ECON1020 Full Lecture Notes
W1: The Capitalist Revolution
Introduction
GDP per capita → Measures value of all goods & services produced in a
economy per person
represents average income level → all products will be eventually sold in the
market & become somebody's income
most popular measure for level of living standards, however;
not entirely based on income level, but to an certain extent it is
graph observations
all countries experienced a rapid & sustained GPD growth from around 1700
→ hockey stick growth
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income disparity between countries in later years → hockey stick growth
began at different times for each country
Inequality
inequality within the world
as countries become richer → inequality increases → applicable between &
within countries
e.g. Singapore → richest country → top 10% earn $67, 436 → bottom 10%
earn $3,652
e.g. Liberia → poorest country → top 10% $994 → bottom 10% earn $17
hockey stick growth → countries who grew first are now richer, however have
greater inequality
gross domestic product → measure of total income & output of the economy in a
given period
per capita → per person → average income
disposable income → total income - taxes + government transfers
GDP is a imperfect measure, however correlates strongly with other
measures of wellbeing
e.g. life expectancy, infant mortality rate, etc
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Hockey Stick Growth
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Ratio Scale
hockey stick growth→ represents the sustained rapid growth in GDP per capita
experienced by countries worldwide
PPP → people purchasing parity → essentially inflation adjustment
timing of growth
occurred at the different times for each country
e.g. Britain → 1650, Japan → 1870, China & India → 1950s
improvements in living standards didn't happen till independence from
colonial rule or interference for some countries
technological revolution
technology → process that uses input to produce output
allows increased output with the same amount of input within a smaller time
frame
revolution driven by scarcity of time → balance between work & leisure
activities
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technology eases balance → more work & more leisure OR less work in
exchange for more leisure
industrial revolution
technological advances in 18th century Britain → transformed agrarian &
craft to commercial & industrial economy
e.g. productivity of labour in producing light
e.g. speed of information=
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environmental consequences
caused by;
expansion of economy → growth of total output
organisation of economy → what things are valued
generally society values "stuff" as opposed to the consequences to
obtaining that "stuff"
technology may have instigated these consequences, however may procure a
solution → issue → motivation & time to develop these technologies to resolve
climate change
Capitalism
institutions → laws & social customs governing the production & distribution of
goods & services
capitalism → economic system where the main institutions are private property,
markets, & firms
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private property → ownership rights over possessions
capital goods → non-labour inputs used in production
does not include essentials → air, knowledge, etc.
markets → way for people to exchange products & services for their mutual
benefit
features;
reciprocated transfers
voluntary
usually competition
firms → business organisation that uses in inputs to produce outputs, & sets
prices to at least cover production costs
features;
Inputs & outputs are private property
uses markets to sell outputs
aim to make profit
pursuit of profit provides an incentive to innovate & adopt new technology →
scarcity of time
capitalism lead to growth of living standards because;
technology → firms competed in markets to create new technology
specialisation → growth of competency in one particular task or expertise
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specialisation → increases labour productivity by becoming better at producing
when focusing on a limited range of activities
learn by doing
taking advantage of natural skill differences
economies of scale
specialisation can only occur if people have another way to acquire
other needed goods → done by markets via capitalism
comparative advantage
e.g. comparative advantage
Greta has absolute advantage in both crops
Greta has comparative advantage in wheat
Carlos has comparative advantage in apples → least disadvantaged
comparative advantage → produce the most output through
specialisation of all individuals involved
divergence of growth
did capitalism cause the hockey stick growth?
natural experiment → division of Germany into 2 seperate economic
systems → west capitalism & east centralism / communism
not all capitalist societies are equally successful
correct incentives
economic → firms, markets, private property
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political → government regulation promotes institutions & provides
essential goods & services
political systems → how governments will be selected, & how those
governments will make & implement decisions
capitalism coexists with many political systems, generally associated with
democracy, however has been with non-democratic societies
Economics
economics → study of how people interact with each other & with their natural
surroundings in producing their livelihoods, & how this changes over time
W2: Technological Change, Population &
Growth
Introduction
major economic changes occurred 200 years ago
why didn't it start earlier, or later?
why did it start in Britain
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real wage index → purchasing power
1850 = 100 → year 1850 used as bench mark
nominal wage → physical number written → doesn't account for purchasing
power / inflation
can be used as another measure of living standards → similar to GDP
2 vertical axes → compare how the variables change in relation to the other
variables
graph observations;
1350 → black plague
population decreases as wages increase
as years pass towards 1600, population increases back up & wages
decrease back down
1800 → Malthus → economist
he said based on past → despite improvements are increasing, as
population increases back up , the living standards will come back down
post malthus
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population & real wage have increased together → disproved Malthus'
theory
technological revolution allowed to escape malthusian trap
Economic Models
building a model
distinguish essential variables relevant to the question
omit unimportant variables → model feature NOT bug
real world complexity is simplified → too simplified, model is useless
steps;
1. capture elements of the economy that matter
2. describe how agents act & interact with each other & other elements
agents → consumers, firms, etc.
3. determine outcomes of actions → equilibrium
equilibrium → situation that is self perpetuating
4. study what happens when conditions change → change a variable in
model
features of a good model
clear → better understand something important
predicts accurately → consistent with real world evidence
improves communication → help understand agreements & disagreements
useful → help find ways to improve the economy
model concepts
ceteris paribus → other things equal
less is more → keep variables constant
incentives → economic rewards or punishments, which influence benefits &
costs of alternative courses of actions
how they affect rational of people
relative prices → compare alternatives
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price of product relative to the cost of other similar products
economic rent → benefit received from a choice, taking into account the next
best alternative
alternative → reservation option
differences between the choices → e.g. going to uni lecture VS skipping
and staying at home
Explaining Growth I
modelling technology
technology → a process that uses inputs to produce an output
e.g. textile production
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manager of textile firm wants to produce 100 metres of cloth
inputs that matter;
how many workers to hire
how much energy/coal to purchase
5 different ways to produce 100 metres of cloth
each technology expressed as a combination of coal & workers
observations;
E is relatively labour intensive
A is relatively coal intensive
no information for cost per unit → unable to determine single cheapest
technology
able to determine which technologies definite will be inefficient
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some technologies dominate other technologies → use less workers &
energy together
tech C is inferior to / dominated by tech A → wont choose C
tech D is inferior to / dominated by tech B → wont choose B
options left → A,B,E
minimising cost
firms aim to maximise profit → minimise costs
profit = revenue - cost
cost = (wages x workers) + (coal cost per ton + no. of tons)
cost = (w x L)+(p x R)
least cost technology
tech B is the cheapest with the 1st input prices → labour intensive is
cheaper with coal cost increase
tech A is the cheapest with 2nd input prices → coal intensive is cheaper with
coal cost reduction
isocost lines → combination of inputs that give the same cost
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slope represents the same cost with different level of each input
C = (w x L)+(p x R)
rearrange to R
=
c
p
−
w
L
p
isocost line for $80 when w = 10, p = 20
R=
80
20
−
10
20 L
= 4 − 0.5L
y = mx+b
4 → intercept
-0.5 → gradient
tech B is the least cost technology
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all other techs have the same slope gradient → same worker + coal
input costs → above line more expensive, below line less expensive
isocost line when changing input variables
Explaining Growth II
change in relative input price → change in firm's technology choice
e.g. increase in coal prices → shift from coal based technology to labour
intensive technology
technology was labour intensive before industrial revolution
increase in wages relative to coal price incentivised firms to innovate capital
intensive technology
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graph observations;
tech B is the cheapest technology when there is a lower relative price of coal
to workers
tech A is the cheapest technology when there is a higher relative price of
workers to coal
graph observations;
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relative input price → England had a higher relative wage price compared to
France
similar in 2nd graph, firms in England had incentive to change their
production from labour intensive to capital intensive → wages become
relatively higher
benefits of innovation
innovation rent → reduction of costs associated with adopting the new
technology
e.g. old tech → $50, new tech → $40, rent → $10
creative destruction → process by which old technologies & the firms that do not
adapt are swept away by the new, because they cannot compete in the market
first adopter → entrepreneur
e.g. textile industry
before industrial revolution → making garments were time consuming →
made at house hold level
by 19th century → single spinning mule operated by a few people could
replace 1000 spinsters
later, these machines were powered by water wheels then later again, coal
powered steamed engines
Explaining Stagnation
minimal growth before the industrial revolution
law of diminishing average product of labour
if one input is fixed (land) & the other is expanded (workers) the average
output per worker decreasesre
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malthus' model
key ideas;
population increases with living standards
law of diminishing returns → income with fall → living standards will faill
reach equilibrium of subsistence / base level
income levels fall back to a subsistence level → enough to sustain
basic human consumption
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malthusian trap
conditions;
diminishing average product of labour
rising fertility in response to wages
absence of continual technology improvement to offset diminishing
returns
technological revolution → condition of no technological improvement was
subverted → able to escape malthusian trap
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W3: Scarcity, Work & Choice A
Introduction
graph observations;
economic progress → consume more goods & enjoy more free time
proportion between income & free time differs
inverse relationship between GDP & annual hours worked → as GDP
increases, hours of free time increase
time has been used for more social connections, leisure, sleep, etc.
