diagram Pnce C onsumer pound mplus 12 10 S 8 6 4 D 2 Quantity 10005 of 2 4 6 8 10 12 poundsday Note that this area is a right triangle whose vertical arm is h4pound and whose horizontal arm is b4000 poundsday And since the area of any triangle is equal to l2bh consumer surplus in this market is equal to l2x4000 poundsdayx4pound 8000 day A useful way of thinking about consumer surplus is to ask what is the highest price consumers would pay in the aggregate for the right to continue participating in this cashew market The answer is 8000 per day since that is the amount by which their combined benefits exceed their combined costs Econ 201 Lecture 11 Example 111 How should Leroy divide his time between picking apples and writing pulp fiction A men39s magazine will pay Leroy 10 cents per word to write fiction articles He must decide how to divide his time between writing fiction which he can do at a constant rate of 200 words per hour and harvesting apples from the trees growing on his land a task only he can perform His return from harvesting apples depends on both the price of apples and the quantity of them he harvests Earnings aside Leroy is indifferent between the two tasks The amount of apples he can harvest depends as shown in the table below on the number of hours he devotes to this activity For each hour Leroy spends picking apples he loses the 20 he could have earned writing pulp fiction He should thus spend an additional hour picking as long as he will add at least 20 worth of apples to his total harvest For example if apples sell for 250 per bushel Leroy would earn 20 for the first hour he spent picking apples but would earn only an additional 10 if he spent a second hour Thus at a price of 250 per bushel Leroy would allocate 1 hour to picking apples during which time he will harvest 8 bushels If the price of apples then rose to 5 per bushel it would pay Leroy to devote a second hour to picking which would mean a total of 12 bushels of apples Once the price of apples reached 667 per bushel he would devote a third hour to picking apples for a total of 15 bushels If the price rose to 10 per bushel he would pick for four hours and get 17 bushels And finally once the price of apples reached 20 per bushel Leroy would supply five hours of applepicking services and would harvest 18 bushels of apples Leroy s individual supply curve for apples relates the amount of apples he is willing to supply at various prices P bu Leroy39s supply curve 2000 0139 apples 1000 I 667 500 I I I 250quot 1 I I d 8 1215118 Qam a 17 An Individual Supply Curve for Apples 2 Market Supply The quantity that corresponds to any given price on the market supply curve is the sum of the quantities supplied at that price by all individual sellers in the market Example 112 If the supply side of the apple market consisted of 100 suppliers just like Leroy what would the market supply curve for apples look like P bu Market supply curve 2000 for apples 1000 I 667 I 500 I I II 23950 i i JIJIJ 100 fbud 8 1215l8Q so a 17 The Market Supply Curve for Apples As noted earlier the typical individual supply curve is upward sloping at least in the short run for two reasons 1 The Fruit Picker39s Rule Always pick the lowhanging fruit first When fruit prices are low it might pay to harvest the lowhanging fruit but not the fruit growing higher up the tree which takes more effort to et to But if fruit prices rise sufficiently it will pay to harvest not only the lowhanging fruit but also the fruit on higher branches 2 Differences among suppliers in opportunity cost People facing unattractive employment opportunities in other occupations may be willing to pick apples even when the price of apples is low Those with more attractive options will pick apples only if the price of apples is relatively high ProfitMaximizing Firms and Perfectly Competitive Markets Definition The profit earned by a firm is the total revenue it receives from the sale of its product minus all costsgexplicit and implicitiincurred in producing it Definition A profitmaximizing firm is one whose primary goal is to maximize the difference between its total revenues and total costs Definition A perfectly competitive market is one in which no individual supplier has significant influence on the market price of the product Wheat Market Photocopying Market Definition A price taker is a firm that has no in uence over the price at which it sells its product Wheat farmers Kinko s Contrast with price setter Microsoft operating systems Intel microprocessors Definition A factor of production is an input used in the production of a good or service Definition A fixed factor of production is an input whose quantity cannot be altered in the short run Definition A variable factor of production is an input whose quantity can be altered in the short run Example Louisville Slugger uses two inputs labor eg woodworkers and capital eg lathes tools buildings to transform raw materials eg lumber into output baseball bats Labor is a variable input and capital is a fixed input 3 Note in the right column that output gains begin to diminish with the third employee Economists refer to this pattern as the law of diminishing returns and it always refers to situations in which at least some factors of production are fixed Here the xed factor is the lathe and the variable factor is labor Some Important Cost Concepts Suppose the lease payment for the Louisville Slugger s lathe and factory is 80 per day This payment is both a xed cost since it does not depend on the number of bats per day the firm makes and for the duration of the lease a sunk cost The company s payment to its employees is called variable cost because unlike fixed cost it varies with the number of bats the company produces The firm s total cost is the sum of its fixed and variable costs The firm s marginal cost finally is the change in total cost divided by the corresponding change in output Louisville slugger pays each employee a wage of 24day Example 113 For each level of employment calculate Louisville Slugger s output fixed cost variable cost total cost and marginal cost per per day 39 day cost SSday Choosing Output to Maximize Pro t 1 a company s goal is to maximize its profit it should continue to expand its output as long as the marginal benefit from expanding is at least as great as the marginal cost Example 114 Suppose the wholesale price of each bat net of lumber and other materials costs is 250 How many bats should Louisville Slugger produce If we compare this marginal benefit 250 per bat with the marginal cost entries shown in table we see that the firm should keep expanding until it reaches 175 bats per day 6 employees per day To confirm that the costbenefit principle thus applied identifies the profitmaximizing number of bottles to produce we can calculate profit levels directly per ICV enue Again note that 6 employees corresponds to the maximumprofit level of output 4 When the law of diminishing returns applies that is when some factors of production are fixed marginal cost goes up as the firm expands production beyond some point Under these circumstances the firm39s best option is to keep expanding output as long as marginal cost is less than price Note in Example ll4 that if the company39s fixed cost had been any more than 29350 per day it would have made a loss at every possible level of output As long as it still had to pay its fixed cost however its best bet would have been to continue producing 175 bats per day because a smaller loss is better than a larger one If a firm in that situation expected conditions to remain the same it would want to get out of the bat business as soon as its equipment lease expired
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