Economics 103
Lecture # 12
Applications of the
Neoclassical Model.
Equilibrium … one more time … with feeling!!
Think of what you’ve
learned so far:
-maximization.
-demand … individual
and market.
-supply … firm and
market.
- CS and PS.
-and the idea that the force of maximization lead to the
equilibrium of P* and Q*.
In this equilibrium MC = MV.
Those who value the goods
most, get them.
Those who have the lowest
costs, make them.
Together, the gains from trade are maximized.
This was Adam Smith’s great insight, the private vice of
the individuals still led to the public virtue of maximized
wealth.
Furthermore, we know in this equilibrium that every individual
is also in equilibrium, and every firm is in equilibrium.
Changes in any parameter lead to changes in the equilibrium.
EG. Suppose there were three identical grocery stores, but not everyone
lives the same distance from each store. The equilibrium might look
like:
Now suppose the third store introduces an innovation that lowers
its costs. What happens?
The supply curve of the third store falls, more people shop there.
Fewer people shop at the other two stores, demand falls.
In equilibrium, the prices, marginal values, and marginal costs
are equal again across all of the stores.
For many, this means
But we don’t want to preach the virtues of the competitive world, we
want to use this model to explain various things around us.
1. Shifting Curves around.
Why have human
egg banks, started to
appear?
At one time the costs were high and
demand low.
Costs have fallen a tremendous amount
and the delay of children has increased
the demand, until a market arises.
2. Trade one more time.
Suppose Tom and Gary are not involved in trade. They generate
consumer and producer surplus by themselves equal to the shaded
area.
If they are allowed to trade:
There is a net benefit to both of them.
What would happen if a third person came along who produced
pigs at a lower price than Gary?
Gain to Tom
Loss to Gary
Gain to
Cindy
Will everyone be in favor of free trade?
- Not Gary!
Net Gain to the
Economy.
3. The effect of a Tax.
a. A $1 per unit tax on human egg storage.
The first effect will
be an increase in the
MC of every firm of
$1.
This means the
market supply curve
will increase by $1
everywhere.
The price to consumers
goes up by 60 cents,
the price to firms goes
down by 40 cents.
What will the share depend on?
What happens if you put a $1 per unit tax on the consumers of
this service?
Now the perceived demand to
the firm has fallen
The interesting thing
is the effect of the tax
is the same.
Note, there is a DWL due to the tax.
Will the govt. want to tax goods with inelastic or elastic demands?
Suppose you wanted to be an egg farmer, but you only knew as
much as these chickens.
Can you just start up an
egg farm and send your
product to market?
You’d run into someone
like this:
4. To grow chickens, turkeys, eggs, milk, and by-products, you need
a quota.
A quota is a license to grow a certain amount of output.
Using our model, what would be the effect of a quota?
Clearly the quota
- decreases output
- increases price
- creates a deadweight loss
- transfers wealth to some
farmers
How much would a quota sell
for?
Do new farmers benefit from
the quota?
What are the incentives of the individual chicken farmer?
Without the quota the farmer
wants to produce Q*, and
makes zero profit.
With the quota the farmer can
earn a profit equal to the shaded
area if he follows his quota.
However, he has an incentive to
produce Q’’ and make even more.
Thus quotas must be policed.
When the tariff is placed on wine imports, the price to domestic
consumers increases by the amount of the tariff.
The quantity demanded
falls, and the quantity
domestically produced
increases.
The total amount imported falls.
Is reducing the amount of imports a good thing?
The tariff generates a wealth transfer from consumers to
the government in the form of tariff revenue.
The tariff also increases the price to domestic firms, causing a
transfer from consumers to firms.
We generally don’t have much to say about transfers.
Finally the tariff creates two deadweight losses.
The yellow area is
the lost consumer’s
surplus.
The blue area is the
DWL that results
from increased costs
of production.
At the international level, tariffs are often considered better than
a quota because:
1. They generate revenue for the government. A quota just
just generates revenue for the foreign firm.
2. They are relatively visible, and easy to reduce through
trade deals.
6. Rent or Price Controls.
Rent controls are often popular
because we tend to think of them
as nothing but a transfer from
wealthy landlords to poor tenants.
But you should be starting to realize that changing prices away
from their equilibrium levels lead to changes in behavior that
are not always good.