resources are scarce → choices need to be made → money / work VS free time
too many hours working costs the free time u could have had
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model of individual choice → indifference curves
how an individual maximises happiness with the constraints faced
what we want → indifference curves VS what we can do → feasible
frontier
Production Functions
e.g. grades & study hours
student needs to choose between study & free time
assume positive relationship between hours studied & GPA
is true → although all other factors must be constant → ceteris paribus
observations;
better environment also impacts GPA → assumption of study hours & GPA
is false
HS + PE has a lower GPA → ceteris paribus → factors aren't being held
constant
production function → shows how inputs translate into outputs, holding other
factors constant
marginal product → change in output per unit change in input
evaluated at a given point
other inputs held constant
average product → average output per unit of input
e.g. studying
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marginal product of the 5th hour
4 hours → 50 mark
5 hours → 57 mark
marginal product → 7
average product of 4 hours
4 hours → 50 marks
average product → 12.5
diminishing marginal product → studying becomes less productive → marginal &
average product decreases as hours increase
production function represents what the student is capable of
final decision would depend student's preference
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Indifference Curves
indifference curves → shows all combinations of goods that give the same
utility/benefit
e.g. student studying → all combinations of studying & free time that give the
same amount of happiness
marginal rate of substitution → the slope of the indifference curve & represents
the tradeoffs that an individual faces
e.g. student studying → how many marks lost for one extra hour of free time
& still feel indifferent
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indifference curve properties;
curves slope downward due to trade offs → inverse relationship
higher curves correspond to higher utility levels → further from origin
curves are usually smooth → incremental changes don't create large jumps
in utility
curves do not cross → rational preference is consistent
curve flattens as you move to the right → vice versa, becomes more vertical
as you go left → relative value of each unit changes depends on abundance
of each in every combination
e.g. student studying → if you have a lot of marks & little free time, you
would be willing to give up more marks for one hour of free time,
however give up less marks as you have more & more free time
Opportunity Cost
opportunity cost → of an action is the net benefit of the next best alternative
action
economic costs = monetary cost + opportunity cost
e.g. opportunity cost of going to 2 concerts
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economic rent → difference between benefit & cost
if the benefit from an action exceeds the economic costs, you receive an
economic rent from choosing it
Feasible Frontier
feasible frontier → maximum output that can be achieved with a given amount of
input
e.g. student studying → output includes both studying & free time hours →
all available resources
marginal rate of transformation → slope of the feasible frontier & represents
tradeoffs that an individual faces
feasible set → all of the combinations of the things under consideration that a
decision-maker could choose given the economic, physical or other constraints
that they face
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observations;
feasible frontier
B is not feasible → outside feasible frontier
points on the feasible frontier → feasible
D is feasible → but resources were not fully used
marginal rate of transformation
A→E
enjoy one more hour of free time at the cost of 3 marks →
opportunity cost of 3
C→F
MRT / opportunity cost of 7
Decision Making Under Scarcity
indifference curves → what you want
trade off you want to make → doesn't translate to reality
feasible frontier → what you can do
actual trade off differences
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optimal decision making
utility maximising choice is where the trade off an individual wants to make
equals the actual trade off that can be made
MRS = MRT, slope of indifference curve = slope of feasible frontier
observations;
F is the most preferred → however not feasible → outside feasible frontier
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A, B, C, D & E are all feasible → on the feasible frontier
C is the least optimal → below feasible frontier
E is the most optimal → MRS = MRT & highest level of utility → higher
indifference curve
W4: Scarcity, Work & Choice B
Hours of Work & Economic Growth
1930 → John Maynard suggested;
in 100 years, technological improvements would make us 8 times better off
only need 15 hours of work per week to satisfy economic needs
reality;
working hours have fallen, but not to the extent suggested above
e.g. farmer deciding hours of work VS free time
application of model of constrained choice to a self sufficient farmer
choosing number of hours to work
assumptions;
only grows gain to eat → no selling of surplus
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not enough grain → will starve
scenario change → production function changes → improvement in
technology
farmer can produce same amount of grain with less hours of work
VS more grain with the same hours of work
how much free time will they choose?
feasible frontier & indifference curves
production choice & technological change
production function → initial technology → PF
point B → works 12 hours → produce 64 units of grain
production function → technological improvement → P Fnew
point C → works 12 hours → produce 74 units of grain
point D → works 8 hours → produce 64 units of grain
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feasible set → turning production function to feasible frontier
adding indifference curves
technological improvement → increasing feasible frontier
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highest level of utility with the initial technology
point A → IC3 → 16 hours of free time → produce 55 units of grain
highest level of utility with the improved technology
point E → IC4 → 17 hours of free time → produce 61 units of grain
conclusion;
technological improvement raised the farmer's standard of living
able to achieve higher utility
increase in both grain produced & free time
however, just one possible result
if feasible frontier or indifference curves were different → optimal choice
would differ
e.g. preference for free time or grain produced
Income & Substitution Effects
budget constraints
what you can afford to buy & consume
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assume spending can not exceed your earnings
c = w(24 − t) = w × working hours
w = wage
t = hours of free time per day
e.g. working hours
calculating budget line
c = 15(24 − t)
c = 360 − 15t
x axis starts at 8 hours → y-int is 240
MRT = 15 → every hour of free time is $15 of consumption
opportunity cost for 1 hour of free time
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slope shape → linear → no diminishing marginal productivity
output is a wage → constant wage → regardless of productivity
Note;
is essentially another feasible frontier → equation used to create
budget line
level of your consumption that you can afford from working →
add indifference curves to find the optimal choice for the level of
consumption that you are happy with
can only do things below the budget line → within budget constraints
another perspective
$360 is the maximum wage earned per day → work 24 hours
worker spends $360 purchasing consumption & free ti,e
at point A → spends $270 on free time & $90 on consumption
model changes;
wage increases
income effect → total earnings increase while work hours stay the
same & opportunity cost of free time
more consumption & more free time
substitution effect → opportunity cost of free time increases
more consumption & less free time
e.g. effects on working hours
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new wage → $25
new budget constraint → feasible set has expanded
increase in feasible frontier → able to reach higher indifference curves
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point D → optimal choice
only 17 hours of free time but consumption equals $175
hypothetical change
no change in opportunity cost of free time
flat addition of money → regardless of hours → some income
even when working 0 hours
dotted line → income increase enough to reach IC4 → point C
would become the best optimal choice
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income effect → hypothetical line
shift from point A to C
increase in consumption & free time → achieved with increase in
income
income effect is positive in terms of free time
substitution effect → steeper line
rise in opportunity cost of free time → make budget constraint
steeper
optimal choice would be point D → more consumption with less free
time
negative substitution effect in terms of free time
overall effect → sum of income & substitution effect
substitution effect was bigger than income effect → negative overall
effect
Application to Technological Change
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differences over times
observations;
US, France & The Netherlands → income effect dominated the substitution
effect → consumption & free time increased
cross country differences
international differences in working hours explained by country differences in
preferences & constraints
impossible to accurately determine countries' indifference curves
determined through data → GPD & hours of free tine → assumes what
is happening is the optimal choice
US & South Korea indifference curves
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observations;
point Q → intersection for indifference curves of US & South Korea
Americans are more willing to give up more daily goods for an hour of
free time than South Koreans → US values free time more than South
Koreans
explanation for differences;
cultural & social norms
e.g. Asian countries encourage overworking
legal & political influences
e.g. legal limits on working hours
social preferences
e.g. social peer pressure
model criticisms
unrealistic → no one calculates MRS & MRT & people are unable to choose
their ideal work hours
still a good approximation → gradually adjust work life balance to a
satisfactory level, choose full or part time or the type of jobs to do
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economic models helps understand real world phenomena
W5: Social Interactions
Introduction
context
previous models are self contained → no dependancy on outside decisions
& influences
individuals motivated by self interest could produce beneficial outcomes to
society
however self interest can be harmful to society
social dilemma → when people do not take adequate account of the effects of
their decisions on others, whether these are positive or negative
selfish decisions result in socially suboptimal outcomes
tragedy of the commons → common property or resources are
overexploited
free riding → benefiting from contributions of others without contributing
oneself
use tools of game theory to model social interactions & explain social
dilemmas
Game Theory & Social Dilemmas I
key terms;
social interaction → situations involving more than one person/party, where
one’s actions affect both their own & other people’s outcomes
strategic interaction → social interaction where people are aware of the
ways that their actions affect others
strategy → actions that people can take when engaging in a social
interaction
game → models of strategic interaction that describes the players, the
feasible strategies, the information that the players have, & their payoffs
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decisions are interdependent on opposing decisions
payoff matrix → table of the game's possible outcomes
game theory → sets of models of strategic interactions that are widely used
in economics & other social sciences
how people make decisions
invisible hand game
rules;
2 farmers decide what crop to grow
one shot game → interact once
decide simultaneously
factors;
players → Anil & Baba
feasible strategies → rice or cassava
information → each player doesn't know what the other will choose
payoffs → depends on market prices & quality of land
invisible hand game outcomes
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best response → strategy that yields the highest payoff, given the other
player’s strategy
if Bala grows rice, Anil's best response is to grow cassava
if Bala grows cassava, Anil's best response is to grow cassava
vice versa for Bala, he's best response for both situations is to grow
rice
dominant strategy → best response to all possible strategies of the other
player, don't always exist in every game
dominant strategy equilibrium → outcome of a game where everyone plays
their dominant strategy
if Anil & Bala played their dominant strategy, the outcome would be
cassava & rice respectively
despite being motivated by self interest, the best outcomes for individuals
also happened to be the best outcome socially → guided by an invisible
hand
prisoner's dilemma game
game
farmers need to use pest control to get rid of pests
conditions are the same except for strategy & payoffs
dominant strategy
Anil → terminator
Bala → terminator
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prisoner's dilemma outcomes
best responses
if Anil uses IPC, Bala's best response is terminator
if Anil uses terminator, Bala's best response is terminator
vice versa, Anil's best response in both situations is to use
terminator
socially optimal strategy → both would use IPC
dominant strategy equilibrium → both would use terminator → both farmer's
dominant strategy
socially sub optimal outcome → thus players are now faced with a social
dilemma issue
prisoners’ dilemma → game in which the payoffs in the dominant strategy
equilibrium are lower for each player & in total than if neither player played
the dominant strategy
socially optimal outcomes are not achieved when dominant strategies
are used
nash equilibrium → set of strategies in which each player's strategy is the best
response to the strategies chosen by everyone else
no incentive to deviate unilaterally
games can have more than 1 nash equilibrium
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how we were able to predict this outcome?
players that value the other's payoff
nobody could make players pay for the consequences of their actions
players could not coordinate their actions beforehand
Resolving Social Dilemmas
social preference
altruism → preference that place value on what happens to other people,
even if it results in lower payoffs for the individual
prisoners dilemma's are easy to resolve if people care about one another
however, more difficult within larger groups
e.g. prisoner's dilemma
feasible frontier → only 4 possibilities, thus no feasible frontier, instead 4
feasible points
selfish preference
Anil doesn't care about Bala's payoffs → vertical indifference curves
Anil does't care about Bala's payoffs, thus curve is vertical
T, I is his preferred outcome
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altruistic preference
Anil cares about Bala's wellbeing → indifference curves are
downward slopping
I, I is his preferred outcome
if both care about each other, both would choose I, I
other social preference
reciprocity → being kind to other who are kind & vice vera to people who are
unkind
fairness / inequality aversion → disliking outcomes where some individuals
receive more than others
social norms → determination of whether being have been nice or not based
on social norms
these motives affect outcomes in public goods game & the ultimatum game
learning about social preferences
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lab experiments
can control participant's decision & outcomes
can create a control group for comparison
results can be replicated & repeated
can control other variable
field experiments
lab experiments may not be accurate to real world decision making
more realistic context & scenarios where people make decisions
public goods game
game
group of farmers
each farmer decides whether or not to contribute to the public good
public good → good which use by one person does not reduce its
availability to others
private good → good that reduces its availability for every use
individual contribution costs $10, everyone benefits $8
observations;
free riding is the dominant strategy for all farmers
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if all contributed. they get $22 each. however, will gain more if they
don't contribute compared to others that do
dominant strategy equilibrium → no one contributes & no one gains
payoffs → social dilemma
similar to prison dilemma, however for more than 2 parties
repeated games
both games above are one shot → no accountability for the
consequences of their actions
however, in the real world, social interactions consist of ongoing
relationships
behaving selfishly in one period has consequences for future
periods → one shot dominant strategy may not be the dominant
strategy in the futures
better outcomes may arise through repeated interactions → social
norms, reciprocity & peer pressure / punishment
repeated public goods game experiment
game
experiment conducted in cities
participants randomly sorted into groups of 4
10 rounds played, each round decide on contribution from their $20
every dollar contributed, every person receives 40c
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outcome
contributions started of high, but gradually decreased over the periods
people are not solely self interested at first → could altruism
however, participants want to punish the free riders → unfairness
reciprocity → people at first treated others well, however as
contributions fell, participants felt to be less generous since others
were as well
experiment change → punish free riders
participants can make a free rider pay $3, costing themselves $1
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outcome
contributions remained the same or increased
thus, with large groups of people, repeated social interactions &
social preferences → punishment can produce a socially better
outcome
ultimatum game
used to study social preferences
2 person one shot sequential game
proposer is given $100 & gives part of that $100 to responder
responder either rejects and nobody gets anything or accepts the offer
strategic interaction
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game provides insights about sharing economic rents that arise
prediction;
in a world where everyone only care about their own payoffs →
responder accepts anything better than nothing, whilst proposers offer
the minimum possible
experimental data
prediction doesn't match
lower offers → more rejections
better offers → fewer rejections
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differing results between populations
Kenyan farmers tended to make better offers
US students tended to make lower offers
reasons → social preferences
Kenyan farmers had a stronger sense of altruism & fairness
differing social norms to US students → higher disregard for other
students
proposers also offered the amount that would likely be accepted by the
responder → maximum payoff for individuals
ultimatum game change
introduced 2 responders → however still only a 2 way split
if no one accepts → no one gets anything
if only 1 responder accepts → that responder and proposer get the split
if both responders accept → one responder is randomly chosen to
receive the split
outcome
competitiveness → rejecting the offer may not punish the proposer,
since the other responder could accept → rejector left with no payout
results are closer to the self interested initial prediction
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coordination issues
if there is more than one nash equilibrium & decisions are chosen
individually → socially optimal outcome could not be chosen
stuck in suboptimal decision → no incentive to change
e.g. anil & bala
past of producing suboptimal decision
if other doesn't change as well, they would get less output →
W6: Property & Power: Mutual Gains &
Conflict
Introduction
institutions → rules that govern how an economy & society works
written→ legal
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unwritten → social norms
affect social outcomes → can affect income people receive for their work
e.g. private property → constraint → individual's are unable to take other
people belongings, at least without consequences
affect decision making
also incentives people to work for things they want to own
questions;
what other factors determine final outcomes?
essentially only institutions affect outcomes
what criteria can we use to evaluate outcomes?
judgement on differing social outcomes → whether its a large pie or
better at splitting the pie
how can we improve final outcomes?
Evaluating Outcomes
many different criteria
Pareto efficiency
fairness / justice
Pareto efficiency
allocation → outcome of an economic interaction, describes who does what
& who gets what
Pareto efficiency→ state where nobody can be better off without making
someone else worse off
Pareto improvement → change that benefits at least one person without
making someone else worse off
if Pareto improvement is possible at an allocation → that allocation isn't
Pareto efficient
vice versa, a Pareto improvement is impossible if an allocation is
Pareto efficient
e.g. Anil & Bala
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2 feasible strategies
terminator → more effective, inexpensive but more damaging to
environment
IPC → less effective, expensive but less damaging to environment
outcomes
if only one choose terminator, the damage is limited
if both choose terminator, water contamination is too serious →
need to buy expensive filtering system
Pareto efficiency
allocation I, T → no Pareto improvements possible as all other
points makes someone, Bala, worse off
as Pareto improvement is not possible → I, T is Pareto efficient
allocation T, I → no Pareto improvement possible → T, I. is Pareto
efficient
allocation T, T → Pareto improvement from T, T to I, I → T, T is not
Pareto efficient
allocation I, I → Pareto efficient
Pareto improvement → I, I Pareto dominates T, T
Pareto efficiency caveats
often more than one Pareto efficient allocation
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unable to choose which one, as Pareto efficiency doesn't determine
which is fairness or better
just cause an allocation is Pareto efficiency, doesn't mean its fair or
should be approved
e.g. Anil & Bala → Anil using IPC & Bala using terminator is Pareto
efficient however Bala free rides & gets the better outcome → unfair
to Anil
fairness / justice
reasons for an unfair allocation
inequality of final outcome → substantive judgement of fairness
e.g. inequality of wealth & income
how they came about → procedural judgement of fairness\
any final results are acceptable as long as the procedure was fair
e.g. forced vs fair play, equal & unequal opportunities
Rawls' veil of ignorance
impartial perspective → when creating a new society, create it without the
hindsight or knowledge of knowing how you would turn out in the new
system
theoretically a fair way to establishing institutions or evaluating
allocations
fairness & economics
does not provide judgements on what is fair
however can clarify;
how institutions → rules affect inequality
tradeoffs in the fairness of outcomes → equality of results vs equality of
opportunities
how public policies can address unfairness
Determining Allocations I
e.g. Angela the farmer
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works on a farm & gets everything she produces
Bruno comes along, but as he doesn't have a farm & wants harvest →
forces Angela to work for him & now she must do what he says
later, rule change → rule of law replaces rule of force
Bruno can't coerce Angela to work, but still owns the land
if Angela wants to farm his land, she must pay him some of the harvset
rule change again → in Angel's favour
she & fellow farmers achieve the right to vote → legislation passes that
increases Angela's claim on the harvest
e.g. coercion → imposing allocations by force
combined feasible set → shows all possible allocations between two parties
not all allocations possible
point H → works 12 hours but Angela receives 0 units of grain → unable
to survive → not feasible. even though its within the feasible frontier
feasible allocations depend on institutions & policies
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feasible frontier → shows all technically feasible outcomes
biological survival constraint → shows all biologically feasible outcomes
similar to indifference curves
as Angela works more, she needs to eat more
biological survival constraint is higher with less free time
feasible allocations by the horizontal & vertical line
horizontal line → minimum amount of grain to live, without working
subsistence level
vertical → maximum hours possible
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best allocation for Bruno given the constraints
work hour with the biggest vertical difference between feasible frontier &
biological survival constraint → maximise Bruno's payoff, whilst
providing Angela with enough to continue working
thus, allocation that maximises his economic rent is when slope of
biological constraint equals slope of feasible frontier → at 13 hours of
free time for Angela
Determining Allocations II
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e.g. voluntary exchange → bargaining
Angela is longer a slave → limited by her agreement, not survival
Bruno can make her an offer to work his land
point Z → Angela's reservation point → no work, gets survival rations
reservation option → if rejects Bruno's offer, she can default to this
option
reservation indifference curve → all allocations have the same value to her
as her reservation option
below & left → worse off
above & right → better off
final allocation determined by;
each party's reservation option → better reservation option gives more
bargaining power
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e.g. Angel has an offer at a different farm for a lower cost
relative bargaining powers between parties
the party with the higher bargaining power would gain a deal more in