What would the effect of a rent control be, and would it necessarily
benefit tenants? All tenants?
The initial effect of a rent control is to lower the price to
tenants.
This increases the quantity
demanded.
It lowers the quantity supplied.
Creating a shortage.
You have a hard time
finding an apartment in
a rent controlled city.
The rent control creates a transfer and some DWL’s
The crosshated area is the
transfer.
The blue area is the lost CS
from tenants who no longer
can rent.
The red area is the lost PS from
landlords who can no longer
rent.
However, at this reduced quantity supplied, the MV is greater
than the marginal cost of housing. Consumers are willing
to pay more for housing than landlords require to rent.
Competition
among renters
will compete this
away.
This competition reduces the net transfer to tenants, and may or may
not increase the DWL.
Whether we count
the blue area as a
DWL depends on
how the competition
takes place.
If waiting … DWL
If “key money” then
transfer.
Note that, at the margin, rents are actually higher!!
7. Warm houses in Cold climates.
Here’s the puzzle:
1. when I visit Ottawa in the winter I’m too hot inside.
2. When I visit Christchurch in the winter, I’m too cold
inside.
Why is it that inside temperatures vary inversely with the outside
temperature?
What is the climate like in Vancouver?
What about Christchurch?
And what about our capital?
This doesn’t include
wind chill or
humidity!
Ottawa has the coldest
average winter temp
than any other capital
city.
People in Ottawa obviously have to spend a lot on heating their
homes, so why would they heat them more?
This sounds like a violation of the law of demand!
The key is to understand the very simple cost function for
heating a home:
TC = price of heat x Barrier [ Temp inside – Temp outside ]
MC = price of heat x Barrier
The total cost functions for different houses looks like the following:
What is the difference
between house 1 and 2?
What is the difference
between house 1 and
3?
Let’s suppose the demand for heat is the same across all three
cities. What would the choice be if all cities had the same
type of house?
Everyone would have
the same inside
temperatures.
But the houses are not the same!
In Vancouver houses:
-.
-
-
In Ottawa:
Houses are:
-
-
In Christchurch the houses are different still.
Houses:
-
Thus the different style of houses leads to different MC of heating.
Which location will
have the highest cost of
heat in total?
8. The Marriage Market.
The neoclassical model we’ve been looking at is great at predicting
the terms of trade (price) and the volume of trade (quantity).
As long as we keep in mind that this is all this model can do, then
there are no limits to the applications.
Thus we can use it to analyze the number of marriages, and the
terms at which people get married.
We cannot use it to discuss institutional questions of marriage
… for that we’ll need to wait for a richer model. Chapters 15-17.
• With that in mind, let’s assume the following:
1. Men and women make their own choices of spouse.
2. All men and women rank each other the same.
3. Monogamy only.
4. No cheating in marriage.
5. A “price” of a spouse exits. This could be the form of a
dowry or bride price, but may just be the value of net
wealth brought to the marriage.
6. The value of wealth brought to a marriage may include
any economic good: dollars, beauty, genetics, personality,
future income, etc.
Under these terms we can draw demand and supply curves for
spouses.
So here is a market for
wives.
The men are doing the demanding
and the women are doing the
supplying.
In equilibrium the price is zero (no net transfer) and there are
four million marriages.
What would the market for husbands look like?
The Market for husbands would be reciprocal.
That is, the demand for husbands is also the supply of wives, and
vice versa.
Once again, there
are 4 million
marriages, and
a zero net price.
If husbands paid $10000 for a wife, then
6M husbands would be demanded, and only
3M would be supplied.
The point of a model like this is to see if it can explain anything.
1. What would be the effect of Polygamy? (more than one wife)
This raises the demand
for wives, increasing the
price of wives.
Women better off,
men worse off.
2. What about Polyandry? (more than one husband)
The same thing. Increased demand for husbands, increase in the
price of husbands. Men benefit in this case.
Why does this grind against our intuition?
-
According to this model, a key factor in terms of the “price” is
the sex ratio: M/F.
If M/F is large, then the “price” to women will increase.
If the M/F ration is low, then the “price” to women will fall.
-
There are lots of examples of swings in the M/F ratio.
1.
2.
3.
4.