their favour
economically feasible set → all possible allocations that would benefit both
parties
e.g. if Angela & Bruno make a deal, both gain
Bruno's reservation option is no farmer & no grain
e.g. coercion vs bargaining
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under coercion
allocation chosen based on slop of biological constraint equals slope of
feasible frontier
Angela works 11 hours a day
total grain output → 10 units
Angela → 4
Bruno → 6
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under bargaining
allocation chosen based on slope of reservation indifference curve
equals slope of feasible frontier
Angela works 8 hours a day
total grain output → 9 units
Angela → 4.5
Bruno → 4.5
total production is lower when bargaining compared to coercion
evaluating outcome → coercion to bargaining
not a Pareto improvement, both Pareto efficient
substantive fairness → improvement
procedural fairness → improvement
bargaining → fair in isolation, unfair given context → Bruno stole
from Angela
Determining Allocations III
Pareto efficiency curve / contract curve → set of all Pareto efficient allocations
line where all points within the feasible set where MRS = MRT
joint output is maximised & the same throughout all points on the curve
however, distribution amount between parties can differ
e.g. Pareto efficiency curve
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point C → Angela gets all grain output
point D → Bruno gets all grain output
at any allocation within the feasible set can experience a Pareto
improvement, as the points on the Pareto curve are the optimal for both,
given that the distribution remains the same
e.g. institutions & policies → legislation
new allocation → give both parties as much as their new reservation option
new law → limits work hours & entitled to 4.5 units of grain
Angela's new reservation option → point F → higher bargaining power
Pareto efficiency curve is now C to G → Bruno's new offer
point F to GH → Pareto improvement
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factors for deterring allocations;
technology & biological factors determine technically feasible allocations
institutions & policies help determine economically feasible allocations
allocation chosen depends on party preferences & their bargaining power
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one party has power to dictate allocations → capture entire surplus
unable to achieve Pareto improvement → Pareto efficient
e.g. Bruno's use of coercion
allocations influenced by legislation → fairer allocations
not necessarily Pareto efficient
e.g. coercion to bargaining → Bruno was worse off
institutions where people can deliberate, agree & enforce alternative allocations
achieve Pareto efficiency & fairness
e.g. Angela & Bruno achieved through legislation & bargaining
Economic & Ethics: More on Fairness
maximise human welfare by producing as many products to satisfy as many
wants & needs
achieved through;
efficiency → most valued products produced at the lowest cost
fairness → intersection between economics & ethics
e.g. price gauging of essentials during COVID pandemic
do people value fairness?
yes → ultimatum game → proposer gave some money to responders
e.g. Kahneman, Knetsh & Thaler → KKT
ultimatum game conducted anonymously
results on average;
proposers offered just less than 50 50 splits
responders tend to reject offers of less than 25%
responders are willing to give up monetary gain to punish proposer for being
unfair
responders value fairness
contradict assumption of ability to satisfy personal wants, regardless of
others
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did proposers offer close to 50 50 splits out of value for fairness or value of
money and so a fear of rejection?
e.g. KKT → variation of ultimatum game
proposers given 2 splits
$18 & $2 for proposer & responder respectively
$10 each
responders given no power to reject
results;
76% of proposers opted for 50 50 split
proposers valued fairness
trade off between efficiency & fairness → decreased efficiency to
achieve fairness
ultimatum game played in small societies in developing countries → same
patterns found
markets markets
evidence some regard markets as unfair allocation mechanism for shortages
of products
e.g. Kahneman survey
football tickets sold in 3 ways;
auction → sold to highest bidder
lottery → sold to drawn names
queue → first come first served
ranking results of which are fair;
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economic efficiency;
markets better than → lotteries better than → queueing
markets allocate products to those who value it the most → willing to
pay
queueing → least efficient
loss of time when expressing preference → waiting in queue
fairness ranking is the reverse of efficiency ranking → trade off between
efficiency & fairness
marketisation of queueing
line sitter services → charge fee to stand in line
capacity of paying has replaced capacity of waiting
increasing encroachment of the market domain on the non market domain
firms provide services like;
apologising
providing a best man or a bridesmaid → writing speeches
kidney transplants
altruism & medicine determine kidney supply & recipients
Iran → able to purchase & sell kidneys
new markets raise questions between economics & ethics
market price established on the ability to purchase a friend
core econ approach to fairness
procedurally judgements of fairness
evaluate an outcome based on how the allocation came about and not
on the characteristics of the outcome itself. Judgements focus on
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whether the actions that produce an outcome are voluntary or
coerced/forced, equal opportunity to participate and deservingness.
substantive judgements of fairness
valuations are based on the allocation itself, not how it was determined
or came about or the actions that produced it. Judgements focus on the
inequality of some aspect of the outcome/allocation – income, happiness
or freedom
ultimatum game → procedurally fair
proposers chosen at random
anonymous
discrimination not possible
voluntary → propose any amount & reject any amount
however;
fairness was determined by the distribution of the pie
unequal splits rejected despite being a Pareto improvement → both
gain money
moral philosophy
consequentialism → substantive judgement → focused on results
deontology → procedural judgement → focused on process
consequentialism
economics is heavily influenced by consequentialist streams of thought →
example of consequentialist thinking
the consequence that is important in economic theory is economic
welfare → arises from the satisfaction of preferences
should be maximised
however, another consequence → outcome fairness
conflicts arise → ultimatum game
rejection of unfair offers → fairness over economic welfare
e.g. minimum wage
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consequentialist perspective → fairness is the specified objective
choices judged on the fairness of their consequences
society decides on the basis of fairness & equity considerations →
earnings of unskilled workers are too low
government legislation of a minimum wage → justified if earnings of
unskilled workers increase as a group, even if it causes some
workers to become unemployed → decreased demand from firms
due to increased costs
earnings will rise if;
percentage increase of wage is greater than the percentage
decrease of unemployment
deontology
method of determining final outcomes determines unfairness
disregard of consequences
no presumption of equality of outcomes
unjust to impose changes to outcomes
libertarianism → type of deontological approach
any outcome from a voluntary exchange is fair & just
2 principles;
state must enforce laws that establish & protect private property
private property may be transferred from one person to another by only
voluntary exchange
market transactions → capitalist acts between consenting adults
forbidding them infringes freedom, dignity & is unfair
all results from this application is fair or just
e.g. minimum wage
libertarian perspective
minimum wage is unfair → prohibit workers & firms from legally
entering a voluntary & mutually beneficial market exchange at a
wage below the minimum wage
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alternative deontological perspective
minimum wage is just & fair
prevent entering into market exchanges that would result in poverty
article 23 united nations universal declaration of human rights
everyone who works has the right to just and favourable
remuneration ensuring for himself and his family an
existence worthy of human dignity
W7: The Firm: Owners, Managers &
Employees
Introduction
work is important for the ecnomoy
workers → income
firm → labour is an input for production
interactions → bargaining determines division of social surplus → profits &
wages → mutual gain & conflicts
determines wages
economy wide effects from firm interactions
Firms
firm → way organising production
characteristics;
individuals who own capital goods used for production
capital goods → non labour inputs the production process
pay wages & salaries to employees
purchase human labour from the labour market
owners direct employees, through managers, in production of goods &
services
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labour inputs
goods & services are properties of the owners → employees not entitled
to the outputs, only the wages & salaries
owners sell goods & services on market with intention of making profit
power
division of labour is coordinated in two ways → firms & markets
division of labour → specialisation & comparative advantage →
efficiency
firm → concentration of economic power at the top → owners issue
commands to workers
markets → decentralised → no power over who sells or buys
able to rejects buyers & sellers
firm structure
owners decide long term strategy
managers implement decisions by assigning tasks to workers
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hierarchy issues;
asymmetric information
owners & managers receive limited information about daily
operations → much less than the workers
difficult for owners & managers to accurately monitor whether tasks
are being performed well
differing policies by firms to resolve this issue → specific
monitoring departments & systems
contracts
contracts → legal document or understanding that specifies a set of actions
that parties to the contract must undertake
violation of contracts have consequences → lawsuit
market → ownership of a product is permanently sold from the seller to the
buyer
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firm → labour contract → temporarily transfer authority over a person's
activities from employee to owner / manager
transfer of ownership → slave contract
relationships
market → limited relationship between buyer & seller → simple exchange
firm → extend over a long period of time
firm specific assets → valuable when employed by a firm
creation of network of colleagues
acquisition of skills necessary for the job
increase in productivity → benefit for both employee & firm
relationship end → value lost to both sides
common interest → firm's success
failure → loss of firm specific assets
Owners & Managers
separation of ownership & control → managers decide how to use owner's
assets & funds
potential conflict of interest
conflict of interest
firms profits belong to owners of the firm's assets
profit → revenue - expenses
left over after wages, salaries, creditors & taxes
revenue is divided between owners, managers & workers
more money for owners → less money for managers & workers &
vice versa
division of revenue → conflict
profit increases due to manager's efforts → owner's benefit, whilst
managers not guaranteed to benefit from it → only receive pay stated
within contract
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why work harder to improve firm performance, when you don't
receive any benefit from it?
aligning interests
link manager's pay to firm performance
in relation to share price → bonuses received
paid in firm's shares
monitor manager's performance to assure incentives align with the owner's
interests
Employees
incomplete contract
hiring employees different from buying products
non labour goods → terms & conditions are straightforward →
permanent ownership, full control, explicit usage details, etc
labour contracts
depend on future events
e.g. barista may have to complete waiting responsibilities if needed
aspects are difficult to measure & base wages on
e.g. barista needs to be friendly → can't exactly measure if they
smile enough, etc
incomplete contract don't specify, in an enforceable way, every aspect of the
exchange that affects the interests of parties
most valuable aspect of an employee is the amount of effort when on
the job → most difficult to enforce or measure
so how do they induce high effort from workers?
piece rate pay → employment in which workers are paid a fixed amount for each
product produced
one way to resolve incomplete contracts → provides incentive to exert effort
e.g. manufacturing line
however not applicable to every jobs
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jobs that require teams or delivering a service
service → if incentivised with piece rate system → lower quality of
service to increase quantity
worker's effort
why some workers still work hard despite lack of system for measuring
effort?
individual work ethic
feelings of responsibility
reciprocate for being treated well by employers
promotions → increase chances → increase salary & well being
benefits for measurable output → billable hours
fear of being fired → receive economic rent from being employed
employment rents
if the only value gained was money, then paying minimum wage to
employees would make them not care about losing
however, workers do care, even in minimum wager positions
theres a difference between value of having a job and value of being
unemployed & searching for a job → employment rent
employment rent receive when employees fear being fired from a job that
pays them more than their reservation option → unemployed
employment rent includes;
lost income
cost of starting a new job → relocation, equipment, gaining new firm
specific assets
loss non wage benefits → work benefits like bonuses, insurance,
loss of use for prior firm specific assets
social costs → stigma of being unemployed, especially being fired
benefits to owners & managers
employees more like to stay → no cost required to rehire & retrain
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leverage over employees → fear of being fired induces high effort
advantages & disadvantages of working
disadvantages
disutility → don't like work or some aspects of work, stress
monetary costs → travelling, equipment
advantages
income
firm specific assets
work place benefits
social status
e.g. calculating employment rents
Maria → earning $12 per hour, 35 hours a week
disutility → costs Maria $2 per hour
total employment rent → unemployed for 44 weeks if fired before
finding another job
reservation option → $6 per hour, 35 hours a week → government
payments
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employment rent per hour
wage − disutility − reservation wage
12 − 2 − 6 = 4
total employment rent
employment rent per hour ×
expected hours of lost work time
4 × 1540 = 6160
Wages & Effort
employer can't directly quantify a worker's level of effort
employment rent → cost of job loss → incentive of performing on the job
firm benefit;
no cost for rehiring & retraining
power over employees → induce effort
increase employment rent → increase wages
employment game
rules;
2 players → employer & worker
sequential → one player makes a move, then second players reacts
employer chooses a wage → if workers works enough, they'll keep
the job at the offered wage
balance wage → high enough to retain productive workers, but
low enough to make a desirable amount of profit
worker chooses level of work effort, taking into account the cost of
losing her job is she does not provide enough effort
payoffs → mutual gains
firm → profit → worker's output - wage
worker → employment rent
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involuntary employment → being out of work, but preferring to have a job at the
wages & working conditions that otherwise identical employed workers have
there must always been some involuntary unemployment → exert force from
workers
no involuntary unemployment → can get another job right after the
previous → no cost of job loss → employment rent of 0 → no incentive
to put effort into work → employer gains no benefit → no incentive to
pay a wage → no jobs offered → no equilibrium
why?
equilibrium → wages & involuntary unemployment
have to be high enough to ensure employment rent is high enough
for workers to put in effort
factors impacting unemployment equilibrium
employee incentive to put in effort is affected by;
utility of items that can be purchased by the wage
e.g. increased material wellbeing → higher utility → higher
employment rent → employee values the money earned more →
higher effort
disutility of effort
e.g. decreases due to department change → higher employment
rent → higher incentive to put in effort
reservation wage
e.g. decrease in government payments → higher employment rent
→ higher incentive to put in effort
probability of getting fired at each effort level → don't want to be fired →
incentive to decrease probability of getting fired by working harder
level of unemployment
e.g. high unemployment levels, means likely take longer to find
another job → increased employment rent → incentive to put in
effort
Principal Agent Models
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e.g. incomplete contracts
lending money → promise of a full repayment plus interest → unenforceable
if unable to be repaid
owners want managers to maximise value of assets → conflict of interest →
managers have own objectives
tenants renting apartments → required to maintain property value → aside
from gross neglect, unable to enforce liability if not maintained
insurance → customers behave decently & not take risk → unenforceable
families purchase educational & health services → unable to specify quality
in contract→ unenforceable
parents care for children → hope to reciprocate care when older →
unenforceable
incomplete contracts can arise when;
difficult to measure → job output & productivity
uncertainty over periods of time → future uncertainty
unverifiable information → hearsay
judiciary is absent → no judge or legal check
preferences for omitting information
principal agent models → relationships where agents are supposed to fulfil the
interest of the principal, however is not guaranteed
e.g. principal → firm, agent → worker
hidden actions problem
agents can take hidden action from the principal → unable to be verified
asymmetrical information → difficult for principals to fully know what is
happening → unaware action is occurring
occurs when;
conflict of interest between principal & agent → agent performs an
actions against the principal's interests
this action can't be stated or enforced via contract
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W8: The Firm & Its Customers
Introduction
many individuals in developed economics work for large firms
over 50% of people in the production sector work for firms with 500+
employees
how firms were able to grow this large & become this successful?
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focus on;
setting the price
quantity decision
to achieve profit
decomposition of profit
profit is total revenue after paying total production costs
economic profit = total revenue − total cost = P (Q) − AC(Q)
P = selling price per unit
Q = quantity
AC = average cost per unit
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economic profit is different to net & gross profit
economic cost → monetary & opportunity cost → total cost
net & gross profit → monetary cost
0 economic profit / normal profit → doesn't no monetary profit was made →
next best alternative would have yielded that same amount → no benefit
production & pricing decisions
to maximise profit → decide quantity → Q & cost → P for production
set Q & P so break even
set Q & P as high as possible → maximise profit
trade off between Q & P
higher price would decrease quantity needed & vice versa
information managers need to make decisions about Q & P → restrictions
production cost → cost of producing at different quantities → what scale
of production
product demand → how many consumers are willing to buy & how much
their willing to pay
Production Key Concepts
firm's cost depend on production scale & type of production technology
advantages of large scale production
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economics of scale → large firms are more profitable due to cost
advantages
fixed cost → independent of production scale
e.g. creating software → only need to be developed once
production cost is lowered by creating more quantities, spreading
the cost
lower cost per input → purchasing inputs on more favourable terms →
grater bargaining power with suppliers
demand advantages → network effects
value of output increases with number of consumers
e.g. social media, like instagram → more valuable with more people
using it
smaller platforms → less value as less interaction from fewer
users
thus, more difficult for new firms to establish themselves in markets
reliant on network effects
diseconomies of scale in large firms
e.g. additional bureaucracy layers from larger amount of employees
hiring of more managers to manage new employees, whilst hiring
more executives to manage the new managers, etc.
cost functions → show how production costs vary with quantity produced
total cost
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increasing quantity increases total costs
at 0 quantity → still production costs incurred → fixed costs
e.g. building, machinery. etc
average cost
TC ÷ Q = cost per unit
calculated from origin to a point on the slope → straight line
rise divided by run → cost per unit
graph observations;
average costs decrease at first → economies of scale
increase afterwards → diseconomies of scale
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this always occurs as productions increases → bureaucracy
issues arise from firm expansion & growth
marginal cost → effect on total cost of producing one more unit of output
ΔTC ÷ ΔQ = marginal cost
calculated by the slope at any point
graph observations;
marginal costs increase with production
relationship between marginal & average costs
statements;
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if AC
> MC → AC is decreasing
if AC
< MC → AC is increasing
MC curves always intersects with AC curve at its lowest point
Pricing & Production Decisions: Profit Maximisation I
pricing & production decisions → managers need to know demand for firm's
products
demand curve → quantity that consumers will buy at each price
theory → firms can estimate demand curve of their products by surveying a
large number of consumers
reality → difficult to acquire that information
willingness to pay → dependent on how much the consumer values the product
product will be bought if price is less or equal to their WTP
trade off between demand & price → intrinsic nature of consumers to pay
less
higher price → lower demand, vice versa
e.g. willingness to pay graph
graph note;
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price → WTP → willingness to pay
P = $3,200
60 consumers with WTP equal & above to P
thus, demand for product at $3,200 is 60
Pricing & Production Decisions: Profit Maximisation II
economic profit = total revenue − total cost = P (Q) − AC(Q)
P = selling price per unit
Q = quantity
AC = average cost per unit
isoprofit curve → shows price & quantity combinations that give the same profit
cost function of AC & MC affect isoprofit curve
firms have sets of isoprofit curves → show combinations required to make
certain profit levels
zero economic profit curve
if price equals average cost→ economic profit is 0
Q × (P − AC) = Q × 0 = 0
AC curve is also 0 profit curve → combination of price & quantity
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is also break even curve for every combinations → P = AC
same shape as AC curve → both economics & diseconomies of scale
marginal cost curve
intersects at lowest point of each isoprofit line
if AC > MC → AC curve slops down
if AC < MC → AC curve slopes up
higher isoprofit curves
combinations of price & quantity to produce the same level of profit
higher curves → higher profit level → higher economic profit
e.g. calculating economic profit
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point G
Q = 23
P = $6,820
Q × (P − AC)
profit at G → 23 x (6,820 - 3,777) = $70,000
note;
isoprofit cures are similar to indifference curves
demand curves → feasible frontier
Pricing & Production Decisions: Profit Maximisation III
profit maximisation → constrained optimisation
demand curve → feasible frontier → MRT
isoprofit curves → indifference curves → MRS
maximised profit where MRS = MRT
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point E → optimal
highest isoprofit curve that is still within the demand curve → maximum
profit
can't go above → no demand
can't go below → less profit
Gains From Trade
measuring surplus
consumer surplus → difference between willingness to pay & purchase price
producer surplus → difference between revenue & marginal cost
different to profit
total surplus = consumer surplus + producer surplus
total gains from trade
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graph observations;
orange area → consumer surplus
purple area → producer surplus
increasing CS → decreases PS & vice versa
deadweight loss → loss of total surplus relative to a Pareto efficient allocation
unused & unexploited gains from trade → some consumers still willing to
pay a price that is above marginal cost
total surplus is highest when demand = marginal cost → pareto efficient
allocation
point E to F → pareto improvement
however,
pareto efficient allocation is not reached as doing so would put the firm
at a lower profit level, despite gaining maximising surplus
Price Elasticity of Demand
price elasticity of demand → how demand changes when price changes
relationship of price increase → demand decrease & vice versa
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elasticity quantifies this relationship
elasticity =
percentage change in demand
percentage change in price
elasticity is always negative → inverse relationship
price elasticity & profits
firm's markup is inversely proportional to price elasticity
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relatively lower markup → flatter slope
price change → large demand change
price sensitive consumers
market with many competitors & alternatives
relatively higher markup → steeper slope
price change → small demand change
more loyal consumers
market with limited competitors & alternatives
price elasticity & policy
good specific taxes depend on elasticity of demand of goods
government raise more tax revenue by levying taxes on price inelastic goods
if tax placed on elastic good → consumers will greatly shift away from it
e.g. taxes on unhealthy goods like snacks → addictive substances →
people will be willing to pay regardless of price
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although taxes have been heavily increased in an effort to reduce
consumption of certain unhealthy goods
price elasticity & market power
profit margin dependent on elasticity of demand
determined by competition;
inelastic → fewer alternatives
firms with market power have enough bargaining power to set prices
without losing customers to competitors
e.g. apple is able to set premium prices, despite communal
backlash, consumers still pay for their products
competition policy → limits market power by preventing firms from colluding
& setting prices high
beneficial to consumers
market power & monopolies
monopolies are an extreme of market power
firm sells specialised products;
little competition → inelastic demand
can set price above marginal cost without losing customers → earn
monopoly rent
market failure → high level of deadweight loss
from the high prices set → many consumers below willingness to
pay
natural monopoly → cheaper for one firm to produce as oppose to multiple
firms
e.g. utilities, public transport
abuse of monopoly is controlled by either being a government
cooporation or heavily controlled & regulated by government
gaining market power by;
innovating → differentiation of products
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firms that invent new products can achieve a temporary monopoly
through patents & copyright laws → prevent other competitors from
entering the market for a certain period
advertising → attract consumers to purchase from their firm
create brand loyalty
reduce competitor's consumers
can be more effective than discounts in increasing demand
W9: Supply & Demand: Price Taking &
Competitive Markets I
Introduction
market where firms produce identical products
how behaviour differs from price setting firms?
can competition improve market outcomes → resolve dead weight loss
model of interactions between price taking firms & customers
perfect competition → extreme competition, firms have no market power
2 perspectives → market & firm
supply & demand model
model of profit maximisation
factors that affect the equilibrium
comparison between price taking & price setting firms
Competitive Equilibrium I
demand curve & willingness to pay
demand curve → total quantity that all consumers together want to buy at
any given price
represents the WTP of buyers
consumers in order of who's willing to pay the highest price to the lowest
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e.g. trade of second hand textbooks
competitive equilibrium
demand comes from buyers with differing willingness to pay
no one will pay above the price of a new copy
WTP depends on work ethic, importance placed on textbook &
available resources to buy books
supply curve & willingness to accept
supply curve → total quantity that all firms together would produce at any
given price
represents the WTA of sellers
sellers have different reservation prices
sellers in order of who's willing to sell the lowest price to the highest
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e.g. trade of second hand textbooks
supply comes from students who have finished the course
supply comes from sellers who differ in their willingness to accept →
reservation price
reservation price → represents value of keeping the book → only willing
to sell if price is the same price or higher
lower reservation price if student is poor or no longer studying
note;
examples show linear lines → simplicity
real supply & demand curves will have exact shapes dependant on valuation
of the market
Competitive Equilibrium II
markets
if market relies on word of mouth → if buyer finds seller → negotiate a
mutually beneficial price
no information on market price → reliance on personal willingness to
pay & sell
seller wants to sell high → buyer wants to buy low
differing incentives → conflicts on price in the market
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information about the other party → higher influence on getting the price you
want to buy / sell at
historical context
traditional markets brought buyers & sellers together → trading routes, set
up shops in the same area near customers
reducing problem of no information → buyers can find sellers & market
price
modern markets
advertisement → information more widely available → what is available,
where to buy, what the price should be
consumers & buyers are still close → shopping centres
second hand goods → in the past involved specialist dealers
modern day → online marketplaces → eBay
consumer benefit → more information → get closer to your reservation price
price → competitors
quality → reviews of goods & services
Competitive Equilibrium III
note;
P* → market price
Q* → market quantity
equilibrium price
alfred marshal → introduced model of supply & demand
price that equated supply & demand → equilibrium price
prices tended to settle at equilibrium level → where supply & demand
equated → equilibrium marketing clearing price
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marketing clearing price
supply equals demand
market equilibrium → if actions of buyers & sellers have no tendency to
change the price or the quantities bought & sold, unless there is a
change in market condition
market with many sellers selling identical goods & many buyers
wanting to buy them → both parties are price takers
competition equilibrium → market where perfect competition has
eliminated bargaining power
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price above equilibrium → excess supply
suppliers benefit by reducing price
price below equilibrium → excess demand
suppliers benefit by increasing price
Competitive Equilibrium IV
price taking firms
unable to benefit at trading at a different price → demand will go to other
firms
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firm demand curve → horizontal
price taker → if price is above market price → no demand → thus price must
be at or below market for demand to come in
profit maximisation
where market price equals MC curve → highest profit point within the
feasible set
price taker firms → must produce quantity where marginal cost is equal to
market price
if;
MC > MP → producing costs more than selling price → loss on every unit
sold above MP
MC < MP → could still produce more units that would sell a profit
MC = MP→ maximum quantity sold before a loss on marginal unit is
incurred
market supply curve → total amount produced by all firms at each price
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if all firms have identical cost functions → identical production
market supply curve = market marginal cost curve
only quantity will change → one firm to entire market
Competitive Equilibrium V
market price is when supply = demand → all parties are price takers
all gain are exploited → no deadweight loss
allocation is Pareto efficient
assuming;
all parties are price takers
contracts are complete → all known information
no external effects → transaction affects only buyers & sellers
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differs to differentiated products → reduce quantity to achieve higher isoprofit
level → dead weight loss
W10: Supply & Demand: Price Taking &
Competitive Markets II
Factors that Affect Equilibrium I
no incentive to change equilibrium point
perfect competition → demand & supply are maximised → both parties are
as happy as possible
changes in supply & demand
exogenous → variable whose value is determined outside the model and is
imposed on the model
outside factor changes supply & demand model
e.g. quinoa demand
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recent years → health consciousness has increased
quinoa is a nutritional product
richer, health conscious consumers contributed to higher demand
increase in demand
demand is higher at each price point → demand curve shifts right/up
response → market price P* increases
increase in quantity supplied → move along the supply curve
suppliers increase quantity supplied
supply curve has not shifted → increase in quantity supplied, NOT
increase in supply
e.g. second hand textbooks
initial equilibrium point
P* → $8
Q* → 24 books
P* = marginal cost
consumer surplus & producer surplus maximised
no deadweight loss → pareto efficient
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increase in demand
more students have entered the uni → more demand for textbooks
demand curve shifts right/up → demand is higher at each price point
excess demand at original P*
if market price remains at $8 → excess demand
incentive for sellers to increase price
more sellers enter the market → market price has increased,
reaching their WTA
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new equilibrium point
new equilibrium point at point B
P* → $10
Q* → 32 books
increase in demand → quantity increase in equilibrium quantity &
price
increase in supply
can shift due to exogenous shocks → outside factor
marginal costs decreases → supply curve shifts down/right
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increase in quantity supplied at each price point
demand curve has not shifted → increase in quantity demanded, NOT
increase in demand
same number of firms supply at higher quantities
e.g. bread bakeries
exogenous shock → better baking technology
initial equilibrium point
P* → $2
Q* → 5,000 loaves
decrease in marginal costs & increase in supply
cost of producing decreases → P* decreases
supply curve shifts right/down → willingness to accept is lower
amount supplied at each price increases → increase in supply
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excess supply at original P*
original price at $2 → more supply than demand
consumer WTP decreases
incentive for suppliers to decrease price
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new equilibrium point at point B
demand curve has not shifted → moved along the demand curve
supply has reached more consumer's WTP
price decrease → increase in quantity demanded, NOT increase
in demand
market entry
supply curve can shift due to market entry & exit
excess supply doesn't introduce more firms
market entry introduces more firms
market entry → increased competition → decreases P* → supply curve
shifts down/right
incentive to enter market
existing firms earn economic rents & cost of entry isn't too high → firms
may enter the market
positive economic profit made by firms within the market
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Factors that Affect Equilibrium II
taxes
governments use taxation to raise revenue
finance government spending
redistribute resources
e.g. tax the rich, give to the poor
affect allocation of products in other ways
e.g. reducing spending on harmful products → alcohol, cigarettes
supply & demand model
taxes on each party shifts their respective curve → price is higher at
each quantity
e.g. ancient Chinese taxes on salt
tax imposed because people needed it → inelastic demand
better to tax inelastic products → people will still pay the higher price
→ higher tax revenue
initial equilibrium
market equilibrium at point A
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30% tax imposed
tax imposed on suppliers → marginal costs are 30% higher at each
quantity
supply curve shifts upwards → higher price
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new equilibrium
equilibrium at point B → moved along the demand curve
consumer price has increased to P1 → incentive to not buy
quantity decreased to Q1 → reduce quantity consumed
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tax paid to the government
P1 − P0 → amount paid to government
P1 − P0 → tax per unit
Q1 (P1 − P0 )→ total tax revenue
P0 → amount paid to supplier
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taxes & welfare effects
tax incidence → how the burden of a tax is distributed between firms and
consumers
although suppliers pay the tax → felt by consumers as well → higher
purchase price
depends on relative elasticity of consumers & producers → less elastic
groups bears more tax burden
maximising gains from trade
before tax → total surplus
equilibrium allocation is maximised
orange → consumer surpluis
blue → producer surplus
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tax reduces consumer surplus
reduces quantity traded → Q* to Q1
increases price paid → P* to P1
consumers between Q1 & Q* no longer are willing to pay → reduces
consumer surplus
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tax reduces producer surplus
reduced reduces quantity traded → Q* to Q1
reduces price received → P* to P0
producers between Q1 & Q* no longer willing to accept → reduces
producer surplus
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tax revenue & deadweight loss
reduced quantity sold → no longer sold due to tax → deadweight loss
green → total tax revenue
not pareto efficient
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maximise tax revenue
tax an inelastic good → tax increase will change quantity traded
minimally
taxes change prices → can create deadweight loss
pareto inefficient allocation → reduced economic efficiency
however, if taxes imposed on certain markets → harmful produts
deadweight loss is outweighed by the social benefit incurred
benefit from decrease in consumption
depends on how government spends the tax revenue
if tax is spent on beneficial things → enhance public welfare
if tax is spent on activities that don't contribute to wellbeing →
deadweight loss incurred is just reduction of living standards
Perfect Competition
characteristics;
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products are homogenous → identical
large number of potential buyers & sellers
no monopoly
buyers & sellers all act independently of each other
no collusion
price information easily available to buyers & sellers
price discrimination to some customers
law of one price → all transactions take place at a single price
at that price → market clearing price → supply equals demand
buyers & sellers are price takers → identical products
all potential gains from trade are realised → no deadweight loss
testing perfect competition
do all trades take place at the same price?
are firms selling goods at a price equal to marginal cost
perfect competition is unrealistic → however, a good approximation to some
markets
same products differ in price between different firms
fulton fish market study → same firm
prices of the same fish differed between customer types
charged differently depending on customer ethnicity → price
discrimination
price setters VS price takers
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W11: The Labour Market: Wages, Profits &
Unemployments
Introduction
how wages & unemployment are determined
e.g. pandemic → high unemployment
how to improve these outcomes
e.g. high unemployment → what can we do ? → government payments
real wage → purchasing power
nominal wage → dollar figure
firms behaviour affect real wage
price setting & wage setting → economy wide unemployment rate & real
wage
nominal wage → amount paid to employees
price of things → set by firms selling products
unemployment exists even in equilbrium
governments policies affect wages & unemployment
Measuring Unemployment
unemployment → people who are;
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not in paid employment or self employment
caveats;
could be retired or children → must follow all 3 rules
available for work
actively seeking/wanting work
labour market
labour force → those who seek/want to work
statistics
participation rate =
labour force
population of working age
unemployed
labour force
employed
population of working age
unemployment rate =
employment rate =
2 countries with same unemployment rates → may assume labour
markets are identical
however, can have different employment rates → one has high
participation rate, one has lower participation rate
unemployment & employment rates can differ → different
denominators
e.g. norway & spain
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norway → better labour market → better policies to encourage
employment
higher participation rate
higher employment rate
lower unemployment rate
Wage Setting
wage setting → firms set wage sufficiently high to make job loss costly to
motivate employees to work hard in the absence of complete contracts
relates to principal agent problem → positive employment rent → employees
motivated to work
real wage
determined by nominal wage & price of goods purchased
real wage decreases if prices increases → inflation
real wage =
wage
price
firms decides;
price → charge consumers
wage → nominal wage paid to workers
how many people to hire → unemployment rate
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adding all of these from all firms → total employment & real wage in a
economy
wage setting curve → real wage level necessary at each level of economy wide
employment to provide workers with incentives to work hard and well
higher unemployment rate → can pay workers less to induce effort
workers have less bargaining power → can't ask for higher wages
higher incentive → many more unemployed workers → easily
replaceable
lower unemployment rate → need to pay workers more to induce effort
workers have more bargaining power → could ask for higher wages
lower incentive → not many unemployed workers → difficult to replace
graph observations;
labour force → value less than 1 → dependant on participation rate
inactive workers are on the right of labour force
employment rate → from origin to vertical dotted line
unemployment rate → between employment rate line & labour force line
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wage setting curve → real wage level needed at each employment rate
to induce effort
higher employment rate → higher real wage needed → WH
lower employment rate → lower real wage needed → WL
e.g. estimate wage curve for US
data used from unemployment rates & wages in local areas
Price Setting
price setting → firms set a markup above the cost of production, to maximise
their profits subject to demand
firm decision on how many people to hire → based on quantity produced
quantity produced → labour hours needed → economy wide
employment rate
profit maximising price → individual firm
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optimal price when demand curve is tangent to the highest isoprofit curve
MRS = MRT
quantity → affects hours of labour needed
wage level → independent from Q*
wage per person per hour doesn't change regardless of production
levels
P* − W = profit per unit output
graph observations;
point A → lower isoprofit curve
reach optimal point B → increase price & decrease quantity
point C → lower isoprofit curve
reach optimal point B → decrease price & increase quantity
price setting curve
all firms within the industry
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price setting curve → real wage paid when firms choose their profit
maximising price
horizontal line that gives value of real wage
real wage independent of employment rate → horizontal line
hours of labour / employment is determined after product price is
determined
W
dependent on firm's markups → P
= wage level
W → economy wide wage level
P → economy wide price level
markup dependant on competition → demand curve
labour productivity determines real wage for given markup
higher labour productivity → markup unchanged → higher price
setting curve → higher real wage
average product of labour → how much each worker makes
graph observations;
point A → above price setting curve
real wage is higher than optimal point's real wage → markup is too
low & quantity produced is too high → employment too high → total
wage amount is too high
W
low price/markup → P → higher real wage value
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point C → below price setting curve
real wage is below optimal point's real wage → mark up is too high
& quantity produced too low → employment too low → total wage
amount is too low
high price/markup → W
→ lower real wage value
P
Labour Market Equilibrium
labour market equilibrium → where wage setting & price setting curves intersect
point X → market equilibrium
no incentive to deviate at the employment and real wage level
all parties are doing the best they can, give what everyone else is doing;
firms offer the minimum wage to induce effort from workers
employment is maximised, given the wage
if above price setting curve → conflicts with firm's profit maximisation
employed workers can't bargain for higher pay or lower work
unemployment > 0 → available workers → can be replaced
unemployed workers can't persuade firms to hire at lower wages
labour discipline concerns → lower wage → lower economic rent →
less effort is induced from worker
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involuntary unemployment
unemployment → excess supply in labour market
always be unemployment in labour market equilibrium
no unemployment → no cost of job loss → no induced effort
some unemployment → motivate to induce effort
for system to work → always some involuntary unemployment
inducing effort compensates for flaws of incomplete contracts
unemployment & aggregate demand
derived demand for labour → firm's demand of labour depend on the
demand for their products
aggregate demand → sum of the demand for all products produced in the
entire economy
demand deficient unemployment → increase in unemployment caused by
fall in aggregate demand
decrease in aggregate demand → decrease in firm output → decrease
in labour demanded → increased unemployment
decrease in aggregate demand → point X to point B
not an equilibrium → price setting curve doesn't meet wage setting curve
to revert back to point X → automatic adjustment
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lower wages without lowering workers effort → lower prices →
increase demand → increase output → increase employment back
to point X
reality of lowering wages
wages tend to not change quickly → sticky
employee resistance → lower morale → strikes
wages negotiated by contracts → change infrequently
lower income → less disposable income → aggregate demand
further decreases]
falling prices → postpone purchases in the hope of purchasing at a
even lower price → further lowering aggregate demand
government intervention
government increase spending to expand aggregate demand
monetary & fiscal policy
e.g. building schools → jobs for builders → income spent on clothing
→ jobs for retail stores → eventually permeates throughout the
entire economy
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e.g. covid-19 stimulus payments → increase income → increase
disposable income → increase aggregate demand
increasing aggregate demand → increase employment
shifting demand curve → firms can achieve higher isoprofit curve →
increased production → increased employment
point B → more optimal; to produce & hire more than reducing wages
Labour Market Policies
shifting price setting curve
education & training → higher labour productivity
increase price setting & average product of labour curves
wage subsidy → government pays part of firm wages → lower productive
cost & prices
change real wage
shifting wage setting curve
lower unemployment benefit → lower reservation wage
shift in labour supply curve
immigration policies → higher labour supply
childcare provision → higher female labour participation
W12: Economic Inequality
Introduction
models of asymmetric economic interactions → bargaining, labour market
asymmetry between parties results in unequal outcomes
why do asymmetries exists?
how to reduce inequalities?
how much equality should society have? → complete equality across
society is also unfair
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Trends in Inequality
inequality within countries
degree of inequality → gini coefficient
0≤G≤1
0 → perfect equality
1 → perfect inequality
market income → income from wages, business & investments
earnings inequality → derived from market income
disposable income → market income minus taxes & transfers
transfers → government added money
note;
wealth → value of assets → net worth
graph observations;
wealth is distributed most unequally
higher equality levels in disposable income → tax and transfer systems
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unequal wealth and market income are redistributed from rich to the
poor
inequality across countries
graph observations;
before 1980s → decline of inequality across all countries
after 1980s
left graph → increased inequality → top 1% are growing richer
right graph → lower inequality relative to the left → inequality levels
has remained somewhat consistent
global inequality
blue line → gini coefficient for entire world
red line → hypothetical line
if everyone in the a country earned that countries's average income
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graph observations;
1980s → between country inequality fell rapidly, but within country
inequality increased → previous graph
net result → global inequality has declined
although both line has decreased → gap between has increased →
infer that global inequality is being mainly driven by inequality within
countries, as it is not declining at the same rate as the hypothetical
line determining inequality between countries
due to economies like USA, China & India → large economics with
even larger levels of inequality
within country inequality
increasing inequality is associated with changing distribution of jobs
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missing middle → low & high paying jobs are increasing, whilst middle
income jobs are growing much less
due to routine tasks being replaced by technology
e.g. accountants → in the past used to be crunching numbers,
nowadays, have become much more skilled higher paying jobs, as
machines have replaced the routine tasks of number crunching
Types of Inequality
categorial inequality → economic differences among people who are treated as
different categories
accidents of birth → no control over situation someone is put in from birth
country of citizenship → passports & borders limits access to
opportunities
gender or ethnic group
parentage
graph observations;
income disparities between men & women at the same education level
categorial inequality → implies potential discrimination → different
treated between groups despite being similar in ability
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inherited inequality
intergenerational inequality → extent to which differences in parental
generations are passed on to the next generation
intergenerational transmission → transfer of parental assets
wealth
genetic make up
parental influence on growth → work ethic, home environment, etc.
graph observations;
percentage of children that stay in the same quintile as their father or
move to the other quintile
US → lower social mobility → many children stay within the same
income level as parents
Denmark → higher social mobility → more children move between
income level as parents → less intergenerational inequality
intergenerational elasticity → percentage difference in the second
generation's status associated with a 1% difference in the adult generation's
status
how richer a child will be from either rich or poor parents
high elasticity → low intergenerational mobility
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relation of intergenerational inequality to cross sectional inequality
earnings inequality positively correlates with intergenerational inequality
reasons for inequality differences;
cultural differences on fairness → policies that reduce cross sectional
inequality & promote intergenerational mobility
improving cross sectional inequality will lead to increased social mobility
→ everyone has an equal opportunity to get a high paying job, allowing
anyone to escape their parental income levels
effects of good & bad shocks → passed onto the next generation →
contributes to cross sectional inequality
e.g. person with good traits to potentially earn more → hit with bad luck
of new tax policy, limiting their ability to earn
Evaluating Inequality
inequality becomes a problem if theres too much of it
study where people in US stated their ideal distribution & estimate of the actual
distribution
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graph observations;
actual inequality is higher than peoples estimates, which was higher then
their ideal distribution
people want decreased inequality but still for some degree to exist
everyone thinks existing inequality is too high
richer people want more inequality as opposed to poorer people → bias
when is inequality unfair?
inequality is unfair dependant on how distribution came about → procedural
justice
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graph observations;
people who believed wealth is gained through risk taking & hard work →
opposed redistributed
gains based on "accidents of birth" → support redistribution
Explaining Inequality
individuals income depends on;
endowments → factors of an individual that affect their income
wealth, physical assets, human capital → knowledge & skills from
education & training
value of items in endowments
technology & institutions affects value of particular endowments
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e.g. bruno and angela
bruno → land owner → more endowments
angela → no land → less endowments
technology determined her level of crop production
institutions & policies → minimum working hours & reservation
wage → government transfers
economic inequality isn't static → can have subsequent effects
existing economic inequality can affect technology & institutions & policies in
future periods
e.g. bruno & angela
angela bargained into a better position
following period → she can purchase better technology to improve
her endowments & improve equality
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e.g. negative policies
wealthier people can influence institutions & policies to reduce
redistribution → increasing economic inequality
differences in endowments → principal agent problem
principal agent relationships → principal can exercise power over agent but
not vice versa
differences in endowments determine the ability to become the principal or
agent
some borrowers can become employers → become wealthy individuals
excluded borrowers & unemployed → principal agent problem → only
people with higher endowments will become borrowers or employed
easier for those who borrowed or employed to stay employed and/or
become wealthy as they have the endowments to become richer →
cycle of wealth & knowledge concentration → increase in inequality
asymmetric information → those neglected will never gain endowments
to enter the cycle → rich get richer, poor stay poor
Addressing Inequality
government policies influence economic inequality;
redistribution → taxes & transfers to reduce differences in disposable
income & expenditure on public services
predistribution → affect equality of endowments
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raising value of endowments of the poor → training, education, property
redistribution
redistribution policies
welfare state → policies that turn market income into final/disposable income
combination of;
taxation → take from the rich
expenditure → give to the poor
in kind transfers → free/subsidised services
social insurance → targeted at specific groups → students,
unemployed, etc.
progressive policies → directly reduce inequality
progressive tax → tax increases as income increases
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poorer people receive much more benefit from taxes → improves
inequality
regressive policies → directly increase inequality
explaining trends in income equality
inequality & economic growth
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graph observations;
most countries have similar growth rates
economic growth has no correlation with inequality
in fact → countries with higher economic growth also have lower
inequality levels
economic benefits of lower inequality
cooperation & trust
economy based on services can't perform well if people are self
interested
higher equality → higher trust in the system and others → able to
perform better and be more productive → higher economic
performance
policies that enhance endowments of the poor
high quality health services & education increase productivity of
people → high endowments will employments & output → improve
economic performance
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